One of the most common pieces of financial advice our clients hear from their friends and family is to invest their excess cash in rental properties. Unfortunately, this is terrible advice for all but a lucky few. There are four big reasons for this: it likely won\u2019t generate the income you expect, it\u2019s hard to generate a compelling return, a lack of diversification is likely to hurt you in the long run and real estate is illiquid, so you can\u2019t necessarily sell it when you want. <\/p>\n\n\n\n
Before you buy a rental property as an investment, consider the reasons you\u2019re unlikely to come out ahead.<\/p>\n\n\n\n
A popular reason we hear for wanting to invest in real estate is a desire for additional income. Unfortunately most real estate investments, especially residential properties bought for investment, don\u2019t generate positive cash flow for quite a while<\/em>. That means you have to fund losses each year. Allow me to illustrate with an example.<\/p>\n\n\n\n Imagine you bought a house or condo for $500,000 and financed it with a mortgage of $400,000 at a 30 year fixed rate (with no points) of 3.8%. Your monthly payment would be $1,864. Your monthly real estate taxes would probably be at least $400. You should also factor in monthly upkeep and insurance, meaning you\u2019d need to charge a monthly rent of almost $3,000 just to break even. For a condo, you\u2019d have to add in homeowner association (HOA) fees. There aren\u2019t many $500,000 homes that can command monthly rent of $3,000 in the areas where our clients live. Eventually, with annual rent increases, you could break even, but it would be a while before you\u2019d generate the income you originally sought with a real estate purchase. Raising rent can also be a challenge in cities like San Francisco that have rent control laws and limit your ability to ask your renter to leave if they don\u2019t pay their rent on time.<\/p>\n\n\n\n Another reason we hear for wanting to own real estate is it is \u201cunderstandable\u201d compared to trying to invest in stocks or bonds, which many people believe requires a knowledge of financial markets. People who are unsure of how to start investing often perceive investing in stocks or bonds as overly risky and worry they won\u2019t be able to time the market correctly. This fear is further stoked by pundits who claim the market is under- or overvalued, despite overwhelming research that market timing is irrelevant to earning a good return. Buying a diversified portfolio of low cost index funds requires very little expertise, especially when managed by an automated advisor like Wealthfront. <\/p>\n\n\n\n In contrast, people think buying an investment property must be like buying a home \u2014 something with which most Americans have experience. But buying a home is very different than buying a property for an investment return. Not all home values appreciate, and that\u2019s OK as long as you can afford your monthly payment and enjoy where you live. But an investment property that doesn\u2019t appreciate represents an enormous opportunity cost because your down payment could have been invested elsewhere. <\/p>\n\n\n\n Generating a compelling return on an investment property requires significant appreciation. That\u2019s because as we explained above, it\u2019s difficult to charge enough rent to offset the full cost of carrying the property and the real estate broker commission. <\/p>\n\n\n\n Again this is best illustrated with an example. Let\u2019s assume you could charge a rent of $2,000 on the previously described $500,000 property (which is pretty steep relative to the mortgage payment) and increase it by 2% per year due to inflation. Let\u2019s further assume the property appreciates at 3% per year (a rate greater than inflation, which is unusual by historical standards), which means it would be worth $580,000 if you sold it after five years. After deducting a 6% real estate commission, the compounded return on your equity investment would be only 4.1% \u2014 and that assumes your rental property was occupied for all five years which is often not the case. The lower the occupancy rate, the lower your return. To make following the numbers easier, we created a spreadsheet that shows our math<\/a>.<\/p>\n\n\n\n Just because something is easier to understand doesn\u2019t make it better. For comparison, Wealthfront\u2019s average portfolio earned just under 8% net of fees over the past eight years<\/a>. And the Wealthfront return is far more tax efficient than the return you would receive on real estate due to the way dividends on your Wealthfront portfolio are taxed and our tax-loss harvesting.<\/p>\n\n\n\n In order to improve upon that 4.1% return, you need to have a nose for the neighborhoods that are likely to appreciate most rapidly and\/or find a terribly mispriced property to buy (into which you can invest a small amount of money and upgrade into something that can command a much higher rent \u2014 even better if you can do the work yourself, but you need to make sure you are being adequately compensated for that time). The challenge is, despite what you may hear or read, a minority of even professional<\/em> real estate investors outperform the average return for the real estate market over the long term. And we\u2019re talking about people who have large staffs to help them find the ideal property and make improvements.<\/p>\n\n\n\n You should think of investing in an individual property the same way you should think about an investment in an individual stock: as a big risk. You are unlikely to outperform the market unless you have an information advantage, which you probably won\u2019t have unless you are a real estate professional or are willing to put lots of time and energy into finding a property.<\/p>\n\n\n\n The idea of trying to choose the \u201cright\u201d individual property is alluring, especially when you think you can get a good deal or buy it with a lot of leverage. That strategy can work well in an up market. However, 2008 taught all of us about the risks of an undiversified real estate portfolio, and reminded us that leverage can work both ways.<\/p>\n\n\n\n Investing in a risky asset class like real estate requires diversification to generate a higher long-term return because you never know when a particular real estate strategy or type of property will fall out of favor. The benefit of a real estate index fund is it\u2019s comprised of many Real Estate Investment Trusts (REITs<\/a>), each of which is diversified among many properties.<\/p>\n\n\n\n That said, diversifying your real estate portfolio is not enough. You also need to diversify across types of investments, or asset classes, to maximize your long-term, risk-adjusted return. Real estate is a great component to have in a portfolio because it can act as a hedge against inflation (real estate tends to be more correlated to inflation than other asset classes), but it generally is not very attractive on its own.<\/p>\n\n\n\n The last major argument against owning investment properties is liquidity. Unlike a real estate index fund, you cannot sell your property whenever you want. It can be hard to predict how long it will take for a residential property to sell (and it often feels like the more eager you are to sell, the longer it takes). Institutional investors generally believe they should earn an extra 3% to 5% annually on their investment to justify having their money tied up. Trying to earn 3% to 5% more than you would on your index fund is almost impossible except for a handful of real estate private equity investors who attract the best and the brightest to do nothing but focus on outperforming the market. Do you really believe you can do it when professionals can\u2019t?<\/p>\n\n\n\nIt’s hard to generate a compelling return<\/h2>\n\n\n\n
It’s better to diversify your investments<\/h2>\n\n\n\n
Liquidity matters<\/h2>\n\n\n\n