Financial markets are cyclical in nature. While the stock markets and the real estate markets have a proven track record of appreciation over time, both markets go through periods during which their underlying assets decrease in value.
Since beginning my career as a CPA twenty years ago, I've seen two significant stock market corrections - a massive one day sell-off during the fall of 1987, and the extended correction during the first few years of the twenty-first century following the tech bubble.
Even after factoring in both sizeable corrections, the Dow Jones Industrial Average is sitting above $12,000, a six-fold increase from its pre-1987 level of $2,000. Anyone who held the basket of 30 Dow stocks since the mid-eighties pocketed a return in excess of 9 percent per year on that investment portfolio over the years.
Real estate has taken a similar path, and is now entering its second major correction in twenty years. The red hot real estate market of the mid-eighties was followed by a steep decline in property values during the early nineties. Over the next ten years, the real estate markets boomed. And today, we won't know the full extent of the current real estate correction until prices once again begin to rebound.
Do you think it's a coincidence that both markets have had two corrections during the past twenty years? Or are periodic downturns just an unavoidable symptom of a cyclical market?
No Sure Thing
Following the tech bubble correction, I had more than a few clients who gave up on stocks in favor of investing in real estate. "You can't make money in the stock market. And real estate never goes down in value," they would explain to me.
"Both stocks and real estate generally make great long-term investments," I would respond. "But real estate can definitely go down in the short-term. Around Boston during the early nineties, they were giving the stuff away to anyone who would take it. Someone even managed to purchase the million square foot Wang Towers for just $500,000 during those years."
Well, all signs indicate that we are in the midst of a real estate correction right now. For property owners, dealing with declining values is tough enough. Here are some other risks and pitfalls associated with owning rental real estate:
Victim of Your Vacancies
A key indicator of the success for any real estate investor is vacancy rates. The less time your units spend vacant, the more rent you will collect.
What happens if you purchase a two-family home, and vacancy rates for residential rentals in the area are running at 6 percent? Owners of large apartment buildings should expect to have six vacant units for every hundred units they own. Because you only own two units, however, you can't possibly match the market vacancy rate in the short-term.
Unless your two family home is fully occupied, there are only two possible vacancy rates for you - 50% or 100%. Over the long-term, the vacancy rates for your two rental units might end up close to the market rate, but those months that you don't have a tenant can be financially devastating.
My brother and I owned a rental condominium for about ten years. Over that period of time, the condo was vacant for about 6 months - or about 5 percent of the time. We survived the six consecutive months with no rental income, but those six months were so financially painful that we ended up selling the condo soon after. (We do continue to own an office condo purchased during the previous market correction that we rent to our CPA firm.)
New Set Of Headaches
Think back to your days as a tenant. When something broke in the apartment, you didn't hesitate to call the landlord to fix it.
Now think about being a homeowner. How tough is it to get a plumber or electrician to come your home to do anything?
Businesses who own a lot of rental property hire people to deal with the repairs and maintenance of their units. When you're a small landlord, you're generally the one stuck with the ongoing task of keeping your tenants happy.
Can't Call "Uncle"
Before the 1986 Tax Act, tax rates were higher than today's rates, and rental losses were fully deductible. If you lost money from your rental property, the government would subsidize a decent percentage of your losses through a tax refund. Thanks to depreciation, you could actually have positive cash flow from your property, and still end up with rental losses and a tax refund from the IRS.
Back in 1986, everything changed for owners of rental real estate due to the introduction to the Passive Loss rules. Allowable rental losses are now limited to just $25,000 per year. Plus, the passive loss rules further reduce your allowable rental losses once your Adjusted Gross Income (AGI) exceeds $100,000, and then fully disallow any losses once your AGI exceeds $150,000. None of these limits have changed in twenty years.
What happens if you're unlucky enough to own a two family property that costs you $2,000 per month to carry, but fortunate enough to earn more than $150k per year? You'll be out of pocket $24,000 each year, and won't be eligible to get any current year tax relief from the IRS.
The good news is that you don't completely lose out on those losses. Any suspended losses are carried forward indefinitely, and can be used to offset future rental gains, including gains realized on the sale of other rental properties. And when you sell a piece of rental property, any unused losses derived from that property are fully allowable to offset your wages and other income.
Lost Tax Break
Many homeowners ask me about converting a principal residence into rental property. For these clients, there is potentially a huge tax pitfall if their home has appreciated in value.
When you sell your home that you have owned and lived in for at least two years out of the five years up to the date of sale, you don't pay any taxes on the first $250,000 ($500,000 if married) of gain realized on the sale of that property, subject to certain exceptions.
So what happens if you decide to hold onto your residence and switch the property into rental use? If you sell the property after renting it out for more than three years, you can no longer exclude paying taxes on the gain (unless you move back into it for a while or purchase a replacement property through a tax deferred exchange).
Plus, you can only use this exclusion once every two years, subject to certain specific exceptions. So if you sell your new home and your former principal residence within two years of each other, you'll most likely end up paying taxes on the gains realized from one of the sales.
I have had a few clients over the years who have sold their converted principal residence just after the three year window has closed. For these clients, they ended up paying substantial taxes due to missing that deadline.
Re-Cycled Cyclical Advice
Since markets tend to be cyclical, the advice tends to be cyclical as well. Here is the generic advice you hear during any market downturn as people begin to panic about their investments. Portfolios that are non-speculative and well balanced tend to rebound at some point following a correction.
The same advice applies to your real estate holdings. If you currently own rental real estate, you should be able to ride out this current correction, provided you aren't too leveraged and your properties aren't too concentrated in the least desirable neighborhoods.
If you're thinking about purchasing some rental real estate or converting your home to a rental property as values decline, keep in mind that there is a chance that the values will decline even further in the short-term. Plus, don't overlook the other risks and pitfalls that are unique to real estate investments.
Even so, by understanding the risks and pitfalls associated with owning rental real estate, you might find that your rental properties make a nice complement to your stocks, bonds, and mutual funds in long run.