Some of your clients are entering or already in retirement. They have moved from wealth accumulation to income with wealth preservation. Some own rental property to generate passive income for this very time in their financial life. When a rental moves front stage to generate income, your clients might ask, “What is a good return rate for a small rental property?” Or the less direct question, “What are your thoughts on my rental?”
It is worth noting that the question is being asked years after the outflow for the investment was made. It could mean that your clients did not take time at purchase to understand the potential role of the investment. Nor the opportunity cost to get there. The question is common and represents an opportunity for a financial planner to help.
For starters, you can remind the client of what figures they should really be focusing on with a rental property.
In financial independence (retirement), net income becomes the primary metric used to measure investment rental performance. Other metrics like appreciation become tertiary. After all, you cannot own a rental for income and sell it to use its proceeds.
Help Reframe Clients’ Questions
The focus on income also allows you to help reframe your clients’ general question, “What is a good return rate…?” to the more meaningful question, “Is my rental’s performance appropriate for my situation?”
Related client questions that can benefit from the same reframing include:
- “What do you think about my rental property?” Using performance as a benchmark for this discussion can turn what could be a loaded question into a period of discovery for the client and advisor.
- “Should we keep our rental property?” This question is often about performance, although the investor may not know to view it in this way. This question can also be about the property’s role in the overall plan.
- “Should we buy more of the same type of rental?” By asking this, the clients assume that the rental is one of the best ways to meet their financial goals. Except for perhaps believing that real estate is more stable than stock market drops and performs at least the same, most clients have never measured this belief. In this case, answering the question about return first helps. For example, if the rental is a smashing success, they might consider owning more. Suppose, instead, the property is dilutive to their plan. Then, they should look further into the circumstances before doubling down on more of the same.
When Emotion is Part of the Equation
Most clients seek to optimize the use of their resources, especially during retirement. Prudent, well-informed decisions take priority over more subjective, emotional decisions. I have found that while a client’s decision might look emotional at first, it is likely based on misinformation they have carried for years. When better educated, most clients go on to make sound financial choices.
In a few cases, the reasons to own rental property is steeped in emotion. For those clients, the balance of this article will not be of value. You will find yourself “planning around” emotional real estate decisions. This is similar to planning for a client who will not budge on a highly concentrated stock position, won’t stop funding an adult child’s bad habits at the expense of their own needs, or refuses to reduce spending beyond reasonable needs.
Measuring Cash Flow
Getting back to “What is a good return rate for a small rental property?” the first step is understanding how the property is currently performing. In my first column in Rethinking65, you will find a simplified version of measuring cash flow. The takeaway was that when doing a back-of-napkin or Excel proforma on income property, most investors and advisors forget to consider several significant expenses that impact an accurate accounting of performance. And more miss the opportunity to factor in the favorable impact of tax deductions.
In this article, let’s assume that you have done an excellent job representing current annual income and expenses. Because income and operating expenses are growing at the same rate over the long term, there won’t be too much variance in your calculation over time. Let’s also assume that the estimated yield on your clients’ rental property is 4.5%. You now have a reference point to help your client with this question.
The challenging part for most advisors is not to immediately jump to a conclusion or make comparisons. Yes, most of the long-term ideas in your basket of investment options will likely outperform 4.5%. But for a moment, suspend this judgment. Instead, let’s honor our clients’ interests and curiosity in rental properties and look at this from a client lens.
It (Always) Depends
Using “it depends” in client conversations can feel to advisors like they are leading clients into a Rubrik’s cube of outcomes. To clients who want a single, clean, and best response, “it depends” can seem like an advisor is hedging, almost afraid to be a little wrong. “It depends” variables generally start with risk tolerance, time horizon and investment goals. Other factors are risk capacity, taxation and life goals. And then you have a set of subjective considerations.
The ultimate list can be as comprehensive as a Michael Kitces review on advisor technology. Let’s pull an investor scenario off the shelf to help us understand the merits of a rental property with a 4.5% yield.
The “Real Estate-Is-Safe” Investor
I don’t have any research on the following statements. Still, I have shared this observation enough times to get consensus from advisors:
- Stock market enthusiasts love equities and find directly-held rental properties tricky, risky and time-consuming. They don’t want to worry about the three Ts — tenants, toilets, and trash. Their participation in real estate might be their home (a lifestyle asset, not an investment asset) and perhaps publicly traded real estate stock.
- On the other side of the street, many real estate-heavy families love real estate and do not trust stocks. They like that rental property gives them direct ownership (no fees or advisors), control (which gives the sense of independence), and the notion that their rental won’t disappear. Further, it seems anything they have done with stocks has failed. Perhaps it went down 2% one year. Or they dipped their toes at the start of a down market and locked in losses soon after, confirming this mistrust. Either way, it was a catastrophe. More likely, an influencer in their life did not honor investment fundamentals and lost considerable money, leaving that mark for friends and family to wear forever.
As I disclosed, this observation is unscientific. Except that while working with both sides of the street, I rarely have had the opportunity to work with clients who own a healthy mix of the two asset classes.
Your basket of investment options doesn’t matter with the real estate-is-safe investor because your basket it is a non-starter. But there is more to this story:
Real estate investors love cash as much as they do not like stocks. It’s not surprising to see an allocation of 95% real estate and 5% cash. Compared to today’s cash equivalent yield, 4.5% looks genius to these investors.
In this example, when the investor is non-responsive to other investment options, then yes … 4.5% return might qualify as a “good” performance for the client.
Planning and Coaching Opportunities
The question for financial advisors becomes, How is this investor profile a good client? For non-planners, this may be a poor match. But for a genuine financial planner (the CFP Board would advocate that there are 90,559 in the U.S.), this can be an outstanding planning client. Some of the planning and financial coaching opportunities are:
- Can the client find another income property with a similar risk profile and higher yield? They will need your help understanding their current property benchmark to determine a potential need.
- Can the client find another income property with a similar yield and lower risk profile? Same work here.
- Can the client diversify their holdings by property type, geography and age of the property? The concept of diversification is fundamental to all investing.
- Does the client have proper risk mitigation, including business rental insurance, entity, and professional property management? You likely have external resources to turn to.
- Are the client’s estate plan documents and assets updated, with current titling? And is the titling or estate strategy appropriate based on current legislation? A real estate-centric estate planning attorney is a big favor for real estate-rich clients.
- Does the client have a written contingency and succession plan? Especially since most want to leave the real estate for adult children. And especially since most adult children would prefer to sell the real estate than run their parent’s old business.
- Is the client’s approach to taxes current? For example, are they qualified to use the Qualified Business Interest (QBI) 199A deduction? Do they have the appropriate entity for their tax situation?
This list is not complete. Unlike an institutional asset manager who takes on these tasks to meet a fund’s criteria, the directly-held real estate investor becomes the person who coordinates these matters. Most do not and would be as happy as your non-real estate clients to pay for this service.
A financial planner can add considerable value to real estate-heavy clients and their practice. You can be the catalyst to help clients improve the quality of their decisions, which can reduce risk, increase cash flow, improve tenant quality, and ultimately enhance the value of their estate. Very few professionals are in the position to offer this type of support. With exceptions, attorneys are too narrow in their scope of work, and tax preparers are less collaborative by the nature of their work.
In my next column, we’ll look further at other circumstances that can influence what is a good real estate return.
Rich Arzaga, CFP, CCIM, helps financial advisors in areas they may want to delegate, including insurance reviews and directly-held real estate investing. He is also a long-time instructor in the UC Berkeley Personal Financial Planning program. He teaches insurance and real estate CFP CE courses. Rich is the founder of The Insurance Whisperer, a fiduciary insurance review and planning service for professional advisors, and the real estate planning firm The Real Estate Whisperer. Contact Rich at email@example.com.