Recognizing the Advantages of Owning Rental Property
A great advantage to building wealth through real estate is the ability to use other people’s money (referred to as OPM in Urban Dictionary and on online real estate investing websites). You’ll likely purchase a rental property with the help of financing from a lender; then your tenants provide the monthly funds for the debt service payments and for ongoing operating expenses and capital improvements.
The wide availability and low cost of real estate financing over the past few years make real estate investing a viable, realistic option for virtually everyone. Even when commercial lender real estate loans were difficult to obtain during the financial crisis of 2008–2012, many deals still went through, thanks to seller financing.
Most people purchase real estate by using leverage gained by borrowing from the seller or a lender. Leverage is the purchase of real estate with financing; it usually consists of a cash down payment from the buyer and a loan or other people’s money. Here are the two types of leverage:
Positive: With this type of leverage, you can earn a return on both your cash investment and the entire value of the real estate. The ability to control significant real estate assets with a small cash investment is one of the best reasons to invest in real estate. You might purchase a $100,000 rental home with $20,000 in cash and a bank loan for $80,000, for example. If the home value doubles in the next decade, and you sell this home for $200,000, you’ve turned your $20,000 cash investment into a $100,000 profit.
Negative: Real estate enjoyed a long run of steady appreciation from the mid-1990s through 2007, but if you were unable to make your loan payments and other financial obligations as a rental property owner, the economic downturn of 2008–2012 illustrated the negative potential of negative leverage. Negative leverage can wipe out your entire investment with a 20 percent decline in the market value of your rental property. So if you buy a rental home for $200,000, with $40,000 in cash and $160,000 from your bank, only to see the economy falter or the local real estate market sour, you may have to sell your rental home for less than your acquisition price. If you sell the home for $160,000 after the costs of sale, you may have just enough to pay off the bank, and your cash down payment of $40,000 evaporates. Unfortunately, negative leverage is the experience of many investors and homeowners who aggressively purchased real estate in the early to mid-2000s with little or no cash down and learned during the Great Recession (2008–2012) that their mortgage balance exceeded the current value of their property.
Despite the occasional downturn in real estate nationally, people with an incredible amount of capital have sought to acquire rental real estate in many markets, even during the pandemic that started in 2020. Though opportunities always exist for patient and persistent investors, finding really good, well-located rental properties is competitive and challenging in many urban markets.
Rental real estate also offers you the opportunity to pay off your mortgage by using your tenants’ money. If you’re prudent in purchasing a well-located property in a stable area, you should have enough income to pay all the operating expenses, utilities, maintenance, taxes, insurance, and debt service. Each month, your property becomes more valuable, while your tenant essentially pays all your expenses, including principal and interest payments on your loan.
Over time, you may find that your rental income collections grow faster than your operating expenses. That’s why many economists feel that real estate is a superior investment, because historically, real estate has been a very effective hedge against inflation. With the unprecedented increase in government spending over the past several years due to the pandemic and federal economic stimulus programs, the role of real estate in preserving the value in an inflationary environment is becoming a stronger driver for demand and much higher prices for all types of income-producing real estate. After your tenants finish paying your mortgage for you, you may suddenly find that you have a positive cash flow — in other words, that you’re making a profit.
Eyeing the Unique Characteristics of a Good Manager
Good management equals good financial results. Having tenants who pay on time, stay for several years, and treat the property and their neighbors with respect is the key to profitable landlording. Finding those people is easier said than done, however. One of the greatest deterrents to financial independence through real estate investments is the fear of management and dealing with tenants, which is why management is so important. But what makes a good manager? The next several sections take a closer look at the many aspects of managing your own rental properties.
Realizing that good management makes a difference
To get a firm grasp on managing your residential rental property, you need to understand what good management is. Good management entails having a well-maintained rental property that’s occupied by a paying tenant on a long-term
