Rentals can be risky

By Mary Holm

Monday 18th March 2002

The real estate market is heating up. And, with a glut of tenants in some places, many will be tempted to invest in an old favourite, rental properties. Is that a good idea?

It depends very much on the property.

Generally speaking, inner city properties seem to be a better bet.

And you'll probably do better with a purpose-built rental property, such as a unit, than with a suburban home. For one thing, the rent is likely to be higher relative to the purchase price.

Whatever the property, though, rentals are riskier than many people realise.

I'm not talking about getting tenants from hell, or no tenants at all for several months.

Even if neither of those happens, owning a single rental property can still be riskier than investing in a broadly diversified share fund.

How come, when property is generally less risky than shares? Two reasons:

If you own your own home as well, you lack diversification.
This is worse if the rental is in the same area and similar to your home.
Many people buy a rental home in their own neighbourhood. They like to drive past to check that the roof is still on.
But they could pay a high price for that security. Suburbs come and go in terms of desirability. If yours loses its charm and you have two properties in it, you get hit twice as hard.
Even if you own a purpose-built rental property on the other side of town, though, both your properties will still be affected by changes in interest rates, immigration and other factors that influence the real estate cycle.
There's another diversification issue, too. You have just two properties.
In a share fund, you'd not only be in a different type of asset from your home, but the fund would hold many different shares, perhaps in many different countries.
If you buy a property with a mortgage - which most people do - you raise your risk.
And the more you borrow, the greater the risk.
Let's say you buy a $100,000 rental property. A couple of years later, you're forced to sell for $90,000.
If you had no mortgage, you've lost 10 per cent.
If you had a $60,000 mortgage, you repay it and your $40,000 deposit has turned into $30,000. That's a 25 per cent loss.
If you had a $90,000 mortgage, you repay it and your $10,000 deposit has gone. That's a 100 per cent loss.
Unlikely? It's happened to more than a few landlords over the last few years.

The reverse is also true. If the house price rises, the bigger your mortgage the bigger your percentage gain. But we're concentrating on risk here.

For simplicity, these examples exclude payments off the mortgage principal. But, given that a mortgaged landlord has to make those payments whereas an unmortgaged one doesn't, and that most of the early payments go on interest, that hardly suggests you're better off with a mortgage.)

It's important to note that you could also borrow to invest in a share fund. That would increase your risk in the same way. But most people don't borrow to make share investments.

Other possible problems to keep in mind:

- You can't usually sell a property as quickly, or cheaply, as units in a share fund.

- You can't easily sell part of a property.

- You're on call for maintenance, or must hire someone to do that.

For all that, though, savvy and lucky landlords have done well - even in recent years when lower inflation has made mortgaged investments less rewarding.

Rental properties aren't necessarily bad investments. But landlords should be aware of the risks they take.

Mary Holm is a freelance journalist and author of "Investing Made Simple", commissioned by the New Zealand Stock Exchange to write an independent personal investment column. She can be reached at maryh@pl.net.

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