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Whenever the market has a good run, as it has lately, people start thinking it may be overvalued and ripe for a fall. Thoughts turn next to other forms of investments, such as real estate or more esoteric alternatives like options, oil or other natural resources, or precious metals. Real estate is probably the most popular of these. Holding Real Estate is a proven wealth-building strategy, but not the only one, and it certainly involves a lot of effort and expense.
In this post, we will discuss the pros and cons of individuals owning rental real estate. There are many ways to participate in Real Estate, both as Equity and Debt Investments. There is a spectrum ranging from “hands-on” vs. “pure investment.” Hands-on involves selecting, buying, and managing a property, typically a single-family home. “Pure Investment” involves buying a diversified index fund of Real Estate Investment Trusts. Real Estate investing involves a vast array of possibilities.
But most typically, the idea of real estate investing starts with acquiring a house and fixing it up to rent out, and then later selling it for a profit. Sometimes, people will move to a bigger home, or change jobs and move to a new city. They then retain ownership of their former home and rent it out. In other cases, the home is chosen and purchased specifically as a rental. I have known people who ended up with a small empire of rental homes that created a secure retirement.
Here are some pros and cons of renting out single-family homes as an investment strategy:
First, the positives:
- Real Estate is an excellent hedge against inflation. With the acceleration in money printing activity in 2020, there is valid concern in thinking the US Dollar might end up someday like the Zimbabwe Dollar. Real estate ownership serves as a hedge against inflation. During periods of inflation, the appreciation of real estate results in a borrower repaying a fixed-rate loan in dollars with lower purchasing power than at the time of borrowing.
- Most families’ biggest asset is their home, and over time, home equity. The United States has the most liberal lending laws in the world when it comes to home buying. In many families, the parent’s home, sold when they pass, transfers significant amounts of wealth. The memory of this shapes perceptions about how easy it may be to accumulate wealth by owning homes.
- Many people are successful at building wealth through strategic acquisition, management, and trading of investment Real Estate. The ability to borrow large sums at favorable interest rates makes it possible to have higher leverage than with equity investments, which are often limited to 50% and subject to margin call if market value declines. On the other hand, mortgages are generally not “callable” in the same way. Leverage on rental Real Estate can be 80% or higher. We will see later that leverage is a negative aspect, too.
- Real Estate is a classic “inefficient market,” in which shrewd participants can negotiate better, or see hidden value in a property. A family member bought a home a few years ago. After they cut down some bushes bordering the back yard, they discovered they had a fantastic view with the San Francisco Bay in the distance. It is possible to buy property well below “market value” in the right circumstances.
- Directly owned Real Estate is not driven by the same market factors as equities, so it is possible to achieve true diversification with Real Estate equity if an investor can afford to own multiple houses in different markets.
There are some negatives, when it comes to renting out real estate, too:
- Dealings with tenants can be a time sink and an emotional drain. A lot more could be written about this. Everyone who I know that has owned property and rented it out has stories about good, and not-so-good tenants.
- Mortgages have to be paid. For much of 2020, there has been a moratorium on evictions in the US, ostensibly to slow the spread of disease. But even before the current troubles, if a tenant loses their job, breaks a lease, or just leaves at the end of a lease, it can be hard to find a new tenant. Since the mortgage has to be paid, the owner has to have extra savings to dip into, until a new tenant can be found.
- Leverage was mentioned above as a positive factor, but it can also be a negative. This leverage applies both to property owned for personal use as well as property rented out, making rental real estate often viewed as having “special powers” to increase returns. In times of recession (local or national) real estate can be very illiquid. When demand ebbs, market prices can fall drastically.
- Owning the “right amount of home” is a financial fundamental. It is easy to buy more home than we can afford – and then compound this buy buying more real estate to rent out. Over-exposure to leveraged real estate can pose significant investing risk. In the Bay Area, just owning one’s own home, with the minimum down payment, can be too much exposure to real estate. Some risks can be covered by insurance, but others cannot. Diversification is harder to achieve when owning single-family homes.
- The last big downturn in real estate lasted several years (2007-2012, varying in different locations and neighborhoods.) Although this has not happened lately, in previous years it has been quite common for landlords to lose their tenants, become unable to pay the mortgage, and then have to sell their rental property at a loss. This can be compounded by borrowing more on their residence in the hope that the situation will turn around before they run out of money.
- Ownership of real property, either directly, or through partnerships or LLCs, introduces tax reporting complexity, recordkeeping requirements, and increases the risk of exposure to audit. Deferral of gains, when combined with depreciation, can result in significant taxable gain on disposition. Many who own property for extended periods defer gains (through §1031 exchanges) and come to believe they can “never sell” because of the taxes they would owe. To be fair, a similar situation exists with highly appreciated stocks, but the fraction of deferred gain to equity in real estate can become exceedingly high because of leverage. Those owning property in multiple states must file state income tax returns.
- Regarding partnerships or shared ownership arrangements: going in together to own a rental property with family or friends has destroyed far too many relationships.
Conclusion
- For Real Estate investing, the main question to consider is whether participation as an owner or investor in rental real estate is the most effective use of time and capital in comparison to alternatives. If a person is handy, or likes to do repairs and manage details, directly owning rental Real Estate can work well.
- There are alternatives to directly owned Real Estate that may provide a good alternative to owning equity asset classes (such as stocks and mutual funds). These ownership alternatives include partnerships, limited partnerships, private loans (secured and unsecured), packaged loans, and others. We have discussed direct ownership of single- family homes here.
- Direct ownership of Real Estate affords the possibility to outperform. Since Real Estate is an inefficient market, it is possible for a skillful negotiator to buy property below market. However, not everyone has the time or ability to develop the skills to succeed.
- Real Estate investment, especially its operation, should be evaluated as a business activity, in comparison to alternative ways to earn money. Examples include the purchase of a franchise business, investing an existing business, or starting a business. Medical professionals often buy interests in outpatient surgical or imaging centers, for example, because they are familiar with the business.
- We generally favor earning money by the highest and best use of one’s own expertise; investments should be entirely passive in the sense that no investor knowledge is needed to achieve returns. Business operation generally involves a combination of labor, skill, and capital.
On Human Nature and the Challenge of Accumulating Wealth – part 6 of a series