By Mark Ward, CFP®, ChFC®
Vice President & Chairman, Investment Policy Committee
This is a hot topic in Austin right now, but the answer to this question is not as simple as you might think. Like many financial questions, it depends mightily on a number of variables, not the least of which is the personal situation and experience of the person asking.
We are big believers in highly diversified investment portfolios, and several of us at Lucien, Stirling & Gray own investment properties ourselves. Many of us also invest in the sector through real estate funds. So if you are asking yourself this question, or if you know someone else who is, you might find some valuable food for thought in this newsletter.
First, we’ve found that most people are focused on their busy lives and careers, and they don’t really have the time or interest in becoming knowledgeable real estate investors themselves. For these folks, we usually recommend hiring experienced professionals by allocating assets to professionally managed real estate funds. When looking at broad national averages, funds in this asset class have historically produced returns similar to those of private ownership of real estate, but without all the direct costs, responsibilities and headaches that can be associated with “doing it yourself.”
At the other end of the risk barbell, we also know people who operate in the more speculative end of real estate investing by engaging in “flipping.” Success in this area requires taking considerable risk, and generally demands a great deal of specialized knowledge and/or skills. One should have both a thorough and realistic understanding of the price to quality ratios in the specific market or neighborhood. It’s also crucial to have good working relationships with timely and trustworthy general contractors and/or subcontractors unless one has these specific abilities oneself. Additionally, one should be very aware of the rules and regulations for building and remodeling in the jurisdiction, and a thorough understanding of how to work the permitting processes.
Those things being said, if you are convinced you are ready to be a landlord we believe the following considerations should be part of your thought process:
First, let’s start by pointing out a common misperception, and that’s the belief many have that they made better returns on their personal residences during their lives than from their stock and bond market investments. I say this because I know how terrible most people are at comparing results between the two. For example, investment account results are tracked for you by your custodian. They keep track of every dollar in, every dollar out, and they often calculate your internal rate of return. The only thing they do not do for you is track your personal after-tax return. In contrast, I have yet to meet a homeowner who kept track of every dollar of maintenance or improvement that went into the property, the interest they’ve paid over the years, the closing costs at original purchase and any subsequent refinancing, and the cumulative taxes paid during the ownership period. This means they have no accurate way to track their actual return on investment. People instead tend to remember only what they paid for a house initially, and what they then sold it for much later. They then use those two end points as a rough (and completely incorrect) means of calculating how much money they made. So please set your return expectations appropriately.
Next, be aware of the tax implications of your actions before you make your investment decisions. Misunderstandings in this area can cause painful monetary consequences if you are not prepared. Here are some common examples: I have seen people keep a former residence and convert it to a rental, not realizing that after just a few years they permanently lose the valuable ability to sell it without paying capital gains taxes on the sale. I have also seen people miss out on the ability to utilize a 1031 exchange when selling one investment property and upgrading to another, which would have forestalled some or all of the taxable gains on the property where allowed by rule. Further, I have seen people buy a vacation home with the expectation of writing off the interest on the loan, and then unknowingly renting the property out for more than 14 days a year and therefore losing the write off. The good news is that these tax errors and many others can easily be avoided by checking with an experienced advisor. Other important considerations have to do with various ownership structures such as sole proprietorship or LLC; understanding how to depreciate property; understanding allowable versus non-allowable write-offs; and how to file the taxes depending on ownership structure. If you have not figured it out yet, a great CPA is likely a very good idea if you want to venture down this road.
Another big consideration is how to manage the rental property once you own it. Are you going to do it yourself? Or does it make sense to pay to have it managed by a property management organization or perhaps a trusted real estate agent? Either way, make sure you get good advice on how to structure the rental agreements, how to insure the properties, how to insure (or not) the plumbing, HVAC, and required appliances under Texas real estate law, and how to solicit, identify, and then choose good renters without doing anything that could be considered discriminatory. Then make sure you fully understand the renter’s rights as mandated by the state, especially the provisions concerning an owner’s rights to access the property while it is occupied. You will want a good resource for on-going market analyses when your leases come due, so that you avoid under-charging or over-charging rents. You will also want the ability to run background checks so you avoid known problem renters. You will need to develop a good record-keeping system to help make your tax filings easier, as well as being able to calculate your return on investment from time to time just to make sure your investment is meeting your expectations. Lastly, I recommend you set aside enough capital to be able to carry your property during periods where it might be unoccupied. I know that might seem like a foreign concept in Austin’s current “hot” rental market, but I assure you that eventually those times will cycle through again.
To conclude, the main point I want to get across here is that like all investments, knowledge is also power when it comes to real estate. So if you develop an interest in direct investment in real estate, please remember to run it by your Advisor here at Lucien, Stirling & Gray so we can help you ask and answer the right questions of yourself. While knowledge by itself is no guarantee of success in any investment, it can help you set realistic expectations for your level of involvement, and perhaps increase your probability of success.