A fascinating joint study by the German central bank and several U.S. and German universities reviewed how different asset classes performed over 145 years, from 1870 to 2015. The researchers compared rental real estate, stocks, bonds, and short-term bills across 16 developed economies.
To the surprise of most, rental real estate generated the highest average returns — and with half the volatility of stocks to boot.
As a longtime real estate investor, it didn’t surprise me. Rental properties come with a slew of advantages for investors, from ongoing income to tax advantages to protection against inflation. These advantages complement stocks’ pros and cons rather perfectly.
Why Invest in Rental Properties?
Make no mistake — it takes more effort on your part to invest directly in real estate than it does to manage paper assets. And it requires more cash on hand, with less liquidity.
So why does anyone do it?
1. Ongoing Income
When people ask me why I invest in both real estate and stocks, I could go on for hours. But if they want a one-sentence answer, I simply say “I get immediate, ongoing income from rental properties, and long-term growth and diversification from stocks.”
If you invest in an index fund mirroring the S&P 500, you can expect dividend yields in the 2% to 3% range. Most of the returns come from long-term growth.
You can’t expect bonds to save the income side of your portfolio. In the new normal of perpetually low interest rates, bonds don’t offer much more in the way of passive income.
But real estate investors routinely earn 8% to 12% yields on the money they invest in rental properties beginning from day one. When you buy a turnkey property through Roofstock, it either comes with a paying tenant already in place, or the property is in rent-ready condition for you to fill immediately.
And unlike a bond’s coupon, rental income rises over time, helping to protect you against the slow decay of inflation.
2. Inflation Protection
Not only do rents rise alongside inflation, but rents actually contribute to inflation. Consider that from 1990 to 2020, inflation cut the value of the dollar roughly in half. But rents have more than tripled in that 30-year span. The median U.S. rent in 1990 was $447 according to the Census Bureau, while in 2020 the median Zillow Rent Index sat at $1,594.
With each year that goes by, landlords can raise rents to keep pace with or even surpass inflation. The value of a currency might change, but the real value of housing has nothing to do with currency. It has everything to do with supply and demand: It’s worth whatever people are willing to pay. This makes rental properties an excellent hedge against inflation.
And rental investors come out farther ahead than just protecting against inflation losses. When you leverage other people’s money, you fix your borrowing expenses in today’s dollars — which tend to lose value over time. So even as your revenue compounds with an extra 2% to 6% per year, your mortgage costs stay fixed.
3. Leveraging Other People’s Money
Investors can typically buy rental properties with only 15% to 25% of their own money, and leverage other people’s money to cover the rest of the cost.
You get to buy and keep the asset, but you don’t have to pay for it all on your own.
It’s a classic case of good debt — debt that makes you richer rather than poorer. If you borrow $80,000 to buy a $100,000 rental property, and you still earn $1,500 in average cash flow each year, then you grow wealthier for having borrowed that debt. (More on cash flow shortly.)
Meanwhile, your tenants pay down that debt for you. Eventually they pay it off entirely, and then your cash flow really balloons.
4. Predictable Returns
When you buy a stock, you hope for the best based on historical returns, and based on your research and opinions about the company’s potential to grow. But you never know what returns it will actually generate for you.
With rental properties, you can forecast your cash flow and income yield with precision. You know the purchase price, you know the market rent, and you can accurately estimate all expenses.
Those expenses include:
- Repairs and Maintenance: Typically 10% to 15% of rent, depending on the property’s condition
- Vacancy Rate: Typically 4% to 8%, but sometimes higher or lower in extremely hot or cold markets
- Property Management Fees: Typically 10% to 15%, including both ongoing rent collection fees and new tenant placement fees
- Property Taxes: Varies by jurisdiction, usually 5% to 15% of rent
- Property Insurance: Varies by property, usually 5% to 15% of rent
- Miscellaneous: Typically 2% to 4% of rent and includes bookkeeping, accounting, travel, legal, and marketing expenses
- Mortgage Principal and Interest if applicable
You can pinpoint each of these expenses for any prospective property. Want to know the property taxes? Look up the local tax rate, then multiply that by the purchase price. Curious about the neighborhood vacancy rate? Ask around among local landlords, property managers, and real estate agents.
The broad rule of thumb in the industry is the “50% rule”: Your nonmortgage expenses often amount to half the monthly rent on average. Remember, you must take into account the irregular but inevitable expenses of owning rentals, such as repairs, maintenance, and vacancies. They don’t hit every month, but they cost significant sums when they do.
Learn how to accurately calculate cash flow, and you’ll never make a bad rental investment again.
5. Appreciation
Less predictable but no less valuable is the potential long-term appreciation among rental properties.
In most cases, real estate grows in value over time. Appreciation helps rental investors grow their net worth over time, even as their mortgage balance shrinks with each passing month.
You earn money on rental cash flow. You earn money on appreciation. And with both, you pay less in taxes than on most other investments.
6. Tax Advantages
Rental properties come with tempting tax benefits that you can take advantage of even if you take the standard deduction rather than itemizing.
Real estate investors can deduct every conceivable expense, including property management fees, mortgage interest, maintenance costs, some closing costs, insurance, and travel to and from the property. You can also deduct paper expenses like depreciation.
That means you can earn a profit and still show a paper loss on your tax return. For example, in the real world you earn $2,000 from rental cash flow, but after deducting for depreciation, you show a loss on your tax return of $3,500. That comes off your taxable income, reducing your tax bill even though you earned a profit.
When you sell the property, you can defer taxes on your profits by taking a 1031 exchange. That way, you can keep trading upward for properties that generate greater and greater passive income, all without paying a cent in capital gains tax.
For a full breakdown of tax advantages, see our overview of how real estate investors can reduce their income taxes.
7. Diversification
Stock returns are great — until a stock market correction sends your stocks tumbling. Then the average investor panics and lets emotion cut their stock returns in half.
Real estate represents a completely distinct asset class with a low correlation to stock returns. Home prices generally don’t fall even in bear markets, with the notable exception of the Great Recession. But in some ways that exception proves the rule: The Great Recession was caused in large part by a housing bubble.
Investors with a diverse portfolio of both stocks and real estate can lean more heavily on whichever asset class happens to perform better at that moment. In 2018, for example, U.S. stocks experienced a deep correction of nearly 20%, but rents rose by a healthy 3.1% according to RENTCafe.
Like your mother always told you, don’t put all your eggs in one basket.
8. Retirement Perks
In the traditional model of retirement, you save up a huge nest egg, retire, then gradually spend down your portfolio. And then hope you don’t outlive your money.
That model comes with several drawbacks. First, you have to calculate a safe withdrawal rate — the percentage of your portfolio that you can safely pull out every year to spend. Similarly, you must calculate how much you need to save for retirement, and hit milestones to stay on track to retire by your target age.
When you pull money out of your nest egg each year, it also leaves you vulnerable to sequence of returns risk. It turns out that the risk of a market crash early in your retirement causes far more damage to your nest egg than a similar crash later in your retirement — even if your long-term average would be the same with either timing.
I don’t particularly like the idea of spending down my nest egg and hoping I don’t run out before I die. I’d like to keep growing wealthier even after I retire, and leave a healthy estate for my children.
So rather than rely on selling off my nest egg, I want assets that will keep generating passive income forever — assets like rental properties.
Risks & Challenges of Rental Properties
No investment is without its downsides, and rental properties are no different.
As you explore the idea of investing in rentals, keep the following risks, downsides, and challenges in mind.
1. Poor Liquidity
With your brokerage account, you can instantly buy stocks, ETFs, mutual funds, commodity funds, and other paper assets with a single click. And in today’s world of commission-free brokers, you can do so for free.
Real estate typically takes months to buy or sell. It takes time to research and find good deals on properties before you can buy. And to sell a property, you typically have to hire a real estate agent and market the property in order to secure a buyer.
Even after signing a contract, it still usually takes a month to settle and receive your funds.
Sure, there are other ways to pull equity from a property. But they involve taking on debt, and usually still take weeks to settle.
2. High Barrier to Entry 1: Knowledge
Anyone can hire a financial advisor or robo-advisor to build a balanced stock portfolio for them. In the case of robo-advisors, many even manage your investments for free, such as SoFi Invest. No special knowledge or skills required. You just sign up, fill in a questionnaire, and let the advisor do the rest.
The same can’t be said for rental properties. Yes, you can invest in them with low risk and high returns — but only if you know what you’re doing.
Just a few of the skills that you may need, depending on your style of rental investing, include:
- Choosing cities and neighborhoods to invest in
- Finding good deals
- Calculating cash flow
- Raising money from lenders or investors
- Screening, managing, and hiring contractors
- Screening tenants
- Hiring and overseeing property managers
This says nothing of the diligence required once you own a property. When a tenant violates your lease agreement, you need to file for eviction, because the process usually takes months. And every month that goes by with you not receiving rent, you lose more money, which you have little hope of ever seeing again.
3. High Barrier to Entry 2: Capital
You can buy shares in ETFs or mutual funds for $100. But you can’t buy a property with only a $100 down payment.
Real estate investors typically put down between 20% and 25% when they buy a property. According to the Federal Reserve, the median home price in the U.S. is $327,100. A 20% down payment then amounts to $65,420, and that doesn’t include closing costs.
“It takes money to make money” certainly holds true in real estate investing.
4. Diversification Challenges
That raises a related point: when it costs tens of thousands of dollars to invest in a single asset, it’s hard to diversify.
With $100 invested in an index fund, you gain exposure to hundreds of companies’ shares, maybe thousands. It makes diversification easy.
Contrast that against sinking $65,420 into a single property.
5. Landlording Headaches
I’ve had tenants call me because a lightbulb went out and they wanted me to come over and replace it. Imagine, a grown woman who doesn’t know how to change a lightbulb.
I’ve had tenants show up at my front door at 9:30 at night. Tenants who did $30,000 in damage to a property. Tenants who used every loophole to drag the eviction process out nearly a year, all while not bothering to pay rent and calling the local housing authority to file complaint after complaint. They even sabotaged the property to cause the issues they were filing the complaints about.
People love to paint landlords with an ugly brush, but landlords endure endless headaches from tenants. You can outsource some of those headaches to a property manager, but not all of them. Ultimately the buck stops with you, and you have to manage the property manager to ensure that they protect your property and your interests.
Alternatives to Diversify Into Real Estate
Before investing in rental properties, ask yourself a simple question: Are you genuinely interested in learning how to invest in real estate, or do you just want the diversification of assets?
It takes time and money to learn everything you need to know to invest soundly in real estate. Some people have a passion for it; they truly enjoy it and want to learn. Others simply want to balance out the stock holdings in their asset allocation.
To the former group, I encourage them to dive in headfirst, and take advantage of all the benefits to rental properties laid out above. To the latter group, I encourage them to explore indirect ways to invest in real estate.
For example, you can buy into a publicly-traded REIT with your brokerage account. Alternatively, you can buy shares in a private REIT, such as Fundrise or Streitwise, that come with fewer restrictions and less volatility, but also less liquidity.
Another type of crowdfunded real estate investment includes debt secured by real estate. One example includes GroundFloor, which lets you pick and choose property loans to invest in, most of which have terms of one year or less.
If you know real estate investors personally, you can lend them a private note. I do this with a couple real estate investors I know, for strong returns with no labor on my part.
Or you can buy into ETFs or mutual funds with a strong connection to the real estate industry. A few examples include funds specializing in homebuilder companies, hotel companies, homebuilder suppliers, or home improvement retail chains.
Final Word
Rental properties offer spectacular benefits to investors, including strong returns, low volatility, inflation-adjusted passive income, tax benefits, and diversification in your portfolio.
They also come with their own challenges and barriers to entry. If just anyone could invest in them effortlessly, they wouldn’t offer those strong returns.
As you explore the idea of buying your first rental property, ask yourself how passionate you are about the prospect. If it doesn’t appeal to you as a side hustle bordering on a hobby, consider other ways to diversify your investments.
But if you love the idea of learning the ropes and collecting rental income, you’ll find few other investments that offer the same advantages.
What appeals to you about investing in rental properties? What’s held you back so far?
