What do you think about rental real estate?
Fritz paid $200,000 for a house in Blue Ridge, GA around 10 years ago while he was still living in the Atlanta area for work. To his surprise he was able to rent out the house 200 days of the year via Airbnb. Other than spending about 10 hours a month to maintain the listing, the rentals paid for his house PLUS provided extra income. Now, Fritz and his better half, Jackie, are living in the house full-time after having retired and escaped the city.
Fritz’s experience really got me to thinking. Bond rates remain at historic lows with no reason to think they’ll increase anytime soon. Bond interest is also taxable fully as ordinary income. So, I wonder if it’d be a superior investment to move your bond funds to rental real estate.
Think about it, if you’re getting 2% on a bond, and right now the 30 year Treasury bond is paying all of 1.67%, after taxes and inflation you’re actually losing money! I’ve yet to meet anyone who invests with the purpose of losing money. So, assuming you’re investing to make money seems maybe bonds aren’t the best bet.
Now, of course, there is no guarantee real estate, especially rental real estate, will appreciate either. However, historically, real estate has increased by the rate of inflation. Yet, the appreciation of real estate is free from tax until you actually sell the property whereas the interest you receive from bonds are taxed when you receive the interest. Interesting, no? AND, price appreciation of real estate compounds whereas the interest on bond is simple interest. Over a long term investment time horizon that difference between simple and compounding interest becomes huge.
Let me explain, inflation is compounding. What costs $1 today will cost $1.22 in 10 years at a 2% inflation. With 2% simple interest, though, what costs $1 today will only cost $1.20 in 10 years. If you look at the same from an investment perspective, what is worth $1 today will be worth $1.22 in 10 years with 2% compounding interest but only $1.20 with 2% simple interest.
But it gets even worse for bonds. Because not only are you only receiving simple interest it is also taxed at receipt. Let’s say you’re in a 25% tax bracket. In our above example you’re only netting 1.50%, NOT 2% because you have to pay 25% tax on the 2% interest you receive!
So, after investing for 10 years at 2% taxed at 25% you only have $1.15. Your investment in real estate is worth 46% MORE than your investment in the bond and that’s not including tax benefits that go along with being in the rental real estate business, nor does it actually include the ability to use the place to vacation if you so desire. Oh, and don’t forget, you might actually have received some income from renting it too!
Secondly, when it comes to housing, why do you think the prices are so high? Well, low mortgage rates are one thing, I grant that. The other thing though is a lack of supply. It’s not like contractors are throwing up houses all over the country every single day. There is a vast shortage of housing across this land.
Then you have to think of the regulations too. More regulations, the more expensive it costs to build, the less people can afford to buy the home, inherently. Basic economics. Less supply without a correlated decrease in demand leads to higher prices. Oh, and don’t forget, people still have to live somewhere.
Housing is not like other goods where we have a substitution effect. Price of beef is high but you still want meat? Chicken will do. In housing it doesn’t work like that. Can’t afford to buy home? Well, you still need shelter. So you’re other option is to rent. And this leads to another factor in favor of those considering the rental real estate market, more demand from renters. Again, basic economics says that increased demand with a decreased supply leads to…? TA DA, higher prices.
Now here is where it gets interesting for those who have bonds as part of their investment portfolio. How many people actually have the cash flow to buy rental real estate? In this day of insane lockdowns where it seems our government’s intent is on making us all rely on a Universal Basic Income (UBI), there will be less and less people who have the resources, or income, to buy second homes or invest in real estate. That means there will be less competition for you in your purchasing decision. And that could lead to potentially a great buy. And who knows, maybe you could be like Fritz and Jackie and let your tenants pay for your property via AIRBNB.
Be careful though because some states limit AIRBNB businesses. Especially in a community dominated by owner-occupied residents. If that is the case, you might buy something today only to have the rug pulled out from underneath you. You’ve got to be diligent in your research.
When the AIRBNB people dominate the neighborhood, you will be fine. That is why you have to be very careful. Know whether the location you live in or the neighbors are okay with short-term rentals.
If you have some cash flow and you can find an opportunity for $200,000 and put half down and take a $100,000 mortgage, for the rest, this business opportunity may cost you approximately $500 a month. Based on the numbers, it seems like rental real estate could work like a charm.