How likely is it that a rental property can have a better ROI than stock market if I have to use a property management company?

Question

I'm in the USA and have a good amount of money available to me and I'm willing to accept high risk when investing, as long as the ROI justifies it. I've toyed with buying a rental property, but I'm uncertain if it's worth looking into. I don't trust myself to be organized enough to do all the things landlords usually do, so if I buy a rental I would probably use a property manager. My question is whether it's likely a rental property can have a better long term ROI than an index fund after factoring in the cost of a property management company.

I realize the exact details depend on my location, time I buy, and how good a deal I get, and that I need to do the research myself. However, before I put the time and cost into learning all that I'd like to know, from a general high level point of view, is the idea feasible and worth looking into, or is it unlikely to beat the stock market in the long run once I factor in property management costs and thus not worth my time even considering?

Given where I live and the demand for rentals here, I'd likely be renting rooms in my rental to 3-5 20-30 year-olds with decent/stable incomes, but potentially not as likely to stay in one place for more then a year or two. I could make a rather large down payment, so my mortgage interest rate is likely to be low, and could likewise pay off any remaining mortgage very fast. Then again, given I'm open to high risk investment and I believe the US gives tax incentives for mortgages, I may be better off taking my time to pay off the mortgage so I have more to invest in stocks.

Answer 1

You want a simple rule of thumb, so let's clean things up with some quick simplifications.

Assume a perfectly efficient rental market, stock market, and real estate market. This means that while the risk of various options may differ, we are assuming that the market perfectly accounts for that risk by offering higher reward to the higher risk option. Assume you consider buying a house to rent, which is identical to the units inside a 1000 unit complex next door, which is entirely owned by a Real Estate Investment Trust.

Your decision is: do you buy a share of the REIT, or do you buy the house to rent out yourself? Either way, you are buying a chunk of land, and a depreciating building, and are thus subject to the rises and falls of the real estate market in your area [again - we are assuming the market is perfectly pricing the different risk associated]. So the only difference is on the rental income side. Another way to put it, simplistically: Are you going to run your rental unit more profitably than the REIT will operate its 1,000 units?

The basic answer is - a small-time landlord can perform basic functions "for free" [well, it costs your time, so this just turns into a job with a vague ROI], and in cases where the small-time landlord is good at these tasks, s/he could theoretically turn a higher profit than a corporate landlord [again, excluding the value of your time]. In cases where you hire someone to do these administrative tasks for you, you have basically already conceded that you are not going to run the rental more efficiently than a company would.

In short, while buying property to rent may or may not make sense given all relevant factors, as soon as you cut someone else into the implied profits you would earn from self-managing the property, you have lost the only theoretical competitive edge you have over simply buying a REIT. What you are left with, then, is a situation where you are considering significant leverage [with a 20% downpayment, you would have 4x leverage], which means any gains from appreciation in property value will be magnified, and the risk from potential property price drops, is likewise significantly higher.

This is why you can find many people touting the benefits of their successful real estate purchases - even if they have monthly losses on rent - because the value of their purchase increased, and they accrued magnified gains due to leverage, which created a risk that they may never have fully understood. ie: if you are losing cash on a monthly basis from rent [which is far more likely if you have to outsource the rental management], all you are left with is a speculative position that wins if the real estate market goes up.

Of course - if you do everything yourself and suck at it, things won't turn out any better for you!

Answer 2

"I've toyed with buying a rental property but I'm uncertain if it's worth looking into"

Don't do it*.

Been there, done that, got the t-shirt. It was profitable. Arguably more profitable for the time period than the stock market, and no brokerage firm is going to let you buy stocks on margin at the leverage that you can mortgage real estate.

But it was a job. Which is why I no longer do it, my day job and consulting gigs became more profitable uses of my time and it wasn't worth keeping the rentals.

It's like running any other business. And while it might make perfect sense for a business owner who has built up a self-sustaining money-making machine of a business to semi-retire and pay somebody else to run it, that is not you who is starting out in real estate from scratch. How do you know what a good real estate investment looks like? Even if you totally trust the property company to manage it, you still have to buy it.

Also, comparing rental real estate to stocks is a bit of an apples-to-oranges comparison: stocks are generally purchased for growth potential with any income like dividends being gravy, but rental real estate is generally purchased for income with any increase in value in the underlying property being gravy. Do you want income right now or growth potential? What's your risk tolerance? Because stock risk when you know nothing about stocks can be mitigated by buying funds but if you buy a property (a large transaction mind) you have to be reasonably certain you're not buying a dud. It's more risk for you, even if real estate is less risky than stocks in general.

Looking at your profile it appears that like me you might be a software engineer. In terms of active investment it is almost certainly going to be more profitable for you to cash in on your expertise by cultivating potential consulting clients or working on up-leveling your next role than it is going to be for you to learn a completely unrelated field from scratch.

* Possible exception: vacation homes.

If you really like vacationing at a particular area and have a truly large amount of money that you don't mind parking for years-to-decades it may make sense to invest in real estate in that place where you use it 1-2 weeks out of the season and rent it the rest of the time via a property management company. You get a guaranteed spot at your favorite getaway destination, and hopefully the rental income covers most-to-all of the expense.

This only really makes sense though if you pretty much always vacation at the same place, and you meet the high bar of capital for entry (absolute minimum 10% down on the second home, likely quite a bit more if you don't want to have to feed it every month), and there's consistent rental income to be made. Not for me, but my extended family has collectively racked up quite a bit of appreciation while doing this (while having spots in great places to visit).