Why Not Real Estate?
Why Not real Estate?
In yesterday’s post I asked why real estate?. The answer seems like a no brainer. There are several benefits including diversification, market inefficiency, and tax efficiency. So far sounds good. But like every asset class, there are also a number of down sides. There is no easy way to make sure money. You are always going to have to work a little and take some risks. Why not real estate?
It’s a little more complicated than the novice thinks. There are several risks and pain points associated with this fickle asset class. Many fortunes have been made and lost bowing to this slippery deity.
Leverage
But isn’t leverage one of the good things about real estate?
Well, yes, it does have its benefits. Starting with small sums of money, one can leverage their way up to owning large numbers of properties. Then with a little time and appreciation, returns sky-rocket. If I put $5K down on a $300K house and sell it later for $310K then I have tripled my money. On the other hand, If I put $10K down on a $300K house and sell it later for $310K than I have only doubled my money.
Although I prefer tripling to doubling, the down side of leveraging is risk. If the market drops drastically and I am unable to rent the property, I may be forced to sell at a loss or declare bankruptcy. The less ownership I have, the less I will be able to withstand the downturns and rebound again.
Why not real estate? Because leverage can kill a financial plan as well as it can support one.
Property Pain Points
Paper assets don’t break down in the middle of the night. VTSAX doesn’t need to be rented every year to make a profit. Taking on physical property involves a number of different types of risk. There is not only the risk that the property will not generate the appropriate returns or appreciation, but also that unexpected mechanical defects will cost both emotionally and fiscally.
If you are a landlord for long enough, some major catastrophe will happen in one of your units. The heater will break. Or a pipe will burst. Or a tree will fall into your roof. The possibilities are endless.
And it is not only acts of nature, but the human foibles you will struggle with. Potential tenants will back out at the last-minute. They will move out early and refuse to pay. Anyone who has gone through the eviction process will tell you how much of a pain it is.
Why not real estate? Because owning property takes a lot of work and sometimes generates more stress than returns.
Liquidity
How do you make money on real estate. You buy, hold, and rent. This is the formula that many of us adhere to. Not only will you cash flow monthly from rental income, but also will likely enjoy a few percentage points of appreciation over the long run.
In order for the investment to go as planned, you have to be ready to park your down payment for a number of years and accept that your money is illiquid. Selling a property takes time and should only be done during a favorable market.
If you find yourself in need of fast cash, you may be forced to sell at a loss.
Why not real estate? because you have to plan on kissing that money goodbye for years, maybe decades.
Final Thoughts
Why real estate? Why not real estate? It all depends on your perspective and risk tolerance. Certainly there is risk involved by over leveraging yourself in this rather illiquid asset. Furthermore, even if not financial stress, there are a number of pain points that come with being a landlord.
Many of these risks can be mitigated by avoiding the four wrongs of real estate, but not all.
if you are going to jump into this asset class, best to do your due diligence and invest wisely.
Real estate can be a double-edged sword as you right pointed out.
I personally try to avoid the Property Pain Points by taking on a passive real estate role (mainly through syndication). I lose some of the return (the syndicator obviously has to make money too) but the trade-off is worth it in my mind as I am happy that all I need to do is collect my “mailbox money” after the initial due diligence part.
Leverage can magnify losses and gains quite a bit. For the most part real estate has shown overall upward trend nationally but of course there are some local markets (like Detroit) that can have drastic declines). Again it pays to do careful analysis before you jump in.
Investing in larger multifamily apartment complexes like I do helps with a lot of things: there are efficiencies of scale at play, there is much more leeway in terms of having the property filled and still have positive cash flow (losing a renter in a single family home means 0 positive cash flow, whereas you can be 80% filled in a large complex and still have net cash flow).
I think the illiquidity is a positive in my mind. It doesn’t have this asset class demonstrate the volatility of the stock market because of it and thus not subject to the whims of daily public perception.
Another thing you did not mention is that there is more cost involved in this asset class. Property taxes are likely to rise through the ownership, insurance costs as well, utilities when not rented, as well as transaction costs with the buying and selling of the property. These dwarf the expense ratios of the typical index fund.
Still in my mind it is worth it for all the tax benefits.
Your last paragraph is full of things most people don’t talk about, There are definite hidden costs.
Excellent points! My thoughts exactly. Even with over a decade of experience, I still have a love/hate relationship with real estate investing. It definitely has its ups and downs. I do try to caution people who want to get into it just because they’ve heard the hype. Like any business, it’s slow and steady to grow. And there are always lessons to be learned. Starting out with small deals is less riskier than doing larger ones in the beginning. As with anything, it’s all about managing your risk.
It definitely is slow and steady. For most of it, profits are spread over many years.
One of our 2 rentals has been vacant since August and we have decided to rent it to my niece starting in December. In the mean time, we are working on it ourselves to revamp nearly everything as it is 35 years old. We had vacation plans and decided not to change them. As a result, we feel the sting of 4 months lost rent, sore backs from manual labor, and wonder whether we should sell. But then the capital gains tax would kill us. Should we do a 1031 to a more favorable property, a better neighborhood, a place we can’t drive to so we are “forced” to have a property manager get someone else to do this work? All of these would mean selling into a market that is slowing, paying a lot of fees and so on.
The good news is that the lack of liquidity has “solved” this all for us. We’ve been through those scenarios many times, and by sticking with this, it is one of the best investments we have. If we could have sold with a click we would not have this excellent cash flow.
Yes. You have to stick with real estate over good times and bad. Kinda like stocks!
A very honest no agenda discussion of real estate. Superb!
Occasionally I leave the agenda behind!
Yup, everything has pros and cons. I have found the pros of real estate far outweighed the cons. My wealth and cash flow have grown a lot over the last 20 years, largely from real estate.
I have found it to be lucrative too.