I started my financial career in banking, eventually progressing to insurance and then to financial advisor over a 24 year career — 21 years as a Series 6 and then Series 7 securities licensed representative. In that span of time, I developed a unique perspective regarding the advantages of the rental market since I owned rental houses and also stocks and mutual funds in my investment portfolio.
First, it should be said that having IRAs, 529 plans for children and 401(k) plans are all excellent vehicles to save for the future. Most investors are limited by the options they are offered. This is true particularly for 401(k) plans where the investor cannot take advantage of owning residential real estate. And although there is an exception for self-directed IRAs, it has limitations — the balance of the account being a notable one.
On the other hand, the advantages of investing in real estate are numerous. First, one advantage of owning rental houses is that you can use leverage of five-to-one compared to the two-to-one in stocks. For example, if an investor buys a $100,000 house, he or she can do so with an investment of $20,000 financing the balance of $80,000 thus owning $100,000 of real estate. Conversely, an investor who owns stocks can invest (“leverage”) the same $20,000 and borrow $20,000 from the brokerage firm where they maintain an account or from a bank who will accept that as collateral.
Both examples involve investing $20,000. In the real estate scenario, the investor has obtained a $100,000 asset. The stock investor will have $40,000 of stock or mutual funds. If both increase in value — let’s say 5% the first year — the real estate investor has made $5,000, while the stock investor has made $2,000. That is significantly more for the real estate investor on the same $20,000 investment. Compound this over 20 or 30 years and it could account for a difference of tens if not hundreds of thousands of dollars.
The second advantage of owning rental properties is that the investor can take depreciation starting the first year, and doing so over time can reduce the tax burden in April because of the IRS’s treatment of rental property. Stocks and mutual funds cannot be depreciated to lessen the tax burden. However, they can be in accounts that are tax-deferred. Rental properties grow tax-deferred as well.
The third reason, and for many the biggest reason, is that people can touch and feel real estate. It is tangible. Some investors want to see their houses with their own eyes. They want to work on these properties to improve the value and positioning that asset, generating greater yields through increased rent. As a rental house increases in value, the owner can “harvest” profits by taking out a new loan or refinancing, thus cashing out. This new money can be used to purchase other houses, increasing the value of the portfolio and creating a higher and larger return. If this process is utilized every few years an investor could own five, six or even 10 rental houses after making one initial purchase. Remember, $100,000, $200,000 or even $300,000 of real estate only requires an attritional $20,000 to $40,000 investment.
Regardless of what individuals believe or chose to do, eventually single-family rental homes provide the small investor the ability to diversify and deliver sold gains that may yield significantly larger profits than alternative investments.