6 factors that make rental real estate a strong investment vs stocks and bonds, as well as real estate opportunities that don’t involve being a direct landlord.
We live in an interesting economy. Interest rates are at an all time low. The stock market has been on a tear the last several decades, but there are signs that it is slowing down, and many smart folks think there are long-term factors that will cause stocks to underperform their historical performance by 1-2 percentage points.
Face with this unique economic climate, what should a thoughtful, financially-minded person do with their wealth?
I’ve been noodling on this with regards to my own portfolio. My latest answer is to add more real estate to the mix. Specifically rental properties.
6 Reasons To Invest In Rental Real Estate
Right Environment: Low Cost of Capital
When the interest rate – the cost of borrowing money – is low, it’s a bad time to be a lender but a good time to be a borrower. Look at how today’s interest rate compares to the last few decades. It doesn’t get much better than this to borrow money on the cheap, and one of the best ways to borrow cheaply for the average American is through a mortgage.
Source: Federal Reserve Board of Governors via FRED, Annotations by JP because the Federal Reserve does not use the term “Total Land of Retirement Suck”
Steady Cash Flow
Particularly for those who are honing in on retirement, steady cash flow is a huge advantage. You have bills that need to be paid monthly. In order to pay those bills, you’ll need to have money coming in monthly.
You can do this one of two ways: 1) Sell some of your illiquid stuff and have the money sit in a checking account so it’s ready when you need to draw cash or 2) find something that will pay you on a similar schedule to when you need the money. Rental properties fit the latter solution to a T.
Low or Zero Taxes on Gains
If you hold the property for at least a year and a day, you will be able to take advantage of capital gains which will be a lower tax rate than your ordinary income tax rates. Even better, you can do a 1031 exchange to sell the property and buy another and pay zero taxes.
That’s right, you keep all those dollars working for you without paying the tax piper.
If you’d like to fully unlock those dollars to put into something else, you can live in the property as your primary residence for at least two out of the past five years before you sell. In that case, a married couple will be able to take the first $500k of gains tax-free, and an individual would be able to take the first $250k of gains tax-free.
Low Volatility/Low Correlation to Stocks
Even during the subprime crisis in which home values plunged as much as 30-40%, you would have been hard-pressed to find the rent rolls of properties decreasing at all. Most properties were still commanding the typical 1-3% annual rent increase. Especially weak markets saw no rent increase or at most a 1-2% decrease.
Income-generating properties were able to ride out literally the worst thing to basically ever happen to the housing market and basically emerge unscathed, as long as you didn’t have to sell for liquidity.
Some markets are still underwater compared to pre-2008 prices, but the math on an income-generating property may not actually incur a loss if the property is meant to be held for income (like a bond) and the owner can afford to be patient and choose his own maturity date unlike an actual bond (i.e. sell the home when the market is healthy enough). I would have loved to collect steady rent checks and sleep well during that time while everyone else was watching their portfolios halve. Indeed, that is why I am trying to build myself a rental real estate portfolio before the next downturn.
Level Playing Field
When you think about who you’re competing with to find and negotiate a good rental real estate deal, I would argue that the field is relatively level compared to other assets. When you’re trying to pick individual stocks, you are up against institutions with hundreds of thousands of dollars to do research, experts who have decades of industry experience, and hedge funders working full-time to uncover proprietary or insider information.
When you’re looking at a single family rental or even a 2-4 family home, these are generally too small to attract the attention of hundred million dollar real estate investment funds, so you’re competing against Joe Schmoe next door.
Since real estate is so geographically restricted, this limits your competition even more. Some folks are willing to buy property and manage it remotely, but most people want to buy a rental within a couple hours’ drive of their own residence. The number of expert landlords you have to compete with is small.
Inefficient Market = Opportunity
When you try and buy a stock or an index fund, there is almost no chance for you to buy the asset at an ‘under-market price’. There are hundreds of thousands of buyers and sellers on the same platform, and their orders are matched by a few markets (i.e. NASDAQ, NYSE, etc.).
By contrast, in your local market most folks who are sellers own only one or two pieces of property. They use a real estate agent to market their property locally. That means there are still opportunities to snag a property at below market prices. Maybe the seller is motivated by emotional reasons, the purchase of another property, or some other reason to part with their current property quickly. Maybe the seller is old and doesn’t want to deal with issues that you would be happy to repair.
Rental investments are not for the faint of heart.
Longer Hold – The transactions costs can equal 8-10% of the purchase price of the property. That means you need to hold the investment for many years so those expenses can be amortized over many years. Otherwise these huge transactions will drag down your returns heavily. I personally am happy to have my capital locked up for 10+ years as long as it’s a high cash-flow property. That means I’m getting a monthly payout to cover my own regular expenses.
Interruptions – When the heater breaks, you’re going to get a call in the middle of a snow storm and have to solve the issue immediately. Plumbing mishap? That’s you, buddy. I hate interruptions. I make economically irrational decisions to avoid interruptions and annoyances in my day – things like paying 2x for a product on Amazon so I don’t have to drive to the store. My solution to this is to hire a property manager, with the acknowledgment that there’s a good chance that I’ll still have to do some of the management anyway (the manager I hire is bad and needs to be replaced, they need my input, etc.).
Messiness – If you find yourself in the unlucky position of dealing with difficult tenants, your quality of life will take a huge downturn. Maybe that’s hounding your tenants for late rental payments. Maybe it’s chasing them down for damage on move-out. Buying stocks doesn’t create this kind of headache. I am leery of this, but when I look at the world of investment opportunities open to me, I’m willing to start small and give it a shot for the potential upside I see in the asset class.
I’m currently pencilling out rental property opportunities within a 2 hour drive of NYC. I don’t have the temperament for being a landlord, so I am factoring in the cost of a flat fee property manager for any investments. I’m also factoring in one month’s vacancy. If I see any opportunities that yield me an expected return of 12% or more, I’m going to jump on it.
Why 12%? Well, my target is to see a 10% return – I need it to be higher than my alternatives if I’m going to all this trouble.
Any return calculation requires an estimate of appreciation and an estimate for rent roll and expenses for a project which I’ve never done before, so I need to give myself a little wiggle room for underestimating my costs or overestimating the market’s growth. 12% is thus the number to beat.
I’d like to deploy $300k-$400k in the near-term. Given that I will likely need to take on mortgages to juice the returns to my 12%+ threshold, I’d be looking for about $1 million worth of property. I’ll give it a year or two so I can see what kinks need to be worked out and whether the asset class suits me. If things go well, I’ll build the position. Ideally I’d reach 50%+ of my portfolio in real estate.
Passive Real Estate Opportunities
Directly-owned properties is just one path I’m researching for our portfolio. There may be opportunities to invest in real estate via a professionally managed organization. Several pathways I’m currently researching:
- Investing in an equity real estate investment trusts (not to be confused with mortgage REITS which have ridiculous volatility). A real estate investment trust is fund that goes out, buys, and manages commercial or residential properties for its owners.
- Investing in individual development projects such as through a crowdfunding platform like RealtyShares.
- Real estate hard money lending. Here I’d just be the lender for a project rather than owning and managing a property, but with the recourse of owning the property if the developer doesn’t pay according to the terms of the loan. There are some opportunities on RealtyShares for this kind of thing but it sounds like most people build this through their own social networks.
Expect more on my research into the space in the months to come.
Learn More About Real Estate
If you’re looking for more info on real estate investing, the site has a few articles in the archives on the subject.
Where To Invest?
Real estate is hyperlocal, which means you really have to factor in the details of your individual market to make a decision. There are, however, several resources to help you benchmark the opportunities available to you against what else is out there.
Bigger Pockets has some great data to get you started. I particularly like their teardown of the best 10 markets for investment properties and the accompany article focused on cities for rental properties. There are forums geared towards your local area where you can discuss the market with other investors.
Source: Bigger Pockets
I’m taking a look at what equity REITs are out there and will report back when I’m done.
How are you invested in real estate besides your primary home? What questions do you have about investing in real estate?