For my first topical post, I decided to tackle the hottest topic of our time. The question comes up often in my work. And why not? Having seen an immense Fed-fueled boom, home prices are searing hot. The 2007-08 housing bust seems a distant memory. Anyone with a home and a phone is getting spammed from call centers India and the Philippines offering to buy property. Our neighbors have all added a bedroom or two so they can enjoy a separate home-office. Stories of soaring rents abound, and the words "passive income" have reached your ears too often to ignore. May be you have an uncle who looks like this guy - and you very much want to be like him.
Whether to own real estate as investment is a fair question to entertain. As a prudent saver, you have accumulated the means to invest and a rentable home is a familiar way to do it. Real estate has, for the most part, been a sound way to build wealth. But such an investment should always be a part of a thoughtful financial plan.
Before we dive in, let me say that this article is focused about the typical non-home real estate investment for the average family - a rental home. It doesn't address investments like land, renovation flips and commercial property, nor does it address how to buy an investment property. I will leave that to real estate experts. The goal here is to address whether and when you should buy a rental home, and weigh the pros and cons relative to investing in stocks and bonds (referred to here as securities for brevity).
Real estate is not a liquid investment
Buying property will lock up your investment for very long periods of time. Initial transaction costs are significant and an early exit from an investment will cost dearly. Yes, there are ways to access some cash through home equity lines of credit or refinancing, but that's only possible if the home has meaningfully appreciated. Securities, on the other hand, can be sold the next business day.
Real estate isn't risk-free
Compared to stock in a given company, the risk profile of a given rental home is generally safer. Afterall, land cannot go bankrupt. Even so, real estate investing is not low-risk. A rental home can sit vacant for long periods, or a weather event can damage a home well beyond what insurance will pay for. Despite these risks, on balance, I will score this aspect as advantage- RE.
Diversifying risk is harder in real estate
While the risk to a single company's stock is much greater than the risk to a single home, it is rather easy to diversify some of the risk in securities. For very little money and effort, you can own a small piece of large portfolios of stocks through a ETFs. On the other hand, it is virtually impossible to escape the concentration of risk that owning a rental home entails. It isn't until you are wealthy enough to own a portfolio of homes, or have access to a real estate investment syndication that you can reduce concentration of risk. Securities beat real estate on diversification.
Debt improves returns, but also magnifies risk
If diversification is risk's wise angel, debt is the sexy seductress. In fact, without debt, real return on housing (7.4%) doesn't compensate for the illiquidity and risk concentration when compared to stocks (8.3%). See source.
Adding a mortgage to the mix increases your investment returns, but also magnifies the potential downside to adverse events. I don't mean to overstate this point, but millions of homeowners learned a traumatic lesson during the housing bust of 2007-08. So, ask yourself - do you have the means, in other savings and cash flow, to weather a difficult spell in the rental market? I call this a draw.
Owning property extracts unanticipated costs, time and effort
If you are considering buying a rental home, you likely already own your primary home, and would likely agree that to own a home is to endure unexpected costs and demands on your time. That is just the physics of home ownership. Yes, you could outsource property management, but that extracts a significant portion of investment returns. Securities win on this one.
So, on balance, the average real estate investment has some very real downsides compared to other investment vehicles. That said, it has a role to play in a comprehensive financial plan. Let's talk about when...
Where real estate sits in the order of investments
One foundational framework in a comprehensive financial plan is the investment ladder. It is a logical sequence of savings and investments that can help in deciding between options. If you are considering investing in real estate for more than your primary home, you should have meaningfully addressed these other elements first:
You have emergency funds in that can cover your expenses for 6-12months
All debts are fully paid off, except for your primary home and perhaps a car
You take full advantage of tax-advantaged plans like 401(k) and HSA
You have fully accounted for major upcoming needs - like a child's upcoming college education
You have sufficient liquid investments that can pay for something large and unexpected like a healthcare emergency
Investment Horizon
Property markets are driven by decisive, but slow shifts in demographics and the local economy. If you have checked off all higher-priority investments discussed above, and weighed the pros and cons of real estate investing, and are still inclined to buy in - your horizon needs to be looooong.
I hope this article has given you new ideas and questions to mull over. Real estate can absolutely play a significant role in a diversified portfolio of investments - but don't rush into it, and make sure it fits your overall financial plan.
This material is intended to be of general interest, not personal financial advice or a recommendation to buy, sell or hold any security or adopt a particular investment strategy. Your circumstances and attitudes toward risk matter, and only an advisor working with you can give you specific advice. All investments carry the risk of loss, including loss of principal. Stock and bond prices can be volatile. Past performance is not an indicator or guarantee of future results. Diversification does not guarantee profit or protect against risk of loss. This material may not be reproduced, distributed or published without prior written permission from Sanjay Pamurthy/Artham Advisors LLC. Data from third party sources quoted here has not independently verified, validated or audited. Although information has been obtained from sources that Artham believes to be reliable, no guarantee can be given as to its accuracy and such information may be incomplete or condensed and may be subject to change at any time without notice. Artham accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments, opinions and analyses in the material is at the sole discretion of the user.
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