It's rare a day goes by that I don't hear from someone who has identified a property that they believe will bring the cash flow in as they start their path to becoming the next Grant Cardone. While it's no secret that real estate has made many people very rich... 90 % of millionaires made their money in real estate according to some sources... there's no shortage of people that have ended up in bankruptcy due to real estate investing... or people that would have done better simply investing in stocks & bonds (via broad market index funds)
To help people seeking my opinion on real estate investing I usually go into asking them about the revenue and expenses of the property. How much will it generate annually? What will the total expense be?
I want to understand the actual returns.
Accurate Revenues & Expenses
These are the numbers that fundamentally matter. With these two numbers stated correctly, you can estimate the annual income.
The key word there is correctly.
Many over estimate the revenue, and understate the expenses.
In amateur calculations, right off the top usually a 100% occupancy is assumed. 100% occupancy is simply unrealistic. Even when dealing with annual rentals, there will be unoccupancy in between tenants.
On the expense side there is a lot to consider. Here's a full list...
The expenses I find commonly omitted or understated are;
Management fees. If you're going to hire a property manager to keep the investment hands off, expect to pay at least 10%. In hot markets like Naples Florida or Breckenridge Colorado the management fees often go upwards of 20% for long term rentals and even higher for short term rentals. Yes you can manage the property yourself and be available for all the those "my lightbulbs burnt out" calls, but you still need to account for the the value of your time
Maintenance. Roofs will need replaced. So will mechanical systems. Exteriors will need repainted. If you haven't had to replace a roof or mechanical system in the last couple of years you'll probably be shocked at what these things cost as a shortage in skilled labor and rising material costs have radically driven up the cost of home services over the last few years.
Property taxes. Because you don't actually own the real estate you own, you'll need to account for the annual property taxes.
Transactional costs. These costs are not a part of the operating costs but rather hair cut you take when buying or selling. When buying you'll typically have to pay doc stamps and other recording costs, along with any closing costs. When selling you'll be eating the realtors commission.
After getting accurate numbers I segue into the cap rate.
The only thing that matters... is your cap rate.
The cap rate simply tells you how much actual income you'll get relative to your investment amount. This number should NOT include mortgage payments or interest. Mortgage payments and interest are a personal cost of buying a property. While they are relevant to actually deciding whether to buy or not, for analytical purposes, they are irrelevant.
Let's take the example of a condo a friend of mine was looking at. They were interested in acquiring more condos in their community because it was a nice area. It had a market value of $215,000 and after all expenses (excluding mortgage and interest) would generate $3,700 in income. $3,700/215,000 = 1.7% cap rate. Suddenly this investment didn't look too good.
What is a good cap rate?
In real estate investment books published in the 2000s you'll often find the rule of thumb cap rate as 10%.
In real estate investment books published in the last couple years, you'll find that number has came down a good bit to with some recommending a 4% - 10% cap rate.
Here's the deal, as more people have gotten into the vogue of real estate investing, returns have gotten arbitraged away forcing investors to accept lower cap rates.
Do your own analysis and you'll see that finding real estate investment with over even a 4% cap rate is quite difficult.
Keep this in mind... regardless of what they say, many of the 'gurus' publishing advice today made their actual money starting from the bottom of the 08/09 recession when cap rates were MUCH higher.
Adding in appreciation.
Beyond cap rate, real estate does appreciate in value which averages 3.9% over the last 25 years. If you buy with the right right cap rate, add in appreciating a 7% return isn't impossible.
But the S&P 500 has had a 9.26% return over the last 25 years, and it never called you to complain about broken faucets, or threatened you with a discrimination lawsuit.
You also paid less taxes on it (more on that below in the cons).
"But with real estate you'll always have something"
With an accurate understand of returns, the picture of real estate investing look less appealing then it initially did. The next argument is typically that with real estate, there will always be something there... Basically it cannot go to zero because there is a physical asset.
This is generally contrasted with stocks which are 'not real'.
Such flawed logic.
Here's a few points:
- Real estate in other countries, and at times and parts of the United States, has gone to zero, to point where it cannot even be given away.
- During the 08/09 recession real estate had a further drawdown then the S&P 500.
- Broad market indexes of stocks have never gone to zero.
When you consider that, the shine of real estate really starts to fade.
The Pros of Real Estate investing.
While clearly not my favorite investment vehicle, real estate does have some pros.
It gets your money in something generating a positive return.
Regardless of the investment vehicle or asset class, not investing in appreciating and/or cash flowing assets is a huge mistake. If real estate investing is the only thing you want to invest it, or your blind to others, be conservative and jump in!
It's easy to get leverage.
If you walk into a bank to barrow money to buy stocks, you're going to be walking out quickly after receiving a hard NO. Borrowing money to invest in real estate is relatively easy as the debt is secured to the real estate.
Naturally this is appealing to people with lower net worth with relatively nothing to invest.
Ironically, getting leverage for stocks is easy when you have a moderate size portfolio, although risky as your leverage ratio is pegged to your equity which can change daily and very fast.
It holds you committed to your strategy.
With any investment sticking to your strategy is essential. In the references I have made to equity investing in this post so far, and what I would recommend to anyone without significant quantitate investing study, I am referencing a 'buy and hold' strategy. In other words, do nothing.
This is difficult when all you have to do is click a button to sell your equities. While it may not seem difficult history shows that investors tend to sell during drawdowns due to emotion (fear) and then repurchase later when the market is higher, thus losing out on the returns of market beta portfolio.
With real estate, selling is not an easy process thus you have to remain committed to your investment and hold your market exposure.
The Cons of Real Estate Investing
It requires your own personal attention (sweat equity).
Once accounting for the true cost of management, the cap rate of real estate is often incredibly low, if not negative.
Yes, you can save the management cost, but that comes at the expense of your own sweat equity. Personally I can get a much better return on my time through other activities ie. a job, or running a business.
You cannot invest small amounts.
Want to re-invest $1,000 per month that your property is producing. You can't invest it in real estate. The power of cumulative returns is substantially limited. With a stock portfolio, everything just keeps reinvesting automatically.
It has high transactional costs
Time to sell your real estate? Here comes a real estate commission haircut.
Oh, you're going to sell it yourself? You'll probably find that after accounting for your time and hiring a closing attorney, you should've just hired that realtor.
Rental income is taxed at ordinary tax rates.
The income produced from your real estate investment, which typically contributing more to gains than asset appreciation, will be taxed at your ordinary income tax rates -- currently 37% for those in the highest tax brackets. This tax hair cut takes a huge whack out of your annual returns. With stocks, in a buy and hold portfolio, very little income is distributed and when it is, it is usually in the form of a 'qualified dividend' taxed at a lower rate.
Returns are typically less than equities
I know you hear about all the 'Grant Cardones' of the world and how everyone prints money with real estate, but historically average real estate investing returns are lower than index fund investing.
When is real estate investing the right choice?
#1 when the cap rate is right. If you can get a property with a 10% cap rate, it is pretty good buy.
#2 when you are prepared to have a job as a property manager. If you want to wear the hat of property manager and take care of properties and residents, by all means, jump into real estate. For me though, I like keeping the money in a brokerage account.