I am a Realtor by profession. Most of my business is in helping people buy and sell a primary residence. I work with a few investors and a few companies with their commercial office spaces. When I talk about “investing” or personal finance, a lot of friends and associates immediately think I’m pushing product and referring to real estate investment. Although I do have investment property, I rarely talk about real estate investing. Some of my Realtor colleagues think investing in real estate is the BEST and ONLY way to go. I disagree. Here’s why…
Stock investing basics
I think investing in the the stock market is for everyone. It’s EASY, less work, more reliable, more liquid, and requires less discipline and skill than investing in real estate. I’m confident that I can buy index funds and get at least an 8% return over any 20 year period. Here’s how I plan on doing it: buy VTSAX and VFWAX, hold onto it, reinvest dividends and interest, and repeat. Sounds pretty simple huh? It is! I can set up automated monthly contributions in about 2 mins and literally not have to tinker with it for years. Yes, the value of stocks will drop at times, but the market will always go back up.
Real estate investing basics
I am ALSO invested in real estate with rental properties. Returns can be huge! Another attractive benefit of rental income is that it’ll likely keep coming in, even when the stock market or property itself drops in price. It’s a great way to diversify your investments and income sources. The investment gets a little more complicated than stocks though. With rental properties you have to go through the whole home buying process (search, negotiation, inspection, mortgage process, etc), put a 20-25% down payment on it, market the property, interview/select renters, form a new business entity, draft a rental agreement/contract, manage your renters, perform routine maintenance on the property, fix things that break, deal with bad renters, find new ones when their lease ends, make mortgage payments, find a way to reinvest your profits, and repeat with each new property. Sounds a little more complicated than stocks huh? IT IS! So with the added work, stress, and risk, you MUST have potential for greater returns.
For me, I won’t even consider a rental property with below an expected 10% annualized return on capital in the first or second year. If the following formula is true, I will consider the investment:
Net Income ÷ Initial Investment ≥ 10%
Here’s how I define net income and initial investment:
Net Income = Expected rents – mortgage payment – property taxes – insurance – HOA payments – expected repair and maintenance costs – owner paid utilities
Initial Investment = down payment + mortgage closing costs + inspection costs + real estate fees + renovation costs (if applicable) + licensing or business setup fees
I have a rental property getting $1350/month in rent. I’ll assume it remains occupied 95% of the time (11½ months/ year). My mortgage, including HOA, taxes and insurance is $900/month. I’m not paying any utilities (the half month I’ll pay each year is about $50). Most months I don’t have any repairs, but I’ll estimate $40/month since I’ll pay for HVAC tune-ups each year and something else always comes up. So Net Income = (1350*12*.95) – (900*12) – 50 – (12*40) = $4,060.
Before this property had renters I put $30,000 as a down payment, I got the seller to pay all my closing costs, I paid $200 in real estate fees to my brokerage, I setup a new business entity for about $100, and I paid $400 in cleaning and repairs. So Initial Investment = $30,700.
So I estimate my annualized return on capital to be 4060 ÷ 30700 or 13.2%. 13.2% is a great return! This number will likely go up in future years as rental rates go up; however, repair costs, property taxes, and HOA costs will probably rise over time too. Imagine I have to replace an AC unit. There goes $4k and basically my entire year’s profits. Unfortunately, these deals are hard to find, especially with how hot the real estate market is in my area. And as you can see, it’s a whole lot more work than stocks.
Other Things to Consider
New HVAC systems, flooring, appliances, roofs, structural problems, or windows can easily take profits from 10% to 0% (or worse). You gotta be prepared for if/when those happen.
Your interest rate will be about .75 – 1% higher on an investment property than on a primary residence. If you don’t move into the property, make sure to account for that.
Your renters will be paying down your mortgage for you as well, but be careful in counting this towards profits/income. On a $200k mortgage, you’ll pay it down about $10k in 3 years of payments. Remember that you only realize those earnings when you sell or refinance. Both of those can be expensive.
Even if you are turning a profit, owning a rental property can limit your ability to buy additional property.
Real estate investment is not for everyone. You gotta know what you are doing, understand your risks, know and stick to your numbers, and realize that if you buy something it can be expensive to get out of it. Feel free to ask me questions if you want my opinion on potential real estate investments.