Having "Passive" Rental Income is NOT part of my financial plan. Here's why.
WRITTEN BY: Gideon Drucker, CFP® AIF® ECA
When I hear a prospective client mention that they're interested in "passive income" via real estate rentals, my immediate reaction is to try and figure out how deep they’ve actually been hoodwinked by this romanticized pipe dream, and if they’re not too far gone to be saved.
From experience, it's just not feasible or appropriate for most of the people that have ever brought it up to me on a first meeting as something they’d like to “get into”. (It's also not necessary....but we'll save that for the end.)
Let's break down why using a real life example.
Let's say you want to buy $500k property in order to turn it into a rental and generate income.
You will put 20% down and finance the remaining $400,000. So, we'll be taking $100k out of your liquid/investable net worth and moving it into a more illiquid/unavailable vehicle. (We'll come back to this.)
(Of course, there's probably closing costs, advertising costs, some maintenance & fix up work that’s required, furniture refurbishments etc. before you can actually put it out there to rent but let’s assume, to keep it simple, that this is the entire up front cost.)
Now you need to find renters. Let's say you get lucky again and find renters immediately so you have very little time of paying the mortgage without receiving rent back...great!
A 30 year $400,000 mortgage at current 7% rates would run you approximately $2,660 per month. So, naturally, you will need to charge more than that to squeeze out that additional cash flow. But wait. You have to account for property taxes, factor in future vacancy rates, and the maintenance work/fixing costs that will come up over time. All of that, conservatively, means you need to charge about 30% more than the rent in order to break even & “run” the rental.
So now, just to break even each month, you no longer need to charge $2,660, you actually need to charge $3,459 before you can start feeling like you truly have “extra” income that your family can benefit from. (Yes, generating adequate rental income becomes an even harder proposition in times of high mortgage rates!)
Now let's talk about the "passive" part. Are you committed to doing all the work yourself? Are you running the property, advertising to find tenants, showing the property, vetting the applicants, responding to maintenance requests, coordinating the repairs, cleaning & staging before each new guest, answering prospective renter emails, collecting and following up on payments, and dealing with legal if there are issues etc?
You could do it all…but make no mistake, it is no longer “passive.” It is a business. Is this what you want to be doing? Is this the best use of your time/energy to maximize your life AND your wealth? Or are you hiring a management company? Because now that's a third party cutting into the margins & the standard property management fees run 10% of your monthly rent…
So, after all of that, and even assuming EVERYTHING goes right, how much extra “income” are you really generating here each month that’s above your costs? $200? $300? $500? We locked up $100k of real capital, which is now unavailable to be used for your family’s OTHER short term financial goals & committed your name to a property for MAYBE that amount of cash flow?!
(Necessary caveat: Of course, it is possible to be profitable in real estate rentals and have this all work out beautifully…I’m absolutely not saying it can’t work. But, my own experience with clients tells me that those that do have successful real estate rental properties have a few things in common. 1. They treat it as both a business & and as a job. 2. They have a sizable cash & investment net worth (at least a $1mm+) BEFORE they look to get involved in any capital-intensive real estate projects!) 3. They inherited the properties and it's already operating like a well-oiled machine as a result.)
Ok, so you might say, “Well, fine, maybe I'm not generating much free cash now...but so what! I’m basically building up equity in a home and I’m not paying anything out of pocket to do so…my renters are doing that for me….that’s a win. I just get to own the house!”
So, this takes us to the second reason that passive real estate investing isn’t usually as great as it’s chalked up to be.
Building up that equity in your house is not costing you NOTHING. It’s costing you the opportunity cost of not doing SOMETHING ELSE... with that initial $100,000 down payment and the $2,660 (plus property taxes, maintenance, vacancy fees etc.) every single month! What else could that money be doing instead of sitting in your new real estate venture? Put even more directly, is the capital outlay ultimately going to appreciate at a better rate than if you had invested that same amount elsewhere?
Let’s see: The S&P 500, representing the stock market as an asset class, has averaged a 10% annualized rate of return over the last 50 years. Housing has gone up about 3.5% in comparison. At these two historical rates, $100,000 put into the capital markets will equal about $1.8mm in 30 years whereas that same $100,000 put into the house on day 1 will be worth approximately $324k when you’re ready to sell in 30 years. (The difference in rate of return on the full purchase price and it’s opportunity cost are even more dramatic.) And that’s not even taking into account that along the way, you have paid property taxes, maintenance fees, housing insurance, liability insurance, normal upkeep costs, home improvements etc.…all of which dramatically lower that 3.5% even further but doesn’t show up in the price when it comes time to sell.
By “investing” in real estate, you’re giving up some dramatic capital appreciation in the hopes that the positive cash flow you generate in income will make up the shortfall? (I’m guessing here as, again, this is not something I would ever do.) There’s a reason that we tell clients (with regards to your primary home) that your home is not an investment…it’s a place to live!
Here’s what it boils down to me though, more than the numbers, the opportunity cost or anything else.
The hassle and “worst case scenario” potential.
Like it or not, when you buy & mortgage a home, whether it’s a primary, a rental, or a vacation home - you are adding a liability to your net worth. You are hoping (and assuming) that you will generate enough rent to offset that liability….but that mortgage bill is coming every single month. You are responsible for paying back that $400,000 mortgage loan whether or not you have stable renters….it is your liability alone.
You are also responsible when a roof leaks, when there’s a water issue, when a tenant wants to get out of their lease early, when 3 nicer Airbnb’s pop up next to you, etc.
There is so much that CAN go wrong that’s out of your control that can devastate even the mediocre returns that you’re hoping to achieve.
I just simply cannot fathom taking on all of the headaches and hassles that real estate can create for you for the sort of returns we’re discussing.
Instead, I can take that $100,000 and add it into my broadly diversified investment portfolio of the greatest companies of America and the world, which has been growing, consistently, at a 10% clip.
There is no maintenance or labor to speak of. There are no property taxes or annoying tenants. There is no “nightmare” scenario in which I lose all of my investment (as stock market declines have only every proven to be temporary - any losses I incur over time would be as a result of my own behavior/decision to sell. The market itself cannot create this loss for me…unlike real estate transactions & real property liabilities).
Then, as I get closer to retirement, and I’m starting to focus more on my need to replace my earned income with “passive” income, I can do a whole lot of things.
I will start drawing down first from the dividends my portfolio has been re-investing for the past 20 years. Then, I will start drawing down principal (which will be made up for the fact that my portfolio is still growing & thus replacing the withdrawals), and then, I will use protected income vehicles like living benefit annuities, cash value insurance, and dividend focused stock market portfolios to enhance the guaranteed portion of my income and protect myself in times of down markets.
I think so many people default to wanting “passive income” via rental properties because it seems “easy”. We all go on vacations. We all understand how it would work to collect a monthly check. On the flip side, NOBODY understands the mechanics of income distribution from one’s investment & retirement portfolios. It’s just not something we learn.
The irony is that THIS is the EASY way to grow your net worth and create a future income stream that isn’t dependent upon the sweat of your brow. This is the way to build up a large enough net worth that you CAN actually live off of your savings & investment returns down the road.
It’s called capital investing.
The CEO’s of the greatest companies of America and the world are allowing you to share proportionally in the growth of their companies without having to justify your returns and without having to share any of your labor, time, or energy to do so. You get to share in the growth of the companies that move the economy forward just by being a common shareholder.
That is passive income. But it takes patience, discipline, and the behavioral fortitude to favor long term wealth over making a quick buck.