Many people look to buy rental property as an investment, much like they would invest in stocks, bonds, index funds, or other assets intended to grow over time. But is buying rental property inherently more profitable than other types of investments?
Expected Returns for Conventional Investments
Let’s start by evaluating the return you can expect from conventional types of investments. If you keep a diversified stock portfolio, or if you invest in an index fund that tracks the S&P 500, we can look at historical average returns to get a ballpark of what you can expect. Over the past century or so, the average annual return is close to 10 percent, though you can’t expect to get that return every year. Adjusted for inflation, that growth rate shrinks to about 7 percent, and nearly half of those gains come from dividends.
“Safer” investments like bonds have a much lower rate of return, at somewhere between 2 and 4 percent of your principal. So how do these returns compare to rental property investments?
Two Types of Returns for Rental Properties
For rental property, there are two types of returns to consider. First, there’s the return you’ll receive on a monthly basis; you’ll charge a rental price (ideally) higher than your total expenses, so you can pocket the difference as a monthly profit. You’ll factor in things like your mortgage payment, your property insurance, and your taxes, then hopefully charge your tenants an amount collectively higher than that total.
In reality, you probably won’t pocket much from this—at least not with one property. Depending on a variety of factors (which we’ll explore in a moment), you’ll likely count on a few hundred dollars per property, at most. That also doesn’t factor in additional maintenance costs you’ll face unexpectedly, or the money you’ll lose when your property is vacant. All in all, you might make $2-5,000 per year, plus or minus a few thousand dollars, which is likely a rate of return strictly less than what you’d get in an average stock portfolio.
However, there’s also another dimension of returns in the rental property world. Typically, property prices tend to rise over time. This is especially true in neighborhoods that get better over time, or in highly competitive areas. That means in addition to the monthly return you get from incoming rent checks, you can expect to make a profit on any property you sell in a competitive area. The rate of return here is highly variable, but should be enough to increase your total expected return.
Much of your profitability will depend on the idiosyncrasies of your local area. Different cities have different rental prices, so two properties of equal value in two different cities may have drastically different rental prices (and accordingly, different monthly returns).
Of course, the rise or fall of your property’s value will also depend on local conditions. If the neighborhood consistently gets better, with better jobs, better education, and better resources overall, you’ll see a much higher return on your property as an investment. Foresight can help you here, but there’s never a guarantee in how a neighborhood will develop in the future.
Property Portfolio and Leverage Considerations
We also need to keep in mind that a robust portfolio of different properties could help you see a better and more consistent return than you’d see with a single property. Having lots of available properties will guard you against the possibility of vacancy since only a fraction of your total portfolio will be empty at any given time.
And unless you’re paying for all your properties outright, having more properties in your portfolio will give you more financial leverage, which, to put it simply, is a way of investing with money you don’t yet have. Though you’ll pay interest on your loans, the total increase in value on your properties would hypothetically be more than enough to justify those payments.
Degree of Effort
There is one serious disadvantage to investing in rental properties, which stocks and bonds don’t share; they require hours of time to maintain, and can be a major source of stress. If a tenant requests a repair, it’s important for you to respond to that repair request quickly. If a tenant misses a payment, you’ll need to follow up with them. In rare cases, your tenants may damage your property or refuse to leave in a timely manner; dealing with eviction cases can be daunting, and can cost you enough money to jeopardize the profitability of your entire operation.
For this reason, many investors take the expected return of a property with a grain of salt; you may make more money from this investment, but it will also take more time out of your day, balancing the advantages.
Diversifying Your Portfolio
Regardless of whether rental property is inherently better or worse than investments like stocks or bonds, they can be a valuable addition to your overall investment portfolio if you’re trying to diversify your assets. Rental properties are much different assets than stocks or bonds, granting you a “real,” tangible asset while also providing you with a steady stream of income. Property prices are also somewhat independent from fluctuations in other markets, making them valuable to own in the event of a market crash.
Are Rental Properties Right for You?
Overall, rental properties could provide a return far greater than your other investments, but they could also lose you money if you don’t know what you’re doing. They’re valuable additions to any portfolio if you take property investing seriously, but they do require lots of time and attention. Rental properties aren’t for everyone, but if you’re willing to put in the effort, they could be the perfect way to round out your investment portfolio.
If you’re interested in getting advice on your first rental property, or if you need help managing your existing portfolio of properties, contact Green Residential today. We’ll help you with a free analysis of your property and provide you with the resources you need to manage it efficiently.