In the previous lesson, you learned all about cash. It’s an important part of any investor’s portfolio.
Cash gives you the liquidity you need to quickly access your money, and you can earn a small, safe return in the meantime through savings accounts, CDs, and other short-term investments.
Today we’re going to talk about real estate – which is almost nothing like cash (other than it takes cash to buy real estate!)
Whether you’re a newbie to real estate or a seasoned investor, you should come away from this lesson with a greater understanding of how real estate fits into your investment portfolio.
What is Real Estate Investing?
When you think of real estate investing, what comes to mind first? For most people, they associate it with owning a house, renting it out to a tenant, and being a landlord.
And while that is one aspect of real estate investing, there are dozens if not hundreds of different ways to invest in real estate. They range from extremely passive to so hands-on it’s basically a second job.
Here are just a few examples:
- Investing in farmland
- Owning rental property
- Investing in commercial real estate through crowdfunding or direct ownership
- Flipping or wholesaling houses
But regardless of how you invest in real estate, at its core, it comes down to owning real property, and making money through rent and the increase of property value over time. If you’re familiar with the stock market, you could consider it as similar to owning a stock, where each month you get a dividend (rent payment), and the value of your stock (property) tends to go up over time with the market.
Real Estate Investing vs. Stocks and Bonds
Speaking of comparing real estate to other forms of investment, some really smart researchers at Harvard put out a study called The Rate of Return on Everything, 1870 – 2015. In it, they compared the return of stocks, bonds, and real estate across multiple countries and time periods.
What they found was very interesting – since 1870, real estate has outperformed every other asset class, with less volatility than stocks (7.06% for real estate vs. 6.88% for stocks and 2.53% for bonds).
They assume an all-cash purchase, so if you factor in the relatively cheap leverage you can obtain on real estate through a conventional mortgage or commercial loan, the returns go even higher!
The 4 Wealth Generators of Real Estate Ownership
So how does real estate generate such great returns over time? Here are the 4 main wealth generators:
- Cash Flow – Every month, you’ll receive a rent check. After paying the bills (mortgage, taxes, insurance, repairs, etc.), the left-over amount is considered the cash flow income.
- Loan Pay-Down – If you have a mortgage on a property, part of your expense is the mortgage payment. With a standard amortizing mortgage, each month part of that payment goes to interest and the other part goes to the principal on the loan. As your loan balance decreases, this increases your equity in the property. If you have a standard 30-year mortgage, after 30 years your tenants will have paid off the house for you!
- Appreciation – Over time, the value of your property will increase (although this is certainly not a steady growth – ask anyone who went through the Great Recession of 2008.) But on average, you might expect the property to go up in value at about the rate of inflation – 3% per year. While that might not sound like a lot, if you put down a 20% downpayment and borrowed the other 80%, you are actually leveraged 5:1. So that 3% increase in property value is actually a 15% increase in your equity.
- Tax Benefits – The wealthy love real estate investing because it’s a hard asset, a hedge against inflation, and it comes with some hefty tax advantages. The U.S. government heavily favors real estate owners by giving them favorable tax treatment. On a typical rental property, you are allowed to take “depreciation”, which is a certain percentage of the value of your property, as a tax loss each year. So even though you might be bringing in a real profit, it is offset by a paper “loss” that reduces or even eliminates the taxes owed.
Pros and Cons of Real Estate as an Investment
In the last section, we saw that there’s a lot to like about real estate investing, but there are some unique risks as well that may not make it well-suited to your particular situation.
Pros of Real Estate Investing
- You have more control of your investment. One of the main benefits of real estate is that you have much more control of your investments than with the stock market. You can literally see and touch your asset, and have the ability to increase its value with “sweat equity” by doing a remodel or buying at a discount. You are also the one in charge of the property management (or at least are in charge of the property manager) and can make day-to-day decisions to improve profitability.
- Real estate lets you use (relatively) safe leverage. I can’t think of any other asset class that allows and even encourages you to leverage your investment – for example, buying a $200,000 property with only a $40,000 down payment. While leverage can be a double-edge sword, responsible leverage in real estate can exponentially increase your wealth-building power.
- Real estate can provide steady cash flow. Would you rather have a $100,000 asset that reliably gives you a dividend of $500 per month, or a $100,000 asset that is subject to the whims of the market – up $10,000 one day and down $20,000 the next? Especially as you get closer to retirement, knowing you have a steady income you can rely on is an important benefit.
- Real estate provides a hedge against inflation. Since you own real property, it will generally hold its value in an inflationary environment, as opposed to stocks or bonds. Over the long term, real estate has reliably kept pace with inflation. And one thing that doesn’t increase with inflation is your mortgage payment. While rents and property values continue to rise, your mortgage payment stays the same. At 3% inflation, after 20 years rents would have almost doubled while your mortgage payment stays the same!
Cons of Real Estate Investing
- Real estate is a long-term investment. Part of the reason for the good returns in real estate is that it is an illiquid investment. Selling a property can take months, and it comes with high transaction costs. You should only invest with money you don’t need for at least 5-10 years.
- Real estate often requires a lot of cash. Even with a mortgage, many people don’t have $20-50,000 lying around to purchase a property. There are ways around this, and you can learn how to invest in real estate with no money, but for the average investor it can be more work than it’s worth.
- Real estate investing is not as passive as other forms of investing. Traditional real estate investing can be time-intensive: hunting for a good deal, finding tenants, dealing with property management and maintenance, etc. That said, there are many ways to invest in real estate that are more passive than owning property, but you will have to give up some of the benefits (high returns, control) in exchange.
3 Ways to Invest in Real Estate
With the theory of real estate investing out of the way, let’s talk about a few options so you can figure out what kind of investor you are, take action, and start investing in real estate today.
REITs (or Real Estate Investment Trusts) are by far the most passive way to invest in real estate. REITs are special entities that own real estate and are required to pay out a certain percentage of their profits to investors.
REITs trade on the public stock exchanges, so they are extremely liquid, and you can even hold them in your 401(k) or IRA. There are all kinds of REITs that specialize in different asset classes (e.g. multifamily, office, retail, industrial, etc.)
One option to get exposure to the overall real estate market in your portfolio is Vanguard’s Real Estate Index Fund. It owns a broad base of REITs that tracks with the overall market and provides a steady dividend (3.2% as of this writing).
Crowdfunding is a relatively new way to invest in real estate. Instead of having to come up with the capital to purchase a property all by yourself, you can pool your money with other investors on a specific project.
Usually, a deal sponsor will find and manage the deal, and you will come in as a limited equity partner and own a certain percentage of the deal.
For example, if you were buying into a 300-unit multifamily property, the sponsor would raise money from investors through crowdfunding and determine a profit share of the cash flow and eventual profits from sale of the property. There are a million ways to structure these deals, but in my experience typical terms would include a preferred return of 8% and a 70/30 split thereafter. This means that passive investors get the first 8% of any profits, and then the remainder is split 70/30 between investors and the sponsor.
While not quite as passive as REITs because you have to analyze individual deals and sponsors, it is still a great way to get into larger real estate deals without tying up as much of your own time and capital.
There are multiple crowdfunding platforms out there such as Crowdstreet, Fundrise, Equity Multiple, Diversyfund, and Groundfloor.
If you’re new to crowdfunding, here is a deep dive into my personal experience with two of the most popular platforms:
- Groundfloor vs. Fundrise (How I Got Started With Real Estate Crowdfunding)
3. Owning Physical Property
Owning rental property is the traditional method of real estate investing. It provides you with the most control and potential return, but is arguably the least passive way to hold real estate in your portfolio.
Just like you should understand the fundamentals of a company before investing in its stock, you also need to be able to analyze a property to know whether or not it meets your investment criteria. For example, many people invest in single-family homes. But what makes a good home for your family doesn’t necessarily make a good investment as a rental.
There are a few rules of thumb to get started, such as the 1% rule that says that a property will generally be cash-flow positive if the monthly rent is 1% or more of the purchase price. There is also the 50% rule, which says that monthly expenses (besides principle and interest payments) will equal roughly 50% of the rent.
Obviously these are generalities, and you will need to run the numbers using actual income and expenses for your potential first rental property. For a residential property, your expenses are more than just the mortgage. You need to include potential vacancy, taxes, insurance, maintenance, utilities, property management, and capital expenditures (big expenses that don’t come up very often, like replacing the roof or HVAC).
Your investment criteria could be based on cash-on-cash return, return on equity, cap rate, or any number of real estate investing calculations. Below I’ll show you that even when you don’t set the bar too high on your investing criteria, you can still do very well investing in rental property.
Case Study: The Power of Real Estate Investing
Here’s a simple example to show the potential of investing in real estate over the long term. For this case study, we’ll use conservative numbers and assume an average deal in an average market.
Suppose Sally bought a single rental property at age 35, and planned to retire 30 years later at age 65. She bought the property for $200,000 and put down $40,000 (20%). She takes out a $160,000 loan at 5% interest over 30 years, which results in a payment of $859 per month. It rents for $2,000 per month (which meets the 1% rule), and her expenses over time average out to $1,000 per month. Her cash flow is $2,000 – $1,000 – $859 = $141 per month or $1,692 per year.
$141 cash flow per month doesn’t sound like much, but that is just one piece of the puzzle. Let’s assume rents and expenses increases at 3% per year, and that the house also appreciates at 3% per year (about the rate of inflation). Over 30 years, the cash flow steadily increases from $141/month to almost $1,500 per month, all while the tenants are paying down the mortgage.
At the end of 30 years, Sally owns the house, now worth $485,000, free and clear. Without a mortgage payment, she is making almost $2,400 per month! In addition, she’s made a little over $260,000 of cash flow along the way. Her initial investment of $40,000 has turned into over $700,000 – not bad!
Here’s what her investment looks like over 30 years, broken out by the 3 components: cash flow, loan paydown, and appreciation.
Final Thoughts on Real Estate Investing
Real estate can be a great way to diversify your investment portfolio. It can provide strong returns over time, and tends to be uncorrelated to the stock market, which can provide some much-needed cushion when the stock market fluctuates.
While it takes some time and education to learn to speak “real estate” and understand the fundamentals of the market, it can be a great way to earn passive income and build your nest egg.
One thing I’ve learned by being a real estate investor myself is that it requires action! I’ve talked to dozens of people that all say they want to invest in real estate. But 1 year, 5 years, even 10 years later they haven’t done anything about it. Now’s the time to get off the fence and take the next step toward becoming an actual real estate investor.
- Real estate investing takes many forms. You don’t necessarily have to be a landlord to invest in real estate.
- Over the last 150 years, real estate compares favorably to investing in stocks and bonds.
- Real estate tends to be uncorrelated to the stock market, which makes it a good way to diversify your portfolio.
- Real estate generates wealth through cash flow, loan paydown, appreciation, and tax benefits.
- Real estate is illiquid, which makes it a bad short-term investment. You should plan to hold for 5-10+ years.
- Real estate has long been used as a hedge against inflation.
- You can passively invest in real estate through REITs or crowdfunding.
- Owning rental properties allows you the most control over your investment, but is less passive.