Investing in Rental Properties

I just watched yet another “Personal Finance Guru” on cable TV who recommends NOT to invest in rental income properties, but instead to invest in municipal bonds, claiming that such debt instruments are paying 5% to 6% tax free and are much safer than rental properties. To use the guru’s favorite retort, “Are you kidding me?!”

With long-term interest rates at historic lows and property prices at affordable lows, the guru says investing in rental real estate is bad idea. By the guru’s illogic, when is rental real estate a good investment? When interest rates are at “Jimmy Carter” double digit highs and property prices are sky rocketing? What nonsense is that? Since when has “Buy Low And Sell Higher” (BLASH) been bad advice?

Low interest rates mean that you can pay down your debt much faster, according to your rental income and operating expenses, and your debt is based on a low purchase price. So, you start with less debt (compared to prices a few years ago) and you can pay down that debt much faster.

Then the guru says that you need at least 12 months of mortgage debt service in a savings account to handle vacancies, because your tenant can lose his job and it takes forever to get him out of the property, while municipal bonds are safe, tax-free and management free.

Here are my thoughts in no specific order:

  • You don’t need 12 months of debt service, but you need some cash reserves to handle vacancies and capital repairs (like a new roof every 10 to 15 years). Your tenant’s rent covers expenses, routine maintenance and debt service, and your tenant’s security deposit covers damage and unpaid rent while you evict the deadbeat.
  • If you rent out a single family home and it becomes vacant, then you have 100% vacancy. Well, you can try my favorite rental property: A multiunit property to reduce the impact of vacancies. A 4-plex can have 1 vacancy and still service its debt, taxes and insurance. A 12-plex can tolerate 3 or 4 vacancies and still service its debt, taxes and insurance. The greater number of units per property means the less impact that a vacancy will have on your net cash flow.
  • You can “ease into” the rental property business by using a well-structured “sandwich lease” and “option to purchase”. You can lease the entire property (with option to purchase) from the owner, and then rent out the individual units at a higher rental rate. This is a kind of “deedless transaction” that gives you control without ownership liability. You make money from the rental spread without a down payment and without getting a new loan. If income drops too severely or expenses rise too much, then you can get out of your lease with the proper contract clauses. If the property performance improves, you exercise your option to buy at the contracted low price or sell your option to another investor. Where’s the risk?
  • You (or your professional manager) can qualify your tenants for good credit and require first, last, and a sufficient security deposit to cover lost rent, damages and eviction fees.
  • A flat-fee eviction attorney can get a non-paying tenant out in 30 days in most jurisdictions. In jurisdictions that enforce longer eviction periods, then you can require larger security deposits.
  • For a nominal fee, a licensed experienced real estate broker can manage the property and qualify tenants for good credit, and handle contracts and repairs.
  • Net rental income after paying expenses and interest on debt can be tax-sheltered through the IRS depreciation allowance. You can get tax-free passive income that you can manage and grow. Can you manage and grow your income with a bond? You must depend on the expertise and skills of the bond fund managers (who take their “cut” first); you have no control with a bond.
  • You can get much higher yields with rental properties compared to bonds when you understand how to structure correctly the financing. With no down payment, your effective yield is infinite.
  • If you make a down payment, then that is an equity investment that can grow by your tenant paying down your debt and by proper management of income and expenses. You don’t need to make a down payment when you understand proper financing structure.
  • If you prefer to be a lender rather than an equity participant, then you can offer private loans for real estate investments. A commercial debt syndicator can combine your private funds with the funds of other private lenders to achieve leverage, and you are paid first before equity investors. You have full access to the property performance data and to the business plan for generating double digit returns on your investment, and to the exit strategy to redeem your investment.
  • You can “participate” with other equity investors or private lenders to share the risk and rewards by using a “group investment” structure (syndication) to achieve leverage.

Real estate is a “borrowed money” business. The value of an income property does not depend on the down payment, but rather on its cash flow. Both debt and equity have “yield requirements” that determine the property value based on the cost and structure of financing.

Investing in rental properties is not about capital gains appreciation, but rather it’s about net cash flow. With a long-term, low fixed rate, no balloon mortgage debt on cash flowing rental property, it doesn’t matter what happens to interest rates. The property can afford to pay for its expenses, debt service and your net cash flow. Capital gain is just a nice bonus when it happens, and long term capital gains tax can be deferred with an IRC 1031 tax-deferred exchange when you want to “trade up” to larger better income property. You can legally defer taxes forever and pass your income property to your heirs on a stepped-up capital basis.

Investing in any kind of bond must be focused on the use of that investment to create value. Investing in a bond to finance operating expenses is insane. If an entity, either a corporation or the government, must borrow to pay for operating expenses, then that entity is INSOLVENT. When you lend to an insolvent entity, just say goodbye to that money. You must find a Greater Fool to buy your bond just to get the return of your principal and forget about a return on your principal. I humbly recommend that you NEVER LEND MONEY TO AN INSOLVENT ENTITY. That money will just go to paying operating expense and you’ll never see it again. That should be common sense, but common sense is so rare these days.

When bond yields (interest rates) spike, the price (principal) of those bonds will drop dramatically. Government entities running huge deficits and borrowing just to pay for general operating expenses and lavish pensions (paying folks not to work) will eventually collapse bond prices. You don’t want to be caught without a chair when the music stops.

Everyone needs a roof over their head and to keep the wind, rain and snow off of their stuff. When approached professionally as a business, rental real estate is the surest path to wealth and financial freedom.

You can learn more about investing in income properties, with or without a down payment, with my course “Introduction to Income Valuation and Syndication” at http://bit.ly/itivas-1.

I teach many strategies for investing in income properties, with or without the deed, to create wealth and financial freedom. You can learn how to retire in 2 or 3 years with massive tax-sheltered passive income with my course “How to Pyramid Your Equity to Create Wealth and Financial Freedom” at http://bit.ly/pyecw-1.

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