Some landlords are only landlords by accident. They bought a house for their use, then they had to move across the country and either didn’t want to sell the house, or couldn’t sell it because its value had dropped too much after they bought it. But for others, owning investment property is a deliberate decision, no different than investing in their 401k or in individual stocks and bonds.
So is real estate a good investment today? Of course, you should consult your financial adviser for an analysis of your personal financial situation, and this shouldn’t be considered investment advice, but we’ll discuss briefly the advantages (and disadvantages) of investing in income properties.
First, you need to determine a base-line for what can generally be expected to earn from a “safe” investment. In most circumstances, the safest investment that can be used as a benchmark is a government treasury. Today, a 30-year U.S. treasury bond has a yield of 3.52%. For someone with a shorter term horizon, a 10-year treasury bond yields 2.72%. So, when you’re determining whether to invest in something else that is higher risk, you should compare how much of a higher return you think you can achieve with that other investment. If it’s only going to yield 4%, most likely, then it probably isn’t worth the added risk unless that added risk is very low.
So, when in investing in real estate, how much more is your risk? Well, you have several key risks. First, the money invested in real estate is not liquid. It’s not easy to get money out of real property quickly. Whether you’re taking out an equity loan, or selling the property, it’s going to take time. You can’t get your equity from a house out in just a few days if you need it. A lack of liquidity is an important risk that should be taken into account. Second, you have liability risks. Tenants can file litigation, a neighbor could file litigation because your tenant’s dog bit them, etc. This risk is relatively low, and you have insurance to cover it, but you still have some risk here. Third, there is a risk of significant repair costs. What happens if the property you just bought ends up having a cracked foundation that wasn’t found on the inspection? That’s a big expense. Therefore, that possibility is a risk. Finally, you have risk that your tenant isn’t going to pay his rent, leaving you with no income from the property while trying to evict him. Or the risk that it takes a long time to get a tenant in the first place.
A smart landlord can mitigate the above risks, and if you hire us, we can certainly help you with risk mitigation. But no matter how much you mitigate the risk, it’s still there to some degree greater than with a government treasury bond. So you do need some risk premium built in to your calculations. How much? That’s a matter of individual preference, and it may change based upon how the real estate market is doing. We can help you analyze that risk if you decide to work with us. But suffice it to say that you always need a “margin of safety,” as Warren Buffett frequently advocates. If you can get 3% from a treasury bond, and you only estimate a 3.5% return from a given property, then the added risk probably isn’t worth that extra half a point.
This is where investors frequently get themselves into trouble when they’re not working with a professional. We frequently get property owners coming to us after they’ve lost many thousands of dollars because they bought a property that they didn’t properly vet, and they’re either having trouble getting it rented, or they’ve wasted many thousands of dollars that they didn’t plan to spend on repairs. We can help you avoid these problems. Experience matters.
But with all of the above in mind, what can you expect to get out of a properly vetted property when compared to other investments? We’ll assume Warren Buffett’s theory that the overall stock market can be expected to return at least an amount equal to inflation + GDP growth + dividends. That number is right around 7%. So we’ll want a return greater than that, since real estate is less liquid than investments in an index fund, and both investments carry greater risks than treasury bonds.
Let’s say you purchase a property for $50k, putting $20k down. Too many people base their returns on the total purchase price, which isn’t accurate. Only the amount put down needs to be figured, since the remainder will be paid over time, and will likely be paid from your tenant’s rent payments. We’ll make assumptions on insurance, taxes, the loan APR, regular maintenance, etc. that are common for properties that we managed. Let’s say you also spend $2k on rent-ready repairs when you buy it, and that the rent is $750/mo. Factoring everything in, your first-year return would be approximately 14%. The following year, when you don’t have the rent-ready expenses for a new property, that return would jump to 24%.
Now, clearly that is much better than the 7% that Warren Buffett has theorized is the long-term expectation of the stock market. But it also comes with less liquidity, and it’s also based upon getting a good deal like a $50k house that only needs $2,000 in repairs and can get $750/mo in rent. That sort of good deal is only likely if you personally have a lot of experience in real estate, or if you’re working with a professional, like us.
What’s more common is something like this: a property owner buys a house for $70k, putting $20k down, and doesn’t realize how much the repairs are going to cost. He dumps $20k into the house to get it rent-ready. He doesn’t have a property manager renting the property, so the house sits vacant for four months while he tries to find a tenant without the benefits of advertising reach that we have. In the end, his return the first year isn’t a return at all. It’s a huge loss. After the lost rent and the huge repair bills, he’s in the hole by $18k, and that’s including all of the benefits of his tax deductions. It takes him four years just to get into the black, let alone see any decent return. Sadly, we see this all the time. The key is to get professional help up front instead of after you’ve already made the mistakes and lost a lot of money.
The point of this article is to show you that real estate can make you a very healthy return that can far exceed the stock market. But it can also cost you your shirt, and many an amateur has filed bankruptcy after a bad real estate investment. You can be in the successful group if you get professional help to avoid the pitfalls. Give us a call.