Starry-eyed About Real Estate Investing? Here's a Dose of Reality.
It seems like everyone has a friend who is “into real estate”. As we walk the path of building wealth, investing in assets that produce a return is a key tenet. There is more than one way to invest and real estate seems to be a popular choice for many.
It’s easy to see why real estate investing looks attractive. There are all sorts of media and marketing around real estate. There are countless reality shows focused on real estate investing, making it look glamorous and fun. You can’t get on social media without seeing ads for courses and programs that promise to teach you the “secrets” of real estate investing. Real estate is a tangible asset that you can touch and walk around in. It feels real.
Contrast that with the stock market and mutual funds, where you send your money into this ethereal intangible bucket that you don’t really understand, have no control over, and which is the topic of constant drama by the news media, therefore making it sound scary, mysterious, and stressful.
With this in mind, it’s no wonder that people are attracted to real estate.
But is it all it’s cracked up to be?
Let me say this: my goal here is not to say that real estate is good or bad. My goal is to inject a dose of reality. I’ve seen too many people get starry-eyed about investing in properties for all the reasons stated above, and then realize it was not what they thought it was.
Can real estate be a good investment? It can. I even acknowledge that it can be one of the three pillars of wealth along with business ownership. But let’s understand the facts before jumping in without a clear view of what we’re getting into.
Note: in this discussion, we are talking about residential rental properties.
To help with this, I asked my community of smart financial advisors to weigh in and we got some excellent feedback.
First, some basics comparing real estate with investing in the market (we’ll use mutual funds as the example). While mutual funds often require no minimum investment (especially if you work with an advisor), real estate has a pretty high barrier to entry. It’s a big purchase. Additionally, mutual funds will never call you at 3 am because of a plumbing issue or a broken heater. Tenants and general maintenance can add a lot of “non-glamorous” time spent on managing a property. Sure, you can hire a management company but this eats into your return.
After having a few rental properties over the last ten years, I concluded that I do not like them. I can find easier ways to make money. Some make sense and bring in cash. Some are good investments and it can make sense to make them part of your overall wealth portfolios. At the same time, I could tell you stories about $25k of damage due to tenants, small claim courts and financial nightmares. Not all rental houses will be successes and in many cases, the headache that comes from owning rentals is way bigger than the money you could make on them.
When looking at real estate, it’s easy to see only the “fun” parts of it and ignore the risks that come with tenants. You’re putting your investment’s day to day stewardship in the hands of strangers who you hope will take care of it. They don’t always take care of it.
Real estate can be part of a balanced portfolio, but it’s not for most people. They usually come in starry-eyed about this “investment they can touch” or, more likely, overwhelmed with fear of the (stock) market. Then we have a conversation about the risk of concentrated positions and the nature of true passive investments. Most of us are already overly concentrated in real estate, just because we own our homes and the last thing we need is more exposure to an asset class with which we have little to no management experience. Real estate is not a no-touch passive investment the way mutual funds can be; it’s a high paying side hustle with leveraged risk.
"I grew up in a real estate family, and avoid it like the plague (for now)."
Ok, so there is a case to be made that real estate has risks and can be high-maintenance, often to a greater extent than people think. But what about the returns? Real estate has to give you a better return than other “boring” investments, right?
"Real estate typically isn’t profitable, yet people are very emotional about it. I rail against it all the time. Even the people who own it and are currently suffering terrible returns are so irrational about it you just can’t convince them of the actual numbers. It’s so misunderstood."
"When people with real estate investment properties start bragging, I usually ask a couple of questions like, “how much did you put into the property for repairs and improvements and over how much time” and I’ve never seen one do better than a stock mutual fund."
Even more interesting, Wes goes on to give us a mental exercise to consider:
"Consider two types of investments:
The first is one you purchase without leverage and with whatever you can afford. It will pay you earnings quarterly or annually, it should appreciate over time, the earnings are taxed at a discount, and you don’t pay any taxes on the accumulated appreciation until you sell it and then at a lower tax rate. You are not required to add to this investment unless you want to and if you do the investment increases dollar for dollar by the amount you invest. This investment is subject to global and national economic risks. This investment is very liquid and can be sold with zero transaction costs within 3 business days. This investment will not call you at random times and request more money. The historic long-term returns are about 10%/year.
The second investment is made with leverage of about 80% - 50%. It will provide monthly income but at unknown periods of time, the income will be suspended. Usually, over the long term the suspension of income will be about 10% of the time. The investment should appreciate and each year you own the investment you will pay a 2% - 5% tax on the current value. When you sell the investment you will pay tax on the accumulated appreciation at a lower rate. The monthly earnings are taxed at regular rates, from time to time you will be required to make additional investments of cash and the value may increase as much as 50% of these cash investments, and sometimes there will be no increase in value for the additional cash investment. You will be called at unpredictable times to spend time working on this investment. This investment will be subject to local economic risks and national risks, sometimes the investment can be destroyed by inherent risk. You will need to purchase insurance to protect it annually. There is no liquidity to this investment; it can take a week to a year to sell and there’s a transaction cost of 6% - 10%. Historically the long term returns have averaged 8% annually.
Which investment would you choose?"
So we’ve heard some pretty compelling reasons to be cautious about real estate investing. Does this mean you should avoid it? Not necessarily! Like pretty much everything in personal finance, it’s personal. There is no one-size-fits-all.
For some, real estate investing might make sense despite the risks. For others, it may not.
I generally caution my clients to avoid prioritizing real estate over mutual funds unless there is a specific reason to do so. For many people, it goes back to the misunderstood concept of “Stock market scary! Real estate, fun!” But as you can see, that’s not the whole story.
So is real estate right for you? Should you avoid it at all costs? Or can you truly build wealth with investment properties? There is no right or wrong answer. But if you do decide to explore real estate as an investment, be sure to do it with your eyes open.