Understanding the Realities of Investing in Real Estate
- May 13, 2017
- by Emily
Investing in real estate has a certain romantic allure that mutual funds lack. Perhaps it’s the years many people spend as renters. It’s a lot easier for us to visualize ourselves as the person receiving that rent check than it is to imagine ourselves making a profit on the stock market.
There’s also the flyers and infomercials that offer to teach anyone how to “establish a passive income” with real estate investing. Buying properties at pennies on the dollar is pure fantasy, except in the depths of a recession when getting a loan or having the cash to buy said property is much harder.
Real estate can be a way to invest, and it can lead to good returns. That doesn’t mean that it’s risk-free or trouble-free. Here are some realities to keep in mind when thinking about investing in real estate.
1. Real Estate Is Work
When you hand over a monthly rent check it’s easy to feel like your landlord doesn’t have to do anything to earn the money. That lazy landlord gets $2100/month for sitting on their butt!!!
Once you become a landlord, though, you realize that fielding maintenance calls, finding new tenants, handling move-outs and arranging repairs is not as “passive” as you imagined. This is a major detail the infomercials always gloss over.
For starters, finding a good rental to invest in or property to flip requires a lot of upfront work. Serious evaluation is required:
- quality of the neighborhood and adjacent properties
- overall condition of the property
- property taxes (any tax liens or upcoming tax increases?)
- nearby schools, shops, and transportation
- comparable rents and property values in the area
- proximity to risks from flooding / erosion / trees falling
- local regulations and tenant rules
If you are looking to rent out that perfect place you just bought, you can hire a property management company. They don’t come cheap. They charge around 10% of the rent just to advertise the property and collect the rent. Monthly repairs and upkeep are assessed separately at an agreed hourly rate. If you have the property manager handle repairs and maintenance, they may not take the same care and attention to detail you would.
Maintenance on a property is non stop. Consider a single family rental home. It will need the gutters cleaned about twice a year. Lawn mowing, weeding, pruning and edging is a weekly requirement during the spring, summer, and fall (you may be able to get your tenant to do the mowing, but good luck with that). It will need exterior paint every 5-10 years. Every time the unit turns over it will need interior paint, possibly new flooring, and hopefully only minor repairs. In most cases, you will have to replace the fences, the roof, and the heating/cooling system every 20-30 years. There are also surprises, such as leaks, clogged plumbing, broken appliances, rodents, insects, a dead possum under the house, etc. If you pay others to take care of all this you probably won’t net much. However if you do the work yourself, your profit margin is higher, the labor is ‘tax free’, but you become a slave to the rental. The best case scenario for maintaining your rentals (if you choose to do it yourself) is to live nearby and have the time, skills, and energy to tackle all the work that will inevitably come up.
2. You’re Running a Business
There’s a misconception among many people that real estate is simple. There are a lot of components to real estate, from financing options, to legal agreements, marketing, tenant rights, etc, which non-insiders don’t understand or even know exist. There are also many different types of real estate investments. Buying a duplex to rent out is not the same as flipping houses. Neither of those require the same skills as developing a property or managing a commercial building.
Just like any other business, if you want to make real estate investment profitable you’ll have to learn the intricacies of the specific type of real estate you’ve decided to invest in. In all likelihood, you won’t be able to learn everything you need to know in an evening or a weekend - it will probably take months or years. Learning everything you need to run a real estate business might also involve some expensive “lessons,” also known as mistakes.
3. Real Estate Is Not Risk-Free
Just like with other types of investments, investing in real estate always carries the risk of losing your money. Especially when investing in physical properties, the returns can be heavily dependent on timing. Buying a property is essentially a lump sum investment, with no possibility of dollar cost averaging or ‘easing into’ the investment.’ Also consider, if you are borrowing, the investment is leveraged making it extra risky. Consider if you put down 25%, but the property drops in value 25%, you have lost 100% on paper.
There are ways to make investing in real estate more or less risky, but some level of risk is unavoidable. Whether it is a natural disaster, a global recession, or decline of the area, it’s not necessarily true that real estate values always go up. Some risks can be mitigated with good insurance, but not all. Beyond standard liability and fire insurance, other types of insurance landlords need are flood insurance, earthquake insurance, and a landlord rider for your liability policy. Still, the property may be turned into a grow operation or meth lab and you can’t insure against that!
One of the risks involved in real estate is related to the fact that it’s a business, not just an investment. If you don’t run a business well, you can lose some or all of the money you invested initially. If you do lose money, it might not be because of bad luck. It might be bad management.
4. You’ll Need Help
It’s unlikely that you’ll be able to do everything from researching the best financing options to installing a new bathtub completely on your own. Even if you don’t plan on using a management company, you’ll want to have a team of professionals you can turn to if the roof starts leaking while you’re on vacation. The most successful home flippers are those with a real estate license and a network of contractors, lenders, and buyers.
5. Using REITs
If all this sounds like too much but you still really want to invest in real estate, there are ETFs and Mutual Funds that focus on real estate, called Real Estate Investment Trusts (REITs). In essence, buying a REIT is placing a directional bet on real estate through the stock market. The actual composition will vary depending on the fund (US rentals, international commercial properties, etc). The good news is REITs provide liquidity (the convenience of being able to sell anytime) and involve none of the work mentioned above. However, the upside is much smaller and the same macro level risks are still there.
The bottom line is that investing in real estate is more difficult than most people realize. If you are prepared to put in the work and you’re clear with yourself about the risks and how to mitigate them, it can be a satisfying investment. If you go in with unrealistic expectations or are uneducated about real estate basics, the results can be financially disastrous.