A financial advisor and his client review her portfolio to see if a rental property would be a worthwhile investment.

August 07, 2019

6 Factors for Determining if a Rental Property is Right for Your Portfolio

Real estate is top-of-mind for savvy investors who recognize the potential a property can add to their portfolios, both in the short and long term.

According to ApartmentList's national rent index, rent continues to rise yearly in almost all of the nation's largest markets, indicating to individuals that a rental property may be a worthwhile investment.

However, just because market trends may show potential for an investment, that doesn't mean you should forget to fully evaluate whether or not it's right for you.

“The first question to ask yourself when you're looking at purchasing and renting out a property is, 'Does it fit into your investment strategy, your portfolio allocation?'" said Bill Ringham, director of Private Wealth Services at RBC Wealth Management-U.S. “It's essential to consider whether or not it makes sense with the diversification of your larger investment portfolio."

Fred Rose, head of Credit and Liquidity Solutions at RBC Wealth Management-U.S., agreed.

“No matter what you invest in, it's critical to be diversified — that's just a good prudent practice," he said. "The unfortunate thing is sometimes I'll see people — especially those who are just starting to grow their wealth — who make rentals a very high portion of their overall portfolio. It's smart to make sure you're not making property 100 percent of your net worth."

While every portfolio is unique, a more balanced portfolio can help you weather market and property fluctuations. While rental properties may offer solid, long-term returns, there are also many potential headaches and unforeseen expenses that could outweigh the benefits, so it's important to weigh the time and costs against the potential returns.

Costs of Managing a Rental Property

There are a multitude of elements that affect the returns you'll get on your property. People can get into trouble when they don't factor in all the obvious and not-so-obvious costs of owning a rental.

“The biggest mistake I see," Rose said, "particularly with novice investors, is they think figuring out if a rental property is a good investment is a simple matter of figuring out if the rent they'll make is equal to or more than their mortgage payments."

For example, an investor might calculate that her mortgage payment will be $1,000 a month, but rent could potentially bring in $1,500 dollars a month.

"Therefore, they think it's a good investment," Rose said. "But that's not the way to look at it. You need to look at the investment, the property itself and the true cost to carry that rental in and of itself."

Things like financing, taxes, possibly hiring help, depreciation, maintenance, legal issues and more all need to be considered.

"Deciding to invest in a rental property can't just be a 'my cost of financing' vs 'my rental income' equation," Rose said.

Choice of Location

“It's a well-worn phrase, but it's true: the three important things to consider in real estate are location, location and location," said Ringham.

He points out, however, that it's not just about investing in a rental property located in a desirable location. Rather, the key to a large return may be finding a property in an up-and-coming neighborhood.

“If your property is already in a fairly established location, you're probably going to pay a premium price for it," he said. "Then you also must look at what's the long-term growth of the value of this underlying property, versus if you're buying in an area that's on the edge of gentrification."

But that doesn't necessarily mean that you want to get too far in front of gentrification, as that might mean no one will want to live there.

"In general, however, if you can predict the next big area or location, then you can make a much better investment," Ringham said.

Time Commitments

Unlike stocks, ETFs or bonds, where most investors are removed from the daily running of a corporation, owning a rental property can be a very hands-on endeavor.

“Those contemplating getting a rental property need to ask themselves 'Am I prepared to be a landlord? Can I fix the broken toilet at 2 in the morning?'" said Ringham. "If you don't want to be a hands-on landlord, then you might ask yourself if you can afford to hire somebody to take care of those kinds of issues. You'll need to figure out whether a rental property is purely an investment or something you're willing to labor over."

Additionally, if you're planning to invest in a multi-unit building, it may make sense to hire someone to manage the property for you.

Unpredictable Tenants

People can be as unpredictable as markets. Tenants could be unruly, damaging to your property, late paying rent or potentially make eviction difficult.

“Tenants can be a big risk factor in your investment," said Rose. “What if they try to get out of a lease or won't pay rent?"

It's critical to be up-to-date on city and state tenant laws so you know what your legal rights and responsibilities are.

"There can be a lot of different rules depending on where you're located," Rose said.

Potential Liabilities

Investing in a rental property could also expose you to complex legal issues, which you should research before making your investment.

“There are liability considerations that come into play," Ringham said. "You'll want to protect yourself if, for example, a tenant slips and falls and wants to sue you."

Ringham suggested looking into the possibility of creating a legal structure that owns a property for asset protection, such as a limited liability company. This involves complex legal structures and filing different tax returns, which can significantly add to the cost of your investment.

Lack of Liquidity

Another important issue to consider is whether you'll need quick access to your assets in the future.

“You should realistically assess your financial ability," noted Ringham. “What is your need for liquidity? Real estate can't be liquidated like investments in the stock market. You might not be able to liquidate or sell your building for some time and could be left without renting it for months or longer."

"Just because something provides a great cash flow for several years doesn't mean it always will, because the property market can change," he added. Even with the option of a home equity line of credit it may not be possible to get the money you may need in case of an unexpected situation.

Evaluating if a Rental Property is Right for You

Rental properties can be a lucrative investment strategy. Because they're much more complex than other investments, it's important to thoroughly evaluate if and how a rental property fits into your unique financial plan.

City National's relationship managers can help you realize your plan for adding a rental property to you portfolio now or in the future. Visit our preferred banking page to learn more about a City National relationship.

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This article is a republication of content originally published by RBC Wealth Management, a division of RBC Capital Markets, LLC, Member NYSE/FINRA/SIPC. © 2019, Royal Bank of Canada, used with permission.

This article is for general information and education only. It is provided as a courtesy to the clients and friends of City National Bank (City National). City National does not warrant that it is accurate or complete. Opinions expressed and estimates or projections given are those of the authors or persons quoted as of the date of the article with no obligation to update or notify of inaccuracy or change. This article may not be reproduced, distributed or further published by any person without the written consent of City National. Please cite source when quoting.

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