Investing 101: Intro to Real Estate

Your parents always told you that money doesn’t grow on trees… but did they ever tell you that it can come out of a faucet?

Okay, you’re right, I am speaking figuratively. You won’t find a faucet at Home Depot that makes cash appear out of thin air. But there is an investment that is almost as good as having a money faucet — owning real estate.

Investing is a wide and complicated subject, and in this introductory series, we’ve been focusing on some of the popular ways to invest your money to help grow it for the future. Most of those methods involve stocks, bonds, mutual funds and other investments into public companies. This kind of traditional investing works well for most people, but your earnings can be unpredictable due to market fluctuations. Real estate, on the other hand, is a very stable investment. Do it right, and it can make you a lot of money.

So what exactly is real estate investing? Simply put, it’s buying property that you don’t need for yourself, and then renting it out to someone who does need it. That person pays you rent every month, and you don’t have to do very much to collect that check (except for maintaining the building). Before you know it, you have a steady flow of cash that you can use for other things. Renting property out to other people is like turning on a money faucet.

Let’s look at some numbers to see how this all plays out. Suppose that you have $100,000 to invest. You could put that money into mutual funds, where you hope to earn 10% per year in interest. You might earn that much, or you might lose some of what you invest. Now, let’s say that you choose to buy a house with that $100,000, and then rent that house out for $700 per month. That’s an income of $8,400 each year, or 8.4%. Which would you rather have — a mutual fund that may pay 10% each year, or a real estate investment that will pay 8.4%? I’d rather take the sure thing.

The situation gets even better than that. During a normal economy, the property that you own is going to appreciate in value, around 3-5%. Add that value to the 8.4% that you’re getting in rent checks, and your total returns on rental property can easily exceed the returns you would get from a mutual fund.

That’s the upside. So what’s the downside? There are several. First of all, owning real estate can be a lot of work. You have to maintain the property (if the plumbing breaks, it’s up to you to fix it). You have to search for tenants, screen applicants, and collect rent. There will be various administrative duties that you’ll have to do to stay legal and current on your taxes. And when a tenant moves out, you have to clean the property, perhaps update the carpet or paint, and then start the process all over again. If you’re trying to do this all in addition to a regular job, it can get to be overwhelming. There are property management companies that will do all of this work for you, but hiring them will cut into your profits.

The bigger downside is that it takes a lot of capital to get started in real estate investing. In our example, we bought a house for $100,000. But unless you’ve received a large gift, inheritance or other windfall, you may not have that kind of cash sitting around. If you’re a young person, you’re especially unlikely to have access to that kind of capital. This means that real estate is an investment most often made by older or wealthier people.

Of course, some people try to get around this problem by using debt. They figure that they can borrow money to buy the rental property, then rent it for more than the mortgage payment costs every month and make a profit. And if everything goes right, this approach might work. But tell me, how often in life does everything go right?

There are a lot of dangers that come with borrowing to invest in real estate. What happens if your rental property needs sudden, major repairs — the kind that an cost $10,000 or more? What happens if a tenant leaves unexpectedly, and you have trouble finding someone to replace them? That can leave you paying the mortgage on the property on your own. Could you afford to do that for six months while you find a new renter?

The risk is that if something goes wrong with your rental property, you won’t have enough cash to cover the problem. If you can’t find a tenant and you can’t make the mortgage payment, the bank is going to repossess the property, and then sue you for whatever is left over. Make a mistake with debt in your investments, and it can bleed over into your personal financial life and ruin that too.

In the last decade, a lot of amateurs tried to make money in real estate investing with borrowed money. When the economy went bust, many of those same people got soaked, losing their investments and more. The same goes for people that tried to make money by buying cheap houses, upgrading them, and then “flipping them,” or by buying houses, holding them for a few years, and then selling them for a profit. Both of those strategies worked for a short time because the housing bubble was pushing home values up artificially in the middle of the last decade.  When the bubble popped, though, those people lost much more than they ever earned.

So, what’s the point of all of this? Real estate investment can be a great idea, but only if you’re doing it with cash. Buying with cash protects you from the risks that come with a mortgage. And like other investment, real estate works best as a long-term strategy. Buying homes for the short term to flip later only works if market conditions are in your favor, and if debt is involved, it brings a substantial amount of risk.

In the end, the best approach with real estate investing is to buy a property with cash, own it long-term, rent it out and then sit back and watch the checks come in every month. You may not be able to do this early in life — I know that I certainly can’t yet. But once you do, you’ll never want to turn the money faucet off.

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Photo by Peter Dutton. Used under Creative Commons License.