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Why I Dislike Real Estate as an Investment
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There are two parts to any investment – cash flow and equity appreciation. Cash flow refers to how much money the investment generates and equity appreciation is how much the investment itself grows in value. When you look at real estate, cash flow refers to any rents you can earn and equity appreciation refers to any increase, or decrease, in the property’s value.
In the last few years, real estate has taken a huge hit because prices simply grew too quickly, financially incapable people were given loans they couldn’t afford, and the myth that “buying a home is the best investment ever” was finally revealed to be the result of incredible anecdotes and not a statistical look at historical home values.
I’ve never liked the idea of real estate as purely an investment for a variety of reasons.
Diversification
Part of the reason probably has to do with our age and our current nest egg. We have already invested close to $300,000 in real estate with our primary home, that we purchased three years ago for $295,000. When you compare that with our retirement and taxable brokerage accounts, our home already represents a significantly portion of our investment allocation.
To go out and buy another piece of property for the purposes of making it an investment would really put our allocation out of whack. That’s the number one reason why investing in real estate is not appealing to me.
Significant Minimum Investments
You can open a Vanguard account, invest it in their STAR fund, for $1,000. Can you buy a piece of property with only $1,000?
When you invest it in a mutual fund, your liability is limited to $1,000. When you buy property, you’re on the hook for a lot more… even if it only requires a $1,000 down payment. Someone could get hurt on your property, it could burn down or be flooded, or it could seized by the government under eminent domain. Insurance will cover against most of those issues but insurance costs money… which leads up to the next reason.
Holding Costs
When you own property, there are significant holding costs involved. You have to pay property taxes, insurance, interest on the mortgage, local and county taxes, utility costs like electricity and water, and that’s outside of any management fees. When you purchase a home, not only are you getting the liability of the mortgage but also all the weight of monthly carrying costs.
If you’ve ever watched a flipping show on those home improvement channels, you’ll know what kind of pressure these holding costs can have. First time flippers almost never finish their projects on time and see those monthly holding costs cut into their profits. These holding costs will eat into your cash flow or your equity appreciation.
Transaction Costs & Time
When you sell a home, you pay 3% to the seller agent and 3% to the buyer’s agent. So you lose 6% of the total value of your property to the transaction. That also doesn’t include any last minute touch-ups to the house that you may need to make, such as a fresh coat of paint or staging fees to make your house look better.
When you get to the time involved, that’s where it really gets serious. How long does it take for a house to sell these days? If you’re lucky, a couple weeks. If you’re not, it could take a year or two. How will the market be in a year or five? Will it be sizzling hot like five years ago or will it be like today? If you need the money for something, you could find yourself taking a hit just to liquidate quickly.
Stock market? Stocks will trade in seconds (minutes if it’s lightly traded) and it’ll cost you less than ten bucks.
Am I Advocating the Stock Market?
In a way, yes I am. It’s liquid, there are little to no holding costs, and the transaction costs are low. It’s just as difficult an investment arena to understand but the system is a lot easier to manage. For individuals at my age, 20s and 30s, I think real estate is a fools errand and the stock market offers the flexibility we need.
If you already have a lot invested in the stock market, perhaps real estate is the way to go. It’s just not the sure thing people always make it out to be. When your friends tell those stories about how someone sold a house they bought in the 80s for $50,000 and sold it for $500,000, ask them how much was paid in interest, property taxes, and real estate agent commissions.. then think about whether a similar investment in the stock market might have yielded similar or better results. 
What are your thoughts about real estate as an investment? I know it is a very popular subject so I’m eager to hear your thoughts!
(Photo: lcd1863)
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Two thoughts:
a.) You can reduce the bite-size and the asset concentration/allocation issue by partnering with someone you truly trust (sibling, cousin etc) – that way you could invest a smaller amount of money. I have seen this model succeed, but also fail in a gruesome way – it really depends on trust, reliability and having the same goals / patience.
b.) You can get the best of real estate and the stock market by investing in REITs. However, I have never taken the time to research them and understand them well enough to invest – thoughts on those Jim?
What about REITs? You can trade them like stocks, but they’re backed by real estate when you pull back the curtain. They’re pretty volatile, but you get around a lot of the disadvantages that you outline.
I tend to agree with you Jim. I think of purchasing real estate as buying a place to live, not as an investment. I invest in real estate by buying a REIT.
Isn’t the minimum for the Vanguard STAR fund $1000 and not $3000?
Whoops, you’re correct, my memory failed me.
I agree with you in general. Buying a home is an expense, not an investment – and a home loan guarantees the greatest possible expense. The stock market is mainstream gambling, but at least you know exactly what you stand to lose. As far as I can see, some legitimate reasons to purchase a home are to live in it, leave it to heirs, not have people stomping over your head upstairs in an apartment or stealing your parking spot, and to enjoy some psychological effect from having territory you consider your own. As someone who has rented for many years and is now considering purchasing a home, I easily concluded that even with a home free of a mortgage payment, our expenses will at least equal paying rent and utilities in our current apartment – and could exceed the costs by up to $500 monthly.
This is a tough economy for a real estate and equally as tough for the securities market.
I have a client (and good friend) who started forty years ago as a bank teller earning $80 per week. He left that and became a real estate salesperson, then a broker, then in the earliest stages began to buy and sell on his own account. Now he’s a serious multimillionaire. Has been for two decades. Through the years there has been some flipping, some foreclosure purchases, some multi-unit apartments, and hundreds of rental houses.
I asked him the other day given this economy whether he would do it again or do something else and he said “Absolutely do it the same way.” I asked why and he said “it’s the simplest reason that gets people involved in rental property in the first place. You buy property and someone else pays for it. Even if you end up selling for $.50 on the dollar, that’s $.50 someone else paid for you.”
My sentiments exactly! The cost of holding real estate eats away at any apprecication one can expect. My back of the envelope is that it costs about $20,000 a year to hold a vacation home, not including the mortgate payment. Utilities, property taxes, insurance, homeowners association fees, upkeep and maintenance…it all adds up.
Buying a home is not an investment, for all the reasons you listed. However, buying and holding investment real estate can definitely be an incredible investment, even with regard for the things you mentioned. Here’s my response to your reasons:
Diversification – “Diversification is a protection against ignorance. It makes very little sense for those who know what they are doing.” – Warren Buffett. On the other hand, when you have tv shows about the average joe blow flipping houses, it’s not surprising to see the financial carnage that ensues.
Minimum investment – True, but not a bad thing. Having a large chunk of money in a business you own is a good motivation to keep it in good financial shape.
Holding and transaction costs – Every investment has some holding cost. Just like any other type of investment, returns should be calculated after including *all* expenses, including tx and holding expenses.
You’re definitely right that real estate is not a sure thing, but it offers a few major advantages:
1. Leverage – Two way street but incredible for those that use it well.
2. Tax advantages
3. Tangible asset very unlikely to lose all value (though because of leverage, it doesn’t have to in order to wipe you out)
There are others, but you get the idea. Investing in the stock market is a lousy way to build wealth. Sorry, but it’s the truth. Look at all the self-made millionaires and billionaires out there. Almost all of them made their money through owning their own company or real estate (a type of owning your own company).
Phenomenally thoughtful response and I agree with your argument that it can be a good investment, but is it better than more flexible alternatives? I think one problem people run into with real estate is that everyone thinks they’re an expert when in reality they probably aren’t (average joe blow flipping houses, they’re never going to do it right the first time and how many times will the novice investor buy and sell homes?).
It is a tangible asset that’s unlikely to lose all value but, as we’ve seen the last few years, people are known to overpay and so homes can lose some of their value. It doesn’t take much % loss for it to hurt, 1% on a $200,000 home is still a solid two thousand bucks. It won’t cripple you, but dang it’s going to hurt.
Jim,
As a rental real estate owner for 6 years I can say that Ryan is right…
1) The fundamental question surrounds balancing the expected ROI after all income and expenses with the risk factor of the investment. Our rental property is worth a net $150K after all fees and taxes on a sale…
Each year, we earn a net $7,500 in income after taxes on the property. That means our ROI is 5% after taxes (equivalent to about a 7% before-tax ROI). That does not take into account any appreciation of the property (we bought in 2001, so we made out well).
We do not have a mortgage – if we did we could make the ROI number come out to 20-30%, but we’d be leveraged and we prefer to be in a debt-free position right now.
2) Rental real estate offers very high tax incentives because you can deduct the mortgage interest and the depreciation on the improvements (not the land). You have to recapture depreciation on a sale but it is limited to 28% or your marginal tax bracket, whichever is less.
3) If you find the right kind of renters (this is **KEY**), you have very little hassle and the rent gets paid on time each month. Credit checks and reference checks are essential.
4) Real property is easy for banks to understand and thus easy to obtain financing for — this allows the ‘average joe’ to take on secured business debt with only 20% down.
You simply can’t find that kind of loan for other types of investments, which means you can’t get your hands on the money to increase your leverage and ROI, even if you wanted to.
5) Expenses for personal property and investment property are treated differently for tax purposes (for instance, there is no mortgage deduction phaseout for investment property for high income earners)… and everything is deductible on rentals (insurance, interest, mortgage insurance, repairs, improvements (via depreciation), marketing, etc), as opposed to just the mortgage interest on personal homes.
6) Personal real property is basically an expense, not an asset (or investment). Once you set a standard of living by buying a particular house, few people are willing to lower that standard until very late in their life – potentially downsizing for retirement. In order to get the “equity” everyone talks about out of your housing “investment,” you have to downsize. It is better than renting, of course, but it isn’t the type of ‘investment’ that any business person would take.
You seem to be mostly talking about flipping houses. I personally don’t think flipping houses is a good idea for the vast majority of people. THeres too much risk there and you have to know what you’re doing to make a profit. Owning rentals is a very different kind of investment and I think its a much better choice for most people. Using your home as an investment is also a different matter. Your home is a place to live, not a cash cow.
I think that real estate can be a very good investment but its not for everyone.
On the down side: Real estate is illiquid so its hard to get to your asset fast and it might not sell for months. The amount of WORK involved in direct real estate ownership is a major issue. Its a LOT easier to simply buy a REIT index fund.
I think Ryan makes some great points – especially,
“Look at all the self-made millionaires and billionaires out there. Almost all of them made their money through owning their own company or real estate (a type of owning your own company).”
Your primary residence is NOT an investment. So, your investment in real estate is 0%.
My answer would be it depends. I would not include most peoples houses as a investment because they honestly are rarely bought as a true one. If you buy a duplex or a rent out rooms in your first house, thats a investment. Simply living there is at best a way to lower costs, worse a unneeded liability.
I would however look at it as a quasi investment. Its not like a stocks and mutual funds were you don’t have involvement with the actual value of the investment. With Property you have to invest time like it is a business. If you lose money, its usually because you made bad business decisions.
As a investment I think its fine as long as you are willing to put the work in. If your not you will lose your money. I think there is greater potential for profit in real estate, however it comes with increased risk and work.
Jim, I agree with you completely. A big part of the reason for the real estate flame out of the past few years has been the shift in the view of housing from a home to an investment. There are all kinds of implications there.
I think most people think real estate investing is easier than it really is. I come from a long line of real estate investors, and you have to view it as a business, not as an investment.
A mutual fund or CD don’t spring a leak in their plumbing in the middle of the night requiring you to get out of bed and deal with the problem. And it’s a LONG term investment, not a place for short term, get rich quick trades. You’re completely dependent on the direction of the market and on the state of the rental market.
Unless you have the time and the stomach, real estate investment is best left to those who do. It’s far messier than most people realize.
Jim, is that the House of Seven Gables in the photo???
It is. Interesting choice for this article, huh?
Completely agree. A house is more a liability than an investment.
If you live in DC where housing is supposed to be “recession-proof”, and it seems to be in the older well-established neighborhoods, then RE is an excellent investment. You will have demand from govies, IMF/World Bank types, they pay your mortgage and your equity grows. It’s a long-term wealth making strategy.
This has got to be the most detailed article I have come across against investing in real estate. You make very valid points. I’m not in a position to do much investing at all right now, but real estate, while seemingly desirable, has been a turn-off mainly due to the maintenance required. I don’t want to worry about the upkeep of a house and tenants. Undeveloped land on the other hand… maybe. They are not making any more of it.
I used to like real estate, until I lost money. The same with stocks. Now I get hardly any interest on savings. Is it better to just pay ahead on fixed expenses and go on a lot of vacations? What is safe and has a guaranteed decent return? Nothing I can see.
John DeFlumeri Jr
“What is safe and has a guaranteed decent return?”
Treasuries (and even that may be too risky for some). Aside from that, nothing. The reality of investing is that it’s hard work and you have to be able to stomach risk. If you can’t, kiss your dreams of building wealth goodbye and try to marry into it instead.
John – “Is it better to just pay ahead on fixed expenses and go on a lot of vacations?”
That’s a deep financial philosophy question. You should write a post on this question and invite opinions. Could make for a most interesting debate.
Jim, from your perspective I’d have to agree. I actually would love to be a RE investor one day, but it works best when you are in a position of strength. That means having little or no mortgage on your rental properties to maximize cashflow, a sizeable emergency fund to access in case a roof needs repaired or something, AND all this should be balanced by a sizeable nest egg invested in mutual funds. In other words, I’d have to be debt free and pulling down tons of dough each month that I can save up to buy properties every year or two.
Great points Jim!
“That means having little or no mortgage on your rental properties to maximize cashflow”
If you do this, there’s almost no point in investing in real estate, as you give up leverage and get a terrible ROI and ROE. That said, it’s important not to be over-leveraged, either, but avoiding debt altogether is foolish.
Thank for posting and stirring the discussion! My 3 points:
1) Your home is not an investment indeed. Proof is that the bigger it is the more it will cost you rather than generating income streams. I recommend Rich Dad, Poor Dad on subject if interested.
2) Leverage is a huge advantage in real estate. You can buy an appartment of say 100k with 20k USD in cash thanks to the use of the house as collateral (e.g. mortgage). This allows for benefiting disproportionally from gains/losses while also building up your net asset base (because in say 10 years the rents will have paid your mortgage & you will only get the revenue).
3) Regarding the cost of real estate, it should be costed in the investment. The stock market is easier (if I may say…) because you have only 4 data points beyond market itself (buy price, sell price, taxes, fees) but the same financial rigour can be applied to real estate when buying for rent (taxes, ownership costs, selling cost, gross yield of rent, cost of mortgage, net yield, etc.). Some factors will come with luck or pain which is part of the market and pleasure of this business (bad renter, issue with walls, area goes up in value, etc.) but it can be made more rational if you want to.
Net, I think that real estate is very attractive because allowing building a solid personal asset base on the long run thanks to leverage. Yet I would agree that it is a question of taste too given the specific parameters involved in this kind of investment.
I recommend staying away from Rich Dad as far as you can. Some nuggets of truth in there but so much more that people can misunderstand and take them off the right track. Look here for more details:
http://www.johntreed.com/Kiyosaki.html
I think whether or not real estate is attractive is driven by relative valuations.
In most parts of semi-rural or suburban US you can buy a condo, house, living unit for about 10-12 annual rents (purchase price = 10-12 * 12 * monthly rent). In and around bigger cities however, that multiple is inflated, often up 20-25 annual rents. I.e. compared to local rents, buying a place in some locations is much more expensive.
The reason for the difference is that 10-12 multiple value derives most its value from future cash flow of a rental property. But for the 20-25 multiple properties, more than half of the value is driven by future appreciation expectations. Comparing it to the stock market, the lower multiple are classic dividend producing stocks whereas the high multiple stocks are typical high growth stocks.
So far, so good.
But what if you want to *invest* in real estate, e.g. by buying a rental property?
I personally find a low multiple income focused property much more attractive, than one that is nearly double the relative price because of high growth hopes for the future. I want to invest in the cash flow, not bet on future appreciation. But that is what many people do when they buy rental properties in expensive locations.
Unfortunately, I live in such an expensive city and for this reason don’t want to invest here. I would actually like to invest in a low multiple area, but that is too far away for me to manage effectively.
Jim, while I agree that your own home is an expense and not an investment, I disagree that real estate itself is a bad investment. A couple huge advantages have been pointed out already, especially that of the possibility of using leverage when buying real estate. Your article asks if you can buy a piece of propety for $1,000…the answer is that yes in fact you can. I am buying property with NONE of my own money, which means I have an infinite return on investment. As far as the monthly expenses, if you buy in a cash flow market you can have a very nice monthly return coming in.
It all comes down to whether your real estate you are buying is an asset and putting money in your pocket, or a liability and taking money out of your pocket. Too many people think negatively of real estate because they think that they have made an investment in an asset, when in reality they have bought a liability that they are speculating will go up in value. That’s not true investing anyway.
If your real estate “investment” isn’t cash flow positive from day one, its not an investment. All the people who were banking on appreciation to make their real estate investments pay off are realizing this now. In the long term, real estate doesn’t appreciate at all, it just goes up at the rate of inflation.
And I also hope the term “buying a home as an investment” dies off soon. A home is something you live in, not an investment.
I’m a cashflow investor myself, but your statement is ridiculous. Investing for cash flow is not the only way to invest in real estate. And while the net rate of appreciation across all real estate might be inflation (debatable), there’s definitely huge variance by location, property type, etc. Is it more speculative? Absolutely. But all investment is speculative to some degree.
Jim, I have to disagree on this one. When you invest $1000 dollars in stocks, your ROI is based on $1000 dollars of your own money. So if you realized a $500 dollar return your ROI is 50%. On the other hand, if you had borrowed $500 and invested $500 you ROI would be 100%. Investing in stocks requires the investor to fund the full amount of the investment, while real estate allows you to only lock up as little as 5% of your investment price. This allows you to take advantage of leverage.
All investments have a level of risk. People who flip houses are in the same league as investors who lost their life savings investing in tech companies prior to the dot com bust. If you don’t know your investment, it’s just plain gambling. The costs associated with a real estate investment should be a non-factor if you have factored that into your operating costs and still have a cash flowing property from the start.
Finding a cash flowing investment property is no different than reading a financial statement for a company you would buy stock in.
Leverage cuts both ways, so to just tout its benefits is misleading.
As for the costs associated, I agree that they can be a non-factor but renting out a property isn’t as trivial as you make it seem. Between finding renters and maintaining the property, including repairs between renters, there are costs that you may not have properly accounted for. It’s not impossible, but hardly trivial.
Sorry Jim, I think you miss the mark on your article.
Not all real estate is created equal, commercial vs. residential. Different risks. Different barriers to entry. All to often I read about people lumping the two together.
Yes your house can be an investment, albeit not so much in this market, but in an appreciating market if you utilize the 2 in 5 tax rule your gains (up to $500K MFJ) are tax free. Now you just need to find a wife who doesn’t get tied down because she likes the neighborhood.
Also, the tax advantages are too great to pass up… 1031 exchanges, which means you don’t have to pay tax on a single dime of appreciation while you keep trading up. I don’t think you can say the same for Vanguard’s stuff. Last time I checked every gain from a Vanguard 1099-B sale triggers tax – notwithstanding the zero cap gain rate lasting till 2010 for Low AGI’s.
Also depreciation may eat up all your cash flow and even the excess paper losses may be deductible depending on AGI. What a good way to shield w-2 income. Equity buildup and tax breaks all by holding real estate.
I’d rather see you write an article on how to price real estate in a down market instead of throwing out the real estate (commercial or residential) investment segment entirely.
You could give suggestions for different investment levels, such a Duplex, 4plex or small commericial 1k – 5k sq ft building for entry level investors. 5-50 apartment building or 10K – 100k sq ft Commercial for medium investors and so on.
Cheers,
Stonewall
Stonewall, it appears that there are aspects of real estate investing that I just missed (tax advantages, difference between commercial and residential, etc.). In the end, the post was less an indictment on real estate investing as it was some of the reasons why I dislike it as an investment.
Unfortunately, I’m not an expert on real estate investing, my tune would probably be different if I was. And I’m entirely unqualified to write the article you suggest.