So You’re Thinking About an ADU
With San Diego’s aggressive promotion of Auxiliary Dwelling Units (ADUs), the topic of owning rental properties has come up a lot recently. Besides the need for additional housing here (and just about every other major metropolitan area in the country), there are some key advantages to owning rental properties, namely:
- Steady, inflation adjusted income. If your property is rented every year and you raise the rent on your property every year, your income will likely keep up with the cost of living.
- Inflation adjusted asset values. If maintained, your property value will track inflation over the long-term.
- Tax deductions. The federal government offers some significant tax advantages for owning real estate. You get to shelter some of your income using the depreciation expense and any interest of your mortgage is deductible, as are most expenses of owning the property.
That said, owning and renting (and managing) your property is one of the more complex ways to invest. Buying real estate is a relatively complex transaction and managing the properties can become a full-time occupation on its own. A single property, or even a few in the same community, is not diversified either by type (e.g.: office, residential, commercial) or by location. It’s very illiquid – hard to sell or get your money out of it.
I’ve had a few conversations with friends and clients who own rental properties recently. Here are some paraphrased quotes from these conversations:
“I don’t dare raise the rent; I have to live next to these people and I don’t want to make them angry.”
“I haven’t raised the rent on my tenants because it took me so long to find a good one and I don’t want to lose him.”
“The property was so beat up it took us months to fix it up again and get it back out on the market.”
“That guy’s dogs are destroying the place and he’s not even supposed to have pets!”
These quotes illustrate some of the downsides to owning rental properties.
- Failing to raise the rent. Whether it’s fear of losing a good tenant or concern about angering a neighbor, this eliminates one of the most important benefits of real estate: inflation adjusted income.
- Deferred maintenance. If you aren’t maintaining the property, it isn’t maintaining its value. This weakens one of the other benefits of property ownership: an asset whose value adjusts with inflation. The longer you put off maintenance, the less favorably your property will compare with similar properties in the area. Also, pulling your property off the market for an extended period of catch-up repairs means you aren’t getting that income, either. If you do the repairs yourself, it’s likely to take longer than if you hire professionals to do the work, causing a trade-off between higher maintenance costs or lower income.
- Maintenance. If the toilet clogs in the middle of the night, the landlord (you) need to get it fixed.
- Some tenants will take advantage of you or just might not be good neighbors. Whether it’s dogs, drums, or drugs, they may know the law better than you, or at least well enough to drag the eviction process out for months. This can be especially problematic if they’re living in an ADU in your back yard.
Professional management can help mitigate some of these risks, but at a higher cost (and thus lower income). You should also build in estimates for vacancy and maintenance when you plan your rental purchase, to help evaluate whether the price you pay for the property represents a reasonable return on your investment.
Real estate can be an important investment portfolio diversifier, since the returns (income plus gains) can be comparable to stocks, but often occur at different times (low correlation). You don’t have to overpay for that diversification. The Vanguard Real Estate ETF (an exchange traded mutual fund) that tracks Real Estate Investment Trusts costs 0.12 percent per year with no up-front commissions (and you don’t have to do the plumbing, either).
This column is prepared by Rick Brooks, CFA®, CFP®. Brooks is director/Investment Management with Blankinship & Foster, LLC, a wealth advisory firm specializing in financial planning and investment management for people preparing for retirement. Brooks can be reached at (858) 755-5166, or by email at rbrooks@bfadvisors.com. Brooks and his family live in Mission Hills.
Category: Architecture, Finances, Housing, Local News, Real Estate
