Reprinted from the October 2014 Sioux Falls Chamber of Commerce’s publication, Chamber News.
A common objection we hear from would-be property investors is, “Why should I invest in rental property instead of the stock market?”
The underlying objection assumes rental property takes more work to manage and produces worse returns than stocks. So why do savvy investors add real estate to their portfolios?
Besides the obvious perk of diversifying their portfolio income, real estate offers four financial benefits, while stocks offer only one or two.
- Income: Income is the rent left over after expenses and debt service have been paid. We also call this benefit “Cash Flow.” Some, but not all, stocks offer this benefit in the form of dividends.
- Principle Reduction: When an investor uses leverage, i.e. a loan to purchase a property, a portion of the monthly mortgage payment goes toward paying the interest and part goes toward the equity. Homeowners are familiar with this concept. However, with rental property, the tenant is making the mortgage payment. The tenant buys the building for the investor! How cool is that? When was the last time you heard of someone buying stock for the investor?
- Depreciation: Tax benefits are perhaps one of the least understood benefits of owning rental property, but perhaps one of the most powerful tools for rental property investors. At the risk of oversimplifying an IRS tax law, depreciation (also known as cost recovery) allows the investor to claim a loss even though they made money on the property. The investor puts money in his or her checking account, but then gets to tell the IRS they lost money. Each situation is different but, sometimes, excess depreciation from the rental property can even decrease taxes an investor owes on the income from their job. (Let’s see a stock do that!) Over time, depreciation “wears out” until the building is completely depreciated and the investor no longer receives the tax benefit. What to do? The investor can use a 1031 exchange to sell the property and buy a different property without paying capital gains tax. The IRS allows a brand new, fresh depreciation on the second property, again allowing investors to put their money in their pocket without paying tax on the income. As with any tax-related issues, it is always more complicated than it first appears and you should consult with your accountant or attorney before making any decisions.
- Appreciation: Most people understand that appreciation is when you get to sell an asset for more than you paid for it. It is the main benefit investors get from a stock. As a general rule, long term real estate appreciation values will keep pace with inflation. Obviously, short-term rates could be higher or lower depending upon the economy.
What about the objection that rental property is more work than owning a stock?
First, if the tenant is buying the property for you, would it kill you to take their phone call? Second, if you hire a property manager, you don’t even have to take the phone call. In addition, a good manager will actually increase your rate of return even after paying the management fee. How is this possible? Time is money in rentals. A manager who can shave off two weeks between tenants turnover, is able to resolve a tenant delinquency quickly, or is able to negotiate better maintenance rates can quickly pay for themselves.
Stocks verses rental property is not an either/or option, it is a both/and solution.