How much real estate is "too much"?

[lauren_knows]

In a thread in another forum, I was talking about my wife and I's long term plan of staying in our current townhouse for 5-7 years, and then "upgrading" to a small place that had a yard.  Someone floated the idea of renting the old place, while still buying a new one.

I live in the suburbs of DC. The housing market is pretty expensive.  We're fortunate to afford what we bought ($380k townhouse that's 40yr old) and it is well within our means.  However, for the sake of argument, if we purchase a $500k home in 5-7 years, and keep the old home... we'd have nearly $900k "invested" into real estate.

When you think about asset allocation, do you ever think being too leveraged into real estate could be detrimental?

I'm curious, because this ultimately plays into how we save/invest for the next 5-7 years. 

[$_gone_amok]

Actually, do you really have nearly $900K invested? The $900K is the cost basis of the properties, assuming you paid 20% down, your total investment should be $180K.

What ratio is $180K comparing to your other investments? You never want to be in a situation where you are house rich and cash poor.  From a FI/ER point of view, it is better accumulate assets that generate the most passive income. I feel real estate tend to be more reliable in that aspect comparing to stocks but I have no empirical data to back this up =)

[totoro]

I consider credit an asset when it comes to investing in real estate.  The issue is ROI.  The real risks are depreciation on your leveraged dollars and big interest rate hikes.  The huge benefit is appreciation on the leveraged portion (your credit working for you).  The saving grace is the overall long-term upward trend in real estate.  If you are cash flow positive and can ride out markets and managing renters is okay for you then maybe it is a winner for you.

I don't think there is a one size fits all formula for this type of asset allocation.  There is a match to your age, interests and aptitudes and available credit.   Other types of investments do not tend to use leverage (credit) - too risky.   If we were at retirement and could not ride out markets we might not want to take this route - we are 40.

We are now working towards buying our fifth property.  At retirement - or as soon as the market has risen substantially - we will sell three and pay off the other two.  Once paid off, the remaining properites will generate $45,000 per year after expenses and provide us with a place to live.  Even if we did not have other investments, this would work as a retirement plan for us.  We would not have this possibility without leverage, although we could have invested our principal elsewhere for a much lower ROI - albeit with less work for renos and maintenance on our part.

[Another Reader]

What you would have invested in real estate in 5 to 7 years when you buy the house is the equity in the townhouse, which will likely be around $125-$140,000, and the down payment on the new house.  At a $100,000 down payment on the new house, you will have maybe $240,000 in gross equity.  Your investment in real estate will grow over time through equity build-up as the mortgages are paid down and from any appreciation.  Your tenants will be buying the equity build-up in the townhouse for you if you decide to keep it.

As long as the overall capitalization rate on the property is greater than the mortgage constant (the interest rate on the loan plus a little extra for amortization), leverage is positive.  Basically, if the net operating income divided by the value is significantly higher than your mortgage rate, you have positive leverage and your ROIC is higher than the overall capitalization rate.

Since you will be maxing out your retirement accounts and throwing money at your taxable accounts, I would not worry about having too much money tied up in real estate in 5 to 7 years.  Look at the ratios then as part of the decision on the townhouse.



 

[arebelspy]

The key is if the real estate is making you money or not, how the local market is, and what your AA is.

I'm planning on being almost 100% real estate for quite awhile, because I'm comfortable with the risks versus rewards.  It all comes down to you sleeping at night.

(Also gone_amok is correct, only count your equity in the houses.  So if they're paid off, yes, 900k, but personally I'd leverage them and invest those earnings into other assets to diversify, and only be 25% RE - assuming 75% LTV, in your circumstance, and assuming no portfolio other than that.)

[HawkeyeNFO]

OP, pm me if you want more details.....

My situation is not terribly different than yours, but let's back up to 2003.  That's when we bought our town house for about $383k, a block away from the Beltway and a Metro station.  We lived there for about 5 or 6 years, then the military moved us elsewhere.  We kept the house, and have refi-ed a few times, to our current rate of 2.625%.  Given that we are still paying on the 2003 price, but rents and property values have gone up and I charge the current market rent, we come out very cash-flow positive (as long as I have quality tenants who pay on time).  We recently moved back to the DC area, and bought another house as a primary residence.  This one is expensive by my standards, but about half the price of anything else in my neighborhood.  So I have a lot of mortgage debt, but it's not a problem.

If the market keeps creeping up more than general inflation where we live (and I suspect it will), once we sell the primary residence (10-15 yrs maybe?), we should have a boatload of cash.  In the meantime, I plan to hang on to the rental townhouse for a long time.  Hell, we may move back there once the kids are outta high school, which eventually leads to big savings on capital gains if we sell it later. 

It has worked for me, and I don't see a problem with what you are envisioning.  If you can get in now while the interest rates are low, when you move out you won't have to refi later, which costs more when it's not your primary residence.

[capital]

In a thread in another forum, I was talking about my wife and I's long term plan of staying in our current townhouse for 5-7 years, and then "upgrading" to a small place that had a yard.  Someone floated the idea of renting the old place, while still buying a new one.

I live in the suburbs of DC. The housing market is pretty expensive.  We're fortunate to afford what we bought ($380k townhouse that's 40yr old) and it is well within our means.  However, for the sake of argument, if we purchase a $500k home in 5-7 years, and keep the old home... we'd have nearly $900k "invested" into real estate.

When you think about asset allocation, do you ever think being too leveraged into real estate could be detrimental?

I'm curious, because this ultimately plays into how we save/invest for the next 5-7 years.

That's a very highly leveraged investment into not-very-diversified assets. They'll probably do well, but if the DC economy does badly you will probably go bankrupt-- a black-swan event, in the words of Taleb.  DC is the seat of taxing authority on the American economy which could stabilize it, but one of the political parties is extremely anti-tax.

Back before "the" real estate bubble, real estate bubbles in this country were generally localized, and housing values in the DC area are significantly above the cost of improvements-- they're based on the value of the permit to build a home within commuting distance of DC jobs.

What if a couple jurisdictions in the DC area did some significant upzoning to permit more condo/apartment/dense single-family construction near Metro lines, followed a couple years later by federal budget cuts resulting in job loss in the DC area? If the homes are in auto-oriented areas, what would happen to their value if in 2040 petroleum were $250/bbl (in 2012 dollars)? In any case, my younger generation seems to have a preference for more urban housing overall, so what will that do to real estate markets in 2040?

Pittsburgh, where I went to school, is a lovely city with a decent economy and a lot of housing priced below replacement value, probably since the steel crash of 1980. A lot of people have lost a lot of money in Detroit. I just wouldn't have $900k (minus whatever equity) in loan liability on assets highly-correlated in value, as two DC-area houses would be.