I have been thinking about taking a loan to buy a flat which I would rent out. My reasoning is that the loan would be paid off over time by the renters. After perhaps 30 years, I'd be left with a free flat.
Obviously this sounds too good to actually work as easily as described because if it did then everyone would do it. What I'm looking for are the reasons why this idea is unrealistic in real life.
It is certainly possible and people have done it before.
However, I can think of a few risks/problems:
Doable? Certainly. But it's not free money. You will have to put in effort to learn (outsourcing everything is expensive), to manage things yourself and to solve critical problems in a creative way. The chances of success also highly depend on the state and development of the market we are talking about, on taxes and regulations in your country, on your personal skills and on the effort you are ready to put in.
I love this question on a few different levels. This is exactly how the majority of rental properties become available in many markets. If your landlord is a person rather than a property management company the chances are quite high that your rent pays their mortgage.
Why isn't everyone doing this?
It's a fairly common and successful investment strategy but don't oversimplify it. It's easy to get wrong and a lot of people have gone broke trying it.
Here's a real life example: My tenant just gave their notice. We needed to redo the house completely after they moved out. Repainting, new carpets, various fixing up etc.
Even doing a lot of the work ourselves it still cost nearly £3000. In addition we couldn't start advertising for new tenants until that work was done which took a couple of weeks so it's now been empty for a month. Which means no income for that month. And no I couldn't take most of that from the deposit (we kept a bit back) as most of it was just wear and tear. After a few years things need replacing.
There's no guarantee as to when a new tenant will be found (we had one accepted offer but they never signed the paperwork and just ghosted the agency so we assume they went elsewhere) so it could potentially be sat there for any amount of time, but with me still paying the mortgage.
So it's costing me X per month. I'm getting no income. And I just had to splash out thousands of pounds to get it ready in the hope of finding a new tenant.
In addition to all that in order to get a decent mortgage I actually paid half the cost of the house myself. So I've invested thousands of pounds up front.
The return on investment for all that is actually reasonable over time. You need to be able to take the rough with the smooth though - it's certainly neither "free money" nor risk free.
People do, in fact, do exactly this. The reason why "everyone" doesn't do it, is that (generally speaking, in the UK) you can only get a buy to let mortgage for 75% of the value of the property. So if the property you are buying costs £300,000, then you could only borrow £225,000 - and would home to come up with an additional £75,000 yourself. Most people simply don't have that much cash available.
Actuall a LOT of people can do it and depending when you do it people made millions with it. Problem obviously is that you will not rent it out for 30 years most likely, so you need interim repairs, upgrades, downtime searching for renters.
But yes, this is how many people make money and make their retirement. Once you hit 5+ appartments thigns get more smoothly.
Overall, buying a property isn't a bad idea if you're sure you want to (and will be able to afford to) hold on to it for a long time.
Other investments may get you more return at less risk, depending on your timing and whether your country offers any tax benefits.
There are two useful concepts for you to look up here: opportunity cost and future value of money.
These are important, because to obtain the loan to buy the property in the first place, you'll need some initial capital.
You can then make a spreadsheet to help you explore this.
First, add up the following for a year to get your expected income after loan repayments for the year:
Next, express that as a proportion of your initial capital outlay to get your annual rate of return.
Play with the assumptions in your spreadsheet a bit to see what might happen in different circumstances. For example, if the interest rate on your loan goes up, or if rental prices crash.
You can compare this rate of return to what you would expect to earn from other investments.
Don't forget to look into risks as well as returns!
I'd just like to provide an anecdotal reference, as we're doing exactly this; please check other answers for in-depth considerations.
We bought a three-room apartment in a panel building (cheaper than normal brick houses, but also somewhat cheaper to rent) a year ago. We took a 5 years loan, and rent the flat out for about 5% more than the loan payments, plus water/gas/etc. After considering the 20% down-payment in addition to the the loan, and the necessary initial renovations, we expect to earn about 9% equivalent per-year interest, compared to the 5%-at-best rates for 5 year deposits. This is however without accounting to two important and unpredictable things: vis maior events, and the change of real estate prices in 10 years from now. Also, that's not money, but real estate, not as easy to access to it as it's for a deposit.
So I'd say it borderline worth it, but risky. This is however in a real-estate-vise relatively cheap country (Hungary)*, in a city other than the capital (Szeged), and which is an university city with a high density of students. And even there, we got the apartment about 15% cheaper than usual, it was a really good deal. Whether it worth it or not has to be calculated for the individual house, based on the interest rates, comparing the price of the flat with for how much could you rent it out, and how much you need to spend on it.
*The price of the house is about the same in as e.g. 1.2 times the list price of a new Ford Mondeo in local currency (as of 2018).
You are unlikely to pay mortages for property from rental income alone as this would lead to a massive case of arbitrage. People would get mortages for properties and rent them out for no real cost, this would in turn lead to massive influx of rental proprties that would tank the rental market overnight. Also if your mortage is equal to rent why are you renting?
The answer is NO!
There is one thing that is always true in financing. You must always pay every loan you take. That's certain.
Now, what you are about to do is to take loan (that you must always pay) and use the financing to purchase a risky asset.
What are the risks in buying a flat?
Some of these can be eliminated away by diversifying, by purchasing let's say 100 flats. But no bank will give you a loan for 100 flats. So the only option to diversify is to buy shares of a real estate fund.
In the country where I live, the biggest drop of house prices in recent history is 50%.
The biggest drop of a well-diversified stock portfolio (worldwide diversification, company size diversification, sector diversification) is also about 50% (ok, the Great Depression had a larger drop, but then again that isn't recent history, it's ancient history).
So, according to the recent history, houses are approximately as risky investment as stocks, if both investments are well-diversified.
A single flat? Much more risky than a well-diversified stock portfolio.
My advice would be to not limit yourself to one type of economic activity (housing), but rather invest money into various different companies in different sectors.
It's easy to buy let's say only $10000 of stocks. I don't think you can find a flat for $10000 in any decent area (except perhaps in very poor countries).
So, by investing in stocks you don't actually need the loan anymore. You can start with small sums and accumulate your investments to larger sums. If you really want to, you can select one of your investments to be a real estate fund.
Edit: calculation of house discount yield in Greater Helsinki region:
Over an extremely long timeframe, building prices, rents and costs rise according to inflation which is 2% per year in Eurozone. I have seen a long-term statistic of house prices in a single area in Netherlands I think (yes it was Netherlands), and over about 400 years the house prices have risen exactly according to inflation (plus or minus 0.1% per year or so). Sometimes house prices were high, other times they were low, but there was no other general rising trend than inflation.
Paying the costs from the rental yield leaves 108 EUR / m2 / year (which rises 2% per year). Investment required is 4500 EUR / m2. This makes the real yield 2.4%. Nominal yield is real yield plus inflation which is 4.4%. Taxes not subtracted from the yields.
Compared to stocks, real yield consists of economic growth (2.5%) and dividend yield (3.5%) which is 6% and nominal yield is real yield plus inflation, i.e. 8%, taxes not subtracted from the yields.
A single flat is of course more risky than a well-diversified flat portfolio. If you buy a single flat, I would demand 9% real yield to take into account the greater risk of a single investment compared to a well-diversified flat portfolio. You can't do that, as you obtain only 2.4% real yield.
If you can diversify by buying let's say 100 flats (like you can buy stocks of 100 companies), 6% real yield is okay. But I calculated only 2.4% real yield in my area...
YMMV. In some areas, you can obtain 6% real yield. That makes investing into a well-diversified flat portfolio or into a real estate fund a good idea.
In other areas, you can obtain 9% real yield. That makes investing into a single flat a good idea.
In my case? I live in a state-subsidized housing, which costs 133 EUR / m2 / year (far from the 200 EUR / m2 / year rents typical of the area), and invest in stocks, yielding 6% really or 8% nominally per year. I'm never going to buy a house, even for living in it myself.
