The risks and rewards of investing in rental properties

Investing in rental properties has long been a popular strategy for building wealth and generating passive income. With the potential for stable returns and property appreciation, it's an attractive option for many investors.

Lorraine-Marie Dellbridge, Rental Manager for Lew Geffen Sotheby’s International Realty in Cape Town’s Southern Suburbs, False Bay and Noordhoek, says like any investment, it comes with its own set of risks and rewards. Understanding these can help investors make informed decisions and optimise their real estate portfolios.

The Rewards of Investing in Rental Properties

1. Steady Income Stream: One of the primary benefits of rental property investment is the steady income stream it can provide. Rental payments from tenants offer regular, predictable cash flow that can help cover mortgage payments, property taxes, maintenance costs, and potentially yield a profit.
2. Appreciation: Over time, real estate tends to appreciate in value. While this isn't guaranteed, properties in desirable locations or areas experiencing growth often see significant increases in value. This appreciation can result in substantial equity gains for investors.
3. Tax Benefits: Real estate investors can take advantage of various tax deductions, such as mortgage interest, property taxes, operating expenses, depreciation, and repairs. These deductions can significantly reduce taxable income, increasing the overall return on investment.
4. Inflation Hedge: Rental properties serve as a hedge against inflation. As the cost of living increases, rental income typically rises, preserving the purchasing power of the income generated. Additionally, property values tend to increase with inflation, protecting the investor's capital.
5. Control Over Investment: Unlike stocks or mutual funds, investors have direct control over their rental properties. They can make decisions about property management, rental rates, and improvements, allowing them to directly influence the investment's performance.

The Risks of Investing in Rental Properties

1. Vacancy Rates: One of the significant risks in rental property investment is the possibility of vacancies. Extended periods without tenants can severely impact cash flow, making it difficult to cover expenses. Effective property management and marketing are essential to minimise vacancy rates.
2. Maintenance and Repairs: Rental properties require ongoing maintenance and repairs, which can be costly and time-consuming. Unexpected repairs, such as plumbing issues or roof replacements, can significantly impact profitability. Proper budgeting and having a reserve fund are crucial for managing these expenses.
3. Tenant Issues: Dealing with tenants can be challenging. Late payments, property damage, and evictions are potential issues that can affect cash flow and increase expenses. Conducting thorough tenant screening and having clear lease agreements can mitigate some of these risks.
4. Market Volatility: Real estate markets can be volatile, and property values are not immune to economic downturns. During a recession or housing market crash, property values can decline, potentially resulting in negative equity or difficulty selling the property.
5. Regulatory Changes: Changes in laws and regulations, such as rent control measures or zoning laws, can impact rental property profitability. Staying informed about local regulations and participating in real estate associations can help investors navigate these changes.
6. High Entry and Exit Costs: Purchasing rental properties involves significant upfront costs, including deposits, transferring costs, and potential renovation expenses. Selling a property also incurs costs such as agent fees and capital gains taxes. These costs can affect the overall return on investment.

South Africa’s rental market is expected to see increased demand in 2024 and beyond, particularly in urban areas and this offers significant potential for investors looking to add property to their investment portfolios.

However, when it comes to letting out a property, investors face a crucial decision: short-term or long-term letting. Each option comes with its own set of pros and cons, and understanding the differences is essential for making informed investment decisions.

Short-Term Letting:

Short-term letting, often facilitated through platforms like Airbnb, involves renting out a property to guests on a temporary basis, typically for periods ranging from a few days to a few weeks. This option offers investors the potential for higher rental yields and greater flexibility compared to long-term letting arrangements.

Pros:

1. Higher Rental Yields: Short-term letting usually commands higher nightly rates compared to long-term rentals, allowing investors to maximise their rental income.
2. Flexibility: Short-term letting offers investors the flexibility to use the property for personal use or to switch between short-term and long-term letting depending on market conditions.
3. Property Maintenance: Short-term guests are less likely to cause wear and tear on the property compared to long-term tenants, reducing maintenance costs for the investor.

Cons:

1. Higher Turnover: Short-term letting requires frequent turnover of guests, leading to higher management and cleaning costs for the investor.
2. Seasonal Demand: Depending on property location and guest demographic, short-term rental demand may fluctuate seasonally, with peak periods generating higher occupancy rates and off-peak periods resulting in lower income potential.
3. Regulatory Challenges: Short-term letting may be subject to regulatory restrictions, zoning laws, and homeowner association rules, requiring investors to stay informed and compliant with local regulations.

Long-Term Letting:

Long-term letting involves renting out a property to tenants on a fixed-term lease, typically for six months to a year or longer. This option offers investors stability and consistency in rental income, albeit at potentially lower yields compared to short-term letting.

Pros:

1. Stable Rental Income: Long-term letting provides investors with a steady stream of rental income, reducing vacancy risks and ensuring consistent cash flow.
2. Reduced Turnover: Long-term tenants tend to stay in the property for extended periods, minimising turnover and vacancy costs for the investor.
3. Lower Management Overhead: Long-term letting requires less intensive management compared to short-term letting, as there is less turnover and fewer guest interactions to manage.

Cons:

1. Lower Rental Yields: Long-term rentals typically command lower rental rates compared to short-term lets, resulting in potentially lower overall rental income for the investor.
2. Limited Flexibility: Long-term letting restricts the investor's ability to use the property for personal use or switch between short-term and long-term letting arrangements.
3. Tenant Issues: Long-term letting may expose investors to potential tenant issues such as late payments, property damage, and eviction proceedings, requiring proactive management and legal intervention.

Balancing Risks and Rewards

To succeed in rental property investment, it's essential to balance the risks and rewards. Conducting thorough market research, understanding local rental demand, and carefully evaluating properties are critical steps in making informed investment decisions. Diversifying investments across different properties or locations can also mitigate risks.

Effective property management is key to maximising rewards and minimizing risks. Whether managing properties personally or hiring a professional management company, maintaining high standards for tenant selection, property maintenance, and financial management is crucial.

While investing in rental properties offers numerous potential rewards, it is not without its risks. By carefully considering these factors and adopting sound investment and management practices, investors can optimise their chances of success in the rental property market.

READ: In the event that a tenant ends the lease early in writing, is he or she still liable for rent?

Carol Reynolds, Pam Golding Properties area manager for Durban Coastal, says he has always maintained that investing in property is generally a safe and reliable long term investment, because as a general rule, property is not a volatile asset class. The rewards far outweigh any risks in my opinion: the rewards are that you can gear your properties so you will only require a small deposit to secure a property.

"This means that your actual cash risk is very low as your cash to  asset value ratio is high and essentially the rent should cover most of your costs. The other upside is that property generally appreciates over time, so as long as you hold onto the property for the medium to long term, you should enjoy capital growth.

“The risks are procuring problem tenants who don't pay the rent, forcing you to undergo an eviction process, but if you do credit checks in advance, this should assist you in placing good tenants. The other risk is the ongoing maintenance required - you will always need to have the additional funds available for property repairs and maintenance," she says.

Reynolds adds that a jump in interest rates is also a risk, as this will impact upon your monthly bond repayments. The normal market factors will also influence risk and reward - you may time it perfectly and buy in a low market and then enjoy a strong upside; alternatively you may buy at the peak of the market and then endure a price deflation period.

"However, overall, if you are mindful of market forces and factors like the interest rate cycle, you can time your purchase to enjoy the upside. For example, now is a great time to invest, as the political climate is looking more favourable, the interest rate cycle is due to start its downward trend and sentiment post-elections is very positive". 

Want all the latest property news and curated hot property listings sent directly to your inbox? Register for Property24’s Hot Properties, Lifestyle and Weekly Property Trends newsletters or follow us on Twitter, Instagram or Facebook.