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In an excellent primer on the drawbacks of real estate investing, Ben Le Fort makes the case that “real estate is the most overrated asset in history.”
However, there are good reasons why people swear by real estate investing.
One major reason is that it’s much easier and less expensive to leverage a real estate investment. That’s called a mortgage. If you put down a 20% payment and finance the other 80%, you’ve just leveraged your money 5-fold.
Historically, residential real estate has returned about 4% a year.
Leveraged 5-fold, that becomes a 20% annual return, which is double the historic ~10% annual return on stocks. After accounting for inflation, the leveraged return on real estate is ~17%, which is 2.5x the ~7% real annual return for stocks.
Next, direct real estate investing in more tax-efficient than investing in a mutual fund. The latter is required by law to annually distribute gains to shareholders, with significant tax consequences if held in a taxable account. With a direct investment in real estate, you don’t get taxed on any appreciation in your property’s value until and unless you sell it, likely after years or decades.
In addition, mortgage interest on your rental property should be fully tax deductible as a business expense.
Finally, the US tax code lets you depreciate the value of real estate, typically over 39 years. This is a deductible expense that reduces your taxes without requiring any ongoing cash outlay. Note however that this depreciation increases your ultimate taxable capital gains once you sell.
To be clear, I agree with many of Le Fort’s points, including:
While real estate does make it hard to diversify, there are two fairly easy ways of doing so, and doing both reduces your risk more than choosing just one or the other.
Here too, there are several things you can do to reduce your real-estate-related effort.
The costs involved in owning a rental property directly are certainly much higher and more varied than the costs of owning shares in an index mutual fund. However, owning shares in a REIT avoid those costs.
For direct ownership, you just have to make sure the property is in an area where you can reasonably charge a high enough rent such that your tenants pay all those plus the principal portion of your mortgage payments (which isn’t a cost, but affects your cashflow), and leave enough over that you’re cashflow-positive even when accounting for months when your property is between tenants.
Another tip here is that you can buy a home warranty to help reduce your risk of massive repair costs. In fact, you might be able to put into your lease agreement that the tenant covers half the copay of any repair claim s/he makes. This will make frivolous repair claims less likely.
Here too, there are advantages to renting out a home you just moved out of, rather than buying an investment property. Typically, lenders charge a lower interest rate on mortgages for primary residences, and those rates don’t change if you move out and turn the property into a rental.
This is one risk that’s hard to sidestep (except through investing in REITs).
However, your property manager can give you an estimate of the fraction of renters they’ve experienced problems with over their entire portfolio of properties under management. If that’s about 1%, you can charge a higher rent to offset that level of risk.
There is no doubt that your risk of losing your investment is much higher when you’re leveraged.
In our example of a 5x leverage, if you’re forced to sell when your asset value drops by just 10%, you just lost half your investment. If you’re forced to sell when it’s down 20%, your entire investment is wiped out. If the asset declines by more than 20% and you’re forced to liquidate, you’d end up owing more than you get for selling the asset.
However, buying stocks on margin (that’s when you borrow money to leverage your stock investment) is far riskier. This is because if and when your investments drop in value, your broker may make that dreaded “margin call” and require you to add money to your investment, and if you can’t or won’t, you’ll be forced to liquidate when prices are low, guaranteeing an outsize loss.
In direct investing in real estate, by comparison, as long as you keep making your mortgage payments, the lender won’t bother you even if the property drops to half its original value. This allows you to wait out the temporary drop in asset value, while being paid by your renters.
Above, I mention that your mortgage interest will be lower if rather than buy an investment property, you lease out your own home once you move to a new one.
However, you can get a similarly lower interest rate if you buy a duplex or quad, live in one unit, and rent out the other(s).
Another advantage here is that it makes it easier to keep an eye on your renter(s) because you literally live next door. This makes it much easier to manage the rental yourself, if you prefer to put in more effort rather than pay a property manager.
All the above may make it seem like a no-brainer that everyone should invest directly in real estate.
That’s hardly the case. Here’s a non-exhaustive list of situations where you should avoid it completely.
There are solid reasons why investing in real estate is a good idea, but as in all investments, it’s crucial to know what you’re investing in, and accept and mitigate the risks through proper diversification.
The above details the advantages of real estate investing, how to look at the risks and mitigate them, and when you should avoid this sort of investing altogether.
Disclaimer: The information in this article is not intended to encourage any lifestyle changes without careful consideration and consultation with a qualified professional. This article is for reference purposes only, is generic in nature, is not intended as individual advice and is not financial or legal advice.