When you buy real estate as an investment, there are no guarantees that it will turn out to be a good investment. The basic idea behind investing in property is to rent it out at a price that will at least cover your cost of ownership, allowing you to use the rent to pay off the mortgage. Once free of the mortgage, you have a revenue stream and an asset that has value -- sometimes.
The Risk of Monthly Costs
The monthly cost of owning investment property includes the mortgage payments, property taxes, insurance, maintenance costs and possibly the cost of utilities. If the rent you receive is less than your monthly costs, you are operating at a loss unless there is some way to reduce costs, such as refinancing. Check with your accountant to see whether that loss is useful as a write-off on your income taxes. Keep in mind that your monthly costs are likely to rise, particularly if you have the kind of mortgage that can price higher depending on market interest rates or the payment structure of the loan. If you have a destructive tenant or an older building, your maintenance costs can be heavy, and your property taxes might also increase. Your accountant can help you establish a point at which cost increases outweigh any tax savings.
The Reality of Rent and Resale Value
The amount you can charge for rent is governed by supply and demand in your area. Many things can cap or drive down rents, such as a large local employer moving out of the area or an increase in the number of rentals available. You can't depend on being able to steadily increase the rent you charge, and there might be long periods when your property is vacant or you have a nonpaying tenant and the additional costs of eviction. There is also no guarantee your property will appreciate in value -- in fact, it might decline in value. If it is worth less than you paid for it, even if you intend to pay off the mortgage and use the property as collateral on borrowings to buy additional property or fund a business, you will incur loss unless its asset value is supporting much more successful ventures.
How to Know When to Get Out
If you buy a property costing $150,000 with a 10 percent down payment, you have invested $15,000 of your own money and borrowed the rest from the bank. Consider what your alternative returns would be if you had taken that $15,000 and invested it in a conservative investment such as a certificate of deposit or a bond. If you had made a good investment in the property, you should be making at least the same return as you would in one of these other investments. If not, the risk of continuing to own the property, with the possibility of increasing costs and decreasing value, is too great to justify it as a good investment. Create best-case and worst-case scenarios, with your accountant's assistance, so you can see how fluctuations in rental rates, property values, maintenance costs, property tax and your mortgage will affect your investment return. If your property doesn't return more than conservative investments, even in your best-case scenario, it is time to get out of that investment and stop the money drip.
Live to Fight Again
It is possible to find investment property that is actually a good investment, but without considering the stability of rent rates in the area, the condition of the property, the costs of ownership and how everything affects your taxes, you can easily end up losing your property to foreclosure. That is why, if you find yourself in a bad investment, getting rid of it before further damage is done allows your finances to recover and gives you an opportunity to use your hard-earned experience in choosing a different property.
Victoria Duff specializes in entrepreneurial subjects, drawing on her experience as an acclaimed start-up facilitator, venture catalyst and investor relations manager. Since 1995 she has written many articles for e-zines and was a regular columnist for "Digital Coast Reporter" and "Developments Magazine." She holds a Bachelor of Arts in public administration from the University of California at Berkeley.