The pros and cons of a buy-and-hold real estate strategy
Warren Buffet once said, “Our favorite holding period is forever.” For many investors, the path to long-term wealth is to buy and hold real estate.
In this article, we’ll explain buying and holding real estate, the pros and cons to consider, and tips that may help you increase potential returns.
- Buy-and-hold real estate is purchased, rented out, and held for an extended period of time.
- Benefits of buying and holding real estate may include recurring rental income, long-term property appreciation, tax benefits, and hedges against inflation.
- Risks of buy-and-hold real estate can be minimized by hiring a property manager to deal with tenants and keep the property maintained and analyzing real estate market trends.
- Investing in smaller markets, regularly increasing rents, and wisely using leverage may increase returns.
What is buy-and-hold real estate?
“Buy and hold” is a strategy used by real estate investors seeking to generate recurring rental income and build wealth over the long term. With buy-and-hold real estate, an investor will typically purchase a rental property, hold it for 5 years or more, and refinance or sell when and if the time is right. This is often done alongside short-term strategies, like fixing and flipping properties.
Some buy-and-hold real estate investors rarely sell. For example, buy-and-hold real estate can also be used as part of the BRRRR method of investing. Instead of selling a property, an investor does a cash-out refinance to pull equity out of one home to buy another. After patiently waiting for both properties to increase in market value, an investor performs a cash-out refinance on both to raise capital for a third cash-flowing investment property.
As Forbes recently reported: “Don’t buy and sell, just buy” is an effective real estate investment strategy that anyone can use to start investing in real estate.
Advantages of buy-and-hold real estate
Investing in buy-and-hold real estate can be similar to owning a blue-chip, dividend-paying stock. However, real estate typically isn’t as exposed to the fluctuations of the stock market and it offers a myriad of tax benefits that other investments do not.
Here are 5 top benefits of buy-and-hold real estate investing to help you decide if this long-term strategy is the right move.
1. Monthly recurring rental income
Buy-and-hold real estate offers the opportunity for a consistent stream of rental income month after month. Through November 2021, single-family rent prices increased by 11.5% year over year, according to a recent report from CoreLogic, a leading property information and analytics provider. In fact, some markets like Miami, Phoenix, and Las Vegas posted annual rent increases of between 16.7% and 33%.
2. Property appreciation long term
Buying and holding real estate also can help you build wealth over the long term. As the Federal Reserve reports, the median sales price of houses has increased by more than 238% over the past 20 years (Q4 2001 versus Q4 2021). That means a home purchased for $150,000 20 years ago would be worth about $357,000 today, appreciating $207,000, provided that the property was properly maintained.
3. Potential hedge against inflation
Real estate also historically acts as a hedge against inflation when bought and held for the long term. Annual increases in inflation, as measured by the consumer price index (CPI), generally can be passed to a tenant in the form of rent price increases, while housing prices historically go up faster than the rate of inflation. Between 2001 and 2020, the U.S. inflation rate totaled 41.26%, while median home sales prices rose by 238%.
4. Buy and hold offers a high ROI
Return on investment (ROI) measures how much profit is made on an investment compared to the cost of the investment. For example, the current 20-Year Treasury Rate is 2.18% (as of January 25, 2022). If an investor used $150,000 to purchase a 20-year treasury security that was held to maturity, the interest income would be $3,270 for an ROI of 2.18%.
Buy-and-hold real estate historically offers a much higher ROI. To illustrate, assume an investor purchased a rental property for $150,000 in cash in 2001. Over the holding period, the property generated a net operating income (NOI) of $9,000 per year, for a total of $180,000. If the property sold today for $357,000, the ROI over the 20-year holding period would be 358%:
- ROI = Gain on investment – Cost of investment / Cost of investment
- ($357,000 gain on sale + $180,000 total NOI) / $150,000 initial purchase price = 3.58 or 358%
It’s important to note that the above example was simplified for this article. The ROI calculations do not take into account factors that could increase or decrease potential returns, such as increase in the annual rent price, vacancy periods due to tenant turnover where no rental income is received, capital expenses, such as replacing a roof or HVAC, or a potential decline in home values.
5. Significant tax benefits
Buy-and-hold real estate also offers several unique tax advantages compared to other investment assets:
- Deductible operating expenses, such as property management fees, repairs and maintenance, property taxes, and insurance
- Mortgage interest deduction
- Depreciation deduction of a residential rental property over a period of 27.5 years to reduce taxable income
- Deferred capital gains tax through a Section 1031 exchange
- Owner expense deductions, such as continuing education, travel, and home office
- Potential exemption from FICA taxes of Social Security and Medicare for income from a rental property
- Potential pass-through deduction of up to 20% of net business income, provided an investor owns a pass-through business and has qualified business income (QBI), according to the IRS
Drawbacks to buy-and-hold real estate
There are plenty of potential benefits to buy-and-hold real estate. But, as with any other investing strategy, there are drawbacks to consider as well.
Unlike other investment assets like stocks and treasury bills that can quickly and easily be sold, real estate can easily take 30 days or more to sell, even when an owner is distressed and willing to sell for less than what the property is worth.
2. Property management
Dealing with tenants and repairs can challenging. Sometimes a tenant needs to be chased down for the rent, or the property has an emergency repair in the middle of the night. That’s why many landlords hire a local property management company.
A good management company has the experience to work with tenants, knows how to keep a rental property well-maintained, and has an established network of cost-effective contractors and vendors.
3. Market cycles
Real estate markets historically move through multiyear cycles of recovery, expansion, hypersupply, and recession.
A buy-and-hold investor who wants to sell may discover that the market is trending downward, which could reduce or even eliminate potential profits. To avoid selling into a down market, investors can plan ahead and monitor market cycles to help them retain or increase gains.
4. Changing neighborhoods
Neighborhoods can change over time, driving property values up or down. Because a rental property can’t be picked up and moved, one of the risks of buy-and-hold real estate is that property value will be diminished if a major employer goes out of business or property taxes are significantly increased.
Of course, the opposite is true as well. Large urban gateway markets used to be the only real estate markets that some investors would consider. Today, small secondary and tertiary markets like Kansas City and Waco are on the radar of remote real estate investors.
Tips for buy-and-hold real estate investing
All investments come with a certain amount of risk in exchange for potential reward. While investors who are extremely risk-averse may opt for a treasury bill that pays an interest rate below the rate of inflation, others choose buy-and-hold real estate investing for a balanced blend of risk and reward.
Here are some things investors can do to minimize risk and increase the potential rewards from buy-and-hold real estate:
- Create a business plan outlining realistic and achievable short- and long-term goals for investing in real estate.
- Analyze past and current trends, and predict future trends, by analyzing data like population and employment growth, change in housing prices, increases or decreases in renter-occupied households, and house price index (HPI).
- Use leverage wisely by making a down payment of 25% or more to reduce the amount of monthly debt service. Purchase multiple properties with financing instead of paying in cash.
- Increase rents to the fair market price each time a lease is renewed to generate an incremental increase in cash flow.
- Create and fund a capital reserve account to have money on hand for unexpected emergency repairs and planned major repairs.
Buy-and-hold real estate can be a good investment strategy for people seeking to build wealth and generate recurring income year after year. Sometimes the best buy-and-hold real estate investments are found in a different city from where an investor lives. Buying rental property in markets where prices are still relatively affordable may generate healthier overall returns than purchasing property in a city where prices are already sky-high.
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