Despite the recent downward movement of the housing industry, there are still many people interested in getting into the rental property market. While such an investment may offer solid, long-term returns, there are also many potential headaches and unforeseen expenses that could outweigh the benefits.
Here are seven key factors to consider when thinking about investing in a rental property.
1. Balance your investment portfolio
“The first question to ask yourself when you're looking at purchasing and renting out a property is, 'Does it fit into your investment strategy, your portfolio allocation?'" says Bill Ringham, director of Private Wealth Services at RBC Wealth Management-U.S. “It's essential to consider whether or not it makes sense with the diversification of your larger investment portfolio."
Fred Rose, head of Credit and Liquidity Solutions at RBC Wealth Management-U.S., agrees. “No matter what you invest in, it's critical to be diversified; that's just a good prudent practice," he says. "The unfortunate thing is sometimes I'll see people — especially those who are just starting to grow their wealth — who make rentals a very high portion of their overall portfolio. It's smart to make sure you're not making property 100 percent of your net worth."
While every portfolio is unique, a more balanced portfolio can help investors weather market and property fluctuations.
2. Choice of location
“It's a well-worn phrase, but it's true: the three important things to consider in real estate are location, location and location," says Ringham. He points out, however, that it's not just about investing in a rental property located in a desirable location; rather, the key to a large return may be finding a property in an up-and-coming neighborhood.
“If your property is already in a fairly established location, you're probably going to pay a premium price for it," he says. "Then you also must look at what's the long-term growth of the value of this underlying property, versus if you're buying in an area that's on the edge of gentrification."
But that doesn't necessarily mean that you want to get too in front of gentrification, as that might mean no one will want to live there.
"In general, however, if you can predict the next big area or location, then you can make a much better investment," Ringham says.
3. Time commitments
Unlike stocks, ETFs or bonds, where most investors are removed from the daily running of a corporation, owning a rental property can be a very hands-on endeavor.
“Those contemplating getting a rental property need to ask themselves 'Am I prepared to be a landlord? Can I fix the broken toilet at two in the morning?'" says Ringham. "If you don't want to be a hands-on landlord, then you might ask yourself if you can afford to hire somebody to take care of those kinds of issues. You'll need to figure out whether a rental property is purely an investment or something you're willing to labor over."
Additionally, if you're planning to invest in a multi-unit building, it may make sense to hire someone to manage the properties for you.
4. Unpredictable tenants
People can be as unpredictable as markets. Tenants could be unruly, damaging to your property, late paying rent or potentially make eviction difficult.
“Tenants can be a big risk factor in your investment," says Rose. “What if they try to get out of a lease or won't pay rent?"
It's critical to be up to date on your city and state's tenant laws so you know what your legal rights and responsibilities are.
"There can be a lot of different rules depending on where you're located," Rose says.
5. Potential liabilities
Investing in a rental property could also expose you to complex legal issues, which you should research before making your investment.
“There are liability considerations that come into play," Ringham says. "You'll want to protect yourself if, for example, a tenant slips and falls and wants to sue you."
Ringham suggests looking into the possibility of creating a legal structure that owns a property for asset protection, such as a limited liability company. This involves complex legal structures and filing different tax returns, which can significantly add to the cost of your investment.
6. Lack of liquidity
Another important issue to consider is whether you'll need quick access to your assets in the future.
“You should realistically assess your financial ability," notes Ringham. “What is your need for liquidity? Real estate can't be liquidated like investments in the stock market. You might not be able to liquidate or sell your building for some time and could be left without renting it for months or longer."
"Just because something provides a great cash flow for several years doesn't mean it always will, because the property market can change," he adds.
7. Weigh up the pros and cons
There are a multitude of elements that affect the returns you'll get on your property. People can get into trouble when they don't factor in all the obvious and not-so-obvious costs of owning a rental.
“The biggest mistake I see," Rose says, "Particularly with novice investors, is they think figuring out if a rental property is a good investment is a simple matter of figuring out if the rent they'll make is equal to or more than their mortgage payments."
For example, an investor might calculate that their mortgage payment will be $1,000 a month, but rent could potentially bring in $1,500 dollars a month.
"Therefore, they think it's a good investment," Rose says. "But that's not the way to look at it. You need to look at the investment, the property itself and the true cost to carry that rental in and of itself."
Things like financing, taxes, possibly hiring help, depreciation, maintenance, legal issues and more all need to be considered.
"Deciding to invest in a rental property can't just be a 'my cost of financing' vs 'my rental income' equation," Rose says.