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There are many reasons to include single-family rentals (SFRs) as part of an investment portfolio. You can even make SFR investing your full-time occupation, as I have done. Overall and long term, real estate has always been a safe investment vehicle with limited volatility. After all, as Mark Twain said, “Buy land; they’re not making it anymore.” But two of the greatest advantages to SFR investing are leverage and taxes.
Simply put, leverage is using borrowed capital to increase your investment capacity. While the amount of leverage you can get depends on a number of factors including the value and condition of the asset and your personal credit situation, it’s not uncommon in real estate investing to be able to leverage your available cash by 80% to 90%.
Let’s say you have $15,000 available to invest. If you put that into the stock market, you can buy $15,000 worth of stock. The stock market can be highly volatile — with big gains come big risks. If you used that $15,000 as an early Apple or Amazon investor, you hit the jackpot. If, instead, you invested in Theranos (as many did), you wouldn’t have a penny left.
What if instead of buying stock, you leveraged your $15,000 of available cash in the form of a mortgage and bought a $150,000 house as an SFR investment? If you bought that home in 2007, it might have dropped 33% in value during the Great Recession, but if you hung on to it, your investment is likely worth more today than when you bought it.
The adage “Location, location, location” definitely affects real estate values. According to data from the U.S. Census Bureau, from 1970 to 2017, median homes in places such as Washington, D.C. (352%), and California (249%) have appreciated substantially more than in areas such as Ohio (30%) and Michigan (41%), but let’s look at how even modest returns affect a leveraged investment.
Asset Appreciation Increases Leveraged Investment Returns
Over time, the Dow Jones Industrial Average has gained about 7% per year. Let’s assume a midmarket real estate return of 3.5%. Compounding over 10 years, your stock market investment will be worth $29,507, a gain of $14,507. On the other hand, your $150,000 SFR property will now be worth $211,590, for a gain of $61,590 on that same $15,000 investment. If you sell or refinance at that point, you could acquire property worth $615,900. That’s how wealth is built.
Of course, this is an oversimplification, and SFR investing is not risk-free. But this does demonstrate the power of leveraged investing. A smart SFR investment will generate enough monthly cash flow (rent) to cover your mortgage and other regular expenses such as insurance, taxes and repairs. It is also important to plan and budget for unexpected expenses such as lost rent when you have a vacancy and major repairs such as appliances and roof.
When (not if) we enter the next negative economic cycle, the value of your SFR investment could go down, but as long as you’re still collecting enough rent to pay your expenses, you’ll be able to weather your paper loss until the market rebounds.
Leveraged SFR investing also gives you the opportunity to grow and diversify your portfolio by investing in multiple properties and even geographic areas (although long-distance management adds challenges and risk). And if you’re thinking, “Great, but where am I going to find a house for $150,000?” there are many markets in the country where good SFR investment properties can still be found for well under this price. This is even true in high-value states such as California, Texas and Colorado, although you’ll need to look at second-tier markets such as Ridgecrest, California; Abilene, Texas; and Pueblo, Colorado.
Taxes, Taxes, No Taxes
You should, of course, consult with your accountant or attorney about your specific situation, but there are also significant tax advantages to SFR investing. As business property, real estate is a depreciating asset. This means you may deduct noncash expenses for depreciation each year. Your mortgage interest is a deductible expense, as are all expenses needed to run the property, such as repairs, and to run your rental business, such as your mileage to the property to collect rent. Unless you are a real estate professional as defined by the IRS, you cannot deduct more of a loss in a given year than your rental income, but any loss carries forward to future years and can reduce the taxable gain if you sell and cash out.
The net result for many SFR investors is that they are able to generate positive cash flow every year, without having an immediate tax burden. Using a process called a 1031 exchange, you can also sell real property investments, including SFRs, invest the profit into a new real property investment and defer all gains on the profit of the sale indefinitely (or until Congress changes the rules).
SFR investing is not for everybody, and in order to be successful, you have to actively run your rental business, find good tenants, perform appropriate maintenance and improvements, etc. Nonetheless, because of the combined advantages of leverage and tax treatments, real estate investing, and SFR in particular, is a great way to build wealth and prosperity.