Opinions on Rental RE vs Bonds

[Earlyout01]

Hello everyone. I am currently 48 years old and will be ER within the next two years, hopefully. I currently have a very aggressive asset allocation in my portfolio and I know that I need to dial it back a little. I have a high risk tolerance and am in a profession that I could easily go back to work on a part time basis if need be and I am not opposed to that idea.

Therefore, my question is that I am considering purchasing a condo for strictly rental purposes in a coastal area that we will be ERing to. I would much rather purchase that as opposed to adding a higher percentage of bonds to my portfolio. The real estate would provide about a 6% ROI net of expenses and barring any unexpected expenses. Being a condo, I would not expect a great deal of appreciation in value, but conversely, I would not expect much of a decrease in value either in a real estate down turn either.

Currently, the idea of holding a piece of rental real estate that I will be purchasing with cash sits better with me mentally versus holding bonds. I am looking for opinions on if I could consider the RE as down side protection in my portfolio instead of holding that percentage of my portfolio in bonds.

Thanks in advance

 

[Another Reader]

What calculation supports your 6% ROI? Please show your math.

Condos in general do not appreciate as much as single family homes. The values go down more and recover more slowly in a downturn. If this is a vacation/beach area, the decline is often worse. You also cannot control special assessments.

I'm a long time landlord, and I have no interest in buying condos as rentals. I would buy a few if we have another downturn like 2008-2013 and hold them as speculation plays.

 

[sengsational]

Bonds and real estate are two different asset classes. So if you wanted to shift your asset allocation toward hard assets, the decision would probably be to put your money in an REIT vs the condo.

But there's a lot more to it than that. You'd probably be leveraged in the condo (ie, you'd have a mortgage). Sometimes the condo association goes nuts on the fees or rules. Some condos have a limit on the percent of condos that can be rented, or implement that rule later. You'll want to keep yourself out of that mess.

All that being said, I kind of like the idea of having ownership of a hard asset in the real world, as opposed to having one through a few bytes in a database somewhere.

 

[JDARNELL]

I like townhouses with a strong HOA balance sheet in a relatively small number of units (110 or less) I find more mature people or professionals like the convenience of everything being done but don't want to be in huge apartment complexes. Throw in a two car garage, gated area, and they rent all day long at least in my area. A true Supply/Demand issue. Appreciation is not as much as single families, however ROI and steady rental income with minimal turnover is great. You also pretty much know what your downside risk is on repairs.

 

[Meadbh]

First, there are always gotchas in real estate. Beware of unanticipated costs. A good investment is cash flow positive from day one, including any mortgage costs.

Assuming the property is a good investment, it's preferable to use leverage. For example, if the ROI on a property purchased in cash is 3%, the same property purchased for 30% down will have an ROI of at least 6% (depending on interest rates). That's simply a function of a smaller amount invested.

 

[VFK57]

I think if your ROI is 6% and a region where the planned condo located is in moderate to strong rentals demand, go for it. Many REIT stocks would give you a better return 6% to 9% with no hassle to manage it or run into a bad renters. Yet REIT(s) are volatile, sometimes dropping their return and value while a condo is a good hedge against higher than normal inflation.

 

[Earlyout01]

What calculation supports your 6% ROI? Please show your math.

Condos in general do not appreciate as much as single family homes. The values go down more and recover more slowly in a downturn. If this is a vacation/beach area, the decline is often worse. You also cannot control special assessments.

I'm a long time landlord, and I have no interest in buying condos as rentals. I would buy a few if we have another downturn like 2008-2013 and hold them as speculation plays.

Thanks for the reply. I am looking for a lower maintenance place to rent and am not overly concerned about the amount of rental income or the appreciation as long as it is similar to bonds over the next 10 years or so as they appear to be pretty dismal in yield and price for the next 10 years as well, and I know that nobody knows what they will actually do. I'm just looking for some downside protection in my asset allocation.

Here's the math
Typical long term rental pays $1500 per month plus utilities= $18,000 per year
HOA $380 per month=$4560 per year
Real estate taxes=$2400 per year
Income tax on rental income less deductions=$1600 per year
Misc expenses=$500 per year (I know probably too low)
Purchase price $155,000
$18,000(income) - $9060(expenses)=$8950
$8940/$155,000(purchase price)=5.8% yearly return

Let me know what you think. Any other advice is appreciated.

 

[Earlyout01]

Bonds and real estate are two different asset classes. So if you wanted to shift your asset allocation toward hard assets, the decision would probably be to put your money in an REIT vs the condo.

But there's a lot more to it than that. You'd probably be leveraged in the condo (ie, you'd have a mortgage). Sometimes the condo association goes nuts on the fees or rules. Some condos have a limit on the percent of condos that can be rented, or implement that rule later. You'll want to keep yourself out of that mess.

All that being said, I kind of like the idea of having ownership of a hard asset in the real world, as opposed to having one through a few bytes in a database somewhere.

No mortgage. I've checked on the rental restrictions and they are pretty liberal. I strongly agree, HOA's are nuts in general and I definitely like the idea of owning a hard asset over a REIT. You could always have a place to live if the world goes to hell in a hand basket.

Thanks for your thoughts.

 

[Earlyout01]

First, there are always gotchas in real estate. Beware of unanticipated costs. A good investment is cash flow positive from day one, including any mortgage costs.

Assuming the property is a good investment, it's preferable to use leverage. For example, if the ROI on a property purchased in cash is 3%, the same property purchased for 30% down will have an ROI of at least 6% (depending on interest rates). That's simply a function of a smaller amount invested.

Thanks. I understand the math. I'm just trying to stay debt free. It's a mental thing for me.

 

[photoguy]

I am looking for opinions on if I could consider the RE as down side protection in my portfolio instead of holding that percentage of my portfolio in bonds.

Here's a contrary opinion.

I don't think residential real estate provides much, if any, downside protection. In the last recession, RE values (and equities) tanked hard whereas bond prices rose substantially. If people are being laid-off, will you be able to keep renters? what happens if the renter just stops paying and you have to evict/find new tenants? You may experience a loss of income and require capital outlays (if they trash the place) at the worst possible time.

No mortgage. I've checked on the rental restrictions and they are pretty liberal. I strongly agree, HOA's are nuts in general and I definitely like the idea of owning a hard asset over a REIT.

In general, REITS are considered highly overvalued right now. Plus they are more volatile than a total market index fund. I personally would not put any new money into a REIT right now.

You could always have a place to live if the world goes to hell in a hand basket.

Well assuming that it's not your condo that goes to hell. The undiversified nature of real estate scares the heck out of me.

Finally, I'm not saying you shouldn't buy a condo, but just that it's downside protection is not anywhere close to the same as owning a government bond.

 

[VFK57]

To make you feel better about your planned investment, compare SF Bay area 2 br condo vs your': average 2br condo (but not in San Francisco) is about $500K while rent is about $2,500, with property tax aprox $575, Assn fee of $350 and maintenance/missed rent time cost of $150, you would get ROI= 3.4%. Still some people invest.

 

[calmloki]

Thanks for the reply. I am looking for a lower maintenance place to rent and am not overly concerned about the amount of rental income or the appreciation as long as it is similar to bonds over the next 10 years or so as they appear to be pretty dismal in yield and price for the next 10 years as well, and I know that nobody knows what they will actually do. I'm just looking for some downside protection in my asset allocation.

Here's the math
Typical long term rental pays $1500 per month plus utilities= $18,000 per year
HOA $380 per month=$4560 per year
Real estate taxes=$2400 per year
Income tax on rental income less deductions=$1600 per year
Misc expenses=$500 per year (I know probably too low)
Purchase price $155,000
$18,000(income) - $9060(expenses)=$8950
$8940/$155,000(purchase price)=5.8% yearly return

Let me know what you think. Any other advice is appreciated.

I don't see management costs. Think in terms of 10-12% of gross rent as a management cut + maybe first month of each new rental contract.
Also missing vacancy rate in your figures. 5% is a commonly used number.
Your maintenance (misc?) costs are way too low. Carpeting and paint and pretty much anything else a tenant touches will be worn out at about double to triple the rate the same things need replacing in your own home. Cleaning between tenants? Just checked - in 2015 our rental expenses were equal to 38% of the income we received. - that number is exclusive of any management costs or mortgages (we're free and clear) and values any time we spent on the rentals at $0.

In the last two months we have had a perfect storm - college students graduated/went home for the summer, leases expired and weren't renewed, an eviction, another couple "urged" to leave, a tenant moved to assisted living, a long term tenant died in her apartment during the weekend of the 4th, dealing with apartments that had belongings left behind, damage done, normal re-carpeting and repainting, advertising and dealing with hundreds of applicant calls, texts, and emails, multiple showings, vetting applicants - this while keeping up with the normal tenant calls for service, repairs and complaints. In total, eleven apartments and a house went vacant; we're down to the house and two apartments left to fill with solid applicants for the apartments - but first the deceased's belongings need to be removed.

I sure don't mind cashing the rent checks and have done so for a living for over 30 years - but its not quite the same as bond income.

 

[Another Reader]

Thanks for the reply. I am looking for a lower maintenance place to rent and am not overly concerned about the amount of rental income or the appreciation as long as it is similar to bonds over the next 10 years or so as they appear to be pretty dismal in yield and price for the next 10 years as well, and I know that nobody knows what they will actually do. I'm just looking for some downside protection in my asset allocation.

Here's the math
Typical long term rental pays $1500 per month plus utilities= $18,000 per year
HOA $380 per month=$4560 per year
Real estate taxes=$2400 per year
Income tax on rental income less deductions=$1600 per year
Misc expenses=$500 per year (I know probably too low)
Purchase price $155,000
$18,000(income) - $9060(expenses)=$8950
$8940/$155,000(purchase price)=5.8% yearly return

Let me know what you think. Any other advice is appreciated.

You are missing vacancy and collection loss. Maybe 5 to 10 percent. Survey property managers in the area and see how many units are for rent in your target complex and competing complexes. What was the vacancy rate in the last downturn? What is tenant quality like? Are there a lot of low grade tenants that skip out without paying or damage the property? Use a number that represents an average of vacancy and collection loss over time.

Your HOA captures some exterior maintenance and repairs. You are responsible for things like paint and carpet, appliances, and fixtures. Paint and carpet are good for 5 to 7 years on average. Appliance lives are 8 to 15 years. Your liability insurance (separate from the complex's, which is probably included in the HOA) may be expensive, as a plumbing leak or fire in your unit will result in claims from adjoining units. Do you need hurricane insurance? $500 a year for repairs, maintenance, and capital improvements for which you are responsible is much too low.

Check the financial status of the association. How well is it funded? Dues hikes over the last few years? Special assessment history and are any planned? How is the maintenance of the common areas and facilities - will capital improvements be needed soon? Your returns for a given year will drop dramatically if you have a $5k special assessment and a two month vacancy.

Income tax is not a property expense. ROI is generally calculated pre-tax.

The minimum rent to value ratio for residential investment properties is one percent for most investors. A lot of investors require a higher rent to value ratio for condos because of the risks.

Real estate is not bought for downside protection. Look at what happened from 2008 to 2013. You buy real estate for cash flow and appreciation over the long term. If that's not your investment objective, look elsewhere.

 

[FreeBear]

Thanks for the reply. I am looking for a lower maintenance place to rent and am not overly concerned about the amount of rental income or the appreciation as long as it is similar to bonds over the next 10 years or so as they appear to be pretty dismal in yield and price for the next 10 years as well, and I know that nobody knows what they will actually do. I'm just looking for some downside protection in my asset allocation.

Here's the math
Typical long term rental pays $1500 per month plus utilities= $18,000 per year
HOA $380 per month=$4560 per year
Real estate taxes=$2400 per year
Income tax on rental income less deductions=$1600 per year
Misc expenses=$500 per year (I know probably too low)
Purchase price $155,000
$18,000(income) - $9060(expenses)=$8950
$8940/$155,000(purchase price)=5.8% yearly return

Let me know what you think. Any other advice is appreciated.

Perhaps 5.8% is best case. More to consider:

Allocation for vacancies?

Allocation for depreciation (need to updates, replace broken/outdated appliances, painting)? Are you handy and willing to put in sweat equity or do you have to pay $$$ someone?

Management fees or will you self manage?

The really scary $$$ thing about HOA's are "special assessments". On $250K units, friends have been hit with $5K, $10K, even $25K special assessments. Sure these are only perhaps one in twenty year events, but they happen. Taller condo, esp. high rise w/ elevators can be most exciting; everything seems to cost a bundle. These seem impossible to predict, even by the current owners, board members, and management. You are held hostage as an owner...

FB

 

[Another Reader]

Oops, I forgot management. You may self manage (i.e. do the job that is typically farmed out), but property management generally runs 8 to 10 percent a year. It's a property expense, which you choose to avoid by self-management.

 

[jkern]

I may have a different experience from others due to where I live (SF Bay Area), but Rental RE has been very very good to me. I currently have 3 condos that net a 10% ROI. They have also doubled in value over the last 5 years. Vacancy rate is ZERO. During a turnover, I'll do a walk through with the old tenant and 1 hour later a walk through with the new tenant.

If the condo complex is good, HOA financially strong, and a strong rental market, I say go for it!

 

[Another Reader]

I may have a different experience from others due to where I live (SF Bay Area), but Rental RE has been very very good to me. I currently have 3 condos that net a 10% ROI. They have also doubled in value over the last 5 years. Vacancy rate is ZERO. During a turnover, I'll do a walk through with the old tenant and 1 hour later a walk through with the new tenant.

If the condo complex is good, HOA financially strong, and a strong rental market, I say go for it!

The Bay Area, Manhattan, and a few other places have ideal rental markets. If the properties doubled in value in the last 5 years and you bought them back then, the return on the current value is much less. Are the investments leveraged or free and clear?

 

[pb4uski]

Bonds and residential real estate are two different animals.... but if your property is in a upscale and robust market then it could make sense, especially if you live close enough to self-manage.

Around here residential real estate (tenants) is a PITA... I'd rather invest in Wellesley.... easier and similar return.

 

[jkern]

The Bay Area, Manhattan, and a few other places have ideal rental markets. If the properties doubled in value in the last 5 years and you bought them back then, the return on the current value is much less. Are the investments leveraged or free and clear?

I purchased the condo's in cash and the ROI is based on the original purchase price. Yes, I bought them 5 years ago.

 

[Sunset]

OP - you forgot to include the depreciation (tax deduction) you HAVE to take (or IRS will consider you did even if you don't).

Why this is important, you are retired, you get nice deduction on the unit, approx $5,500 per year.
The problem is when you sell it, you have to reclaim all those deductions and pay 25% tax rate on them, even if your marginal rate is 0%.

So unless your marginal rate when retired is 25% or greater, you lose money on the "benefit" of the depreciation.

 

[Another Reader]

I purchased the condo's in cash and the ROI is based on the original purchase price. Yes, I bought them 5 years ago.

Are you planning on selling or holding? The age-old problem with selling is finding replacements, especially replacements that meet the acceptable income ratio.

 

[Big_Hitter]

I'd get tax exempt bonds, not funds

 

[rayvt]

Owing rental real estate is a job, not an investment.

 

[Big_Hitter]

Owing rental real estate is a job, not an investment.

not if you use a property manager

 

[Earlyout01]

I want to thank everyone for their words of wisdom and advice. I will have to think long and hard before I make this purchase. It's probably going to be more hassle than I want to deal with, especially since I'm still slaving away at 11 hour days for the next year or so with my eye on the ER prize. Maybe I'll reconsider after assessing my free time in ER.