Are Rental Properties Good Investments?

Over the past six months, Wealthfront has given a seminar on how to invest well to more than 50 Bay Area-based companies, including Facebook (FB), LinkedIn (LNKD) and Yelp (YELP). The seminar helps the audience learn how to use Modern Portfolio Theory[1] to better manage investment portfolios. (Here’s a link to our slideshare presentation covering some of the same ground and to our seminar page)

As you might expect, we talk about the idea that investing in individual stocks actually hurts portfolio returns over time.

At almost every seminar, we get a question from the audience related to how someone should think about investing in real estate – not the home in which a person lives, but real estate rental properties. The more the Bay Area property market booms, the more seductive the prospect of owning rental property seems to become. Some people get sucked in, too, by the idea that they can invest using borrowed dollars.

portfolio diversification through real estate

Unless you are an incredibly savvy real estate investor, you are probably better off owning a real estate ETF as one of the six components experts suggest for a diversified portfolio: U.S. Stocks, Foreign Stocks, Emerging Markets, Real Estate, Natural Resources, and Bonds

We always answer the question the same way, though. You should think of a physical real estate investment the same way you should think about an investment in a particular stock: As a big risk. You are unlikely to outperform the market unless you have an information advantage (which you are unlikely to have unless you are a real estate professional or are willing to put lots of time and energy into finding the property).

Returns

You can reap some of the benefits of owning real estate – an asset class that traditionally is thought of as a hedge against inflation  — by owning a diversified collection of residential and commercial properties in the form of an ETF. The Vanguard REIT ETF, VNQ, which Wealthfront recommends for its clients, owns shares in Real Estate Investment Trusts including Simon Property Group, which owns retail properties, Ventas Inc., which owns healthcare properties, and Vornado Realty Trust, a big commercial office building REIT.

A real estate ETF, owned as part of a broadly diversified portfolio, is likely to lead to better risk-adjusted returns.

Income

Many people are interested in owning real estate for the consistent income.  REITs by law must pay out 90% of their income, so their dividends should address those income goals.

The idea of trying to choose the “right” individual property is alluring, especially when you think you can get a good deal on the property or buy it with a great deal of leverage. That strategy can work well in an up market. However, 2008 taught all of us about the risks of an undiversified real estate portfolio, and that leverage can work both ways.

The bottom line? Unless you are an incredibly savvy real estate investor, you are probably better off owning a real estate ETF as one of the six components of a diversified portfolio.

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14 Responses to “Are Rental Properties Good Investments?”

  1. Z1 Bhubaneswar July 28, 2012 at 4:49 am #

    Hi,
    I would really like to thank you for sharing such informative ideas with everyone. Real estate is an imperishable asset, ever increasing in value. It is the most solid security that human ingenuity has devised. It is the basis of all security and about the only indestructible security. Your posting gives an overall idea to the people about Real Estate. I would like to know some tips to increase the profit margin for Real Estate business in India.

  2. Acrux July 30, 2012 at 5:19 am #

    Hi,
    I just went through your blog and found it very interesting. You have mentioned here some points which will be very useful for everyone who are searching for some idea related to property. Buying a property is a very good investment but all should be aware of everything. Can you suggest some necessary steps to be taken while buying residential property?
    Waiting for your next blog…!

  3. tyler July 31, 2012 at 11:22 am #

    Great information on whether or not rental properties are a good investment. It usually depends on the individual and their willingness to exposure to risk, their background in maintenance and general knowledge of management and handy work. Thanks for sharing.

  4. Ms. Taylor Morrison August 11, 2012 at 8:30 am #

    Definately rental properties are a good investment. I am a Realestate Investor and a Professional Property Scout. I can find deeply discounted homes/foreclosures you can make money on.
    You simply need to find properties that you can buy for cheap, repair and resell for a profit.

    I have many properties right now that are between $3k and $30k to purchase and they are not bad homes.. but may need some work on them.

    Theres always going to be renters..especially people whose credit is not good but they have option money to put down on the property. In your contract you state if they fail to make a payment they will remove themselves. Ive had many put down up to $25k down on a home and have turned out to be great renter/buyers. When I got the property for $5k and sold it for $85,000 to my lease option buyers.. I would say that this is a good profit. You make money off the top, middle and bottom..

    Broke down let me show you what I mean
    I bought the property for $5K and put $5k into the property so I invested $10k
    I lease option it to my client for $25k down and payments of $600 a month at 6% interest
    So they paid for my initial investment of $10K.. I made $10k and will make pure profit off the monthly payments which is free an clear……and when the house sells.. I make even more money.

    So yes if you find someone that knows what they are doing in this Investment Market and will partner with you ie: for example hire me to find the property, you buy it, you hire me to do the remodel and resell it for you on a Lease Optioin to Buy, and we both make money

    There will always be people out there needing a home..

    There is also Bulk Properties you can buy as well and you definately make money if you have money to put into the property to get it to where its liveable and resellable.

    Ms. Taylor Morrison
    Email: mstaylormorrison@yahoo.com

    • EJ December 12, 2012 at 11:51 pm #

      Ms. Morrison,

      What the article was focusing on is that REITs can do perform the same type of due diligence, so by investing with them you get the benefit of diversification.

  5. Custodian Wealth Builders August 28, 2012 at 3:44 am #

    Investing in real estate for the first time can be a difficult thing. The person who has yet to invest in rental properties, may have lots of questions about the process, benefits, etc. Thanks for sharing great information regarding real estate investing beginners.

  6. hayek September 18, 2012 at 11:26 am #

    I think rental properties are great but you must be prepared to do a lot of dirty, hard work. I have several properties in my small home town that are less than half the price of a bay area home. I pay the mortgage and my parents take care of the properties and pick up rent.

    Finding the right place requires months of keeping you ears to the street. You can’t be afraid to kick out residents. You WILL have to do a lot of manual work to get them in top shape. But they are solid money makers. Just 17 months ago I purchased a 9 unit complex of small apartments for ~$500,000 including upgrades and remodeling, putting $250 down. They make $6000 a month, $1500 for my parents troubles, $2000 for the 15 yr mortgage, $2000 in savings. Another $1500 of my bay area engineer salary goes the mortgage, instead of 401k’s, to own it in full as soon as possible.

  7. Kristin Ward February 13, 2013 at 9:08 am #

    Rental properties are a good long term investment. However you will need to invest a good deal in it first. Its not just about the property, it takes time and funds to repair everything, find good tenants and set things up. Its also a lot of work. You are responsible for basic repairs, advertising for tenants, screening tenants, and dealing with tenant complaints. Its basically a full time job.

    • Andy Rachleff February 13, 2013 at 10:38 am #

      The question isn’t whether a rental property can be a good investment. it’s whether a non professional real estate investor should make the investment

      • Zach April 5, 2013 at 12:59 pm #

        I think what a lot of people don’t realize is that buying property to rent out can require a significant time commitment. Let’s say, for example, a pipe breaks or there is a leak, your tenant will call you, and, as the landlord, you’ll have to deal with the problem. Investing in a REIT, of course, doesn’t require this time commitment.

  8. Sree V July 15, 2013 at 3:21 pm #

    Hi,
    I found the analysis included in this post lacking in depth. The article makes it sound as if investing and getting returns from REITs is a slam dunk. As someone who has invested in REITs and Rental Property in the Bay Area, let me tell you that my REIT (Inland American) has been devalued 40% from when I first opted in. Sure I do get the 6% Dividend, but I suspect it will never go back to its original listing price. So as with anything else, unless you do your homework, and have a bit of luck, you can lose money with REITs as well.

    Regarding the comment “whether a non professional real estate investor should make the investment ” – The same applies for investing in REITs isnt it, since IM not an investment “professional”.

    I hope the article was not a plug for having Wealthfront manage your assets :-)

    • Andy Rachleff July 15, 2013 at 3:55 pm #

      Sree,
      I agree with your assertion if you’re taking about individual or a few REITs. In contrast Wealthfront suggests you invest in index funds that include thousands of REITs thereby diversifying away the individual company risk. That leaves you with market risk which you will have whether you own one or thousands of properties, but at least you won’t be subject to the vagaries of an individual geography’s market. A number of academic studies have shown that you are far better off on a risk adjusted basis owning an index fund than individual properties. Sure it’s possible that you picked the one property that did well, but unless you do it for a living that is highly unlikely.

  9. Sarah Liotti August 6, 2013 at 7:05 pm #

    In my own honest opinion, investing in the real estate market is good. You can predict whether when to put your investments up on sale. You can also take time to have real estate rentals so you can generate money from it.

    • Andy Rachleff August 7, 2013 at 7:56 am #

      Real Estate can be a very good investment. The problem is the likelihood that you outperform the market if you are not a professinal is very low. In that case you are much better off with a diversified pool that comes with an index fund/ETF.

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