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The Business of Renting Residential Real Estate

I am often surprised at how individuals evaluate risk when making business and investing decisions. All too often, only one side of the risk equation is ever considered and a comparison of alternatives is often ignored.

If you are considering purchasing a home and offering it for rent, you should be aware of the risks associated with real estate investing and evaluate them against alternative investments.

Comparing Returns

From 1978 until 2003, the average annual return on residential real estate has yielded less than a 6% rate of return. Compare that to the 8.6% return of the Toronto Stock Exchange for the same period, and you can see that historical returns less than stellar. However, that comparison only takes into consideration the increase in value of the real estate and ignores the rental income.

Add In Rental Income & What Happens

Assume that the average annual increase in value of  real estate is 6% and after you cover all of your direct rental and maintenance costs, you have a net rental income of $12,000 a year. If the cost of the property was $200,000, your annual return on your investment is 12%!

Now 12% sounds much better than the 8.6% you might expect from the TSX. However, in reality, the difference amounts to only 3.4% or $6,800 a year. This 3.4% we call a risk premium. The risk premium needs to be compared to the amount risk we assume in a particular investment!

Diversification Risk

The main risk of real estate investing for the average individual is diversification risk.

Diversification means that you own a basket of investments and if one of the investments fails, your overall portfolio should not fail. The more investments you have in your portfolio, the lower your overall risk. Similarly, the more investments in your portfolio, the less likely you are to beat the market.

Having a single rental property as your only investment is highly risky: If the housing market falls (and they often do), how long will it take to recoup your original investment? In the above example, I question whether a 3.4% risk premium is worth it. On the other hand, if the property cost only $100,000 the additional risk may be worth it.

Rental Market Risk

This is the risk that the rental market in your area collapses and you are unable to find a tenant for your property. Before jumping into to the rental market, you should determine what the vacancy rate is in your area.

A vacancy rate of 2% means that you can expect to have your property vacancy for less than a month at any given time.

Default or Credit Risk

This is the risk that your tenant fails to pay their rent on time and you have to undertake proceedings to evict them and collect your rent.

Leverage Risk

Many people use a mortgage to acquire real estate. While the effects of leverage are impressive, the risks associated with leverage are equally impressive: If your mortgage payments exceed the amount you are collecting in net rental, you could have a cash flow crisis.

Additionally, if the value of residential real estate falls, you could end up with a mortgage that is worth more than the property purchased. This may post a challenge if you decide to sell your property.

What Tax Software Should You Choose?

If you have rental income or have investment income (interest dividends or capital gains) to report, you should be using TurboTax Premier Edition (Formerly QuickTax) [1]. You can use the on-line edition for only $29.99 per return or you can download the CD version to use on your computer for $69.99 (the CD version lets you prepare up to 12 returns!).