FINANCIAL PROBLEM SOLVED!

"Being a landlord sounds good"

Problem

Since interest rates are so low, my wife and I thought we'd buy a small house in a residential area, rent it out, and get income as well as future appreciation. We can afford a 50 percent down payment. Is there any reason we shouldn't do this?

Solution

Don't even consider it if the money you'd spend is part of your retirement assets, you'll need it for major expenses within the next 10 years, or the rest of your investments aren't well diversified. Also make sure you're aware of the potential expenses involved with the house. Have the property inspected to get a better idea of its condition and what may need maintenance or replacement, such as the furnace or roof. Factor these expenses into your calculations for return on investment and purchase price. And keep in mind that you may need to hold the house for a long time to realize any price appreciation. In some areas, the real estate market is at its peak. If you buy at the top, it could take a decade or longer to recoup your investment.

Also consider the time and effort involved with being a landlord. Who will deal with renters who don't pay, frozen pipes that rupture, or routine maintenance? Who'll keep the unit rented? If you plan to hire people for these tasks, factor the costs of doing so into the analysis.

Regarding the rate of return on the property, at a minimum you should expect to earn as much as you could from a real estate investment trust. A number of REITs pay fairly high dividends, and many are quality investments. Moreover, unlike a rental house, REITs are liquid. If there's little difference in current cash flow and expected return, you'd be much better off with the REIT.

If you decide to buy the house, putting down a significant amount of cash will lower your mortgage payments and give you greater flexibility in your rental rates, which will help you be competitive. It will also increase your cash flow, give you more of an equity cushion, and lessen the risk that you won't be able to make the mortgage payments.

I recommend that you put at least 20 percent down, so you'll also avoid private mortgage insurance, which will cut your cost. Making a down payment of 50 percent, however, will reduce your benefit from low interest rates. Essentially you'd be investing your cash for a pre-tax return equal to the mortgage rate. Today that might seem good, but in a couple of years you might regret that you didn't borrow more so you could put your savings into higher-paying securities, instead.

From a tax standpoint, you can deduct most expenses directly related to the ownership and rental of this property. You'll subtract these, as well as depreciation and most professional management fees, from the income the property generates. The net result is taxable to you as ordinary income. Losses may or may not be deductible, depending on several factors, including your adjusted gross income (AGI) and whether you take an active management role in the rental business. Consult with your accountant before buying real estate, so you'll understand the impact of that property on your tax return.

This issue's problem solver is John W. Ueleke, CFP, ChFC, CLU (johnu@legacywealth.com), a financial adviser with Legacy Wealth Management in Mem phis, TN.

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Leslie Kane. Financial Problem Solved! "Being a landlord sounds good".

Medical Economics

May 9, 2003;80:83.