Rental real estate can be an extremely powerful way to build wealth and generate passive income, but not every rental property is a good investment. In fact, there are several scenarios in which buying a rental property can set you up in a worse position down the line.
To help you avoid unnecessary headaches or getting stuck with a money pit, here are three reasons rental real estate is a bad investment and tips on how to avoid these scenarios.
1. Little to no cash flow
Rental real estate is an investment, one that should be considered for the potential income it can produce today and in the future. Many investors people put a lot of weight on the possible appreciation of a rental property — that is, the increase in the property’s value over time. But appreciation isn’t guaranteed. Markets change, and there is always a chance that the home will be worth less when it’s time to sell.
Cash flow should be equally considered when it comes to evaluating a rental property’s potential. Rather than simply hoping for enough rental income to pay for the property’s expenses and maintenance over time, try to achieve a positive cash flow — the greater the cash flow, the safer it is.
A property that produces $100 in passive income or less doesn’t leave much wiggle room if the market turns and rents slump, the tenant stops paying and you have to evict, or you are slapped with an expensive repair. Focusing on cash flow first means you are guaranteed to earn money today, but hopefully in the future too.
2. Investing in the wrong area
Rental markets are highly localized, with a unique supply and demand for each ZIP code, borough, and neighborhood. Tenant quality, the safety of the neighborhood, and the amount of demand for rental properties in that area will determine if the investment is a profitable and passive one or a total nightmare.
Highly affluent areas with expensive real estate prices may check the boxes for safety but not demand or return. Low-income neighborhoods may produce tremendous cash flow but have higher rates of crime or higher tenant turnover rates. Finding the happy medium between affordability, safety, and stable rental demand is the ultimate goal for buying rental property in any market.
While neighborhoods and the property’s price can have an impact, it’s also extremely important to understand how to vet and underwrite tenants. Have a strict screening process that looks at the complete picture of the tenant, not just their credit score or income, and always follow federal and local laws for screening tenants. Poor tenant underwriting can lead to a nightmare tenant, no matter where your property is located.
3. The rental overextends you
Being overextended on a rental property is not a good position to be in, no matter how lucrative the property could be down the road. It’s important to make sure you go into the investment with enough cash for the down payment, which will be around 20% or more, as well as several thousand dollars in savings to have as a safety net for unexpected repairs or expenses that could arise while you build up capital reserves from rent.
You should never buy a property without knowing you can maintain the debt obligations associated with it on your current income. Economic circumstances can change. Your income may fluctuate, and if the tenant isn’t paying or the property is vacant longer than expected, you are still responsible for it. If you aren’t yet there financially, wait until you have more savings, and don’t spread yourself thin.
Think it through
Rental properties will always be available, with some periods offering more opportunities than others. Be patient and make sure the investment makes sense from all perspectives. Let the numbers drive your decision and make sure you are educated on what to look for and how to evaluate and prevent risks, and you’ll greatly reduce your risk of a bad investment.
The Motley Fool has a disclosure policy.