Episode 20: 20 important factors to consider before venturing into rental real estate

In this episode, the host discusses 20 important factors to consider before venturing into rental real estate. They emphasize the importance of understanding the active nature of rental real estate, the entry costs, the amount of leverage, and the need for proper planning and risk management. They also highlight the potential tax complications and the illiquid nature of real estate investments

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Transcript

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Today's episode of retire early retire. Now we're going to talk about 20 important factors you should consider before venturing into real estate

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And welcome to the 20th episode of retire early retire. Now I'm your host hunter Kelly owner of Palm valley wealth management. And this podcast helps hi, earning families and pre-retirees put their money where their values are.

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If this is your first time listening. Go ahead and subscribe to the podcast on your favorite podcasting app. Leave a five star review and share this with a friend as we're still trying to grow this podcast. And again, I just. Really want to add value to your financial world and help you make sound financial decisions through this educational podcast. and if you want more help or you need more help, I love working with individuals through my wealth management firm, Palm valley wealth management. And again, thank you for listening and hopefully you find this one valuable today. like I said, in the intro, we're going to talk about 20 factors that you can should consider before. investing in rental real estate. Was in a mastermind group or a have a mastermind group that I talk with advisors and we do a lot of casework and then working on our business as well. and we often find that our clients are, not considering. Many or any of these factors when wanting to consider real estate? they generally see some stuff on social media or books and all these real estate quote unquote gurus make it seem like, oh, you buy a piece of real estate and boom. You're magically wealthy. And that is not the case. Real estate is hard. as an investment standpoint, finding a good property to make a good return on all the work that's involved. and sometimes you can get overexposed leverage wise, and these are all things that we'll talk about here in just a second. But it's not always as glamorous as it seems.

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Now with that being said, there are a lot of good things about real estate. And what I find the best thing about real estate is, is if you use leverage wisely, Um, that can really help your investment grow much quicker in ways that maybe the stock market can't or other types of investments. So take leverage for instance, right? You go out and you buy a priests piece of property for 500,000. You only put 10% down. So your initial investment is$50,000. Well, if that investment grows by 10%, it is on the full value of that property. Not just the 50,000. Whereas if you put 50,000 into the stock market, And you got 10%. Well, you're only getting 10% of that 50,000. So, um, using that leverage can certainly help grow your wealth more. Now there's a lot more to consider. With real estate. But what people get caught up in is that leverage. And so that's where you can kind of get the blinders and then you don't consider these other factors. And you can get burned quite badly. Right? And so let's hop into number one. One big misconception about rental real estate is a lot of people consider it to be passive income rental real estate is not passive by any stretch of the imagination. So if you think of it, Like a business and not just a, just owning a property or what have you. if you think of a, as a business, you are. Making material key decisions about this property or quote-unquote this business, right? So you're actively working in the business. Even if you have a management company doing the day-to-day work, you need to decide how much money is going in there for repairs and remodels. Finding renters or finding that rental management property. company to manage the property on a day to day or month to month basis. Things of that nature. So it is not passive. If you truly want a passive investment, you either need to go to a. like the stock market. or maybe even a Reed, which is a real estate investment trust where you are hands-off you have. Basically just your cash in those investments. But you are not making any day-to-day or month to month. Year to year decisions about those businesses or those pieces of property. The obviously there are other passive. Investments as well, but those are just two that came off the top of my mind. So again, real estate rental real estate is not passive. and then the next thing to consider is the entry cost. It is not very cheap sometimes to get into these properties, especially with interest rates rising over the last year and a half, two years. the more. Those insure rates have risen. The more you need to put down to get to a point where the mortgage payment makes sense for the amount of rent that you're charging and everything else. you may not have 20, 30, 40, 50, sometimes a hundred thousand dollars to put down. Or if you do, I see people taking money out of their emergency funds and other accounts that are designated for other expenses. Down the road to do this. you don't want to be taking a ton of liquidity out of your financial world to get into this. Uh, real estate that may only net you a few hundred dollars a month or a thousand bucks a month. you really need to consider, okay, how much do I need to put down and how do I get into this? What's the mortgage going to cost me and what can I charge for rent and all of that. And then the next thing is we'll consider the amount of leverage. So number three is consider the amount of leverage. How much am I. Income is going to debt. Right. And so a lot of people, again, don't they just say, oh, I'll get a renter in there. No big deal. Well, if your debt to income ratio is. Significantly higher because you're taking out this mortgage. Get a rental. Oh now. All the income or most of that income that you're receiving for a rent, maybe go into that mortgage. payment. So you may not reap the benefits that you want. So if the objective is to have a little bit of extra cashflow each month, but all of that is going to now this new mortgage. Yes. She may be increasing. your net worth or your investment because the property is appreciating in value, but, on the short term, your negative cashflow or. Or at the very least, breaking even, and. And now your illiquid. From an investment standpoint and you have less liquidity because you had to put money down to get into the mortgage. there's a lot of things to consider, especially around the leverage and how you're going to finance the property. The next thing. That. I commonly see and makes it a big headache for everyone involved the accountant. The person doing the day-to-day accounting, as far as the payroll. I wouldn't call it payroll, but collecting red. And then paying all the expenses, the mortgage taxes and all that. creating a separate bank account. So you have to remember to create that separate bank account. one to make it easy for the IRS know, Hey, this is designated for my rental. makes it easier so that at the end of the year, you see all the rent that came in and all the expenses that went out, whether that's for the mortgage repairs. Taxes. anything that is related to that rental, that's the only thing that touches that bank account. And after that, we need to consider, how do we want to title this property? You are, increasing your risk of being sued, right? one thing that I advise and generally get an attorney involved, if the client needs help with that, As, how do we mitigate this risk? Now we're buying this piece of property. If there's a slip and fall or some sort of injury. Some sort of property damage. The last thing we want is the rest of their net worth. Being at risk of. some sort of liability because of this rental property. So one title and it property, whether we need to put it in a trust or an LLC. that's where we kind of let the attorney come in and take over there. but getting it properly titled, and then getting proper insurance on this, piece of property. So number seven. After, the increase of risk of being sued and title. Titling this property. properly. Is. The increased cost of insurance or getting proper insurance. Right. not often, but sometimes people will make their primary residence. They'll move out of their primary residence and they'll go live somewhere else. And they'll rent. That particular home that they just moved out of, but then not change the homeowner's policy. That is a big no-no. just thinking about it from the insurance standpoint, their view of it. It's an increased risk, right? there's other people living in that house. So now they need a different form or a different type of home insurance. To make sure that they can properly cover this property. if you ever move out of your house and make it a rental, then you want to contact your insurance agent or the carrier that you have to make sure that you can get that switch to more of a rental type policy. And then on top of that, if your net worth is fairly significant, You will want to make sure that you have an umbrella policy. I've talked about this in other episodes, but essentially that umbrella policy is going to cover you over and above any liability. that you have, obviously when, in terms of the policy, the umbrella policy will cover over the amount of insurance you have on that property, on other policies as well. So if you have a.$500,000 liability policy on that particular property. And you get sued and you're liable, let's say 750,000 will. That umbrella policy will cover that amount above$500,000. Right. So very generic example there, a lot of details. I could go through there, but, you want to make sure that you have that umbrella policy too. Again. Decrease your risk of being sued and then having to come out of pocket for any liability that you're responsible for. And so number nine is extra. Estate planning. Right. If you have a property that's out of state, you're going to want to do extra estate planning to avoid probate. If you have kids that are going to inherit this same thing. because it can be, and this is the next point. It could be a real pain in the butt. for your kids to have to sell properties. So there's a client I worked with at my old firm. And she had, I got a small strip mall, commercial property, not in a very, nice part of town. And so the value of it wasn't very high, but it took them. Over a year to get that thing sold. it was a big headache. Ended up selling it for a lot less than what she wanted to because of the headache and everything else. so doing that proper estate planning. Maybe selling the property before you pass away. So have a plan of what you want to do with that property. Talk to your kids. Or whoever's going to inherit that property. Hey, what do you want to do with this property? Do you want me to keep continuing to manage it? And then you take it over or are you just going to sell it anyways? Do you want to sell it? Would you rather me sell it? Because again, selling these properties are not very liquid. especially if it's like a strip mall or something else where there's a higher value in a smaller market for buying those pieces of property. it may take time and effort. just having that conversation with the person that's going to inherit. We'll help you one do the estate planning and to eliminate headaches on their end. when they receive that property. the next thing is it's going to complicate your taxes. So now there's appreciation. You're going to have a profit loss essentially on your tax return. You're going to pay. You're probably a Lusher on the calendar yourself. You're going to have to hire an accountant. Whereas, if you were just a W2 employee, working at some sort of large corporation, you may be able to get away with doing your taxes on your own. but now because of the real estate, you either need to be an expert in how to file real estate tax returns, or you need to hire someone, which, because it's a. An increase. Complexity you'll have to pay more for that tax return as well. Just consider that, Hey, if you want to deal with more tax headache, then you may not want to. Do you may not want to get into real estate, but if that's no big deal to you, well, then that's not a big deal. And it's not a factor. And so the next thing is that the property is essentially ill liquid. in the sense of, if you think about the stock market or you think about funds, that are publicly traded or just cash in general. if you need equity out of that property. Then, and you need to sell it. Well, Let's say you put it on the market and you get a contract on that property that day. The earliest that you're probably going to get those funds are probably 30 days. So again, you just need to have a plan for, I don't. Whether it's, having some sort of emergency fund. If you can't get a renter in, then you have to make mortgage payments while you're waiting on them. Or, not putting yourself in a position where you need to sell that property to fund something else. Right? Because again, at the earliest is probably 30 days before you can get that money. you just want to be cautious that, Hey, this is illiquid. Piece of property. I better not need these, the psychiatry. 2 3, 4 a week later. because you're not gonna be able to get it. The next thing is depreciation and recapture. So this kind of goes along with complicating your taxes. you'll be able to depreciate the property and that's great. That'll decrease your income. toward that real estate property. But let's say you're in a low or incur. Income earning years and you start appreciating. Well, you may be deferring a 12% effective tax rate. 15%. Effective tax rate. And then you go to plan the, sell the property. Let's say 20 years later. And now you're in a 25% effective tax rate. Where you're going to have to pay all that depreciation. Let's say you depreciated it.$250,000 and you go to sell. Well, all of that depreciation is going to be counted as recapture, and you're going to have to pay. ordinary income tax on that recapture. So if you have a higher tax rate, then you're actually not getting Ford appreciation on it. So you just want to be able to plan that out. Right. Making sure that if there is a time period where you're not going to have a lot of income and you want to liquidate these properties, you may want to time it to where your income is very low. So that recapture rate as much lower than. if you were again, making a significant amount of income relative to what you have over your lifetime. And so the next thing is investment risk. a lot of times I see real estate people, whether it's on Instagram, just talking about there. Their portfolio or clients that are work with. they are. Extremely concentrated in real estate, which again, I think real estate is a good investment for a lot of reasons. But just like, I wouldn't advise someone to have 80% apple SOC. I wouldn't advise someone to have 80% real estate. because again, You're putting yourself at risk. If the values of homes or commercial properties, whatever you're invested in starts to decline significantly. Well now your overall net worth and your financial situation is starting to decline significantly. So making sure that you're not overexposed as far as. And investment in real estate. To again. diversify that risk spread that risk over multiple asset classes. So having some real estate, but also having some growth companies, having some international companies. So on and so forth, right? So that your risk of going to zero. Is mitigated as much as possible. And so the next type of risk is location risk or concentration of location risks. I think about wrenchers and Florida or, real estate investors in Florida. You have multiple properties in Florida? Well, what's the big risk and Florida hurricanes, right? And so if you have, let's say 10, 15, 20 properties in Florida. And it's all down in Miami or key west, or anywhere that major hurricanes come in Florida, which is pretty much everywhere. You're at risk for all of those properties, gaining significant damage and you having to file multiple claims on those properties. And not to mention that it's very difficult to get insurance right now. in Florida, because of that reason, all of claims. and all the issues that go along with that because of these hurricanes. if you're looking to get into. Investing in real estate. And you want to have multiple properties, maybe consider spreading them out a little bit more so that the risk of natural disaster, hurricanes, tornadoes, snow, whatever. The. Potential risk is gets mitigated. Just like you would want to diversify. your investments from asset allocation standpoint. Now. Consider the amount of remodels and repairs over time. What I find is most people when they start to calculate their rate of return on these properties, they're not considering all the money that they're putting in over time. Whether that's having to re replace a toilet or AC unit or some sort of appliance in the middle of a renters stay or lease. And then obviously the turnover. So replacing carpet floors, painting. fixing the roof w. Whatever it is in between transitioning to a new renter. And so that can really drag down your investment returns. So as you start looking at properties, One you need to look at well, how often, or how old is the property? What am I going to need to change some of these things anyways? Is it a year from now? Is it 10 years from now? Is the house relatively new? That will help you start to calculate less, take an estimated guess or what I think I will need to put in as far as money and start to estimate. Okay, well, the rate of return is going to be this or that. And maybe it ends up being less than what you get in the stock market, or maybe it's more or slightly more, but you're having to put in a lot more time and effort to. Find renters and do all this work, coordinate all the remodels and repairs and all that. and it may not be worth. That right. So let's say you get an 8% return in a portfolio of stocks or what have you. Versus a 10% real estate, but the time that you put into that real estate kind of negates that extra 2%, it may not be worth it to you, or if you can find a really valuable. Property where you're getting a 15, 20% return. Well, then that may be worth your time. to do all those things. Right. And so just making sure that you're considering all those costs. And then the next cost you should consider are the closing costs. Right? whether that's closing on, A mortgage. Of a property that you just bought. or closing on selling that property, whether you're a 10 31, exchanging it to a new property, or just cashing out that equity, there's always costs associated with that. generally here in Florida, the seller's going to have to pay 6%, three to the, real estate agent that is representing you. And then three to the one representing the buyer. so there's, there's 6% off the top and then there's a closing costs to the title company and all that. Consider those costs as well. And that'll drag down that investment return and. Then also, I just mentioned it, but 10 30 ones, they can sometimes be difficult if you're not familiar with it. So make sure that you have proper representation when you're doing those 10 30 ones, whether it be a CPA or some sort of attorney that works in real estate so that when you do those transactions, you don't get surprised because the IRS thinks that you owe. taxes on that former property that you had before. Those are totally things that you should consider before purchasing real estate. Again, I think real estate can be a great investment for people that want to put the time, the effort and understand how leverage works. But if you don't spend the time and effort to doing that research real estate can really burn you. Whether that's not getting the proper. Ready to return because you're not charging proper rent. Or you don't understand the costs that you put into that property from a remodel and repair standpoint. Whatever the case may be. or just over leveraging yourself and then being in a bind when you, when you don't have rent coming in for a few months. Whatever the case may be. really consider these things. If you wanting, if you're wanting to get into real estate. And if you've liked this podcast, I have more podcasts on financial topics like this. So go ahead and give those a listen. Also give me a follow and leave a five star review on your favorite podcasting app. Thanks again for listening and I look forward to the next one.

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This podcast is for educational purposes. Only. This is not financial advice. This is not investment advice. This communication should not be relied upon as a sole factor in an investment making or financial planning decision. If you would like help, please seek a financial tax legal or insurance professional. Please keep Palm valley wealth management in mind when making those considerations.