Your financial objectives should drive your decision.
As a general guideline you need to determine your long term financial goals first and then structure your investments to help you achieve your goals. If you are thinking about whether you should keep your current home and rent it out and then buy another in my opinion is putting the cart before the horse. Determine your goals first and then see if the rental property is worth while.
My thoughts on real estate investing…
While real estate investing is a valid endeavour you really need to consider if the amount of time you plan on putting into it is worth the risk associated with the investment. The risks of real estate investing as I see them (and this is not a comprehensive list) are:
- Liquidity. Your capital is tied up in property that is not liquid. Should you run into a cash flow crisis you could be forced into foreclosure or bankruptcy even though you have a large net worth. To mitigate this risk you will need to reduce the amount of leverage you have (i.e. but as much down on the properties as possible).
- Vacancy risk. There may be periods where your property may be vacant and you need to plan accordingly to service the property regularly and keep any financial commitments on the property.
- Maintenance risk. Real estate needs maintenance. Over the long term this can and will cut into the value of your property and affect your cash flows. If the value of the property increases over time, remember that you will need to make periodic upgrades to help improve the value as well.
- Tenant risk. You can do all the due diligence in the world but there is still a risk you can have a bad tenant that will not pay or worse could trash your property. Tenants don’t own the property and may not be motivated to care for your property.
- Market risk. Your property value is subject to market conditions and the value of your property can fluctuate over time. Generally, the longer you hold the property the better but values may decrease in the short term.
- Personal time risk. This is one type of risk many may not consider. In some cases the amount of time you spend on your rental property doing maintenance, paying bills, searching for tenant, keeping financial records and doing your taxes may be more than you bargained for. This is not to say that this type of investment will suck all of your free time, but think about how much time you want to invest and how much time you think these activities will take.
- Opportunity cost. Simply stated opportunity cost is the risk that you could have invested your money elsewhere and achieved a better return. That is to say are you better off investing in the stock market or real estate? And are the projected returns better over time?
Finally you should consider your annualized after tax return on investment in the real estate and compare it to the after tax return on investment on a portfolio of all equity securities. In most cases you’ll probably end up earning more in percentage terms on the market portfolio simply because the cost to maintain the property eats into your returns. Build a spreadsheet and compare the alternatives.