Out of the hundreds of people I’ve worked with over the years, a little over a hundred have investment real estate that they collect rental income from. While investment real estate can be a tool for providing cash flow, it is not the only way to achieve this goal. This is a discussion some of the risks associated with investment real estate and some alternative ways to generate a passive income.
Investment Property As An Income-Producer
When purchasing an investment property, many investors have a goal of increasing their total cash flow. To determine if a property is a good investment, they look to return on investment in rental income from their investment. The way of calculating this, most simply, is taking your rental income, subtracting your costs, and dividing by your home price. Some material cost considerations include property taxes, insurance costs, maintenance expenses, and mortgage interest.
Here are some of the major risks associated with utilizing investment real estate to achieve these cash flow dreams:
Liquidity Risk
A residential or commercial property is not a liquid asset. If you need cash, you will likely need to work with a broker, pay fees, and wait a significant time before you can liquidate. If you need to liquidate immediately, you may need to sell at a discount. Real estate is also indivisible; you can’t sell half of a house to free up cash.
Diversification Risk
Having an asset in a single location exposes you to unique risks associated with that location. Local laws could prohibit a particular way of renting or limit ability to raise rents with inflation. There could also be environmental factors (like wildfires) that affect a single area, causing insurance costs and other expenses to increase.
Principal Risk
You can lose your entire investment amount, there is no performance guarantee.
Interest Rate Risk
Home prices can be sensitive to movements in interest rates. We are also in a high interest rate environment currently, meaning that the cost of borrowing money is high, which can narrow margins of rental income.
Occupancy/Turnover Risk
If your property has high turnover, or occupancy below expectations, income potential is negatively impacted. I have a friend who purchased an investment property near a university before the start of the global pandemic. He was assured that because of the university nearby, he was all but guaranteed to always have occupants. The property ended up being unoccupied and a cash drain for over a year.
Alternative Ways To Create Income From Assets
There are a lot of draws to owning investment property. It is seen by many as a conservative investment and you can see it, feel it, live in it. There is something satisfying about being able to touch your investment, but there are other ways to create income from assets without involving real estate, including:
Purchasing/Investing In A Business
Realistically, starting a business requires a lot of blood, sweat, tears, and usually, years without making a profit. Stepping into an established business with a robust business model may provide people the passive income they are seeking. I urge caution in this decision as well. Working with a professional like a business broker can support in issue spotting and avoiding making a bad purchase. You should also take steps to work with your own legal advisor to address protecting yourself and limiting your liability. You should know about the type of business or work closely with someone who has personal experience. If you’re a doctor, maybe don’t buy into a restaurant without doing your homework.
Bonds
You may think of your grandmother when you hear the word “bond,” but the purpose of a bond is to generate a consistent and predictable income. A bond is a debt instrument where you are the lender collecting the interest payments, also called coupons. Investors could also gain coupon payments income tax-free through municipal bonds, depending on the issuer and state of residence. Often, for investors who want the potential for inflation protection and asset growth, you may still want to add some equities to their portfolio. Considering working with a qualified financial professional to discuss what may be an appropriate asset mix for your personal goals.
Annuities
Annuities were created to guarantee a cash flow to investors. They are issued and backed by the claims-paying abilities of life insurance companies. There are a lot of material considerations that go into an annuity purchase so you should consider working with a qualified financial professional. Annuities tend to be most suited for retirees, not people who are looking to create an income before the age of 59 ½.
Conclusion
Investing in general involves risk, including total loss of principal invested. In a world where so many are looking for the potential for supplemental income and possibly early retirement, investment real estate has become increasingly popular. People should think critically about cash flow expectations from investment real estate and consider alternatives for creating the cash flow for financial independence.
This informational and educational article does not offer or constitute, and should not be relied upon, as investment or financial advice. Your unique needs, goals and circumstances require the individualized attention of your own financial and other professionals whose advice and services will prevail over any information provided in this article. Equitable Advisors, LLC and its associates and affiliates do not provide tax, legal, real estate, or real estate-related advice or services. Equitable Advisors, LLC (Equitable Financial Advisors in MI and TN) and its affiliates do not endorse, approve or make any representations as to the accuracy, completeness or appropriateness of any part of any content linked to from this article.
Cicely Jones (CA Insurance Lic. #:0K81625) offers securities through Equitable Advisors, LLC (NY, NY 212-314-4600), member FINRA, SIPC (Equitable Financial Advisors in MI & TN) and offers annuity and insurance products through Equitable Network, LLC, which conducts business in California as Equitable Network Insurance Agency of California, LLC). Financial Professionals may transact business and/or respond to inquiries only in state(s) in which they are properly qualified. Any compensation that Ms. Jones may receive for the publication of this article is earned separate from, and entirely outside of her capacities with, Equitable Advisors, LLC and Equitable Network, LLC (Equitable Network Insurance Agency of California, LLC). AGE-5774268.1(07/23)(exp.07/25)
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