I have heard people say that the first home you buy should be an investment property. This seems very odd at first, but when you think about it, there is a lot of sound logic behind that statement. In previous posts we have talked about the true costs of ownership and lack of material benefits over renting. However, this was from the perspective of living in a home.
Real Estate market value only returns 1% per Year
One of the main reason is the opportunity cost of putting large sums of money in a home. Robert Shiller has won a noble price for his work studying housing and came to the conclusion that on average single family homes gain 1% per year in market value. This will be the return whether you live in it or rent it out. A lot of people buy a home to live in thinking it is an investment, but it should better be thought of as a consumption item that has a marketable floating price.
The difference between the two results in that the house you live in costs you money each month in mortgage interest, property taxes, insurance, and maintenance. The rental property, if managed well, will provide money each month in the form of rent (similar to a stock dividend) before subtracting operating costs. Now generally unless you can contract out a lot of the responsibilities you will have to spend some time managing it. Therefore, generally I don’t think of investment real estate as a passive venture. I think of it as a small business where the more work you do yourself the greater the return will be. Again there is opportunity cost for your time to weight as well.
This article will not get into how to be successful in this venture, but I do want to note buying the right property, at the right price, and getting the right tenants will largely determine success. Just because you can make profits renting our real estate does not mean there are not better investment options available. It is important to weight risk and return of all available investments. The stock market is a true passive investment, but it also has considerable risk. Some people prefer real estate as it gives them more of a hands on investment in which they can increase the return in bad times, but again this additional profit is coming from more of their work and not the investment itself.
If you have a strong believe in rental real estate being the best place to invest your money you may best be served by investing in REITS. These are companies that invest in hundreds and thousands of different types of real estate. This may include office space, retail, single family homes, apartment complex, and even trailer parks. You can buy ETF’s that own a mixture of all of the above. The benefit to reits is they are professionally managed. You do pay for this service as management costs are deducted from profits before any money is returned to shareholders. Depending on the company these fees can be quite reasonable due to economy of scale. They can hire employees to oversee many developments at once, think bulk discounts at the grocery store.
- Diversification! For most of us we could only purchase a single rental property. If anything goes wrong with the house itself, the neighborhood, or bad tenants we could take a major loss. REITS can have a few properties drastically underperformed, but still turn a nice profit overall.
- Expert Professional Management. We like to think we are all real estate experts, and with practice we can learn a lot, but it is hard to compete with the big boys so why not join them.
- Truely passive income. You do not have to worry about getting a call from tenants about water pouring in through a crack in the roof at midnight.
- If you purchase rental real estate with a mortgage you will be employing leverage. Many argue this in favor of REITS to amplify the gains. Keep in mind that leverage goes both ways and can be problematic in a recession. Also be careful to check how leverage RETIS are that you invest in.
- With REITS you Cannot do work yourself to add value, but you have risk in one localized building.
I believe that REITS are the way to go for many reasons:
- You cannot put a dollar figure on not having to do any work or think about the investment with REITS
- You can invest much smaller amounts of money in REITS than buying a whole house
- There is more money left over to invest in other assets to have a diversified portfolio