Why is Investing in Rental Real Estate a Bad Idea?
By AJ Ayers, CFP®
Perhaps you’ve seen the trending Twitter topic about AirBnb horror stories? It’s not just the guests that are having bad experiences with AirBnB these days; it’s hosts facing higher vacancy rates and rising maintenance costs.
Investing in real estate has long been considered a reliable path to financial success, and rental properties are often hailed as a lucrative investment option. It’s the American Dream, baby! However, it is crucial to understand that, like any investment, rental real estate has its share of risks and drawbacks. We will delve into a compelling case study to shed light on the negative aspects of investing in rental real estate and why it can sometimes be a detrimental financial decision.
You can’t scroll through Twitter or Instagram these days without smacking into a “rental real estate guru” hawking a get-rich-quick scheme for “passive income.” I refuse to link to any of them here, sorry.
Well, there’s nothing quick about rental real estate, and it’s certainly not passive in a literal sense. It’s a slow, arduous, dangerous, and extremely risky type of investing that is often most lucrative for the snake oil salesmen with their online courses peddling the “secret” to unsuspecting investors.
Some very successful entrepreneurs have built fortunes building up rental real estate portfolios, but this is certainly not the norm. Like many risky investment success stories, these entrepreneurs were at the right place at the right time and effectively struck gold. And now they are the pickaxe salesman during the proverbial gold rush.
Forgive my harsh tone, but I’m sick of really smart people falling for the whole rental real estate farce. I’ve seen some compelling speakers extoll the virtues of buying up property and renting it out, but there’s always more to the story.
Here are the top 5 reasons we think investing in rental real estate is a bad idea:
Complexity. Owning any piece of real estate is NEVER as easy as it seems. There are banks, insurance companies, repair persons, homeowners associations, utility companies, neighbors, community boards, and co-op boards to contend with. If you think your life is a little hectic now, just wait until you have a mortgage, an electric bill, a water bill, an HoA bill, monthly meetings, tax assessments, and more.
Time is money. Are you great at fixing overflowing toilets? Awesome. Are you available 24/7 for emergencies? If not, do you have thousands of dollars of cash lying around to pay someone else to fix them? Or if you do want a full hands-off and genuinely “passive” experience? Be prepared to part with 20-30% of your rental income for a hands-off management company. Yes, everything COULD be fine and nothing could ever break, but changes are something will do wrong - do you have the time to fix it?
Concentrated risk. Your wealth is tied up in one single asset. If the unexpected comes, like a hurricane or urban blight, your investment could evaporate overnight, or you could be forced to hold it for years until the recovery comes.
The opportunity cost of a down payment. We can argue about general stock market returns all day, but long-term stock market returns have averaged in the upper single digits. If we invest in rental real estate, we have to consider the lost gains if we were to invest that cash in the stock market instead.
Unknown “fixed” costs. Things that seem to be fixed like property taxes and HoA fees do go up, and often by a lot. A rental may start as cashflow positive in the first year or so, but an increase in taxes or HoA fees can zap hose profits overnight.
Let’s look at a case study.
(Disclosure: this is not based on an actual client situation, actual outcomes may vary)
Case Study: The Gilmore’s Rental Real Estate Nightmare
Meet the Gilmore family. Rory and Jess Gilmore are busy journalists who have recently inherited a pile of cash and decided to invest in a rental property. They paid for an online course teaching them the basics of rental real estate and feel excited about the passive income they are about to generate. Jess is handy and loves interior design. Armed with their inheritance, they purchased a residential property in an up-and-coming neighborhood, believing it to be a wise financial move. However, their investment journey took an unexpected turn, leading to a series of detrimental outcomes.
Vacancy and Income Loss: Upon purchasing the property, the Gilmores encountered difficulty in finding tenants. The property remained vacant for months, causing a significant loss of potential rental income. They struggled to cover mortgage payments and property maintenance expenses which quickly depleted their emergency fund.
Unexpected Expenses: While the Gilmores budgeted for regular property maintenance, they were unprepared for unforeseen repairs and emergencies. A leaky roof was the first major expense. The inspection didn’t reveal the issue and the repairs cost $11,000. Jess had to take a few days off work to oversee the repairs because they have issues with contractors in the past. The short-term temporary tenants also had to move out during the repairs and were compensated for a hotel room. The stress has introduced tension between Jess and Rory and now Rory is questioning whether she wanted to do this in the first place.
Difficult Tenants and Legal Hassles: After finally securing tenants, the Gilmores faced an array of challenges. The really nice couple of graphic designers they rented to turned out to be nightmares. They were often late with rent payments and had a large party that led to a noise complaint. These issues led to legal disputes and the need for costly eviction procedures. The Gilmores found themselves embroiled in a time-consuming and stressful process, further depleting their bank accounts and actually causing marital stress.
Market Fluctuations: Real estate markets are subject to fluctuations, and the Gilmores experienced the downside of this volatility. Due to economic downturns and a saturated rental market, they struggled to increase rental rates or find new tenants willing to pay the desired price. As a result, their expected returns diminished, stifling their investment goals.
Regulatory and Tax Changes: The Gilmores were caught off guard by regulatory changes, including stricter rental property regulations and tax reforms. These changes increased compliance costs and reduced tax advantages previously associated with rental real estate investments. Their financial calculations were thrown into disarray, and their anticipated profits were significantly diminished.
Ultimately, the Gilmores decided to sell the property at a small profit after two years. It wasn’t a positive experience for them.
Investors should carefully assess their financial capabilities, market conditions, and potential risks before diving into rental real estate. Conducting thorough due diligence, creating a contingency fund, and seeking professional advice can mitigate some of these risks and improve the chances of success. Ultimately, it is vital to recognize that rental real estate, like any investment, carries inherent risks and may not always deliver the anticipated returns. What’s irksome about investing in real estate vs a security like a stock or ETF is that rental real estate must be sold to another human in a complex transaction that often requires brokers, lawyers, a fresh coat of paint, and more. You can offload a poorly performing stock in about 30 seconds by selling it via a brokerage platform. Selling a poorly performing rental property can take months or even years.