|Investing in Rental Property 101
How your clients can make a smart investment in rental property now.
February 18, 2010
Did your client make an investment in rental property and lose their shirt?
They’re not alone.
Many people have lost a ton of money with their investments in rental property over the last few years because of which they don’t even want to hear the words “real estate” discussed. I know of more than one case in which that debacle cost a couple their money and marriage.
Why This Might Be One of the Best Times Ever to Make an Investment in Rental Property
Take a look at what’s happened to prices in different markets since 2006. The market in Los Angeles has lost over 30 percent. That means your investor-clients can buy real estate at a 30-percent discount -- not too shabby … or is it?
While real estate has been a traditional wealth builder (and even I think now is a great time to look at it), I still believe your clients need to be very careful right now.
In my opinion, real estate is all about cash-flow. If this wasn’t true in the go-go days from 2000 through 2006, it’s certainly true now. What I mean of course is that your clients shouldn’t pay more for a property than the rents justify.
Where people got into trouble was when they bought property for the appreciation only (that often didn’t appear). They didn’t care that they needed to shell out hundreds of dollars from their pocket each month on top of the rent they got.
Example: A house in a decent neighborhood in Los Angeles was priced at over $1million in 2006. That house could have been rented out for $3,500 a month. Today, that same house goes for about $725,000 and it can still be rented for $3,250. Is now a good time to buy that house?
Not if your clients are looking at it as an investment.
The monthly payments on this house (assuming you put 30% down and finance the balance) are about $2,725 a month. That’s without taxes, insurance or vacancy. If you figure all that in, you are still looking at a negative cash flow. While the possibilities for appreciation are greater now than they were two years ago, it’s still a risky deal.
What if your clients lose a tenant and their job during the same month? What if property taxes go up? What if a tenant causes damage to your client’s rental property? Too much risk for me.
On the other hand, what if your clients look at other markets.
In my opinion, they should only invest in real estate that pays them five percent (at least) on their 30 percent down payment AFTER all the expenses are paid. Let’s look at a more moderate example.
Assume they could buy a home for $100,000 with $30,000 down. My advice would be to only do so if AFTER ALL EXPENSES they receive $1,500 profit per year. The $1,500 represents a five percent return on the down payment of $30,000. That works out to $125 per month.
Is this going to be possible in every market? Nope. It’s not possible in my neighborhood … that’s for sure.
But it is possible in other markets.
Of course, this may require partnering with people outside your clients’ stomping grounds, so be it.
Do they have a friend in Florida? How about a chum in Chicago? Your clients could easily make rental properties into a successful small business.
They should find out what the market is doing. Ask for realtor referrals. Get more than one. Try to get a friend involved so he or she can go out and inspect the neighborhoods and the house itself. Offer them a piece of the action for a reduced investment in return for their management of the property.
Have your clients considered an investment in rental property now.
Additional Resources: The AICPA PFP Section provides information, tools, advocacy and guidance to CPAs who specialize in providing tax, retirement, estate, risk management and investment advice to individuals and their closely held entities. All members of the AICPA are eligible to join the PFP section. For CPAs who want to demonstrate their expertise in this subject matter apply to become a PFS Credential holder.
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Neal Frankle, CFP, is the author of Why Smart People Lose a Fortune: 5 Steps to Restoring Your Wealth and Sanity.
The material in this article is general information and not meant to provide specific investment, tax or legal advice. Investing in the stock market involves risk.