Why rental homes are solid investment

Some months ago, I was speaking at a large real estate conference in San Francisco. After I gave my talk, as I was standing at the back of the room listening to the next speaker, a real estate broker from Marin County asked me if I thought rental houses are still good investments.

We commiserated about how difficult it is to buy a rental house that commands enough rent to pay its expenses. Then he told me how he had had recent success buying break-even rental houses in Sonoma County.

I'm a longtime rental house investor. While I drove home from that meeting, I thought about why rental houses usually make such great investments. In most cities, rental houses don't produce enough cash flow to be called terrific investments. But sound, well-located rental houses have an advantage few other investments can match: terrific long-term market value appreciation.

Additional rental house advantages include the tax benefits and leverage opportunities. (Real estate leverage means investing a small amount to control a property, borrowing the rest of the purchase price secured by a mortgage, and probably earning a big profit.)

What has been your best investment? A hot stock? Your own business? Perhaps your house? For most of us, our personal residence has been our best investment. Although there are temporary ups and downs in home market values, the long-term trend is always up. But there are plateaus along the way. Sometimes there are even dips in market value, usually caused by local economic conditions.

Coming out ahead

Consider how much you invested in your down payment when you bought your home. For most of us, it was 10 percent or less. On average, the National Association of Realtors reports home values now appreciate about 5 percent a year. That means on my 10 percent down payment, if my home went up in market value 5 percent in the past 12 months, I earned a 50 percent return on my investment.

Sure, I had to pay the mortgage payments, property taxes and maintenance. But those costs, especially after the itemized tax deductions, are about what it would cost to rent an equivalent house or apartment.

But the big advantage of home ownership is building equity. If owning one home is such a great investment, why not own several? Better yet, why not get my rental house tenants to pay my carrying costs? That is the basic reason why so many investors own one or more rental houses.

The way I, and most rental house investors, got started was to keep a former home when moving to a better residence. My first property purchase was a triplex where I lived in the front house and the rent from the two back apartments paid most of the expenses.

However, I got tired of living so close to my tenants. And I wanted to move to a better neighborhood. So I rented my former residence and moved to an upscale area. Meanwhile, I enjoyed receiving the rent checks from my tenants. After my tenants in the front house kept pestering me to buy the property, I eventually caved in and sold it to them for roughly five times my original purchase price. But, looking back many years later, I never should have sold because today's market value is at least four times my far too-low sales price.

The point of this example is the real profits of owning rental houses are the long-term profits. Even if there is a modest negative cash flow (meaning the expenses exceed the rent income) during ownership, that's all right as long as the rental house is going up in market value.

There is a huge difference between investing in rental houses and investing in other income properties, such as apartments.

The market value of apartments, and commercial income properties, is determined by their ``cap rate.'' That means net operating income divided by the property value. To illustrate, suppose a small apartment building produces $10,000 annual net operating income and its seller is asking $100,000 for the property. That's a 10 percent ``cap rate.'' However, suppose the seller is asking $150,000 for the same property. Now the ``cap rate'' or return on sales price drops to a 7 percent capitalization rate.

Viewed another way, if you know local income properties sell for a 9 percent ``cap rate'' and an income property produces $12,000 annual net operating income, it is worth about $133,000. The higher the cap rate, the lower the property value.

By contrast, single-family rental house valuations have nothing to do with ``cap rates.'' Instead, they depend on recent sales (not asking) prices of comparable nearby houses. Unlike apartments and other income properties, the market value of rental houses has nothing to do with their rental income.

That's why many rental house investors are willing to carry a negative-cash-flow rental house if it is gradually increasing in long-term market value.

Tax deductions

Just to add more excitement to investing in rental houses, there is a little secret that most prospective rental house investors don't understand.

Unless you earn more than $100,000 annual adjusted gross income from your job and other ordinary income sources, you can deduct up to $25,000 tax losses from your rental property from your ordinary income, thus reducing your income taxes.

Most of this tax loss from rental houses and income properties is from the special non-cash tax deduction for depreciation. Depreciation is defined as a non-cash deduction for estimated wear, tear and obsolescence.

But there is a disadvantage to investing in rental houses. This disadvantage is known as ``tenants and toilets.'' That means the investor must manage the tenants and the property maintenance.

After more than 35 years of renting to tenants, I can report most of my tenants have been excellent to superb. But a few were awful. Fortunately, the 95 percent good tenants helped pay for my rental house investments. The key to successful rental houses is screening tenants very carefully before they move in. In addition to running credit checks and verifying employment, the most important test is to phone the rental applicant's two previous landlords.

The key question to ask is ``Would you rent to your former tenant again?''