Real estate is a hot asset class these days. Everybody wants to own rental property. But is investing in real estate worth it?
Normally I would say yes, of course it is. After all, 70%+ of my personal net worth is tied up in real estate!
But you caught me on a bad day (or bad couple of months). It seems like everything that could go wrong is going wrong at my rental properties, and my cash reserves are dwindling to dangerously low levels.
So I figured now would be a good time to reflect on both the good and the bad of real estate investing, and help you decide if real estate is a good investment for you.
What Counts as “Real Estate Investing”?
There are a lot of ways to “invest” in real estate. I think what most people think of first when they hear the words “real estate investing” is buying rental properties for cash flow and long term appreciation. But there are lots of different ways to make money in real estate that all get lumped under the same umbrella even though they are vastly different strategies.
Here are just a few, ordered from most passive to least passive:
- Investing in a real estate investment trust (REIT)
- Participating in syndications as a limited partner
- Buy and hold rental properties
- Wholesaling houses
- Flipping houses
So when you ask the question of whether real estate investing is worth it, you need to define what you mean by real estate investing.
Moving some money from your S&P index fund over to a REIT is as easy as a click of a button. But flipping houses is more like building a business than investing in stocks.
Which end of the spectrum you end up on is really determined by what you’re trying to accomplish, hence the next question…
Define Your Goals – Is Real Estate Investing Worth It Compared to What?
What is your goal with investing in real estate?
If you think buying a rental property is an easy way to diversify your stock portfolio and collect a consistent paycheck every month without lifting a finger, you are going to be sorely disappointed.
On the other hand, if you want to grow your wealth exponentially within a few years, that is pretty much impossible in the stock market. You don’t have the control, and there is no consistent way to pick the next Apple, Facebook, or Google no matter how many hours of research you put in.
But with real estate, if you are willing to get your hands dirty and work hard, you can double, triple, or quadruple your net worth in a relatively short amount of time.
I’ve always personally considered real estate as a side hustle, not an investment per se. My goal was to accelerate my path to financial independence, and in doing so was able to add $1M to my net worth in 5 years. But it took a lot of work to get there. It was my second job!
And now that we’ve built up equity in real estate, our goals have also shifted. We have 2 young kids at home and life is busy with many other things. So we are scaling back on real estate and looking for ways to invest more passively through real estate crowdfunding or just maintaining our small rental property portfolio.
So evaluate your goals. What kind of returns are you looking for? Do you want passive income (and lower ROI), or do you have the time to dedicate to building a true real estate business?
WHY YOU SHOULD INVEST IN REAL ESTATE
What are the pros and cons of real estate investing? There’s no one-size-fits-all answer for everyone. But here are the main benefits I’ve found of investing in real estate.
1. Cash Flow
Cash flow is the #1 reason I started investing in rental properties, before I found out about the other benefits (appreciation, leverage, favorable tax treatment, etc.)
The relatively stable cash flow generated from real estate provides a great annuity to fund your living expenses, while in the background the tenant is paying off your mortgage and the home is appreciating and adding to your net worth.
I like to think of rental property cash flow as similar to a stock dividend. It pays out on a regular schedule without affecting the value of the underlying asset (the house or the stock).
The main benefit of real estate cash flow, is that it is much higher than a stock dividend, and the underlying asset is not subject to as much fluctuation as a stock. While it is true that the Great Recession caused both the housing and stock market to lose value, real estate is generally a much slower moving asset class and the loss of value was more gradual than the almost immediate 30%+ drop in the stock market.
If you are interested in real estate investing, I think cash flow is one of the most important factors to consider. In my own personal investing, I look for at least 10% cash on cash returns when buying a property. This provides not only a stable source of income, but a buffer in bad economic times when rents fall or vacancies rise. The last thing you want is to be stuck with a rental property that is constantly losing money every month. Even if you are betting on appreciation to eventually bail you out, that is more akin to gambling than investing.
A quick way to evaluate a rental property is with the one percent rule, which states that the monthly rent should be at least 1% of the all-in purchase price. This is just a rule of thumb, and your cash flow depends on a lot of factors, but it is a good place to start when running the numbers on a potential rental.
2. Cheap and Relatively Safe Leverage
Interest rates have never been lower than they are now. Capital is plentiful and cheap, and the U.S. government has decided that subsidizing home buyers by providing generous mortgage terms and tax incentives is good for the country.
Even post-recession, you can buy an owner-occupied home with as little as 3% down. For an investment property, it is not uncommon to only put 20% down for the first few houses.
The common wisdom espoused by those against real estate investment is that appreciation rates have only matched or barely beat inflation over the long term. And I don’t think anyone can argue with that – see the Case Shiller index data compiled below going back all the way to 1890. At least until the latest bubble, the inflation-adjusted index was relatively flat.
Case Shiller Home Price Index 1890 – 2019
So what does that have to do with leverage?
Here’s a case study: Let’s say on average, inflation is 3% per year, and therefore home prices go up 3% per year. And let’s also say that you can get a 30-year mortgage with 25% down. That means you for every $25,000 of cash you put in, you are buying $100,000 worth of house. So if the value rises 3% in a year, that is $3,000. A 3% return is nothing to get excited about. But remember, you only have $25,000 invested. That $3,000 increase is equal to a 12% return on your invested capital!
The power of leverage in real estate is that it can increase your returns exponentially over the long term. There are obviously risks involved with leveraging, and the 2008 recession showed that if you had zero (or even negative) equity in your property you were in big trouble during the downturn. But if you use a responsible amount of leverage, you can increase your returns with relatively little risk.
You will have to decide what a responsible amount of leverage is for you, but to give you an idea, overall my portfolio is leveraged at around 50-60%, which means real estate values would have to drop 40%+ before I would be underwater. And even if I lost that much equity, as long as I had a cash flow buffer to weather the storm, it is only a loss on paper. I could wait out any downturn while still collecting cash flow or at least breaking even every month.
A 40%+ drop in the stock market would have a much more detrimental effect to my ability to draw an income from my investment portfolio than in real estate.
3. You Are in Control
Want to become a millionaire in 5 years starting from zero? You can do that with real estate.
Already have cash and want a safe place to diversify your investments and earn a decent return uncorrelated to the stock market? You can do that with real estate too.
Because real estate investing encompasses so many different strategies, there really is something for everyone.
I personally chose the path of being more of a real estate entrepreneur than merely an investor. When my wife and I started, we didn’t have a lot of cash, but what we did have was time and the desire to work hard to build wealth. We earned active “side hustle” income through multiple methods such as:
- House flipping
- Real estate commissions
We then then used that income to invest in somewhat more passive rental properties, and eventually into even more passive private equity commercial real estate deals.
By developing the skill of finding good deals, learning how to restore unloved houses to their former glory, and how to create “sweat equity”, you are in control of how much money you earn in real estate. Unless you’re the next Warren Buffett, you just don’t have that opportunity in the stock market.
For example, we try to buy our houses at 80% of market value minus repairs. So if a home is worth $150,000 once it’s rehabbed, and it will take $30,000, we want to buy it at no more than $90,000. That means that every time we buy a house, we are adding $20-30,000 to our net worth – equity we are creating out of thin air by finding good deals and doing the work to bring them up to market value.
WHY YOU SHOULD NOT INVEST IN REAL ESTATE
There are lots of benefits to investing in real estate, but some major cons as well. With higher returns come higher risk, and higher stress. If you’re not prepared to weather the storms, real estate investing may not be right for you.
1. Rental Real Estate Is Not a Passive Investment
When most people think of investing, they think of the stock market. And more specifically, probably an index fund that tracks the market. That is the definition of a passive investment.
We’ve grown our net worth over $1M in the last 5 years thanks to real estate – something we never could have done investing in the stock market. But there was nothing passive about it.
Finding below-market deals takes work. Rehabbing houses that have been vacant for 3 years is risky (and a lot of work). Dealing with tenants and ongoing rental property maintenance is certainly even more work.
Is it worth it? 95% of the time, I’d say the answer for me is a resounding YES. But real estate investing is a roller coaster of highs and lows.
That other 5% of the time, when thinks look dark and there doesn’t seem to be a light at the end of the tunnel, I sometimes consider just selling everything and being done with it. Even though real estate investing has been the most lucrative thing I’ve ever done!
To make matters worse, with rental properties, the harder I work, the more money I’m losing.
When things are going well, the rent hits my bank account every month and I don’t hear a word from the tenants. In my 5+ years as a landlord now, I’ve realized everything comes in waves. I’ll go 3 or 4 months without a phone call (and therefore no work on my part), and then it seems when I do get a call about a maintenance issue, it’s like an avalanche and several properties have something go wrong at the same time.
Not only is it costing me money to repair, but I’m also scrambling to line up contractors, diagnose problems, and communicate with tenants during the process. Definitely not my idea of a stress-free passive income stream!
Now you may say it’s my own fault for managing my own properties and not hiring a property manager. And in some respects you would be right. But overall for the work I put in and the management fees I avoid by doing it myself, I am earning at least $50-100 per hour for my effort.
And not to rain on your parade, but hiring a property manager is not the secret to passive income either. When you use a management company, you are just adding a layer between you and the day-to-day tenant problems (which is nice). But now you have to manage the manager, and sometimes that can be even more frustrating because you don’t have as much control as you do when you self-manage.
I only have one property that is professionally managed, and I can say that everything was rainbows and butterflies until it wasn’t. We had a tenant that stopped paying rent and was evicted. That went smoothly. It has now been 3 months and the house is still not ready to be listed for rent. I have almost gotten to the point where I am threatening to get on a plane to come deal with it myself.
I can say with certainty I have never threatened to come sit in Vanguard’s offices because they were mishandling my VTSAX index fund investment.
2. Real Estate Requires A Lot of Cash
Speaking of the non-passive nature of real estate investing, when things go wrong they not only take your time but your money. In the last 2 months I have had to spend roughly the following:
- $18,000 (redo roof on our duplex so it slopes – goodbye flat roof and constant leaks!)
- $1,000 (remove a tree that fell on our rental house)
- $400 (remove another tree that fell on the neighbor’s car…we had a big storm come through recently that caused a lot of damage)
- $5,000 (make ready expenses from a tenant turnover – painting, fixing miscellaneous stuff)
- $1,000 (more stuff that needed to be fixed that we didn’t realize until tenant moved in)
- $4,000 (french drain to keep water from getting into one of the houses during the aforementioned rash of massive storms)
- $5,000 and counting (eviction and tenant turnover expenses for our out-of-state rental)
Don’t cry for me quite yet – most of these costs were built into my expense models and money was set aside each month for capex, maintenance, and tenant turnover expenses. A few of them were unexpected or due to my own mistakes in buying these properties (like buying a duplex with a flat roof – I will never do that again). We had 3 or 4 years of above average returns, and it just so happens that a lot of these expenses came due at the same time. Unlucky? Maybe. But not unplanned.
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Drove by one of our rental properties today. This beautiful tree will have to go 😢 But, out of all of our houses, this is the only tree we will have to take out! Counting our blessings. . . . #grateful #landlordproblems #landlordlife #dallasrentals #dallasrealestateinvestor #eastdallas #casaviewhomes #severeweather #cleanup
Even though I’ve said you can invest in real estate with no money, that doesn’t mean you can continue to run a real estate business with zero cash reserves. Sure, I have several individual deals that I have no personal money invested in, but I still have to have money set aside for the inevitable expenses that occur over time.
If you aren’t disciplined in keeping cash reserves on hand or are living paycheck to paycheck, real estate investing is probably not for you (at least right now).
3. Real Estate is Illiquid
Unlike your stock portfolio that you can liquidate in 15 seconds, the equity trapped in real estate is not so easily tapped. In fact, I would argue that the illiquidity of real estate is actually a pro and a con. Because of that, the real estate market is less efficient than the stock market, and a savvy investor can use that to his or her advantage to find better deals.
For several years I was actively involved in wholesaling, which is basically helping people solve the problem of turning their house into cash immediately for a fee. I would look for distressed properties, homeowners in financial distress, or tired landlords and offer them quick cash for their property in exchange for getting a discount to full market value. If done correctly (and with integrity), you are providing a valuable service to people in need of cash now and making a profit as well.
From an investor’s perspective, real estate is a great asset to build wealth over the long term. But with high transaction costs (8-10%+ when you sell) and the time and effort it takes to sell, it is not the right place for money you might need in the next 3-5 or even 10 years.
There is something to be said for the flexibility offered by paper investments such as stocks and bonds that can be sold quickly if you ever have an emergency need. If you need to get that cash out of your real estate portfolio quickly, you will pay a steep premium to do so.
IS INVESTING IN REAL ESTATE WORTH IT?
For me the answer is yes. Without real estate we wouldn’t be nearly as far along on our path to financial freedom.
But not everyone is cut out to be a real estate investor. It takes a time commitment some people can’t or are unwilling to give. There are always headaches and new problems to solve to close a deal, find a solid contractor, or fix a tenant issue.
In some respects, investing in real estate takes the mindset of an entrepreneur – a can-do attitude, willingness to step out into the unknown, and ability to make decisions with incomplete information.
While I am probably the most risk-averse entrepreneur out there, and often succumb to analysis paralysis, I’ve grown a lot through my journey in real estate. I am a bit of an anxious person by nature which is not the best combination with the many unknowns and new challenges that come up in real estate investing. But I have learned how to push through that to some degree.
And even more important is my WHY – I invest in real estate to reach financial freedom so at some point I no longer have to work for a paycheck and can choose what to do with my time. I think having that mindset is one of the most important things you can do to push through barriers and achieve great success in anything you do – whether it be real estate investing, building a business, or getting ahead in your 9-5 career.
Do you think investing in real estate is worth it? If you haven’t started but want to, what’s holding you back?