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The 5 Financial Pitfalls of a Rental

Updated: Apr 24, 2020



In a previous post we discussed the intangible differences between investing in a rental property and making an investment in commercial multifamily. This post will focus on the tangible side of things, or in other words direct financial considerations when choosing between the two. Any investment in real estate can be considered a good investment if the numbers work. But make no mistake about it, the different asset classes within real estate can yield very different returns and risk profiles.

A discussion about both the intangible and tangible considerations between a rental and commercial multifamily would not be complete without an honest assessment of your goals.

The reasons why someone would even want to consider an investment into real estate must be considered before choosing between the two. Some investors are primarily concerned with short or medium term gain as opposed to long term capital appreciation. Some investors may derive value from the effort that comes from managing their own rental.


So I would ask you;

  • What are your core goals for making an investment into real estate?

  • Are you interested in owning an asset outright towards the end of your Single Family Home Mortgage?

  • Are you drawn to the cash flow of a paid off rental?

  • Do you want something tangible to own?

  • Are you looking for an asset to pass along to your kids?

  • Does the idea of somebody else paying off your mortgage for you interest you?

If you answered yes to any or all of those questions, a rental property will certainly do that for you - At the end of your mortgage, you will own your rental, it will be cash flowing, the property will be in your name, it can be passed along to your kids and you will reap the rewards of somebody paying off your mortgage for you.


The rest of this article is meant to give you some additional information and concepts in deciding if your interest in real estate investing should end with a rental. To recap, some of the intangibles you may want to consider when deciding on investing in a rental property are:

  • Time Investment

  • Financial Risk

  • Tax efficiency

  • Value-Add

  • Active Management

  • Future Growth Prospects

To this list, we are going to add some key financial considerations when choosing between these two types of investments:

  • Total Interest Paid

  • Deleveraging

  • Ceiling on Value-Add

  • Economies of Scale

  • Capital Expenditures & Maintenance

Purchasing a piece of real estate is a big deal, it is by far the biggest investment anybody will ever make in their life. Using a loan to purchase that real estate turns it into an even bigger deal. As Amercians, buying a single family home has become so ingrained into our culture that it has become part of ‘The American Dream’. And considering we all need a place to live, there are some benefits to owning your own primary residence that can’t be quantified. However my goal is to place a speed bump in the line of thinking that owning and managing a rental property reaps the biggest financial rewards in real estate. That discussion begins with Total Interest Paid. Here’s some numbers:


A $500,000 loan, at 5% interest (a historically low interest rate) will end up costing you $466,279 in interest. Let me say that again, when you take out a loan to purchase a single family home or small residential property, over the course of the loan term you will pay almost double. For a 30yr mortgage, at 5.3% interest, you will pay as much in principal as you will in interest. Total Interest Paid is a massive expense that is often not considered for rental property purchases. Some of you might be saying well I used a 15yr fixed mortgage instead of a 30. Total Interest Paid in that scenario is $211,715. I would argue that number is still significant.


Try your own numbers here with this basic amortization/mortgage calculator to see how much interest you would pay.


If you take into consideration that this interest paydown doesn’t occur evenly over the loan term, a more stark picture is painted. Because of the way an amortization schedule works, interest paydown is weighted heavily to occur towards the beginning of a loan, the first 10-15 years. Meaning if some sort of life situation occurs or if you simply wanted to reposition your equity into something else, all of that paid interest is gone.

The momentum gained from continuing to pay your mortgage evaporates the moment you decide to sell - the bank received hundreds of thousands in interest, yet never had to hand over title.

Deleveraging

Another important consideration is the deleveraging that occurs the longer you hold onto a rental property. As you (or your tenant) pays the mortgage, a portion of each payment goes towards the principal balance. While on the one hand, every payment partially contributes to the equity growth, the other hand reveals the property is becoming deleveraged. The reason rental property investors perceive good returns is because of the leverage they used in the first place. They are using a relatively small down payment to control an asset that is 4x-10x the size. Any gain on that asset is passed directly to the owner. However over time, that leverage is translated into equity all the way until a point where the loan is paid off, and the SFH is owned outright. At that point, your investment is earning 3-4%, the long term appreciation rate on single family homes.


One way around deleveraging is taking that equity and reinvesting it into another rental property. By doing this its possible to ‘releverage’. The caveat of doing that is additional closing costs, mortgage fees, broker commissions, impact on your debt to income ratio/credit risk, and in a sense you are now running a business. Again, you’re encouraged to ask yourself what your long term goals are. If wealth accumulation is the goal, commercial multifamily offers a different route in getting there.


Ceiling on Value-Add

The reason why real estate investing can be so lucrative compared with other investments can be boiled down to a few core reasons. Leverage is one, Value-Add is another. The big boys of real estate investing are developers. Developers assume large amounts of risk and costs up front to build brand new commercial properties. At the far other end of the spectrum are institutional investors who purchase Core and Core-Plus assets where that risk is all but entirely removed. Somewhere in the middle are Value-Add investors, where fyre CAPITAL operates.

The biggest gains in real estate investing are found in the places where the most value can be created. A developer creates value from the ground up, Value-Add investors create value from the inside out.

The reason value-add investors can create such wealth is this process of value creation. Value creation through renovations, property improvements, and operational efficiencies lead to great returns for our investors. We focus on this very specific time window in the life cycle of a real estate investment. Once completed, we repeat it from property to property. So in a sense, we ‘live’ in that most lucrative phase of the real estate life cycle. We are not buy and hold investors, holding onto properties for 30 years. The more time we spend inside that buy and hold window, the less opportunity we have to create value.


A rental property investor’s time horizon is much longer and more closely resembles a buy and hold strategy. There may be opportunities to incrementally increase the value of a SFH, but the vast majority of time spent on the property is not in that heavy value creation phase...it is in the hold phase. For this reason, investments in commercial multifamily value-add properties can be much more lucrative than an investment in a buy and hold rental.


Economies of Scale

Economies of Scale is the name we give to the cost savings, buying power, and revenue multiplication that comes with owning properties with unit counts in the hundreds. Most of the properties we acquire are 200-500 units in size.

  • It’s cheaper to purchase 500 Moen faucets on a per unit basis than a single purchase for one home. Those savings are passed onto our investors in the form of returns.

  • Our property management fees are a fraction of our Net Operating Income. Rental property owners routinely pay 10%, we pay 3-4%.

  • Materials costs, construction bids, and virtually every other expense related to physical improvement is a small fraction cost on a per unit basis compared to a rental property.

  • Economies of scale extends to operational efficiencies as well.

Capital Expenditures & Maintenance

Over time throughout the life of a buy and hold strategy in rental properties, expenses will come up. Often these expenses are large and/or unforeseen. These cash outlays for capital improvements often go underestimated or unaccounted for altogether. Once a capital expenditure hits, years of cash flow can be wiped out. When we take a step back and look at the overall financial picture over the life cycle for a property, often we can be surprised on what the profitability was.


In conclusion, rental property investing can make sense under the right circumstances, with the right management. But if total wealth creation is the goal, we are partial to commercial multifamily. If owning a property is your goal, for the sake of owning a property, perhaps rental properties are for you. An alternative long term strategy is to invest in an asset that will grow and appreciate at a potentially much faster rate.

If the day comes when you’d like to own a property outright, pay cash for it. In this way, you can avoid an interest expense that will virtually double the cost of your property.

Summary

A close examination of your investing goals is mandatory in determining which real estate investment is right for you. Intangible considerations between a rental property investment and a commercial multifamily investment include Time Investment, Financial Risk, Tax efficiency, Value-Add, Active Management and Future Growth Prospects. Tangible differences between the two include Total Interest Paid, Deleveraging, A Ceiling on Value-Add, Economies of Scale, and Capital Expenditures/Maintenance. When taking a step back and considering the long term financial profile of investing in a rental property, there are many financial considerations to take into account.


Invest with fyre CAPITAL

fyre CAPITAL is a commercial multifamily investment firm. We purchase and/or partner in 150-600 unit, value-add apartment communities in fast-growing Tier 1 & 2 U.S. markets. Together with our strategic partners, fyre CAPITAL represents over 500 Million Dollars of successful real estate acquisitions. Our developers, sponsors and capital partners have amassed a network of over 1,500 unique investors. We provide new opportunities to invest in projects targeting a 14%-21% Internal Rate of Return . If you would like to join us on our next project, your first step is to Submit an Interest Card. We look forward to partnering with you.