The Money Mustache Community
Learning, Sharing, and Teaching => Real Estate and Landlording => Topic started by: arebelspy on November 08, 2015, 05:44:55 PM
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This sounded like a fun math problem, and there was so much bad math and rationale in this thread that inspired this post (http://forum.mrmoneymustache.com/welcome-to-the-forum/stocks-do-beat-real-estate-in-the-long-run-even-with-leverage/), I figured I might as well work something out.
I pictured an investor, mid-20s, with enough for a rental down payment, who is wondering if they should buy a single rental property to hold for 30-50 years, or if they should invest that down payment in stocks.
Here's my baseline assumptions:
- You are 25 years old. You have saved up after college, and you have 22k to invest.
- You don't want to start a whole real estate business or empire, but are considering getting a single rental. You don't want to do any work on it yourself, so you will hire out all labor, property management, etc.
- You will pay market price for a 100k home, get 1% of the purchase price in monthly rent ($1000), and expenses will run 50% of your gross rents (500).
- Your interest rate is 4.5%, so your P&I payment on 80k for 30 years is 405.35 monthly.
- You will put down 20% (20k), and finance 80% (80k), and pay 2k closing costs. No PMI.
- Inflation runs 3%, and the house appreciates at the rate of inflation.
- Stocks return 7% real, so 10% including the 3% inflation.
- After getting the one house, you will reinvest all net rents received into the stock market for the same returns as the stock returns, because you just wanted this one home, so once per year you take your annual profits of $1,135.80 and invest them in the stock markets.
- I'm ignoring taxes for simplicity's sake, but the real estate should come out ahead, because depreciation on a 100k home is much more than the $1,135 annual profits.
We want to compare the returns of the two after 30 years, and after 50 years.
22k invested in stocks, at a 10% nominal return, is worth $383,886.85 after 30 years.
22k invested in stocks, at a 10% nominal return, is worth $2,582,598.76 after 50 years.
The 100k house at 3% return is worth $242,726.25 after 30 years.
The 100k house at 3% return is worth $438,390.60 after 50 years.
That's just a straightforward time value of money calculation. So just on appreciation, the stocks win. However, now we add in the rents:
$1,135.80 invested annually in stocks, at a 10% nominal return, is worth $186,832.31 after 30 years.
$1,135.80 invested annually in stocks, at a 10% nominal return, is worth $1,321,967.31 after 30 years.
After 30 years, RE total: $429,558.56 Stock total: $383,886.85 Winner: Real Estate.
After 50 years, RE total: $1,760,357.91 Stock total: $2,582,598.76 Winner: Stocks.
During the years you have leverage (those 30 years), real estate comes out ahead. Stocks start to pull ahead after that, because the bulk of your investment in RE is in an asset earning 3% (the inflation rate) versus stock's 10%.
Now, if we keep all other assumptions the same (cost of house, expenses, etc.) and just tweak how much rent we're getting (i.e. buy at a better price-to-rent ratio than the 1% rule), we find that real estate equals stocks after 50 years at a ratio of 1.12% monthly rent to purchase price (in our example that would be monthly rent of $1120). At that price, you'd net $1,842.25 annually which, when invested for 50 years, along with the ~438k of real estate, would equal stock's 2.58MM. And it would be well ahead of stocks at the 30 year mark, it takes stocks til year 50 to catch up in that scenario.
If you can get a much better price to rent ratio, you'll do even better. For example a 1.5% price-to-rent ratio ($1500 monthly rent, in this example) leaves real estate with over 5.25 million after 50 years, more than double stocks.
Let me know if I missed anything, but I think all my assumptions were very reasonable. No big advantages to real estate that one can get (buying much better than the 1% rule, managing it yourself or doing any "sweat equity" to save on the expenses, buying a deal at below market, etc.). I included closing costs and used a reasonable interest rate. I did ignore taxes, but that should help the real estate case due to depreciation.
tl;dr The question was "What wins in the long run?" The answer is: it depends on how good the real estate investment is. At a 1% rule, it's pretty even between the two scenarios: Real estate wins over a 30 year timeframe, stocks win over a 50 year timeframe. At a much better ratio, like 1.5%, real estate wins hands down, with over double the money of stocks. At a worse ratio, naturally stocks would win.
Thoughts? Math I screwed up? Quibbles with assumptions?
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After 30 years one could simply releverage the real estate and buy another property. Thus the nominal yield difference would not be 7%. One could also do this long before 30 years and the whole analysis would change. The major advantage for the real estate is the ability to leverage it cheaply.
One could also buy multifamily properties with higher capitalization rates than residential real estate and the whole analysis would change.
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After 30 years one could simply releverage the real estate and buy another property. Thus the nominal yield difference would not be 7%.
Yup. RE beats stocks over 30 years (as it does even in the 1% rule scenario) due to leverage. If you keep releveraging, buy more properties, etc., you can continually beat it. However, one of my stipulations is that the individual didn't want to buy more and more real estate, continually leveraging, building a whole business. They were willing to buy just a single house, and were just curious if their 22k should go into stocks, or real estate.
But as you point out, if they were willing to continue buying more real estate, if one beats it via leverage, continually leveraging (assuming favorable rates) will continue to beat it.
One could also buy multifamily properties with higher capitalization rates than residential real estate and the whole analysis would change.
Yup. RE beats stocks at a 1.12% price-to-rent ratio or higher over 50 years. Any better than that and it starts to crush stocks (earning over double after 50 years at a 1.5% ratio). If you change assumptions to be even higher returns (via multifamily, commerical, whatever), then naturally it will do even better. But this scenario was buying a single house, and seeing how it would do. Multifamily is more work, and this hypothetical investor didn't want any more work. But your point is correct: higher returns in the assumptions for RE will lead to even better numbers for RE by the end.
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Enclosed is a spreadsheet from BiggerPockets that a CFA in Minnesota modified from my original model posted over there. If you wish to do a more detailed analysis this would be a great tool to start with. I know this says it is for small apartment complexes, but it will work just fine if tuned properly for one property.
Real capitalization rates on residential real estate are generally around the 5% or so range (in many markets....some lower) because you're bidding with owner-occupants. For those interested these articles are what I consider some of the better ones on the internet for a quick education on real estate yield calculations:
http://www.johntreed.net/positive.html
http://www.creonline.com/cap-rate-formula.html
So it is very easy to state that 5% real capitalization rates will under-perform stock index yields in the absence of leverage in the long run. This will be the case in the long run even if you buy at a discount. This, however, ignores leverage and many other pieces of the analysis. The enclosed spreadsheet would give you a more detailed analysis if you want to take the time to see for yourself.
[attachment deleted by admin]
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Methinks you missed the point of this thread. Yes, believe it or not, I know how to calculate real estate returns. :)
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However, one of my stipulations is that the individual didn't want to buy more and more real estate, continually leveraging, building a whole business. They were willing to buy just a single house, and were just curious if their 22k should go into stocks, or real estate.
Okay....fine. Just releverage at year 30 and place the capital into index funds instead. Problem solved....and the conclusion is the same ;-)
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After 30 years, RE total: $429,558.56 Stock total: $383,886.85 Winner: Real Estate.
After 50 years, RE total: $1,760,357.91 Stock total: $2,582,598.76 Winner: Stocks.
This is basically what I came up when I ran my own independent analysis about a year ago. Real estate was clearly better in the short term, but over lifetime-length time scales stocks always came out ahead.
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Methinks you missed the point of this thread. Yes, believe it or not, I know how to calculate real estate returns. :)
I wasn't challenging your analysis. I was attempting to provide a tool to make the analysis more precise. There are about 10 (or more) variables to control for to really do it correctly. Tax shields, tax rates, loan types, leveraging assumptions, inflation rates, what you invest cash flows in, etc. all matter in the real world analysis.
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After 30 years, RE total: $429,558.56 Stock total: $383,886.85 Winner: Real Estate.
After 50 years, RE total: $1,760,357.91 Stock total: $2,582,598.76 Winner: Stocks.
This is basically what I came up when I ran my own independent analysis about a year ago. Real estate was clearly better in the short term, but over lifetime-length time scales stocks always came out ahead.
Only for a mediocre real estate investment. For a good one, RE should come out ahead on any length time frame, whether you invest the proceeds in more RE, or in stocks after you have your fill of RE.
Even if it's just a mediocre one, RE beating stocks via leverage over the short term seems like a good reason for someone about to FIRE at age 50-55 or so to take out a mortgage and get a rental--besides giving them something to do in ER (could be a pro or con), it likely leaves them with more money over their expected lifetime, and provides a better inflation hedge in case we see some big inflation.
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Methinks you missed the point of this thread. Yes, believe it or not, I know how to calculate real estate returns. :)
I wasn't challenging your analysis. I was attempting to provide a tool to make the analysis more precise. There are about 10 (or more) variables to control for to really do it correctly. Tax shields, tax rates, loan types, leveraging assumptions, inflation rates, what you invest cash flows in, etc. all matter in the real world analysis.
Gotcha. I absolutely agree, and I have my own spreadsheets that model all of that.
I was attempting to provide a simple analysis though, where we can show the math in the post without needing a spreadsheet. I'd absolutely recommend anyone actually investing in RE to do a very thorough analysis before they buy, specific to the property their looking at. This is for those wondering about the rough general numbers.
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Okay...well to piggyback on that here is more evidence that real estate wins:
-Tax shields over 27.5 years will yield $3k+ in tax shields annually (assuming a normal property basis in many cities), which will translate to at least 25% of that number in real world tax savings annually for most posters on this board during the accumulation phase. So let's call this $750 that we can now save in taxes and place into service in index funds annually
-You could, in theory, use interest-only loans with long bullets and increase your cash flow. You'd lose the loan amortization, but the money would be more effectively used in index funds from the increased cash flows. You'd of course need to account for the transaction costs during a refinance and see if it helps over your hold period
-Inflation will erode the real value of your loan and rents will, in theory, keep pace with inflation
Those three factors alone will be a big deal in the real world and will make the real estate outpace index fund investing by a wider margin.
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The thing I really dislike about real estate is that it is an inherently riskier investment.
The risk of total loss is far more real for a single home than for a diversified portfolio of stocks.
The rental market can change, a neighborhood can worsen, an earthquake or flood can happen.
And leverage only increases your downside exposure.
You can insure against some of this of course, but if you insure against all of it, your returns will be severely effected.
Add on to that poor liquidity, the hassle of having to deal with tenants, finding competent managers, vacancies, etc, and I would take on a well diversified investment portfolio any day of the week.
It's just so much less work for a better return long term.
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The rental market can change, a neighborhood can worsen, an earthquake or flood can happen.
The house could also burn down.
Of course, my rental property insurance includes a rebuilding cost payment for a total cost of less than $1k.
Crazy as it sounds, my $80,000 rental properties that cost me $45,000 would cost about $140,000 to rebuild.
Let's assume the house burns down in the first year.
I would collect the $140,000, pay $10,000 to have the lot cleared off, and sell the lot to a builder for $30,000, which would be a profit of (drum roll please):
140,000 - 10,000 + 30,000 - 45,000 - 1,000 equals $114,000 in profits, for a 250+% return on investment.
It would be an even better return on investment if I had leveraged 80% of the purchase and repair price, giving me a 1000+% return on investment. If it burned down empty and no one was killed or injured, how much better could it get?
If I had owned a block or two of Chicago when Mrs. O'Leary's cow kicked over the lantern and burned the town down, my family would still be stinking rich from the event...
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Yeah. Everyone has fire insurance.
But do you have flood/earthquake/tornado/hurricane insurance?
This are all low probability events, but they would be devastating to a levered landlord with no house and no income stream.
I just detest taking risks for which I don't get paid.
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rents will, in theory, keep pace with inflation
That's a good point, I used flat, fixed rents for the full 30-50 years, which won't be the case.
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um... since im assuming you are picking real estate and not buying the entire listing book... why isnt your stock investor picking sectors or even individual companies?
it would be like comparing donald trump to warren buffett...
sure i get index makes it safer for most people, but if you are saying to be selective in real estate, why cant the investor be as selective?
and in the end, the total amount isnt really important once you have enough for your needs... do the math on which is quicker to fi instead.
i get tempted one by real estate, but it just isnt for me... i could see getting into it after fi but not before. im on a 15 year plan with stocks for fi, real estate may or may not speed it up, but such a short time span, my own savings rate would add more than the investment would unless i leverage at a rate more than i am comfortable with
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um... since im assuming you are picking real estate and not buying the entire listing book... why isnt your stock investor picking sectors or even individual companies?
it would be like comparing donald trump to warren buffett...
sure i get index makes it safer for most people, but if you are saying to be selective in real estate, why cant the investor be as selective?
Aside from getting into a debate about picking individual stocks and it being better/worse than an index, I'll just point out that I didn't have the person pick a particularly good deal, I had them buy at market prices. Picking a good deal would have had them them paying 70k or less for a 100k property. Instead they paid the full market value.
One can get 1%, 1.12%, or 1.5% in good markets, even paying retail prices.
If I cherrypicked good investments (note that every single one of my investments are above the 1% rule), it would be even more lopsided. I was trying to pick an "average" scenario where we compare the index to a property bought not at a discount, but market prices.
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oh, i thought the 1% was being selective... didnt know it was fairly common...
i meant that you select safe area so house isnt burned down too. and other factors like selecting tenants. to me, real estate has a lot of selection involved vs dumping into an index. or is renting to drug dealers who pay rent in cash a thing now?
even your post on buying non local, you select the people you trust to work with...
i dont have to trust any of the companies with an index
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oh, i thought the 1% was being selective... didnt know it was fairly common...
It's a rough rule of thumb, but one many of us follow, and has been around a LONG time. It's not being selective on a particular property necessarily, no.
i meant that you select safe area so house isnt burned down too.
It sounds like you're just making up objections. I mean.. are there areas where it's common for houses to burn down all the time? If no, what are you talking about? If yes... don't buy in that area?
and other factors like selecting tenants. to me, real estate has a lot of selection involved vs dumping into an index. or is renting to drug dealers who pay rent in cash a thing now?
Yes, you'll need to vet your property manager, but no, a good one isn't renting to drug dealers. All the work was outsourced in this scenario, and we're just assuming an average property bought from an average real estate agent off the MLS, with average tenants. Nothing special. It would be easy to rig it if our investor in question had any sort of real estate knowledge, but we were presuming they didn't.
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hm then I guess it is pretty average? I'm not in real estate, thought it would be more picking and choosing than that
to me, being a landlord is more akin to being a business owner than just an investor. which is why I suggested comparing the investor with someone who does investments as a business, like or someone who did it full time buffet
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to me, being a landlord is more akin to being a business owner than just an investor. which is why I suggested comparing the investor with someone who does investments as a business, like or someone who did it full time buffet
Yes, if you get multiple real estate investments, it absolutely is more akin to a business. A single rental one does no work on? Not so much. That'd be like owning a "business" of having a yard sale twice a year with the junk you clean out from your garage. Technically you can call it that, but it's barely so. :)
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It sounds like you're just making up objections. I mean.. are there areas where it's common for houses to burn down all the time? If no, what are you talking about? If yes... don't buy in that area?
I bet you can CRUSH the 1% rule in Aleppo right now!
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I think this thread is hilarious! You post that my math is bad but yet yours is are so clearly biased AND wrong it is ridiculous. Your expenses at that interest rate with that down payment are more than $500 a month just for debt service. Factor in repairs and your profits are actually less than your numbers above, about half of what you thought you were getting each month in profit.
Then you use a house where the appreciation rate is actually likely less than 3% per year over the long run, otherwise the house would cost much more. Studies by Harvard economists and others show that housing appreciates at .08% over the long run in the vast majority of cases.
Then on top of it, you only factor in stock growth, not dividends when you factor your 10% nominal return. In reality it is 12% when you factor in the dividends.
Yep, there's bad math alright, but it's in this thread. You cherry picked every scenario and the numbers to tilt the favor into the ONE asset class you are most heavily invested with your 15 ish rental properties. Biased perspective looks for evidence to support a decision he already made and skews the numbers.
Hilarious. Carry on...I guess everyone thinks that because they bought houses at the market bottom they must be an investing genius and real estate is the new gold mine. Study after study has proven that you are wrong....But keep believing whatever you like.
There is one way to really benefit from a combination of the two asset classes. Leverage and tax benefits are what give real estate the nod. Just cash out refinance equity every few years and put it in an index fund. Your leveraged real estate provides high rates of return on the money you have invested, is a tax shelter an you can tap the equity to invest in the stock market, while you live off the rents still, letting the stocks compound untouched.
But to say that real estate is a better investment based on the carefully crafted numbers that are 1) wrong as far as expenses and profits, and 2) leave out the stock dividends is more revealing of your bias than anything. It has been proven by economist after economist after economist and study after study that stocks beat real estate in the long run. The longer the holding period the better the return on stocks compared to RE.
Again, in your scenario you inflate the returns that you would actually receive on a property like that, and leave out the dividends of stocks. Yet you reinvest the rents but not the dividends of stocks that you don't even take into account. A lower interest rate asset doesn't beat a higher interest rate asset in the long run, dollar for dollar invested.
But as I said above, if you buy in equity play markets and pull that cash out and reinvest it in index funds, you get the best of both worlds. Leverage and tax benefits are the things that make real estate attractive. Pulling equity out to reinvest in index funds gives you the best of both worlds. Plus it helps you diversify. I wouldn't want all of my nest egg to be in Las Vegas Nevada...
http://www.nytimes.com/2005/08/19/realestate/in-the-long-run-sleep-at-home-and-invest-in-the-stock-market.html?_r=2
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Instead of claiming that study after study proves something why not post the study so people can examine it? I agree that the OP did not account for all variables, but you can't just snipe and avoid serving up alternative math instead.
The 50% rule already accounts for repairs, etc. so I am not sure how that criticism is valid.
Stock returns can be cherry-picked, but 12% or so nominal returns probably already factor in dividend reinvestment. How is this data cherry-picked? I'm not saying it isn't. I am saying that you have failed to provide evidence that it is cherry-picked.
How about we try to be constructive with our posts and dialog instead of complaining?
Edit: I see that he used 10% in the OP instead of 12% including dividends. Carry on with the complaining.
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Then you use a house where the appreciation rate is actually likely less than 3% per year over the long run, otherwise the house would cost much more. Studies by Harvard economists and others show that housing appreciates at .08% over the long run in the vast majority of cases.
Yeah, I have to say, of the half dozen houses I know something about regarding values over time (father, father-in-law, 2 rentals by sister-in-law, friend's house, our own house), in three different states, the only one that went up by more than enough to pay a 5% sales commission over 10-20 years was ours, which went up by a grand total of 30% over 18 years. Those don't seem like good odds for a 3%/year compounding value of a house.
Of course, if you get lucky and live in an area with a hot real estate market, like California, or Seattle, or Denver, I'm sure you could do better. As you could if you get lucky and invest in developing country stocks, or tech stocks, or medical stocks at the right time. The difference being that I don't have to live in a developing country to invest in their stocks, but I'd be pretty hesitant to invest in Denver real estate if I live in Alabama, for example. :)
I suspect the big advantage real estate has over stocks is not so much the leverage, but rather an inefficient market. If you really know your area and rent and purchase prices, and keep track of what comes on the market, you can buy that "half off" house, a short sale or fixer-upper. Buying a stock that you know is only selling for half of what it should be is pretty hard without insider trading. . .
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I think this thread is hilarious! You post that my math is bad but yet yours is are so clearly biased AND wrong it is ridiculous. Your expenses at that interest rate with that down payment are more than $500 a month just for debt service. Factor in repairs and your profits are actually less than your numbers above, about half of what you thought you were getting each month in profit.
Then you use a house where the appreciation rate is actually likely less than 3% per year over the long run, otherwise the house would cost much more. Studies by Harvard economists and others show that housing appreciates at .08% over the long run in the vast majority of cases.
Then on top of it, you only factor in stock growth, not dividends when you factor your 10% nominal return. In reality it is 12% when you factor in the dividends.
Yep, there's bad math alright, but it's in this thread. You cherry picked every scenario and the numbers to tilt the favor into the ONE asset class you are most heavily invested with your 15 ish rental properties. Biased perspective looks for evidence to support a decision he already made and skews the numbers.
Hilarious. Carry on...I guess everyone thinks that because they bought houses at the market bottom they must be an investing genius and real estate is the new gold mine. Study after study has proven that you are wrong....But keep believing whatever you like.
There is one way to really benefit from a combination of the two asset classes. Leverage and tax benefits are what give real estate the nod. Just cash out refinance equity every few years and put it in an index fund. Your leveraged real estate provides high rates of return on the money you have invested, is a tax shelter an you can tap the equity to invest in the stock market, while you live off the rents still, letting the stocks compound untouched.
But to say that real estate is a better investment based on the carefully crafted numbers that are 1) wrong as far as expenses and profits, and 2) leave out the stock dividends is more revealing of your bias than anything. It has been proven by economist after economist after economist and study after study that stocks beat real estate in the long run. The longer the holding period the better the return on stocks compared to RE.
Again, in your scenario you inflate the returns that you would actually receive on a property like that, and leave out the dividends of stocks. Yet you reinvest the rents but not the dividends of stocks that you don't even take into account. A lower interest rate asset doesn't beat a higher interest rate asset in the long run, dollar for dollar invested.
But as I said above, if you buy in equity play markets and pull that cash out and reinvest it in index funds, you get the best of both worlds. Leverage and tax benefits are the things that make real estate attractive. Pulling equity out to reinvest in index funds gives you the best of both worlds. Plus it helps you diversify. I wouldn't want all of my nest egg to be in Las Vegas Nevada...
http://www.nytimes.com/2005/08/19/realestate/in-the-long-run-sleep-at-home-and-invest-in-the-stock-market.html?_r=2
This is a fair criticism.
In all of these projections, the conclusions are only as good as the assumptions used to project into the future.
Real estate ends up being a different flavor of investment, but it's pretty clear that indexing is easier and has been more profitable in the past.
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I suspect the big advantage real estate has over stocks is not so much the leverage, but rather an inefficient market. If you really know your area and rent and purchase prices, and keep track of what comes on the market, you can buy that "half off" house, a short sale or fixer-upper. Buying a stock that you know is only selling for half of what it should be is pretty hard without insider trading. . .
It depends.
If you are planning to optimize your ROE then buying the house at a discount and selling quickly will be optimal. If, however, you plan to hold the property long-term the leverage will dominate purchasing it at a discount. You're not really getting leverage very easily on purchasing at a discount because the lender will generally use the lower of the purchase price or the appraised value for lending. So the LTC and not the LTV will drive your financing setup. You could get high-priced debt on the appraised value in situations where the appraised value exceeds the purchase price, but that would defeat the purpose of doing so. You could also make the assumption that you'll refinance the discount portion later on after the note has seasoned for a year or two.
Real capitalization rates for SFRs are probably in the 3-6% range absent a great purchase which can drive the yield well north of this. With good positive operating leverage you'll be able to lever this well north of 12%. The advantage of this leverage is that you don't have margin calls and it is long-term, fixed-rate FNMA (gov-mint coked) debt. If you want to get really fancy you can purchased properties subject-to and eliminate personal liability too.
The reason people are going to talk past each other in this thread is because the model is inherently unstable because there are more variables than there are fixed items. Hold period is a big one that you have to make an assumption on. When you sell quickly people will claim "real estate is a job" and the whole conversation will go round and round arguing about what it means to have a job.
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I think this thread is hilarious! You post that my math is bad but yet yours is are so clearly biased AND wrong it is ridiculous. Your expenses at that interest rate with that down payment are more than $500 a month just for debt service. Factor in repairs and your profits are actually less than your numbers above, about half of what you thought you were getting each month in profit.
I think the math looks pretty good. He is usually industry standards. I don't agree with all industry standards because my property taxes, insurance and vacancy are lower than normal. I don't 100% agree with the 50% rule because I think there are ways to beat it. However, it is an industry standard.
Then you use a house where the appreciation rate is actually likely less than 3% per year over the long run, otherwise the house would cost much more. Studies by Harvard economists and others show that housing appreciates at .08% over the long run in the vast majority of cases.
This assumption looks good to me and is another industry standard. If anything, I would argue appreciation higher than inflation especially if you bought at the bottom in Las Vegas or Florida at the bottom of the market.
Then on top of it, you only factor in stock growth, not dividends when you factor your 10% nominal return. In reality it is 12% when you factor in the dividends.
If you claim higher stock returns you need to understand that rental cash flow is also going into the stock market so it's not going to be that much different
Yep, there's bad math alright, but it's in this thread. You cherry picked every scenario and the numbers to tilt the favor into the ONE asset class you are most heavily invested with your 15 ish rental properties. Biased perspective looks for evidence to support a decision he already made and skews the numbers.
He doesn't mention anything about 15 rental properties. The post is for people considering one rental property.
Hilarious. Carry on...I guess everyone thinks that because they bought houses at the market bottom they must be an investing genius and real estate is the new gold mine. Study after study has proven that you are wrong....But keep believing whatever you like.
I don't understand this argument. This seems more like a personal attack.
There is one way to really benefit from a combination of the two asset classes. Leverage and tax benefits are what give real estate the nod. Just cash out refinance equity every few years and put it in an index fund. Your leveraged real estate provides high rates of return on the money you have invested, is a tax shelter an you can tap the equity to invest in the stock market, while you live off the rents still, letting the stocks compound untouched.
You are both in agreement that houses win with leverage. If you don't have leverage then stocks win. I don't see a disagreement here. I think you are both in agreement.
But to say that real estate is a better investment based on the carefully crafted numbers that are 1) wrong as far as expenses and profits, and 2) leave out the stock dividends is more revealing of your bias than anything. It has been proven by economist after economist after economist and study after study that stocks beat real estate in the long run. The longer the holding period the better the return on stocks compared to RE.
This seems to be repeating an earlier point about dividends
Again, in your scenario you inflate the returns that you would actually receive on a property like that, and leave out the dividends of stocks. Yet you reinvest the rents but not the dividends of stocks that you don't even take into account. A lower interest rate asset doesn't beat a higher interest rate asset in the long run, dollar for dollar invested.
This seems to be the same point about dividends again
But as I said above, if you buy in equity play markets and pull that cash out and reinvest it in index funds, you get the best of both worlds. Leverage and tax benefits are the things that make real estate attractive. Pulling equity out to reinvest in index funds gives you the best of both worlds. Plus it helps you diversify. I wouldn't want all of my nest egg to be in Las Vegas Nevada...
His post doesn't say anything about Las Vegas and his numbers do not represent Las Vegas. He picked generic numbers that would work for many places across the United States
http://www.nytimes.com/2005/08/19/realestate/in-the-long-run-sleep-at-home-and-invest-in-the-stock-market.html?_r=2
THank you for providing the article. I look forward to reading it.
I really like the simplified argument. If you have leverage, real estate typically wins. If you do not have leverage, then stocks win. It makes a lot of sense. Not because of the numbers posted in this thread, but because I also have similar spread sheets and have come to similar conclusions. It is supposed to be theoretical. The numbers are going to be very different if you apply it to a specific situation that we have all gone through.
I have never tried to respond to specific comments before. Hopefully people are able to read it.
[Mod Edit: Quote Tags fixed.]
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Interesting & fun scenario ARS. 1 beef & 1 question re: the methodology...
1. Beef. Your example does not compare stocks to Real Estate. It compares Stocks to a combination of Real Estate & Stocks... Perhaps a better methodology for the real estate scenario is to reinvest accumulated cash flow back into another house w/ the same parameters of 20% down, 2% closing fees, 50% costs, etc. In the meantime while the cash accumulates, the money would grow risk free at the 3% inflation rate (a generous claim in today's environment, but one that could play out over the decades). That way, you can purely compare a compounding stock portfolio to a compounding, leveraged real estate portfolio.
2. Question. Does the $1k annual gross income in the real estate scenario also inflate at 3%? I didn't dive into the maths to check for myself. It should IMO.
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tl;dr The question was "What wins in the long run?" The answer is: it depends on how good the real estate investment is. At a 1% rule, it's pretty even between the two scenarios: Real estate wins over a 30 year timeframe, stocks win over a 50 year timeframe. At a much better ratio, like 1.5%, real estate wins hands down, with over double the money of stocks. At a worse ratio, naturally stocks would win.
Thoughts? Math I screwed up? Quibbles with assumptions?
I think your math is correct and it does make sense. It comes down to the exact numbers, however. All of the current has really been mentioned already, but I'd like to spell it our, mostly as an excercise for myself:
Your assumed real rate of return of the rental is 6% (12*500/100000).
Your assumed real rate of return of stocks is 7%.
If the real estate in the example were not leveraged, stocks would win over any timeframe.
If we take the leverage into account:
Getting 6% return on 100% of the price is 0.06; you are paying 4.5%*80%=0.036; so your actual rate of return on your 20% you invested from your own money (I think that is what fancy business types call "return on equity") is
(0.06-0.036)/20% = 12%
So this the actual rate of return on your money in the rental case before you start paying it off. As you are paying off the loan, you are deleveraging and the rate of return goes down, converging against 6%. That's why the rental wins short-term and the stock win long-term.
As to the closing costs: In the very very short term, stocks would again win, but then none of us care about the very short term.
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Edit: I see that he used 10% in the OP instead of 12% including dividends. Carry on with the complaining.
10% is fine for a back of the envelope calculation like this one. Since 1929, the S&P including dividends has nominally returned 10% on average. There have been fairly long periods of time when that number was higher or lower, but 10% is fine if we are taking a SWAG.
The only problem I see with the calculation that one you pointed out: The stock market and house appreciation returns assume inflation, but the rents don't.
Not sure what Bearded Man is going on about.
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I'd like to see an analysis, including taxes, of investing in real estate "normally" (i.e., not inside an IRA) vs. investing in stock indexes inside tax-advantaged accounts, for someone with a reasonably-high W-2 income (say, $100K, MFJ -- or maybe do a couple of scenarios at different income levels).
For me, probably the biggest reason that I haven't yet bought investment property is the idea of "losing out" on tax-advantaged space (as I haven't gotten to the point where I can max it all out, pay off my student loans, and save up a down payment at the same time yet), but I don't know enough about calculating the tax-shelter effect of real estate to figure out if that's actually a valid concern or not.
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I think this thread is hilarious! You post that my math is bad but yet yours is are so clearly biased AND wrong it is ridiculous.
Oh boy, I thought the math was straightforward..guess not.
I see 3 math criticisms in your post.
1:
Your expenses at that interest rate with that down payment are more than $500 a month just for debt service. Factor in repairs and your profits are actually less than your numbers above, about half of what you thought you were getting each month in profit.
Wrong. You did not read closely/correctly.
I included both expenses and debt service. The house rented for 1000/month. I put 50% towards expenses ($500), and used an amortization calculator to calculate $405.35 of debt service per month on an 80k loan at 4.5%. That leaves $94.65 per month profit, or $1,135.80 annually.
2:
Then you use a house where the appreciation rate is actually likely less than 3% per year over the long run, otherwise the house would cost much more. Studies by Harvard economists and others show that housing appreciates at .08% over the long run in the vast majority of cases.
Wrong. I used 3% nominal appreciation, which is 0% real for our assumed 3% inflation. I used lower than that 0.08% you quoted.
3:
Then on top of it, you only factor in stock growth, not dividends when you factor your 10% nominal return. In reality it is 12% when you factor in the dividends.
This is the only potential criticism that's valid. If you think 12% returns are what will happen going forward in the stock market, feel free to use those in the analysis, and tweak what variables in real estate you'd like as well. I think 10% is reasonable, as Telecaster pointed out:
10% is fine for a back of the envelope calculation like this one. Since 1929, the S&P including dividends has nominally returned 10% on average. There have been fairly long periods of time when that number was higher or lower, but 10% is fine if we are taking a SWAG.
Further, since both are investing in stocks, it hurts both cases (though pure stocks more, obviously), plus not accounting for rent inflation should help cancel most of this out.
Yep, there's bad math alright, but it's in this thread. You cherry picked every scenario and the numbers to tilt the favor into the ONE asset class you are most heavily invested with your 15 ish rental properties. Biased perspective looks for evidence to support a decision he already made and skews the numbers.
If I wanted to skew the numbers, I would have started with much better, not neutral assumptions. Hell, if I wanted to skew the numbers, I wouldn't have to cherry pick them, but could just use my own.
I was trying to come up with a fairly neutral analysis. The point of my analysis wasn't to argue for one over the other. I wrote my assumptions without knowing the outcome, just trying to make a neutral scenario to find out if someone in their mid-20s with a down payment would be better buying a single rental (assuming it was a reasonable deal, but nothing special), and then all stocks, or just going for stocks right away. If the leverage alone made it worth it.
The only problem I see with the calculation that one you pointed out: The stock market and house appreciation returns assume inflation, but the rents don't.
Not sure what Bearded Man is going on about.
Yes, and the rent appreciation would only tilt it more towards RE. Having realized I missed that after posting, and based on the conclusions that were drawn, it didn't seem worth redoing.
I think Bearded Man took offense at my first sentence, which wasn't even directed at him, and went on tilt. Unfortunately he severely misread things, and his main two criticisms were both incorrect.
Bearded Man, I hope you can calm down, try not to take offense like someone is personally attacking you when trying to analyze real estate versus stocks, and actually read the analysis. If you have any legitimate criticisms, great! Feel free to post. But vitriol won't help anyone.
Interesting & fun scenario ARS. 1 beef & 1 question re: the methodology...
1. Beef. Your example does not compare stocks to Real Estate. It compares Stocks to a combination of Real Estate & Stocks... Perhaps a better methodology for the real estate scenario is to reinvest accumulated cash flow back into another house w/ the same parameters of 20% down, 2% closing fees, 50% costs, etc. In the meantime while the cash accumulates, the money would grow risk free at the 3% inflation rate (a generous claim in today's environment, but one that could play out over the decades). That way, you can purely compare a compounding stock portfolio to a compounding, leveraged real estate portfolio.
Right. I specifically didn't want to do that. Most people aren't going to buy a home, then another, then another, and end up with a dozen. It's just not something they desire to do. But many would be willing to buy a single rental home, if it was worth it. I attempted to look at if it was, or not.
2. Question. Does the $1k annual gross income in the real estate scenario also inflate at 3%? I didn't dive into the maths to check for myself. It should IMO.
No, that was the one math mistake, realized above:
http://forum.mrmoneymustache.com/real-estate-and-landlording/real-estate-returns-vs-stock-returns-the-maths/msg863755/#msg863755
That should tilt the analysis much more in favor of real estate. I'm open to any other math criticisms, but that's the only valid one so far, and not a product of someone misreading something.
Your assumed real rate of return of the rental is 6% (12*500/100000).
Your assumed real rate of return of stocks is 7%.
If the real estate in the example were not leveraged, stocks would win over any timeframe.
Absolutely. But since RE does have leverage, it was interesting to compare them.
I'd like to see an analysis, including taxes, of investing in real estate "normally" (i.e., not inside an IRA) vs. investing in stock indexes inside tax-advantaged accounts, for someone with a reasonably-high W-2 income (say, $100K, MFJ -- or maybe do a couple of scenarios at different income levels).
For me, probably the biggest reason that I haven't yet bought investment property is the idea of "losing out" on tax-advantaged space (as I haven't gotten to the point where I can max it all out, pay off my student loans, and save up a down payment at the same time yet), but I don't know enough about calculating the tax-shelter effect of real estate to figure out if that's actually a valid concern or not.
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Then on top of it, you only factor in stock growth, not dividends when you factor your 10% nominal return. In reality it is 12% when you factor in the dividends.
http://dqydj.net/sp-500-return-calculator/
The S&P index return since inception, including reinvested dividends, is 9.012%. If you only count the modern S&P 500 index (since 1957), you get 9.98%. The numbers for the total market (dividends included) roughly match those S&P returns.
http://www.investopedia.com/walkthrough/corporate-finance/4/capital-markets/history-stocks-bonds.aspx?header_alt=false
Siegel also gives an average compound inflation-adjusted rate of return of 6.8% for the stock market from 1802 to 2002. He further notes, "A 6.8% annual rate of return means that if all dividends are reinvested, the purchasing power of stocks has doubled, on average, every ten years over the past two centuries."
Backing out the inflation adjustment, you get about 9.8% for the entire market.
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Cool. I just picked 10%, mostly cause it was in the ballpark and a round number. There's no reason one couldn't use 9%, or 12%. Obviously these assumptions will way skew your results, so I was just trying to pick something "reasonable." Glad to see history is pretty close to 10%, close enough that it shouldn't even really be a nitpick.
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I got another question
Right. I specifically didn't want to do that. Most people aren't going to buy a home, then another, then another, and end up with a dozen. It's just not something they desire to do. But many would be willing to buy a single rental home, if it was worth it. I attempted to look at if it was, or not.
Where's the person living while they do this?
Sure I am investing in stocks now and living in my house... I'm not entirely sure I could "afford" to leverage another house, or are you saying that I could? And what bank is going to give 2 mortgages to someone with an average salary?
So if I am investing $500/month into stocks, I would transfer all of that into the rental payments for the duration of the mortgage? Then use the rents to buy stocks? It's a round about way, but the only way I could think of if I had to cover vacancies... and in the end $500 or so/month would be invested in stocks as long as there is a tenant. And if I lose job for some reason, I end up losing both houses? At least with stocks, I don't lose that portion if I am out of work...
Or are you referring to duplexes where the land lord is living in half of the house? It almost sounds like your real estate is a "free" meal, all the expenses is covered by the rent and you are only fronting the down payment/closing costs? But I'm fairly certain it isn't as risk free as you make it sound but I just don't know enough about it to put it to words.
if it is that risk free, want to mentor me in finding a local rental? :D
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I got another question
Right. I specifically didn't want to do that. Most people aren't going to buy a home, then another, then another, and end up with a dozen. It's just not something they desire to do. But many would be willing to buy a single rental home, if it was worth it. I attempted to look at if it was, or not.
Where's the person living while they do this?
Wherever they were living before this.
I was presuming they have their living situation figured out. I'm not going to decide buy versus rent for them. But a Mustachian who comes out of college at 22, gets a job, decides to buy, or rent, and then after a few years they're 25 and wondering "Should I buy a rental, or not?" may find an analysis like this useful.
I'm not trying to decide their whole life--where they live, for example. I don't know how they saved up the 22k for the down payment/closing costs. My assumptions are much more simple than that. :)
Sure I am investing in stocks now and living in my house... I'm not entirely sure I could "afford" to leverage another house, or are you saying that I could? And what bank is going to give 2 mortgages to someone with an average salary
Yes, probably. It'll depend on your situation, check with a mortgage broker, but many people can qualify for a rental (or multiple) while owning a home.
So if I am investing $500/month into stocks, I would transfer all of that into the rental payments for the duration of the mortgage? Then use the rents to buy stocks? It's a round about way, but the only way I could think of if I had to cover vacancies... and in the end $500 or so/month would be invested in stocks as long as there is a tenant.
Not exactly. The rental, being cash flow positive, should pay all of its expenses (via the assumed 50% rule), including setting aside reserves to cover the mortgage when there is vacancies. So you'll get 1000/mo in rent. $500 will go to expenses (insurance, repairs, property tax, property manager, setting aside money for capital expenses and vacancies, etc.), $405.35 will go to P&I, and $94.65 will be profit. The $500/mo you're already investing in stocks is irrelevant--keep investing it! It's not used to pay the mortgage, the rent is (and the reserves, when there's vacancies).
And if I lose job for some reason, I end up losing both houses? At least with stocks, I don't lose that portion if I am out of work...
No, the rental is cash flow positive, so if you lose your job it pays for itself and helps pay for your other expenses.
Or are you referring to duplexes where the land lord is living in half of the house? It almost sounds like your real estate is a "free" meal, all the expenses is covered by the rent and you are only fronting the down payment/closing costs? But I'm fairly certain it isn't as risk free as you make it sound but I just don't know enough about it to put it to words.
No, I didn't mean living in part of it. Hope the above cleared up some of your confusion. :)
if it is that risk free, want to mentor me in finding a local rental? :D
I don't know if your local area is good or not. You may want to look into the numbers, and if it's not, also consider investing outside your area.
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I'd like to see an analysis, including taxes, of investing in real estate "normally" (i.e., not inside an IRA) vs. investing in stock indexes inside tax-advantaged accounts, for someone with a reasonably-high W-2 income (say, $100K, MFJ -- or maybe do a couple of scenarios at different income levels).
For me, probably the biggest reason that I haven't yet bought investment property is the idea of "losing out" on tax-advantaged space (as I haven't gotten to the point where I can max it all out, pay off my student loans, and save up a down payment at the same time yet), but I don't know enough about calculating the tax-shelter effect of real estate to figure out if that's actually a valid concern or not.
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What happened? Did you start to respond but then changed your mind?
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What happened? Did you start to respond but then changed your mind?
That is exactly what happened! I was going to opine, but then realized I didn't have enough knowledge or data for that particular question (or rather, I might, but I'm not confident enough to be sure), so decided not to just guess. :)
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The tax shelter impact of real estate investing is ridiculously complicated. After $150k you lose out on many things unless you can structure your affairs properly to be able to play the tax maze game. For instance, my wife is a 50% owner in our operations business and thus we can call these "passive gains" which can then be offset by passive losses. Modeling this is necessarily going to be situation-specific and it would be very hard to model precisely in all scenarios.
However, this is the tail wagging the dog. Your goal should be maximal after-tax profits; not minimal taxes. Leveraging something with real yields of 4-6% by 4:1 or more at normal debt service costs you're going to get a higher than 10% (or 12% for the snipers) real return.
For those worried about down payments there are techniques to purchase distressed sales for very little (or no) money down. It isn't easy to find good projects like this, but they do exist. Since this thread is centered around non-exotic topics though I won't elaborate or sidetrack it.
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However, this is the tail wagging the dog. Your goal should be maximal after-tax profits; not minimal taxes. Leveraging something with real yields of 4-6% by 4:1 or more at normal debt service costs you're going to get a higher than 10% (or 12% for the snipers) real return.
That's what I'd like to see the math to prove. People say that real estate is great because you can deduct depreciation, but I want to see how big an effect that is compared to the above-the-line retirement deductions + Saver's Credit.
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However, this is the tail wagging the dog. Your goal should be maximal after-tax profits; not minimal taxes. Leveraging something with real yields of 4-6% by 4:1 or more at normal debt service costs you're going to get a higher than 10% (or 12% for the snipers) real return.
That's what I'd like to see the math to prove. People say that real estate is great because you can deduct depreciation, but I want to see how big an effect that is compared to the above-the-line retirement deductions + Saver's Credit.
The tax benefits are small from holding real estate because it has to be amortized straight-line over 27.5 years for residential projects unless you do a chattel appraisal or some such.
Your question/point really has more to do with trading off contributions to tax-advantaged accounts with purchasing leveraged real estate though. One thing I will point out is that you can set up a SoloK or other retirement construct (SEP, etc.) and purchase rentals with it. There are tax considerations like UDFI to account for if you leverage the project with non-recourse loans.
I'm too lazy to do a full analysis, but there is really no reason you can't do both if you invest effort in learning to purchase real estate with seller financing. This is obviously more work, but if you do so you can use the AND operator instead of the OR operator when analyzing stock indexing and real estate investment.
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That's what I'd like to see the math to prove. People say that real estate is great because you can deduct depreciation, but I want to see how big an effect that is compared to the above-the-line retirement deductions + Saver's Credit.
The proper way to frame the question is that depreciation is one of the things that may make a real estate deal attractive.
There are any number of real estate investment calculators online. Google one up and punch in your own set of numbers and compare it to your personal situation.
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That's what I'd like to see the math to prove. People say that real estate is great because you can deduct depreciation, but I want to see how big an effect that is compared to the above-the-line retirement deductions + Saver's Credit.
The proper way to frame the question is that depreciation is one of the things that may make a real estate deal attractive.
There are any number of real estate investment calculators online. Google one up and punch in your own set of numbers and compare it to your personal situation.
In addition to your personal situation, there's the issue that deducting depreciation on real estate is tax deferral, not tax avoidance. Like a traditional 401k, there may be ways to avoid taxes on the back end when you sell real estate, but that is an additional complicating factor.
The zeroeth-order approximation should be that depreciation doesn't markedly effect returns on real estate, because an individual's future tax rate may be greater than, equal to, or less than their current tax rate.
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That's what I'd like to see the math to prove. People say that real estate is great because you can deduct depreciation, but I want to see how big an effect that is compared to the above-the-line retirement deductions + Saver's Credit.
The proper way to frame the question is that depreciation is one of the things that may make a real estate deal attractive.
There are any number of real estate investment calculators online. Google one up and punch in your own set of numbers and compare it to your personal situation.
In addition to your personal situation, there's the issue that deducting depreciation on real estate is tax deferral, not tax avoidance. Like a traditional 401k, there may be ways to avoid taxes on the back end when you sell real estate, but that is an additional complicating factor.
The zeroeth-order approximation should be that depreciation doesn't markedly effect returns on real estate, because an individual's future tax rate may be greater than, equal to, or less than their current tax rate.
The only ways to avoid, rather than defer the depreciation recapture (which is taxed at 25%) is to:
1) Sell the property for a loss.
2) Die.
Neither is a good tax planning mechanism.
The short answer to Jack's question is, much like comparing real estate returns to stock market returns, you are comparing apples to cell phones. They're very different. There are many variables making the comparison difficult, and situational. If you must choose one over the other strictly from a tax planning viewpoint for a mustachian, I see more benefit in the 401K tax deferral than I do the real estate investment tax benefits.
That's not intended to argue for Stocks rather than Real Estate. That's a separate issue and I align more with the Real Estate argument. I'm merely referring to the tax benefits of each. And this is a generic, 10,000 foot level view. Not one size fits all.
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That's what I'd like to see the math to prove. People say that real estate is great because you can deduct depreciation, but I want to see how big an effect that is compared to the above-the-line retirement deductions + Saver's Credit.
The proper way to frame the question is that depreciation is one of the things that may make a real estate deal attractive.
There are any number of real estate investment calculators online. Google one up and punch in your own set of numbers and compare it to your personal situation.
In addition to your personal situation, there's the issue that deducting depreciation on real estate is tax deferral, not tax avoidance. Like a traditional 401k, there may be ways to avoid taxes on the back end when you sell real estate, but that is an additional complicating factor.
The zeroeth-order approximation should be that depreciation doesn't markedly effect returns on real estate, because an individual's future tax rate may be greater than, equal to, or less than their current tax rate.
The only ways to avoid, rather than defer the depreciation recapture (which is taxed at 25%) is to:
1) Sell the property for a loss.
2) Die.
Neither is a good tax planning mechanism.
Does dying actually avoid depreciation recapture? I.e. does the basis get re-set as of date of death for heirs?
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The only ways to avoid, rather than defer the depreciation recapture (which is taxed at 25%) is to:
1) Sell the property for a loss.
2) Die.
Neither is a good tax planning mechanism.
Does dying actually avoid depreciation recapture? I.e. does the basis get re-set as of date of death for heirs?
It can. Again, individual circumstances will dictate this. With proper estate tax planning, the answer is yes. When someone dies holding ownership in real estate, or a business, or whatever, the heirs can make a 754 election commonly referred to as a step-up in basis.
The Bush tax cuts created a strange anomaly. All the estate planning professionals starting telling people they should plan to die in 2010. There was no estate tax. This is when George Steinbrenner died. So his $1B inheritance from the NY Yankees was not hit with any estate tax. The flip side of that coin: his heirs were not eligible to make a 754 election, so his cost basis carries forward to them.
When you make a 754 election, you get the FMV at date of death as your basis. The difference between that and the cost basis held by the decedent is taxable income to the estate. As long as you remain under the $5.X million lifetime exemption, this completely avoid the depreciation recapture tax.
Some people continually utilize the 1031 exchange rules (like-kind) which is tax deferral. However, if you combine that with the 754 election upon death, it becomes a valid tax avoidance strategy.
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The only ways to avoid, rather than defer the depreciation recapture (which is taxed at 25%) is to:
1) Sell the property for a loss.
2) Die.
Neither is a good tax planning mechanism.
Does dying actually avoid depreciation recapture? I.e. does the basis get re-set as of date of death for heirs?
It can. Again, individual circumstances will dictate this. With proper estate tax planning, the answer is yes. When someone dies holding ownership in real estate, or a business, or whatever, the heirs can make a 754 election commonly referred to as a step-up in basis.
Fun! Thanks for the info.
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Well....if you continually defer taxes until you die and exchange for larger properties you never have to pay the recapture tax. This situation really isn't deferral in that case. It just necessitates that you keep your equity accumulated in like-kind investments which could generate levered returns in excess of what index funds will generate as this thread shows.
Claiming that dying is the only way to avoid the tax is correct, but covers up the idea of continually exchanging combined with refinancing can give you access to the equity tax free.
Edit: Here is an article from BP on this for anyone interested in learning more about navigating this tax game:
https://www.biggerpockets.com/renewsblog/2014/08/21/strategy-take-cash-1031-exchange-tax-free/
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Does dying actually avoid depreciation recapture? I.e. does the basis get re-set as of date of death for heirs?
It does for you. You're dead :)
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Well....if you continually defer taxes until you die and exchange for larger properties you never have to pay the recapture tax. This situation really isn't deferral in that case. It just necessitates that you keep your equity accumulated in like-kind investments which could generate levered returns in excess of what index funds will generate as this thread shows.
Claiming that dying is the only way to avoid the tax is correct, but covers up the idea of continually exchanging combined with refinancing can give you access to the equity tax free.
Edit: Here is an article from BP on this for anyone interested in learning more about navigating this tax game:
https://www.biggerpockets.com/renewsblog/2014/08/21/strategy-take-cash-1031-exchange-tax-free/
So I agree with you, but just so we're all clear on what's going on here:
Every like kind exchange decreases cost basis of the next purchase. Every decrease in cost basis decreases depreciation. Every decrease in depreciation increases annual taxes at your marginal rate.
So you won't technically pay depreciation recapture, but it's very possible you will pay additional annual taxes if you do this a lot. If you make a lot of money, you could be paying well in excess of the 25% rate each year because of this.
Even if you 1031 until you die, then your heirs 754, you aren't avoiding all the taxes.
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Every like kind exchange decreases cost basis of the next purchase. Every decrease in cost basis decreases depreciation. Every decrease in depreciation increases annual taxes at your marginal rate.
So you won't technically pay depreciation recapture, but it's very possible you will pay additional annual taxes if you do this a lot. If you make a lot of money, you could be paying well in excess of the 25% rate each year because of this.
Even if you 1031 until you die, then your heirs 754, you aren't avoiding all the taxes.
I'm not sure that this is correct. Perhaps you can use an example to illustrate what you're claiming.
There are several things happening here. Why could one not exchange for a property that is MUCH more valuable and still get plenty of adjusted basis for depreciation and thus an increase in tax shields? Your claim above is that every like-kind exchange decreases cost basis on the next purchase. Is this what you meant to claim?
Another problem with the absolute assertions above is that your tax situation may change year to year. As a business owner I know my income is lumpy and some years I have far more passive income to offset with passive losses and/or suspended losses.
I wasn't claiming you'd avoid ALL taxes, but you certainly should be able to avoid the recapture tax if you do things properly. Avoiding the marginal federal taxes year-to-year is a complicated game with many pieces, some of which are dependent on systemic things going on in the economy that drive banner years.
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We're waaay off topic, but I don't think rebs will mind since he's an RE investor. I'm typing on a phone so this will be choppy/imperfect.
It's correct. At least what I'm attemting to write is correct. It might not be coming accross properly. Example:
Buy 100,000
8 yrs of depreciation (~3,600/yr) ~30,000
Sell 125,000
Gain 55,000
1031 exchange
Buy 160,000
Less rolled in gain 55,000
Cost basis 105,000
Annual Depreciation ~4,000
Depreciation is higher. So is cost basis. I wasn't trying to say your cost basis would be lower compared to the old property, I was trying to say it would be decreased by the deferred gain. Every year your depreciation will be lower with a 1031 exchange than it would be without it (if you'd paid the tax rather than rolling the gain). So you pay some tax at marginal rates as a result of decreased basis.
Yes you might not pay every year due to offsetting passive losses. But the effect still increases taxes at some point through current taxes, reduced passive loss carryovers, etc.
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I'm pretty tired so maybe I am missing something, but why not just buy another asset worth $500k instead of $160k? Sure, your cost basis will be lower than it would be absent exchanging, but your depreciation will be much higher from buying a more expensive asset.
I read your second paragraph several times, but I am not following the logic. Sure, if you compare the cost basis with and without exchanging you can claim this is "extra" in marginal rates absent other variables. However, you'll have more depreciation if you purchase a higher-priced asset and thus higher tax shields. Thus you're better off than you would be absent the higher-priced asset.
Your last paragraph is the one I am not following. Higher tax shields equals less in taxes overall. You may be paying more than you would absent the basis adjustment, but it is still less than you would without the asset you exchanged to. I'm not sure how you get an increase out of this logic.
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It comes down to this simple fact: you are buying something and reducing your cost basis by the deferred gain. Buy a new one for $10M, it really doesn't matter. Whatever the new cost, it will be reduced by the pior deferred gain. Therefore, the deferred gain reverses itself by 1/27.5 every year. It's deferral, not avoidance, and that's the point I'm trying to make.
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I get that you're trying to make the point that it is deferral, but it doesn't make sense. If you defer it forever by exchanging to higher-priced assets you'll get more in tax shields and thus less in taxes as compared with either selling or not having the asset to begin with. Thus by definition an indefinite deferral that gives you higher tax shields for your lifetime means you don't pay any taxes at all. This is avoidance entirely; not deferral.
You'll also pay less in taxes over the course of your lifetime by owning the assets and thus you'd need to count this "extra cash" as accretive to your overall wealth. Each year you'd be able to contribute more to your investment vehicle of choice and this would need to be added to what you are gaining by selecting to invest in real estate instead of index funds.
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Cheddar's point, as I understand it, is you're taking less depreciation on the new asset than you would be if you bought it outright, due o the decreased basis from the 1031, so you're in essence paying on that tax deferred.
Compare the amount of taxes paid (and depreciated) from someone who bought a 5MM property versus someone who rolled into one via 1031. Since the person who rolled into it has a lower basis, their amount of depreciation taken is lower, meaning they pay more taxes overall on the new property. Those extra taxes? They're essentially undoing the taxes you saved, (this is the 1/27.5/yr CS mentioned), so you deferred them TO THAT POINT, but didn't totally eliminate them (by being able to 100% defer, then leave to heirs on a stepped up basis).
Does that make more sense?
CS, let me know if I got that right, cause your point was brand new to me, and pretty revolutionary--I had always thought what mr_orange is arguing, that you're totally deferring it, but it seems not, based on your point, which makes sense to me when I think about it as a comparison of two identical properties--the 1031 reducing the basis leads to less eligible depreciation on the next one, meaning you're paying more taxes on that, undoing the less taxes you paid earlier.
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Then on top of it, you only factor in stock growth, not dividends when you factor your 10% nominal return. In reality it is 12% when you factor in the dividends.
There are two general ways to forecast future returns for the broad stock market (add inflation for both if you don't want to calculate the real return, it would make the numbers look bigger) :
1) return = current dividend yield + growth
Right now it is about 2%+ 2% = 4%, or a little less.
2) return = 10-year averaged earnings / price
1 / 26 = 4%, or a little less
Both estimates show a little under 4%. Expecting anything more than 4% from US stocks right now is speculative. Obviously the actual return will be completely different every year, but a 12% US stock return starting today is an optimistic assumption for the next 30 years. In the past dividends were higher, growth was higher, and prices were relatively lower, which is why 12% was true in the past. I think this makes real estate look attractive right now.
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Isn't the higher ROI in RE essentially compensation for the higher risk? When you are leveraged, you are exposed to a higher risk since you have to repay the mortgage regardless of whether you have a tenant or a Detroit scenario reduces the rent you can get for your property. If things go really south you could go bancrupt.
When you are long in stocks, assuming a standard investment portfolio without borrowing etc, your stocks will never be able to cause you to go bancrupt. You have less exposure to risk and therefore lower ROI.
We learned in 2008 that real estate doesn't "always go up", and what overleveraged real estate can do to your net worth. Your stock portfolio doesn't cost money to own, even if it is way down. So you can simply sit on your portfolio until the market goes back up. That proved to be an excellent strategy from 2008 until now. Real estate costs money to own. So cash flow is necessary just to keep owning it. That is true whether the property is rented or not. Or whether the tenant trashes the place or not. You should be compensated for taking on that additional risk. The theoretical example proposed by OP shows that it is.
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2008 doesnt make a hard argument against rentals though. it was the home buyers that got hit, i dont remember rents dropping to $0... even the people who had to leave their homes, they ended up renting until they couldnt do that either... but the landlords didnt give them free housing
the biggest hit to them would be the house value not the cash flow... i think, i could be wrong but it sounded like that was what they said over on bigger pockets
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Does that make more sense? paying more taxes on that, undoing the less taxes you paid earlier.
I understand the point CS is making, but I don't understand how this reduces your tax shields relative to what you had when you owned the asset you exchanged from if you purchase the correct asset to exchange to. Sure, your cost basis is higher, but so is your asset value and thus your tax shields are bigger; thus lower taxes in future years assuming you can take the passive losses.
If you continue trading up in asset prices and you eventually die you never pay higher taxes and thus you have eliminated the tax entirely; not deferred it.
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Ok, back at my desk and with a clear head.
Rebs summarized it pretty well and he gets it; glad I was of some help. It sounds like mr_orange get's the basic point I'm making:
I understand the point CS is making
So, on to this part:
, but I don't understand how this reduces your tax shields relative to what you had when you owned the asset you exchanged from if you purchase the correct asset to exchange to. Sure, your cost basis is higher, but so is your asset value and thus your tax shields are bigger; thus lower taxes in future years assuming you can take the passive losses.
If you continue trading up in asset prices and you eventually die you never pay higher taxes and thus you have eliminated the tax entirely; not deferred it.
I'm not sure what you mean by tax shields, and I know a little about tax. Is this a real estate term? Are you just referring to deductions? Shielding your positive cash flow with deductible losses?
Let me liken this to the mortgage interest deduction, of which I'm a huge fan. People often argue you shouldn't pay off your mortgage because you'll lose a tax deduction. That's a silly argument, and it's not why I keep my mortgage (You can read about that in 100 places on this forum). What those people are petitioning for is to pay $1 to save $0.25.
When you buy a more expensive property, you obviously pay more money for it. Hopefully that yields higher returns. For now let's leave that out of the equation, because we're already muddy enough. When you 1031 from $100,000 purchase, to $200,000 purchase, to $400,000 purchase, to $600,000 purchase you are likely not paying any depreciation recapture as a one time expense. Your tax deductions will continue to rise, but so will your deferred gain each time.
After doing this many times for many years you will likely end up spending $5M on a property, and then taking $3M worth of depreciation over the final 27.5 years presuming you hold your final property for that term and die anytime after that.
I'm going to attempt a quick spreadsheet detailing this and post here. Maybe that will help.
I'm all for 1031 exchanges. The alternative is a big cap gain and depreciation recapture tax. Proper tax planning can do wonders. I just don't want people to think the 1031 doesn't have an affect on your annual tax return; it does. It's just a slow bleed from a gut shot rather than a grenade.
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Here is a real world example.
I purchased 100 acres of farm real estate 25 years ago for $75,000. It's now easily worth $650,000
It has kicked me back approx. $6000 annually (after taxes) all that time, totaling $150,000
So I turned $75,000 into $800,000 in 25 years with real estate.
By my math, that same amount invested would need to consistently have yielded a 10.25% return to do the same.
Could that have been done with stocks ..... maybe?
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Here's a spreadsheet showing what I'm talking about.
I don't know you mr_orange, so I don't know your plan. I read a little of your journal a few months back, and if I remember correctly you are going big, very big. This model might not fit what you're doing. Adjust accordingly if need be, but this is a valid strategy I've seen clients use: sell every 7 years.
What you'll notice, particularly once a gain gets rolled into a new property twice, is the cost basis and related depreciation is substantially reduced by the deferred gain. Your depreciable base is diluted. You may still have losses, particularly if you go more aggressive and buy at higher prices. However, the rolled up gain still reduces that basis, and reduces your depreciation accordingly.
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However, the rolled up gain still reduces that basis, and reduces your depreciation accordingly.
To me this is the key. I don't think we're disagreeing on anything other than the strategy. I'm saying that you continue buying bigger properties and getting more basis to depreciate and thus I am not losing this paper expense to shield my taxes. In fact, it gets bigger with each purchase if done properly.
You're saying that each time you exchange that which you can depreciate relative to purchasing for cash is reduced. That's fine, but my goal is to increase my depreciation expense that shields passive income with passive losses.
So the answer to me is that it depends. That is why this comparison exercise is difficult. It depends on what you're doing. Depreciation is really a small benefit as compared with the inexpensive leverage and inflation hedging. So maybe we should agree that we're looking at things differently and move on ;-)
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So maybe we should agree that we're looking at things differently and move on ;-)
I can't agree to that! (Sorry, Simpsons quote).
Yeah, we are just looking from different angles here. We both understand what's going on.
Hopefully the banter helped someone.
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Quick question that might sway this in investor's favor...
You have many rentals and know what to look for...
If your example, the guy only wants one rental... how likely is he to make the best choices in it if he is the new to it? What kind of missteps do people take with first rental?
It seems easier to dig a bigger hole with rental than putting into a total index. Higher learning curve + leverage...
This would be me being so hesitant on rentals... I don't know what could go wrong
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So maybe we should agree that we're looking at things differently and move on ;-)
I can't agree to that! (Sorry, Simpsons quote).
Yeah, we are just looking from different angles here. We both understand what's going on.
Hopefully the banter helped someone.
It helped me! (Well, sort of; I can't claim I grok it yet.)
However, I still have a question: mr_orange's plan involves exchanging a single property for a single successively larger one, over and over again. But isn't that kind of risky compared to buying additional cheap properties (e.g. buying four more $100K houses instead of 1031-exchanging the first one for one $500K house)? Can you still use the same basis/depreciation strategy, or would it not work in that case?
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Quick question that might sway this in investor's favor...
You have many rentals and know what to look for...
If your example, the guy only wants one rental... how likely is he to make the best choices in it if he is the new to it? What kind of missteps do people take with first rental?
It seems easier to dig a bigger hole with rental than putting into a total index. Higher learning curve + leverage...
This would be me being so hesitant on rentals... I don't know what could go wrong
These are very valid points. You have to assume that the purchaser knows what they're doing and most people won't when they get started. So to me this is the most valid reason to select index funds of those that are presented in this thread.
Another issue with purchasing rentals is that sourcing the right ones takes a lot of work or access to insiders that can help you do it for a fee of some sort. People that are new to the game are unlikely to have either of these.
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It helped me! (Well, sort of; I can't claim I grok it yet.)
However, I still have a question: mr_orange's plan involves exchanging a single property for a single successively larger one, over and over again. But isn't that kind of risky compared to buying additional cheap properties (e.g. buying four more $100K houses instead of 1031-exchanging the first one for one $500K house)? Can you still use the same basis/depreciation strategy, or would it not work in that case?
At some point you'll likely need properties with higher density or commercial properties to keep the tax shields. Note that commercial properties are generally depreciated over 39 years instead of 27.5. Buying expensive rentals will lead us into a whole debate about appreciation versus cash flow and how one is "betting" and is based on a greater fool theory. It is far easier to assume you'll be buying denser property with tangible cash flows to avoid this discussion.
The upside is that the denser properties are probably going to give you better yields with level leverage assumptions. Thus you're more likely to make more cash flow AND have more corresponding paper expense from depreciation to offset the cash flow assuming your tax situation allows for it. The worst that will happen is that the paper losses will be suspended and can (or may) be used in later years.
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It helped me! (Well, sort of; I can't claim I grok it yet.)
However, I still have a question: mr_orange's plan involves exchanging a single property for a single successively larger one, over and over again. But isn't that kind of risky compared to buying additional cheap properties (e.g. buying four more $100K houses instead of 1031-exchanging the first one for one $500K house)? Can you still use the same basis/depreciation strategy, or would it not work in that case?
At some point you'll likely need properties with higher density or commercial properties to keep the tax shields. Note that commercial properties are generally depreciated over 39 years instead of 27.5. Buying expensive rentals will lead us into a whole debate about appreciation versus cash flow and how one is "betting" and is based on a greater fool theory. It is far easier to assume you'll be buying denser property with tangible cash flows to avoid this discussion.
The upside is that the denser properties are probably going to give you better yields with level leverage assumptions. Thus you're more likely to make more cash flow AND have more corresponding paper expense from depreciation to offset the cash flow assuming your tax situation allows for it. The worst that will happen is that the paper losses will be suspended and can (or may) be used in later years.
One other note related to your question Jack: You MUST upgrade to completely avoid tax. You have to buy a property for higher than the rolled up gain. You have to obtain a mortgage bigger than your current mortgage. If you don't, at least part of the gain becomes subject to tax. You could also do multiple properties, and have multiple 1031's. You could buy 1 property/year, then in year 7 sell 3 of those 7 and roll up the gain from those 3 into a single larger property.
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At some point you'll likely need properties with higher density or commercial properties to keep the tax shields. Note that commercial properties are generally depreciated over 39 years instead of 27.5. Buying expensive rentals will lead us into a whole debate about appreciation versus cash flow and how one is "betting" and is based on a greater fool theory. It is far easier to assume you'll be buying denser property with tangible cash flows to avoid this discussion.
The upside is that the denser properties are probably going to give you better yields with level leverage assumptions. Thus you're more likely to make more cash flow AND have more corresponding paper expense from depreciation to offset the cash flow assuming your tax situation allows for it. The worst that will happen is that the paper losses will be suspended and can (or may) be used in later years.
Oh, I get it! I was thinking in terms of switching to nicer and nicer single-family houses but you're talking about switching to apartment complexes with more and more units. That makes more sense, then.
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Yes....apartments or other projects like single-tenant NNN leased buildings, retail space, etc.
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•Your interest rate is 4.5%, so your P&I payment on 80k for 30 years is 405.35 monthly.
•You will put down 20% (20k), and finance 80% (80k), and pay 2k closing costs. No PMI.
•Inflation runs 3%, and the house appreciates at the rate of inflation.
•Stocks return 7% real, so 10% including the 3% inflation.
I looked over the assumptions you made and could come up with one possible inconsistency. Your interest rate is 4.5% and the inflation rate is 3%. When I checked some historical data (quickly searched online) it seems like those numbers don't occur at the same time. Inflation is close to zero at the moment and interest rates are just under 4.5%. A quick look at years when inflation was around 3% show interest rates between 6 and 9%.
I don't know how this will affect the final numbers in your calculation (I imagine it will hurt the case for owning the rental), but perhaps something to consider.
For what it's worth, I'm a firm believer that people should be careful not to assume too easily that owning a house (whether you rent it out or not) is a good investment. In many case it can be a fantastic investment, but just because in many US markets (which have been strongly growing markets) it has been a good investment, doesn't mean that it will be always or everywhere. Success stories tend to be shared more readily than failures.
Thanks for the work on the simplified calculation. These are helpful for understanding the trade-offs.
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I agree that those don't happen together historically traditionally, however the reason why I used those is because you're locking in a 30 year fixed loan, and that's the current rate. Yet for inflation, our calculations are for the next 30 years and 50 years. Even if inflation is about 0% now, while that loan rate is locked in, do you think there will be 0% inflation over the next 30 years? 0% over the next 50 years? I think 3% is a reasonable guess for inflation over the next 30 or 50 years. I actually think it could be higher, which would help the real estate numbers, but I don't think it will be below 3% for that whole time period.
It's just an artifact of our rates being low now, but being able to lock them in for a long time period, while there will be inflation over that long time period.
Does that reasoning make sense?
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Since leverage is the dominant component of why real estate tops stocks the fact that debt is historically cheap right now is a big deal. One could argue that the asset prices are higher now because of this, but I am not sure how much this really matters when developers are putting new product into service.
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Since leverage is the dominant component of why real estate tops stocks the fact that debt is historically cheap right now is a big deal. One could argue that the asset prices are higher now because of this, but I am not sure how much this really matters when developers are putting new product into service.
I agree. Also, as long as the numbers make sense and it cash flows at a return one is happy with, it doesn't matter if asset prices are higher than they theoretically "should be."
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Does your assumption include the investor increasing his contributions (the P&I 405.35/month) to the stock market after the mortgage(30yr) is paid off? Or what does he do with the $405.35 after 30yrs?
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Does your assumption include the investor increasing his contributions (the P&I 405.35/month) to the stock market after the mortgage(30yr) is paid off? Or what does he do with the $405.35 after 30yrs?
Dammit! Great catch.
No, so that's another factor I missed, that's in favor of the RE scenario.
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Here is a real world example.
I purchased 100 acres of farm real estate 25 years ago for $75,000. It's now easily worth $650,000
It has kicked me back approx. $6000 annually (after taxes) all that time, totaling $150,000
So I turned $75,000 into $800,000 in 25 years with real estate.
By my math, that same amount invested would need to consistently have yielded a 10.25% return to do the same.
Could that have been done with stocks ..... maybe?
Only read a couple of posts but, Yes, If you had invested in a single stock called Microsoft, you'd be a billionaire probably. You're comparing real estate picking to stock picking. There's a lot of real estate that people bought 25 years ago in a city called Detroit. What do you suppose that is worth now?
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I'll keep playing, please feel free to poke holes in this...
going by your OP...
22k invested in stocks, at a 10% nominal return, is worth $383,886.85 after 30 years.
The 100k house at 3% return is worth $242,726.25 after 30 years.
After 30 years,
Using the 4% wr, you get $15,355 per year from $383,886.
Assuming 3% return, you get $14,563 per year profit in rent.
(Assumes 1%, or $2,427/month rent gross, and 50% expenses)
But, if the house/rent senario, you assume you never have to touch your principal (house) but the stock senario (4%swr) assumes you do/might have to.
Thoughts???
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I'll keep playing, please feel free to poke holes in this...
going by your OP...
22k invested in stocks, at a 10% nominal return, is worth $383,886.85 after 30 years.
The 100k house at 3% return is worth $242,726.25 after 30 years.
After 30 years,
Using the 4% wr, you get $15,355 per year from $383,886.
Assuming 3% return, you get $14,563 per year profit in rent.
(Assumes 1%, or $2,427/month rent gross, and 50% expenses)
But, if the house/rent senario, you assume you never have to touch your principal (house) but the stock senario (4%swr) assumes you do/might have to.
Thoughts???
Good idea for the comparison, but you forgot about all the rents received along the way. So those rents, which totaled an extra $186,832.31 (and that was with my mistake of not increasing them yearly, it'll actually be much more than that).. taking 4% SWR of that investment, $7,473.29, and adding it to the rents, you're at:
Using the 4% wr, you get $15,355 per year from $383,886.
Assuming 1% and 50% rule for the house, you get $14,563 per year profit in rent + $7,473.29 from 4% of the rent stache = $22,036.29 annually. (or about 44% higher than the stock 4% WR scenario).
Plus, yes, the stability of rents and less sequence of returns risk (assuming proper reserves).
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1. I don't understand why you compare a leveraged investment to one that is not, this doesn't seem like a fair comparison. It's like comparing how much a a person can bench on steroids, to someone who isn't.
2. the house is a control investment, vs a non-control passive minority investment in stocks (Marty Whitman from Third Avenue describes this concept well in his books). This has some implications, a. liability (more in the house case) b. control of cash flows c. ability to apply leverage d. time commitment.
Why not compare a privately held business to housing investment, because that is the true comparison that could be made, your effectively starting a rental company when you rent out the house. Or the inverse would be comparing REITS to stocks.
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1. I don't understand why you compare a leveraged investment to one that is not, this doesn't seem like a fair comparison. It's like comparing how much a a person can bench on steroids, to someone who isn't.
2. the house is a control investment, vs a non-control passive minority investment in stocks (Marty Whitman from Third Avenue describes this concept well in his books). This has some implications, a. liability (more in the house case) b. control of cash flows c. ability to apply leverage d. time commitment.
Returns are returns, no? I don't care if I'm using leverage or margin, both are simply tools. What matters isn't how you finance the deal, it's what the returns are. Where can I put my money to make the most amount of money back?
Most people only correlate risk with reward. Reward truly comes from both risk AND work. Real estate returns are generally higher not because of leverage alone, but because there is considerably more work involved than simply investing in index funds. One is remiss to not calculate their time and work spent into their "rewards"/yields. I think there are many investors out there who obviously have control over their stock holdings, Warren Buffett being the most notable example. I think with both stocks and real estate, there are things you can control and things you can't. So I guess the more appropriate comparison is individual stock picking and individual house buying, since I think there is a level of control to both (and plenty of things you can't control in both).
Anyway, I think most small time investors are perfectly justified in comparing real estate to indexes, since both are in the realm of understandability until you start to add in lots of business knowledge specific to starting a business or stock picking. I do definitely consider owning rental property to be a business, but it's probably one of the simplest and most straight-forward, something nearly anyone can understand.
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Nice post Undercover.
Yes, the investments are very different in their nature. Comparing real estate levered to a stock or index levered is apples and oranges as well because the nature of the leverage is very different. One set requires margin calls, mark to market, etc. The other is fixed-rate, long term, and government subsidized both from a rate perspective and with depreciation to shield taxes. Thus the margin accounts impute significantly more risk daily than that of real estate leverage.
Real estate also has significant transfer or exchange costs ("transaction costs") and is not traded by supercomputers on standardized exchanges. Thus the ability to exploit market inefficiencies is far greater when sellers need access to liquidity in a hurry.
For the average small investor that takes the time to understand real estate I think that they can make far more over the long haul than they can with indexing. The time component should include not only the time spent sourcing deals, but all of the extra time and effort spent learning and putting a given strategy into practice in a given market. The extent to which this is job-like depends on the person and the strategy employed. Most of the people I know that are successful at finding projects consistently below market do spend a lot of time on these activities and thus it is fair to consider this more of a business. However, the example herein does not rely on the ability to find a project below market and thus these criticisms carry less weight for this thread.
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Thanks for this thread.
The point that I'm taking home is that the returns are not all that different. We choose to do the extra work that real estate entails because of the feeling of control. We can control who we select as tenants. We can control the rent we charge and the upgrades to choose. We can control in which neighborhoods we choose to buy. It's a feeling of comfort. Sure there is risk, but we can do something to manage it. We're much better at screening tenants now. Wall Street is out of my control, so I don't like that feeling. That has value for us. So, that's why we're 80% real estate and 20% index funds.
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1. I don't understand why you compare a leveraged investment to one that is not, this doesn't seem like a fair comparison. It's like comparing how much a a person can bench on steroids, to someone who isn't.
Because equities typically don't come with leverage, and real estate typically does. Real estate leverage is much more common (many more people will get mortgages than margin loans), and is much safer--there is no margin call on a mortgage. Pay your minimum payment, and you're good.
The reason this comparison is made is NOT because it's apples-to-apples. It's because it's the choice people often make.
The scenario in the OP was someone in their mid-20s with a chunk of cash saved up (22k) who's wondering if they should buy a rental or invest in stocks. This is a very common scenario, and we see people on here all the time wondering if they should get a rental.
That is the comparison they're making, and that's why it's comparing these two. Not because they're the same, but because they're different, and the person is wondering which is better. That's a larger question than just the money aspect, but this attempts to show some numbers to help think through the scenario monetarily.
2. the house is a control investment, vs a non-control passive minority investment in stocks (Marty Whitman from Third Avenue describes this concept well in his books). This has some implications, a. liability (more in the house case) b. control of cash flows c. ability to apply leverage d. time commitment.
Absolutely.
Why not compare a privately held business to housing investment, because that is the true comparison that could be made, your effectively starting a rental company when you rent out the house. Or the inverse would be comparing REITS to stocks.
Starting a business comes with a lot more paperwork, legal and financial filings, etc. You should treat your RE like a business, and be professional towards your tenants, but having a rental property is nowhere near the work a business is (not to mention the fact that it may only take you a few minutes a month, a far cry from most businesses).
Your objections are valid, but not the point of this thread.
Someone in their mid-20s looking to invest isn't going "should I start a business?". They aren't saying "REITs or stocks?" (well sometimes they are, but that's a more straightforward question). They're asking "is a rental right for me"?
And they need to look into if they want to be a landlord. If they want the extra work. But they also want to know the math on which is better. Even if stocks aren't apples-to-apples.
Does the comparison make sense now? :)
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Thanks for this analysis! I am responding mostly just to follow, but also a question. How do you factor in the cost of PAYING rent if you don't own a home? Where I live, my mortgage is under $1500 but to rent a comparable place would be about $3500/month (which raises a very good question about whether I should be renting my place out and living somewhere else, but that's not on the table right now...). This additional amount is money I can invest now, but couldn't if I didn't own my home.
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Thanks for this analysis! I am responding mostly just to follow, but also a question. How do you factor in the cost of PAYING rent if you don't own a home? Where I live, my mortgage is under $1500 but to rent a comparable place would be about $3500/month (which raises a very good question about whether I should be renting my place out and living somewhere else, but that's not on the table right now...). This additional amount is money I can invest now, but couldn't if I didn't own my home.
That's a totally different question..and whether or not you should buy vs. rent has a lot of different factors, monetary and non.
I prefer the NYT Buy vs. Rent calculator for the monetary aspects of it.
http://www.nytimes.com/interactive/2014/upshot/buy-rent-calculator.html
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That's not my question, or at least I didn't intend it to be. Let's say I have $300k to invest. I can buy a house and live in it for almost-free, or I can invest it and instead pay $1k/month in rent. I know this obviously relates to the rent v. buy question, but it seems like it should also factor into the REI v. stocks question where there are different expenses associated with each approach.
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That's not my question, or at least I didn't intend it to be. Let's say I have $300k to invest. I can buy a house and live in it for almost-free, or I can invest it and instead pay $1k/month in rent. I know this obviously relates to the rent v. but question, but it seems like it should also factor into the REI v. stocks question where there are different expenses associated with each approach.
It's just an opportunity cost question, and likely depends on if it's better to buy or rent in your area (the rent v buy question). If you have a specific scenario in mind, feel free to start a thread with the numbers. :)
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(https://49.media.tumblr.com/tumblr_m8l60jLcij1ra5p9wo1_500.gif)
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1. I don't understand why you compare a leveraged investment to one that is not, this doesn't seem like a fair comparison. It's like comparing how much a a person can bench on steroids, to someone who isn't.
Because equities typically don't come with leverage, and real estate typically does. Real estate leverage is much more common (many more people will get mortgages than margin loans), and is much safer--there is no margin call on a mortgage. Pay your minimum payment, and you're good.
The reason this comparison is made is NOT because it's apples-to-apples. It's because it's the choice people often make.
The scenario in the OP was someone in their mid-20s with a chunk of cash saved up (22k) who's wondering if they should buy a rental or invest in stocks. This is a very common scenario, and we see people on here all the time wondering if they should get a rental.
That is the comparison they're making, and that's why it's comparing these two. Not because they're the same, but because they're different, and the person is wondering which is better. That's a larger question than just the money aspect, but this attempts to show some numbers to help think through the scenario monetarily.
2. the house is a control investment, vs a non-control passive minority investment in stocks (Marty Whitman from Third Avenue describes this concept well in his books). This has some implications, a. liability (more in the house case) b. control of cash flows c. ability to apply leverage d. time commitment.
Absolutely.
Why not compare a privately held business to housing investment, because that is the true comparison that could be made, your effectively starting a rental company when you rent out the house. Or the inverse would be comparing REITS to stocks.
Starting a business comes with a lot more paperwork, legal and financial filings, etc. You should treat your RE like a business, and be professional towards your tenants, but having a rental property is nowhere near the work a business is (not to mention the fact that it may only take you a few minutes a month, a far cry from most businesses).
Your objections are valid, but not the point of this thread.
Someone in their mid-20s looking to invest isn't going "should I start a business?". They aren't saying "REITs or stocks?" (well sometimes they are, but that's a more straightforward question). They're asking "is a rental right for me"?
And they need to look into if they want to be a landlord. If they want the extra work. But they also want to know the math on which is better. Even if stocks aren't apples-to-apples.
Does the comparison make sense now? :)
No and I don't say it just to be argumentative, I just feel strongly that the comparison is dangerous without context. While I can understand people may ask themselves which is better a leveraged real estate investment or indexing (stocks), I think making the comparison is a false dilemma and may lead to erroneous conclusions. In my way of thinking when you say 'better' it should encompass both the upside and the downside possibilities. I mentioned it before but an investment in a single house carries much more risk then an investment in an index. To be more specific what happens if you can't rent it for a period of time? What happens if you get tenants that trash it, or don't pay the rent? What about if you become ill and cannot manage the property for a period of time? What about accounting for the expenses of repairs (most will say 10-20% of the per month rents). All of these things and others eat into the returns over time and will defy your original assumptions. Also the liquidity of the house is much lower then that of stocks. In addition if you are just renting the house out like you mention and not treating it like a business, you are opening yourself up to a great deal of personal liability, not the case with stocks.
Second in you original comparison you make some assumptions about what you can get for rent. By doing that you are in essence setting some value criteria on which you would or would not buy a house (the 1% rule). 1% of the house price per month is a 12% annualized return , then you add in the leverage and the 3% appreciation of course the house will come out ahead. The problem is that when people go to buy the house, they must find a house with the correct criteria, if they can't then they will be missing out on the returns in the interim. So that is another risk, maybe call it deal risk? What happens if you can't find a deal that meets your criteria? Also to apply leverage interest rates are obviously a factor, what about interest rate risk? A corollary to that is there are stocks that can offer the same or better return unleveraged, if like the house you select companies based specific criteria, which obviously entails more risk and specific knowledge.
Third, Tax efficiency, the building but not the land can be depreciated over the useful life of the property, shielding some income from tax depending on your tax bracket. However when that is used up you are liable for more tax on the rental income. Because a large part of the return from the house is from the rental income you are paying more tax over the life of the investment. When you have capital appreciation in stocks, and don't sell the stock there is no tax, allowing the money to compound tax free which is very powerful. Some investors have written specifically about this principle, Tweedy Browne comes to mind. In the house case you do get some tax free compounding, but taking your assumption of 3% it's much less. Not to mention the transaction cost of buying and selling the house compared to stocks.
To sum it up, I think that the investment you understand the best is going to be the best one. I think simply extrapolating out returns for both a house and stocks ignores many factors which make comparing raw returns meaningless. Because you are not accounting for risk/time commitment/personal liability etc, which all have real probabilities associated, which don't show up in the calculation but will effect the results in the end.
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To be more specific what happens if you can't rent it for a period of time? What happens if you get tenants that trash it, or don't pay the rent? What about if you become ill and cannot manage the property for a period of time? What about accounting for the expenses of repairs (most will say 10-20% of the per month rents). All of these things and others eat into the returns over time and will defy your original assumptions.
All of those were accounted for in my numbers. Did you read the scenario? I didn't just take gross rents, I subtracted out vacancy (your first question), repairs (second question), management (3rd question), repairs again, etc.
Of course those numbers eat into your return, but they don't "defy" my original assumptions, because I assumed they would happen and accounted for them.
Also the liquidity of the house is much lower then that of stocks. In addition if you are just renting the house out like you mention and not treating it like a business, you are opening yourself up to a great deal of personal liability, not the case with stocks.
Yes, liquidity is lower. Irrelevant if you aren't selling. And might even be a good thing--how many people panic sell stocks over bad feelings in the market and lose on returns? A little illiquidity could help prevent that. And insurance was included in the numbers for liability purposes.
Second in you original comparison you make some assumptions about what you can get for rent. By doing that you are in essence setting some value criteria on which you would or would not buy a house (the 1% rule). 1% of the house price per month is a 12% annualized return , then you add in the leverage and the 3% appreciation of course the house will come out ahead.
12% gross return, but with half going to expenses, it's a 6% net on the rents. You seem (with this comment, and the above) to have missed all the money going to expenses.
The problem is that when people go to buy the house, they must find a house with the correct criteria, if they can't then they will be missing out on the returns in the interim. So that is another risk, maybe call it deal risk? What happens if you can't find a deal that meets your criteria?
You don't buy it.
There's no "deal risk" as you term it, because if you can't find a property that meets that minimum criteria, you don't invest. Plenty of markets offer it, but if you can't find it, you go with the equities scenario. Why would you buy into a suboptimal deal? To claim the scenario doesn't work because it doesn't account for people buying bad deals is like claiming my stock comparison doesn't work because it doesn't account for the fact that most people buy high and sell low, so I should compound at a number closer to 2-3% real instead of 7% real.
No, I'd rather do a pure comparison and not assume my investor is an idiot. :)
Also to apply leverage interest rates are obviously a factor, what about interest rate risk? A corollary to that is there are stocks that can offer the same or better return unleveraged, if like the house you select companies based specific criteria, which obviously entails more risk and specific knowledge.
It was a fixed interest rate. There is no interest rate risk in this scenario.
Third, Tax efficiency, the building but not the land can be depreciated over the useful life of the property, shielding some income from tax depending on your tax bracket.
Yes, I didn't even count that benefit for real estate. It would certainly help the RE scenario.
However when that is used up you are liable for more tax on the rental income. Because a large part of the return from the house is from the rental income you are paying more tax over the life of the investment. When you have capital appreciation in stocks, and don't sell the stock there is no tax, allowing the money to compound tax free which is very powerful.
You get depreciation for 27.5 years. In our 30 year scenario it's almost the full time, enough that it will much more help than hurt the RE case.
Not to mention the transaction cost of buying and selling the house compared to stocks.
I counted the buying transaction costs (see: closing costs paid in the scenario), but not selling because they never sold.
Most of the criticisms on the thread have been complaints from people who didn't read, or didn't understand, the scenario.
Complaints about not taking into account things that actually were taken into account, or complaints about it not being apples to apples. It's not supposed to be. See earlier reply to this Dr Pepper guy. :)
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I just wanted to point out that depreciating a normally-priced rental over 27.5 years generally gives you more paper losses than your actual realized cash flow. Thus you may be able to actually lower your income depending on your tax situation. This does not heighten your tax burden at your top marginal rate; it lowers it in many cases. This is a major benefit of real estate that indexing will not give you.
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I just wanted to point out that depreciating a normally-priced rental over 27.5 years generally gives you more paper losses than your actual realized cash flow. Thus you may be able to actually lower your income depending on your tax situation. This does not heighten your tax burden at your top marginal rate; it lowers it in many cases. This is a major benefit of real estate that indexing will not give you.
Only if your deal is pretty poor.
Even using our assumptions in the OP (a mediocre 1% rule), your depreciation on a 100k property is about 2.9k/yr (say 20k land, so 80k to depreciate over 27.5 yrs), and our cash flow is right around that, at 1135/yr plus the $1300 and growing to principal each year is $2400ish. So it shields a little (as mentioned in the OP, but not accounted for).
But if you purchase a much better deal (say 1.5% or higher), it'll cash flow much more, with no more depreciation, so the depreciation won't even cover the cash flow, let alone other income.
If you purchase a poor deal with little cash flow (say, 0.5% rule) the depreciation would cover the small cash flow and some extra other income.
But shielding other income with depreciation isn't something to be proud of, as it's likely an indication you have a mediocre to poor deal (or bought in an area with no cash flow and are gambling on appreciation).
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"Gambling on appreciation" is really in the eye of the beholder. Much of the money on real estate is made on appreciation from most of the wealthy investors I know. There are probably 1000 threads on this on Biggerpockets so if people want to read about them there is plenty of information over there. Suffice it to say that each person's situation is unique and you can't paint with a broad brush.
$100k with an $80k depreciable basis is also not typical in many locales. Many markets have asset prices much higher than that and thus will have larger tax shields with lower cash flows. Someone that buys in this manner is not doing it because they're an idiot. They're doing it because they wish to take advantage of some combination of the other reasons to purchase real estate. Cash flow is one item, but appreciation, tax shields, and amortization of the loan are all big factors as well.
The "1% rule" or any derivative of it is, at best, a blunt instrument for evaluating a purchase. You really need to do a full-up financial model and price in what your equity is worth. Ray Alcorn has a great article about this I think folks following this thread would benefit from reading:
http://www.reiclub.com/articles/deriving-cap-rate
Simple rule of thumb investing using the 50% rule, 2% rule, etc. are good for newbs, but people really should do a full analysis of each project before they make the leap.
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Gambling on appreciation has largely worked in highly desired markets - Manhattan, San Francisco, Silicon Valley, Orange County, and Hawaii, to name a few. Not so much in areas that appreciate at rates close to inflation. Timing of the transactions and buying right are also important. I will also note that buy and hold is not a major factor in your current investing strategy. It will be interesting to see how those properties you bought as long term rentals perform for you over time.
We will see if you feel the same way about appreciation after an extended downturn in your market. Check back with us then.
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"Gambling on appreciation" is really in the eye of the beholder. Much of the money on real estate is made on appreciation from most of the wealthy investors I know. There are probably 1000 threads on this on Biggerpockets so if people want to read about them there is plenty of information over there. Suffice it to say that each person's situation is unique and you can't paint with a broad brush.
$100k with an $80k depreciable basis is also not typical in many locales. Many markets have asset prices much higher than that and thus will have larger tax shields with lower cash flows. Someone that buys in this manner is not doing it because they're an idiot. They're doing it because they wish to take advantage of some combination of the other reasons to purchase real estate. Cash flow is one item, but appreciation, tax shields, and amortization of the loan are all big factors as well.
All of this is true. And also irrelevant to this thread. Relevant to a "how to speculate on real estate" thread, absolutely. Relevant to a scenario of someone wanting to buy a single rental property for cash flow if and only if it puts them ahead of that same money in index funds (while using a mortgage)? Not so much. :)
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We will see if you feel the same way about appreciation after an extended downturn in your market. Check back with us then.
I haven't purchased a rental in a long time. I like to wait until the market craters to buy rentals. Right now I am busy selling development projects to generate cash.
This isn't my first rodeo. I have been investing in property for 13 years now and am well-aware of the market cycles.
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All of this is true. And also irrelevant to this thread. Relevant to a "how to speculate on real estate" thread, absolutely. Relevant to a scenario of someone wanting to buy a single rental property for cash flow if and only if it puts them ahead of that same money in index funds (while using a mortgage)? Not so much. :)
I'm not following this. Appreciation, amortization of a loan, and tax shields are all relevant considerations with even a single rental. Where was it specified that we're only considering cash flow? It's your thread so make up whatever rules you want, but it was not clear to me that these were constraints.
Just because something is not throwing off big cash flows doesn't mean it is speculating either. Small cash flows (or even break even ones) that are fully shielded by paper losses also get even small appreciation upside and loan amortization. Many of these properties don't meet the "2% rule" threshold and are BETTER investments than D class rentals that blindly meet the rule and people feel are "good investments." The investment needs to fit with the person's individual strategy and needs as an investor.
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All of this is true. And also irrelevant to this thread. Relevant to a "how to speculate on real estate" thread, absolutely. Relevant to a scenario of someone wanting to buy a single rental property for cash flow if and only if it puts them ahead of that same money in index funds (while using a mortgage)? Not so much. :)
I'm not following this. Appreciation, amortization of a loan, and tax shields are all relevant considerations with even a single rental. Where was it specified that we're only considering cash flow? It's your thread so make up whatever rules you want, but it was not clear to me that these were constraints.
Because it was specified a 100k property, with a certain return, etc. etc.
Then you went on about how people invest for different reasons, may have large depreciations, 100k may not be normal for some areas, yadda, yadda (all the stuff I quoted last post).
Which is all true, but irrelevant to this thread. :)
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Oh...okay. I thought we diverted to talking about stuff in the abstract. Forgive me.
Carry on.
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Sounds like comparing apples to oranges. This thread consists of an infinite amount of hypothetical comparisons between two completely different asset classes which have unlimited variables which could brand either as the obvious winner.
First, can we elaborate on the definition of 'returns' for the purpose of this thread? Does this mean yield? Growth? Net Growth? Deferred Growth? Risk-adjusted growth? Leveraged growth? Passive return?
I mean, really, throw $100k into VTSAX and wait 30 years vs. throw $100k at a condominium and never post an ad for tenants? Or throw $100k into one individual stock versus $100k as a down payment on a 4plex in an up-and-coming area of town?
The most important considerations are going to be knowledge, experience, tolerance, leverage, risk tolerance, patience, activity, and tax-efficiency.
For the passive and tax-efficient return I'm seeking, my choice would be stocks :)
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First, can we elaborate on the definition of 'returns' for the purpose of this thread? Does this mean yield? Growth? Net Growth? Deferred Growth? Risk-adjusted growth? Leveraged growth? Passive return?
None of these definitions matter if you simply look at the cash flows. A simple IRR calculation can be used to compare the two. You, of course, have to make hundreds of assumptions when you do this and thus what is optimal will vary based on the individual and the scenario.
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The most important considerations are going to be knowledge, experience, tolerance, leverage, risk tolerance, patience, activity, and tax-efficiency.
For the passive and tax-efficient return I'm seeking, my choice would be stocks :)
For the same reasons I choose rental real estate.
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Thoughts? Math I screwed up? Quibbles with assumptions?
I don't think there's anything wrong with your assumptions, but you can restructure them to get a different picture as well.
The stock market, presumably an index fund or other broad slice, won't have as much variability as a single home, so having a range of values/probabilities for rental returns would probably provide a wider view. I'd suggest using real market returns (S&P is 5+% over the past 50 years IIRC), but that's difficult because there's no record of comparable home prices/rental returns that I'm aware of.
Maybe you could model what would happen if you bought at a local maximum in prices (both for housing and the market) rather than assuming you'll see the same average returns yoy? There are probably a bunch of other things you could do too. Anything that models some kind of variable you'd see irl could be useful.
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The broad stock market has lost 50% of its value twice in less than the last few decades. If you were unfortunate enough to need liquidity during these times I would say the likelihood that the volatility was drastically higher in this type of investment than it is with real estate in your area is pretty good. In my neck of the woods real estate lost about 15% of value during the mortgage crisis. Rents on my properties dipped a bit, but it paled in comparison to the lunacy going on in the stock market.
I do agree that there are risks with each type of investment, but real estate debt is not callable if you get the right financing. This combined with a long time horizon and focusing on rents instead of appreciation makes the risk dynamics much different than they are with margin accounts purchasing publicly-traded securities. You could, of course, combine them in some fashion and borrow against the real estate via HELOC or something else and invest that money in the market instead of using a margin account.
I also agree that there are too many variables and the ones selected in the OP are a small subset of the considerations one should have when deciding which strategy is best for their situation. If you learn to do things properly you can purchase real estate with very little money and enjoy a lot of the upside. This allows you to continue investing in index funds as well and do BOTH. You do have to trade off time and effort for this and thus some people claim it is "a job." This is a pretty trivial analysis to me, but everyone needs to decide how they allocate their money limited resource; their time.
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Thoughts? Math I screwed up? Quibbles with assumptions?
I don't think there's anything wrong with your assumptions, but you can restructure them to get a different picture as well.
The stock market, presumably an index fund or other broad slice, won't have as much variability as a single home, so having a range of values/probabilities for rental returns would probably provide a wider view. I'd suggest using real market returns (S&P is 5+% over the past 50 years IIRC), but that's difficult because there's no record of comparable home prices/rental returns that I'm aware of.
Maybe you could model what would happen if you bought at a local maximum in prices (both for housing and the market) rather than assuming you'll see the same average returns yoy? There are probably a bunch of other things you could do too. Anything that models some kind of variable you'd see irl could be useful.
Good idea. Basically my assumption was to give a baseline (1% rule) and if your area met that, you could use this comparison as a basis.
If your area was better, you'll do better than this rough estimate, if your area's worse, you'll do worse.
Naturally you'll want to run more specific numbers of your own scenarios, but this was just a generic comparison with bland numbers.
Good point though that it's very dependent on your area.
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The broad stock market has lost 50% of its value twice in less than the last few decades.
I call bullshit, sorry. Why would you make something like that up when it's so easy to disprove? The rest of your otherwise solid argument loses credibility when you lead with such an obviously misleading statement.
The recent "Great Recession" crash of 2007-09 was a little over 50% peak to trough, very briefly. The only other market loss of that size or larger was the "Great Depression" of 1929, at over 80%, but that was almost 90 years ago. Maybe you meant "in the entire history of the US stock market" instead of "in the last few decades"? Otherwise, you're grossly overestimating the risks to a 100% equity investor, of which we have very few. Mixed portfolios are much more muted.
I think part of the reason why real estate losses appear more muted than stock losses is that stocks are exactly priced daily. Real estate "value" is significantly more subjective and we retroactively tend to measure losses by average price trends in the relevant area or neighborhood. If you were to sell you real estate TODAY in the same way that you can sell your stocks today, at today's price on five minutes of advance notice, I'm sure the RE price would be much more volatile. For all of the same reasons. I'm just not sure you can defensibly compare the volatility of the two markets when one has second to second volatility but huge liquidity and the other has no fixed measure of value and extremely low liquidity. I suspect the net effect is that RE looks significantly less volatile.
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The S&P was down 49% between 2000-2002. Peaked out at 1,527 on March 24, 2000 and bottomed at 777 on Oct 9, 2002.
I wouldn't call BS. Mr. O may be off by a point, but that's close enough to 50% to count. IMO.
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I thought I'd add my $.02 primarily as a stock guy, but I do now have a few years of real estate investing under my belt and have been paying attention to RE price for 35 years.
I think Arebelspy has done a very good job laying out the financials for real estate.
Obviously assumptions matter a ton, probably for real estate more than practically any other investment so figuring out what the likely return of an RE investment is really hard. The only thing that would be comparable is to develop an intrinsic value calculation of a large corporation. It is certainly easier to make an estimate for index equity investing, by using historical average, or a consensus of experts like Bogle etc going forward.
Regarding volatility. I don't see how people believe that real estate is more volatility. By any statistical measure, the volatility of S&P is much higher than an RE index like Case-Shiller. The peak in CS from 2006 to trough (2011) drop of 34% (inflation adjusted) was by far the worse in any history. Historical a 10% drop in a year is rare and 22% is the worse 2 year period I could find 1909/1910. In contrast, 10% drops in the market happen severals times in a decade, and we have had 25 bear markets since 1929.
While I suspect Sol is right that RE volatility would be higher if we could buy or sell houses in 5 minutes, but we can't. I think the volatility of RE is lower because it is inherently easier for the average person to figure out the intrinsic value of a property. The value of a property has two parts, it is utility function (i.e. a source of housing for family) and its investment potential how much in might appreciate in the future. If a property cost $150K, and an identical property rents for $1,000/month, the only question is how much am I willing to pay for the potential appreciation. In depressed markets, that number maybe 0 or even negative (depreciation/wear and tear and expectations that prices will decline). In contrast, most individuals and probably more than few money managers think that stocks have little or no intrinsic value. "It is a casino, stocks are all valued on the greater fool theory". I think it's worth noting that despite the terrific liquidity of stocks, and the crappy liquidity of RE, it is still much cheaper to borrow money for real estate than on with a well-diversified stock portfolio. This says something about the relative risk associated with each asset class.
Now there are certainly risks to buying a single property, but think these fall into diversification risk rather than the inherent risk in real estate.
My biggest disagreement with Arebelspy is the 1% rule and perhaps more specifically his characterizing investing properties cash flow positive as being investing and investing in areas where you get say less than 1% as being speculating.
If never lived in an area where you could get close to 1%. The only time I even saw it was buying properties in Vegas in 2011,2012. The current property I'm buying there has .83% (10%/year) rent.
I bet on the coasts more money has been made in real estate in the last 30-year from appreciation than collecting rents. I know my first house I bought 30 years ago is now worth almost exactly 10x what I paid for it in 1985. That works to 8%/year in appreciation, I think it. would have taken about 5 years, the house to turn cash flow positive (thanks primarily to huge drop interest rates and doing a refi). Zillow says it could rent for $4,500/month, which is small compared to the $150K/year it's appreciated over the last 5 years. Somebody buying the house today with 20% down is looking at a negative cash flow of at least $2,500/month.
Yet it is still possible that it's a great investment. You put $300K down on $1.5Mill house lose $30K/year in cash flow, but you are making $150K or even 100K/year in appreciation that is a terrific cash on cash return.
To me, it is the difference between investing in dividend stocks vs growth stocks. You can make money in both, dividend stocks are less volatility over the short run, but don't necessarily do any better over the long term. It is in this high appreciation areas were the benefits of leverage really shine.
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it is still much cheaper to borrow money for real estate than on with a well-diversified stock portfolio. This says something about the relative risk associated with each asset class.
I think the reason is because the bank can take the house from you to cover their costs AND they typically demand a down payment to ensure that they get most of their money back even if the price has gone down in the meantime.
Not to mention, I seem to have read (I'm not American nor do I live there) that government policy has pushed for housing loans to be made widely available. Wasn't there a government program that "bailed out" home owners from bad mortgages. Sounds like protection for the banks as much as the home owners.
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I call bullshit, sorry. Why would you make something like that up when it's so easy to disprove? The rest of your otherwise solid argument loses credibility when you lead with such an obviously misleading statement.
Well at least you apologized for being wrong. Maybe you can go do a bit of research and get back with us. Someone else above has already pointed out that you're wrong so I won't bother writing any more about it.
The recent "Great Recession" crash of 2007-09 was a little over 50% peak to trough, very briefly. The only other market loss of that size or larger was the "Great Depression" of 1929, at over 80%, but that was almost 90 years ago. Maybe you meant "in the entire history of the US stock market" instead of "in the last few decades"? Otherwise, you're grossly overestimating the risks to a 100% equity investor, of which we have very few. Mixed portfolios are much more muted.
Nope....I meant exactly what I wrote. Again, go do a bit of research and get back with us. It is "very easy to disprove" (by your own admission) that what I wrote is accurate to within 1%.
I think part of the reason why real estate losses appear more muted than stock losses is that stocks are exactly priced daily. Real estate "value" is significantly more subjective and we retroactively tend to measure losses by average price trends in the relevant area or neighborhood. If you were to sell you real estate TODAY in the same way that you can sell your stocks today, at today's price on five minutes of advance notice, I'm sure the RE price would be much more volatile. For all of the same reasons. I'm just not sure you can defensibly compare the volatility of the two markets when one has second to second volatility but huge liquidity and the other has no fixed measure of value and extremely low liquidity. I suspect the net effect is that RE looks significantly less volatile.
Real estate gets priced daily too. There are people that trade in these submarkets and know what comparable sales should be each day. Sure, the trades don't clear daily and there is obviously less liquidity and are higher transaction costs.
I don't have any studies to point to, but I do have experience. The submarkets I trade real estate in are far less volatile than the stock market is over my investing lifetime. YMMV. Again, it depends on how you bound your analysis and what assumptions you make. In general I still believe real estate is less volatile than the index funds are in most areas of the country. This may not be the case for many submarkets on the coasts or in select other spots. This thread is primarily aimed at "1-2%" type deals which are likely to be highly correlated with low appreciation areas and thus I'd argue that for the purposes of this discussion the markets are probably FAR less volatile than index funds.
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it is still much cheaper to borrow money for real estate than on with a well-diversified stock portfolio. This says something about the relative risk associated with each asset class.
I think the reason is because the bank can take the house from you to cover their costs AND they typically demand a down payment to ensure that they get most of their money back even if the price has gone down in the meantime.
Not to mention, I seem to have read (I'm not American nor do I live there) that government policy has pushed for housing loans to be made widely available. Wasn't there a government program that "bailed out" home owners from bad mortgages. Sounds like protection for the banks as much as the home owners.
The bigger reason for cheap money financing real estate is that the government interferes in the market and makes rates much lower than they would be absent guarantees, etc. These "private companies" are backed by implicit government assistance as we saw during the crisis and thus the price of debt is far lower than it would be absent this distortion.
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it is still much cheaper to borrow money for real estate than on with a well-diversified stock portfolio. This says something about the relative risk associated with each asset class.
I think the reason is because the bank can take the house from you to cover their costs AND they typically demand a down payment to ensure that they get most of their money back even if the price has gone down in the meantime.
Not to mention, I seem to have read (I'm not American nor do I live there) that government policy has pushed for housing loans to be made widely available. Wasn't there a government program that "bailed out" home owners from bad mortgages. Sounds like protection for the banks as much as the home owners.
Banks/Brokerage use your stock portfolio as collateral when making margin loans. If the stock value falls they typically give you only a day or two to come up with more money, or they sell your stock to get their money back. In contrast repossessing a house is an expensive and time-consuming process for banks typically taking 6 months. Borrowing says 400K from Schwab on margin loan I'll pay 6.875% vs 2.75% for 15-year loan. Now its true that government policy interferes with the free market. which accounts for some of the price disparity. However, much of the reason that home mortgage rates are so low in the country, is up until the great recession, they have been very very safe loans for banks to make.
In Canada, which doesn't have the nearly the government support for home loans, it looks like mortgage rates are about 2% for a 5 year variable mortgage vs margin rates of 4.25% (TD Ameritrade).
Since you don't live in the US could you tell us what mortgage rates vs margin loans are in your country?
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Since you don't live in the US could you tell us what mortgage rates vs margin loans are in your country?
Live in the Netherlands. I don't use margin loans. A quick look on the internet showed a rate of around 6%, but also very few places that even offer the service. Mortgage rates are around 4% (though I don't pay much attention to those either).
However, much of the reason that home mortgage rates are so low in the country, is up until the great recession, they have been very very safe loans for banks to make.
Why do you think they became less safe?
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Since you don't live in the US could you tell us what mortgage rates vs margin loans are in your country?
Live in the Netherlands. I don't use margin loans. A quick look on the internet showed a rate of around 6%, but also very few places that even offer the service. Mortgage rates are around 4% (though I don't pay much attention to those either).
However, much of the reason that home mortgage rates are so low in the country, is up until the great recession, they have been very very safe loans for banks to make.
Why do you think they became less safe?
The short version is.
During the Great Recession hundreds of banks and shadow banks went bankrupt due to people who stopped paying their mortgage, generally due to people simply not being able to afford them, (lost jobs etc.) but in many case because the price of the house dropped so much that the mortgage balance was much higher than the value of the house. So even after the bank repossessed the house they took massive losses. The properties I bought in Vegas in 2009-2011 all mortgages for more than twice what I paid for them. Now in many cases the taxpayers ended up directly or indirectly absorbing the loss.
I'm not sure if mortgage loans are actually less safe than they were in the past, what has changed is the perception. Prior to 2007/2008 nobody believed we could have a large nationwide decline in housing prices, now we know differently.
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I don't think that the price crash is what makes them risky...
banks wouldn't have so much problem if they could have unloaded the foreclosed homes to new buyers... the price was something they could have eaten. But there were no buyers... which is why they took such a big hit.
I mean, a banks "profit" model is to keep money changing hands, not sitting in place or holding inventory... The actual value doesn't seem to matter as much, the fed kind of props real estate up so they don't lose all that much money on foreclosures.
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Why do you think they became less safe?
The short version is.
*snip*
Here's the even shorter, actual root cause: lenders lowered standards to extend a run of high profits.
That's what produced the conditions for the widespread defaults you mention, triggering the sequence of events detailed above. After the stock shakeup in the early 2000s, rate cuts produced a favorable environment for real estate financing, and once mortgage companies had adjusted to the new level of income in what should have been a temporary boom, they set about developing new programs to keep the deals turning. At some point the only way to keep clients flooding in was to turn an increasingly blind eye to - or even actively conceal - more and more risk factors in those clients' financials. The standard practice of packaging and selling loans virtually eliminated their own exposure to that risk, so it became a systemic issue that poisoned whole asset classes.
Interestingly enough, there were investors who saw this coming and tried to profit from it, but many made the wrong plays and lost money. Michael Lewis' book The Big Short (https://en.wikipedia.org/wiki/The_Big_Short) goes into much of this. (I bought it before I rediscovered libraries and, in classic form, have yet to read it)
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Also, more on topic, thanks to ARS for posting this thread because the really simple big-picture principles it illustrates are helping to inform strategic discussions this week with my investing partners.
The biggest one for me is the illustration of how leverage gives real estate the edge over passive stock investing. My partners are debt-averse - a bit of the broad-brush Dave Ramsey "debt bad cash good" approach has rubbed off on them - but with an affordable local market, multiple high-margin units throwing off cash, and another $1k/mo from our continued contributions, leverage-based risks are strongly mitigated. I've been working on my own models lately to illustrate how much faster we can grow our portfolio with higher leverage, and this helps me get past the self-doubt that creeps up when all I have is my own math to make the case.
Second, reducing rental investing to a passive approach and still finding the right characteristics to make this all work - that is key to formalizing our strategy as we grow beyond our self-management/maintenance capability and outsource those functions.
So, thanks again ARS.
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Thanks. I'm glad someone got some use out of it. :)
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[
Here's the even shorter, actual root cause: lenders lowered standards to extend a run of high profits.
Interestingly enough, there were investors who saw this coming and tried to profit from it, but many made the wrong plays and lost money. Michael Lewis' book The Big Short (https://en.wikipedia.org/wiki/The_Big_Short) goes into much of this. (I bought it before I rediscovered libraries and, in classic form, have yet to read it)
Read Lewis book, afterwords you'll realize it's more complicated than that. To Big to Fail, by NY/CNBC reporter Aaron Sorkin, Hank Paulsons On The Brink , and Tim Geitner's Stress Test are all worth reading. One of the great things about retirement is you have to time to read extensively on subjects!. The Big Short, is the best written of the bunch Michael Lewis has knack for turning even the most arcane subjects into Clancy thrillers.
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Thanks. I'm glad someone got some use out of it. :)
Interesting thread topic. But this is just an assumption right? It doesn't mean stocks will outperform long term or real estate short term right?
We're assuming that past 30-50 years is the same as the next 30-50 years right? But nothing suggests the case that stocks/RE will deliver returns like they have in the past.
And doesn't this vary by area as well? I'm in NJ, and RE and property taxes are ridiculously high. A whole year's rent just covers property taxes in some cases, it's not even paying the mortgage or barely paying it. A 300K house rents less than 2K/month w/property taxes in 7-9K. Would you consider real estate rental to be worthy in this case? Or would you pick stocks?
Plus real estate rentals are a lot of work. The time and effort you put into it could be used for working more hours or doing more Mustachian things to cut costs. Investing in index funds is pretty simple and doesn't take long at all, no hours of research, labor, maintenance, etc. There's too much variability to account for.
And correct me (since I'm not so familiar w/real estate) but aren't real estate prices being propped up by the Fed buying mortgages through Freddie/Fannie Mae? (it's what Shiller said but I want to know your opinion)
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And doesn't this vary by area as well? I'm in NJ, and RE and property taxes are ridiculously high. A whole year's rent just covers property taxes in some cases, it's not even paying the mortgage or barely paying it. A 300K house rents less than 2K/month w/property taxes in 7-9K. Would you consider real estate rental to be worthy in this case? Or would you pick stocks?
Varies by region, neighborhood, national RE market situation, etc etc. (My very simplified example) During the middle of the downturn (2009-2011) I picked up three bank foreclosure SFR's I then turned into rentals. It took between $2k-$6k each to get them to a good condition. They were quickly rented and gave me an average positive cashflow of ~$400/month/property (after property tax, insurance, mortgage, property management). For the three properties combined, it was approximately $75k for the down payments, closing costs and repairs. They returned an immediate $14.4k annual cash flow (19.2% return!!!).
I can not find a deal today anywhere close to as good. Property prices have doubled but rents have gone up maybe 10%-20%. If I try to buy in the same area now, I would have a clear negative monthly cash flow.
That said, it is certainly easier to rent for cash flow in some areas over others. Some areas (NY/NJ/DC) with high property tax, high property cost and mediocre rent make it almost impossible to get a positive return. I'm just trying to point out you can stay in the same area but have a significantly different situation year by year.
Also, if you are trying to compare versus other long-term investment vehicles (such as an index fund) you have to do a lot more research and include a bunch of factors. Property appreciation, rent appreciation, paying off the principal, tax implications, vacancy rate, maintenance, etc etc. When I did the above properties, I only considered the monthly cash flow. 5 years later, the cash flow has almost fully returned everything I put into the properties. However, the principal reduction adds about another $27k, I get to depreciate the buildings which helps lower my taxes and, most importantly, the properties have appreciated in value by more than all the other benefits I listed, combined. :O
For my example, my real estate returns FAR FAR FAR outstripped what I would have received in an index fund. However, that national real estate market was an abnormal situation.
* Real world example but greatly simplified
Plus real estate rentals are a lot of work. The time and effort you put into it could be used for working more hours or doing more Mustachian things to cut costs. Investing in index funds is pretty simple and doesn't take long at all, no hours of research, labor, maintenance, etc. There's too much variability to account for.
Property managers solve this. I pay about 7% of the monthly rents to the property manager. In return, they do a very good job researching tenants and solving problems (if you do your research and pick a good property management company). In the example above, I included the property management costs.
And correct me (since I'm not so familiar w/real estate) but aren't real estate prices being propped up by the Fed buying mortgages through Freddie/Fannie Mae? (it's what Shiller said but I want to know your opinion)
Close but I think that's a bit off. In my opinion, real estate prices are being propped/driven by the current low interest rates. The largest determining factor of mortgage interest rates is the 10-year Treasury Bond. When the Federal Reserve was buying bonds through Qualitative Easing (QE), it drove down the interest rates. Now that QE is over and the Fed is talking about raising some of the other interest rates they directly control (fed discount rate), 10-year Treasury (and thus mortgage rates) should start rising as well. When those rates rise, I think the overall RE market will stagnate or even deflate. Depends how quickly rates rise.
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Good idea. Basically my assumption was to give a baseline (1% rule) and if your area met that, you could use this comparison as a basis.
If your area was better, you'll do better than this rough estimate, if your area's worse, you'll do worse.
Naturally you'll want to run more specific numbers of your own scenarios, but this was just a generic comparison with bland numbers.
Good point though that it's very dependent on your area.
I think rentals, at least since 1970, are actually trailing inflation. Not by much, but it looks like rental prices are ~8% lower than inflation over the past 45 years.
https://research.stlouisfed.org/fred2/series/CUUR0000SEHA
The biggest difference though is the tax rates. If you're in the 15% income tax bracket, you'll have to pay that on earnings from a rental, but there aren't any taxes on qualified dividends in that bracket.
https://en.wikipedia.org/wiki/Qualified_dividend
The S&P 500 is also a little lower at a real 6.1%.
Like always, the devil's in the details.
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And doesn't this vary by area as well?
The markets vary, but the criteria don't. Yes, this means the feasibility of running this game varies dramatically by locale. More to follow.
I'm in NJ, and RE and property taxes are ridiculously high. A whole year's rent just covers property taxes in some cases, it's not even paying the mortgage or barely paying it. A 300K house rents less than 2K/month w/property taxes in 7-9K. Would you consider real estate rental to be worthy in this case? Or would you pick stocks?
This scenario begins with an assumed rent-to-price ratio (1%) and expense-to-rent ratio (50%), and shows that a rental can beat the market if these criteria are met.
In some markets, those metrics can be easily exceeded. In others, they can't. If your local market doesn't qualify, it doesn't mean you can't make money on rentals - but you're relying on appreciation to boost the total return, which makes it a speculative play, outside the bounds of this comparison.
Plus real estate rentals are a lot of work. The time and effort you put into it could be used for working more hours or doing more Mustachian things to cut costs. Investing in index funds is pretty simple and doesn't take long at all, no hours of research, labor, maintenance, etc. There's too much variability to account for.
Management and maintenance by paid professionals are baked into the math here. As for market research... some of us are weird enough to actually enjoy that shit. If enough of my rentals beat the S&P, I can probably subtract a $50/hr wage from the whole proposition and still come out ahead, but I'm having so much fun that I don't actually care. If it turns you off - more opportunities and higher returns for the rest of us, and thank you! ;)
And correct me (since I'm not so familiar w/real estate) but aren't real estate prices being propped up by the Fed buying mortgages through Freddie/Fannie Mae? (it's what Shiller said but I want to know your opinion)
Find the discussion thread here on the possibility of a second real estate bubble, and you'll see that there are pro and con arguments. But massive runups in value are localized (many markets are unaffected) and they simply underscore the importance of cash-flow analysis. If higher prices and higher taxes in your market mean you can't find 1% rent/price and 50% costs/rent, then look elsewhere. 1.2% and even 1.5% are feasible where I live, but we're looking 100 miles away for 1.75% on our next buy. Even with pessimistic assumptions for overhead costs and debt service, it's a 15% leveraged cap rate, and that assumes no appreciation at all, ever. Tweak the numbers back to just "average" and it's 25-30%. What this illustrates is the same conclusion stated in the OP: real estate investors can beat average stock returns by selecting high-cashflow properties and leveraging them at a lower APR than they earn.
Or, if this is already sounding like too much of a chore, stick to index funds. Save enough and you'll FIRE either way.
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Great explanation Zephyr. Thanks.
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Great explanation Zephyr. Thanks.
\m/ ^_^ \m/ (aw, shucks)
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To me the upshot of this thread is:
1. If you don't have much time to find the right projects or invest the effort to learn to work on real estate where you can deliver good returns you're probably better off indexing and forgetting about the marginal extra yield you will get
2. If you do have the time and inclination to invest in real estate you'll clearly do better than investing in index funds using the proper leverage conditions
Item 2 could have a similar argument for several other types of small businesses as well, but you'd have to impute the value of your effort in each. Real estate, done properly, doesn't require a ton of effort and this is less job-like than many other small businesses.
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Yup. It's close either way. Get in a good market, use leverage, and you can easily get a high yield, beat index funds, and FIRE early.
In a bad market and don't want to invest outside your market? Skip real estate, take the returns equities give you, and be happy. Don't try to force RE to happen, because it's not always the right call.
It's close enough that it depends on you hitting these assumptions--if you're way above or below, it makes it a lot more obvious which way you should go.
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@orange, but then you'd have more than 1 rental to get the point of learning all that... that throws this entire thread out the window :D, imaginary guy only wanted one rental, but somehow didn't have any of the learning curve problems
though yes, I'd agree that real estate might return more in the "short" term, once you get a portfolio big enough, who cares? Does it really matter once you hit FI? If you want to keep growing portfolio with real estate, you'd have to keep buying more since leverage seems to be what gives real estate the advantage... because once paid off, it seems like rental return is about even with stocks but more money is tied up
real estate = get to FI faster (maybe?), stocks = enjoy FI life and still grow money without working at finding/buying new property?
Seem to be why most of the "wealthy" people in world are investors, just not enough properties they can buy up in large enough chunks to make it worth their time? And they rather not go looking for individual rentals for a good deal when they can just pick up entire companies. Though in that case, they might be treating the companies as rentals on a different scale? :D I wonder if Warren Buffet evaluates what companies to buy like how you guys would evaulate what rentals to buy.
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Listen to one of my interviews on the Radical Personal Finance podcast on investing in real estate vs. Index funds for early retirement, eyem. It may clarify some things go for you. :)
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ugh... link? I'm not familiar with that podcast, thanks in advance
all I got from google is this http://radicalpersonalfinance.com/archive/, and I don't know which one is yours
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@orange, but then you'd have more than 1 rental to get the point of learning all that... that throws this entire thread out the window :D, imaginary guy only wanted one rental, but somehow didn't have any of the learning curve problems
though yes, I'd agree that real estate might return more in the "short" term, once you get a portfolio big enough, who cares? Does it really matter once you hit FI? If you want to keep growing portfolio with real estate, you'd have to keep buying more since leverage seems to be what gives real estate the advantage... because once paid off, it seems like rental return is about even with stocks but more money is tied up
real estate = get to FI faster (maybe?), stocks = enjoy FI life and still grow money without working at finding/buying new property?
Seem to be why most of the "wealthy" people in world are investors, just not enough properties they can buy up in large enough chunks to make it worth their time? And they rather not go looking for individual rentals for a good deal when they can just pick up entire companies. Though in that case, they might be treating the companies as rentals on a different scale? :D I wonder if Warren Buffet evaluates what companies to buy like how you guys would evaulate what rentals to buy.
Fair points above.
I guess another thing I'd add is to me there is value in learning the skill because it will allow me to continually add duckets to my pile and incrementally increase what I can spend monthly. I don't really buy into the minimalist approach and thus take a lot of heat about it on the site. This comment is, however, independent of the fact that I think rentals done properly will get most people on this forum to FIRE faster if they're willing to invest the time in it.
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Interesting 'maths', I think what I learned is that you need about 10% annual net yield on a property to be about equal to investing in an index. I really don't have the time or interest to look around at real estate to make it work, but it's nice to have a rule of thumb, if you can confirm that this is roughly what you would consider 'break even' between the two investments over a 30 year horizon.
Also, would you recommend being a landlord over flipping? I am a bit more interested in the 'Cheddar-Flipper' model, and have the liquidity and desire to branch out and learn new skills.
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ugh... link? I'm not familiar with that podcast, thanks in advance
all I got from google is this http://radicalpersonalfinance.com/archive/, and I don't know which one is yours
Did you put in the word arebelspy into your google search? On my phone, but if you still can't find it, I'll dig up the link. It's the first one, not the pay down debt or invest one.
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Interesting 'maths', I think what I learned is that you need about 10% annual net yield on a property to be about equal to investing in an index. I really don't have the time or interest to look around at real estate to make it work, but it's nice to have a rule of thumb, if you can confirm that this is roughly what you would consider 'break even' between the two investments over a 30 year horizon.
I wouldn't be investing in properties that didn't get me double digit returns, no.
Also, would you recommend being a landlord over flipping? I am a bit more interested in the 'Cheddar-Flipper' model, and have the liquidity and desire to branch out and learn new skills.
Flipping is not real estate investing, that's a real estate job. Fine, if you want to do that, but very different things.
Cheddar, as the passive money partner, is more on the passive investing side, but because he's investing in other's flips. Flipping on your own is much more of a real estate business.
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Interesting 'maths', I think what I learned is that you need about 10% annual net yield on a property to be about equal to investing in an index. I really don't have the time or interest to look around at real estate to make it work, but it's nice to have a rule of thumb, if you can confirm that this is roughly what you would consider 'break even' between the two investments over a 30 year horizon.
I wouldn't be investing in properties that didn't get me double digit returns, no.
Also, would you recommend being a landlord over flipping? I am a bit more interested in the 'Cheddar-Flipper' model, and have the liquidity and desire to branch out and learn new skills.
Flipping is not real estate investing, that's a real estate job. Fine, if you want to do that, but very different things.
Cheddar, as the passive money partner, is more on the passive investing side, but because he's investing in other's flips. Flipping on your own is much more of a real estate business.
I'm trying to do both. Flipping for some (hopefully) quick capital so I can buy more rentals for long-term cash flow. Among the many problems with flipping is the fact that it's a quick hit. It's not a passive, sustainable cash flow source. You have to churn to make the profit, so you inevitably have to continue shopping. Not a bad thing, but if the inventory runs dry or the housing market declines or you can't find proper contactors, you can't rely on it as a constant flow of cash.
However, from my limited experience the returns (or maths) aren't even comparable to index investing. But I still buy the shit out of those indexes whenever I can for diversification and to stay invested all year.
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Thanks guys. Either way, getting in to real estate will require some work for me. Maybe I'm blinded by the excitement of flipping - making a profit in a reasonable time frame and making the world a slightly better place... The only landlording I can see myself getting in to is buying a vacation property that I can hopefully rent out year-round.
A big advantage of Indexing is that it takes almost no real time to figure the expected return (7% real), set up a Vanguard account with automatic transfers, and a tiny amount of time to report dividends to the IRS each year (manually transferring a number from a statement, or getting the tax software to do it). I am only considering getting into real estate (as someone who is already FI) for the benefits like diversification, stable cash flow, and hopefully enjoyment of learning a new skill or having a 'free' (or at least subsidized) place to stay in Hawaii or Italy...
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If you want a place to to stay (ala vacation home you use sometimes) the math almost always pens out as better to just rent a place on vacation and invest your money somewhere more lucrative.
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I found your podcast :D http://radicalpersonalfinance.com/78/ I'm listening to it. You need to tell him to get better music >.>
and I never realized your name was A Rebel Spy >.> I kept reading it as are-bel-spy as well
glad to hear that you made mistakes on first rental as well... so I'm still not sure of your use of example in starting this thread, he didn't make a mistake in the calculations
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Thanks guys. Either way, getting in to real estate will require some work for me. Maybe I'm blinded by the excitement of flipping - making a profit in a reasonable time frame and making the world a slightly better place... The only landlording I can see myself getting in to is buying a vacation property that I can hopefully rent out year-round.
Flipping seems like a very different skillset. One that I wish I had, since someone just flipped a house near where I live for a 1.2M profit before expenses in a year.
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Flipping seems like a very different skillset. One that I wish I had, since someone just flipped a house near where I live for a 1.2M profit before expenses in a year.
that's not really a skill if it was just timing... you could be the guy that timed the stocks as well, at least from my point of view on this one. Unless he is doing it consistantly...
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Flipping seems like a very different skillset. One that I wish I had, since someone just flipped a house near where I live for a 1.2M profit before expenses in a year.
that's not really a skill if it was just timing... you could be the guy that timed the stocks as well, at least from my point of view on this one. Unless he is doing it consistantly...
There's a lot of skill. It's no different than what mr_orange said here:
To me the upshot of this thread is:
1. If you don't have much time to find the right projects or invest the effort to learn to work on real estate where you can deliver good returns you're probably better off indexing and forgetting about the marginal extra yield you will get
2. If you do have the time and inclination to invest in real estate you'll clearly do better than investing in index funds using the proper leverage conditions
Item 2 could have a similar argument for several other types of small businesses as well, but you'd have to impute the value of your effort in each. Real estate, done properly, doesn't require a ton of effort and this is less job-like than many other small businesses.
You don't just pick a house, buy it, make a few changes, then sell it while hoping the real estate market has produced a nice return. You get to know the market, find a wholesaler (or do some marketing on your own) to purchase a house at substantially under market value less rehab costs. You make your money when you buy. Then you either do the work yourself which takes tremendous skill, or you find, negotiate with, and supervise contractors to do the work which takes a whole different set of skills.
There is some timing/luck, but not as much as you'd think.
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Flipping seems like a very different skillset. One that I wish I had, since someone just flipped a house near where I live for a 1.2M profit before expenses in a year.
that's not really a skill if it was just timing... you could be the guy that timed the stocks as well, at least from my point of view on this one. Unless he is doing it consistantly...
There is pretty clear skill involved. Need to be able to assess the state of the house, organize the various remodeling, stage it well, sell it at or above market rate. There is no way I would have been able to flip that house for that amount of profit, I could not have made it look as nice or found someone willing to pay as much. Its pretty clear that the person or people responsible for that flip know what they are doing. As a result, they are handsomely rewarded, although I imagine even they were probably surprised by the ~1M profit.
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Great explanation Zephyr. Thanks.
+1 And thank you Vee2001. Helped clarify RE for me. Lol you can enjoy RE, I'm too busy to be able to manage properties but still learn for the future when I hope to have more time.
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I found your podcast :D http://radicalpersonalfinance.com/78/ I'm listening to it. You need to tell him to get better music >.>
and I never realized your name was A Rebel Spy >.> I kept reading it as are-bel-spy as well
glad to hear that you made mistakes on first rental as well... so I'm still not sure of your use of example in starting this thread, he didn't make a mistake in the calculations
The mistake was not buying with strict enough criteria--I didn't quite meet the 1% rule on that first one. The imaginary person in our OP is starting with that as a baseline. :)
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How Trump Stacks Up Against Vanguard 500 Index (VFINX)
I recently ran across an interesting Trump story at NationalJournal.com, where they suggest the famous billionaire could have been even richer by “doing nothing.”
Here are some of the key points in the story (taken verbatim):
•While many Trump supporters believe he is a self-made man, it was actually his father, Fred Trump, who built the real-estate empire that Donald Trump took over in 1974.
•If he’d invested the $200 million that Forbes magazine determined he was worth in 1982 into that index fund, it would have grown to more than $8 billion today.
•(That $8 billion) exceeds by billions recent estimates of Trump’s worth by financial publications.
•Coincidentally, there was a self-made businessman who was also worth about $40 million in 1974: Warren Buffett. Had Trump allowed Buffett to manage his fortune, too, Trump might also be worth what Buffett is today: about $67 billion — or about 22 times more.
Currently, the Forbes net worth for Donald Trump is pegged at $4 billion. That’s half what he could have produced by simply investing in a mutual fund like Vanguard S&P 500 Index.
Source: http://investorplace.com/2015/09/donald-trump-vs-vanguard-500-index-vfinx/#.VmKEehtdE5s
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Yeah there's a thread discussing that article.
IIRC: Basically that timeframe is assuming he invested in RE from 74 to 82, then switched to index funds, perfectly timing the markets. Probably not realistic. If he had done RE or index funds straight from 74, apparently he'd have had about the same as now.
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I found your podcast :D http://radicalpersonalfinance.com/78/ I'm listening to it. You need to tell him to get better music >.>
and I never realized your name was A Rebel Spy >.> I kept reading it as are-bel-spy as well
glad to hear that you made mistakes on first rental as well... so I'm still not sure of your use of example in starting this thread, he didn't make a mistake in the calculations
The mistake was not buying with strict enough criteria--I didn't quite meet the 1% rule on that first one. The imaginary person in our OP is starting with that as a baseline. :)
and that would be a learning curve... how would someone who never owned a rental to know this? because he read it online as a rule? even investors tinker with aa when starting out to find what they like... no matter what the internet says
i just find that you are passing a lot of what you learned already as things a first time rental owner would know since it is things you look for now.
unless you disclaimer the guy as experienced already and just getting around to buying a rental... in which case he would already be swayed to real estate... and the entire thing would be in that favor
basically, like you said in podcast, the returns of both are good, and simple things sway one or other or both in favor depending on person. so no "maths" would justify one over the other
kind of like you assume the investor isnt in a high fee fund... its just by chance that i am investing in modern times when vanguard is around. what happened before vanguard and no low fee funds? what happened when mortgage rates were double digits?
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I was going for an average scenario, today.
Naturally any change in the inputs changes the outputs.
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Off-topic, A Rebel Spy! I had no idea either ... always read it as Arebelspy as one word, like ere a bell's pee. Ha! Oops. Nice to be corrected ...
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Off-topic, A Rebel Spy! I had no idea either ... always read it as Arebelspy as one word, like ere a bell's pee. Ha! Oops. Nice to be corrected ...
Rebs should collect all of the different ways he has heard this post expressed and compile them into a book. There are probably a hundred from just this forum alone.
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It's always been A Rebel Spy to me, but I'm a hardcore Star Wars fan from way back.
See you guys at the premiere!! Right, guys?
Guys?
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How Trump Stacks Up Against Vanguard 500 Index (VFINX)
I recently ran across an interesting Trump story at NationalJournal.com, where they suggest the famous billionaire could have been even richer by “doing nothing.”
Here are some of the key points in the story (taken verbatim):
•While many Trump supporters believe he is a self-made man, it was actually his father, Fred Trump, who built the real-estate empire that Donald Trump took over in 1974.
•If he’d invested the $200 million that Forbes magazine determined he was worth in 1982 into that index fund, it would have grown to more than $8 billion today.
•(That $8 billion) exceeds by billions recent estimates of Trump’s worth by financial publications.
•Coincidentally, there was a self-made businessman who was also worth about $40 million in 1974: Warren Buffett. Had Trump allowed Buffett to manage his fortune, too, Trump might also be worth what Buffett is today: about $67 billion — or about 22 times more.
Currently, the Forbes net worth for Donald Trump is pegged at $4 billion. That’s half what he could have produced by simply investing in a mutual fund like Vanguard S&P 500 Index.
Source: http://investorplace.com/2015/09/donald-trump-vs-vanguard-500-index-vfinx/#.VmKEehtdE5s
I'm not a fan, but as ARS points out, this isn't entirely a fair comparison.
What I will say is, Trump didn't buy established cash-flow properties, and he lost a lot of money along the way in bad deals. If it weren't for lawyers and bankruptcy laws, he'd have a lot less money because his plays are often highly speculative, risky developments. When he hits a home run, he makes a shit-ton. And sometimes he strikes out. This is the opposite of the systematic approach we're talking about, where choosing the right initial conditions means beating the market with mechanical, almost brutal precision.
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I think the math is great but in the end there are a ton a variables that you cant calculate. first being the 50% rule you can definitely tweak that in your favor if u do the upkeep yourself which is something you can learn overtime. 2nd Finding tenants quickly and lowering the vacancy rate is also something that should improve as you get better and more experience.3d as you said u can do better then the 1% rule even more so if u only have one property maybe not by a lot but say the place cost $100,000 and u get $1,100 or 1,200 rent its not that big of a jump but when u run calculations running 30-50 years that adds up fast. The main argument I make with RE AND STOCKS is when u buy a stock do u have any control in what the company does? When you decide to buy and rent you have all the control. On the downside if you put money into stocks u have no control and u don't have to do any work but if u invest in RE even if u hire someone else to do the work it will inevitably be more work then stocks you will still have to find tenants or file the paperwork for the business entity u form and the taxes required, etc, etc...
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I think the math is great but in the end there are a ton a variables that you cant calculate. first being the 50% rule you can definitely tweak that in your favor if u do the upkeep yourself which is something you can learn overtime. 2nd Finding tenants quickly and lowering the vacancy rate is also something that should improve as you get better and more experience.3d as you said u can do better then the 1% rule even more so if u only have one property maybe not by a lot but say the place cost $100,000 and u get $1,100 or 1,200 rent its not that big of a jump but when u run calculations running 30-50 years that adds up fast. The main argument I make with RE AND STOCKS is when u buy a stock do u have any control in what the company does? When you decide to buy and rent you have all the control. On the downside if you put money into stocks u have no control and u don't have to do any work but if u invest in RE even if u hire someone else to do the work it will inevitably be more work then stocks you will still have to find tenants or file the paperwork for the business entity u form and the taxes required, etc, etc...
The things you list (such as doing repairs yourself) are true, but add more work. I was assuming outsourcing everything to make it as passive as possible.
As far as control, I don't want any control over what Apple, P&G, Nestle, etc. are doing. I just want a share of their profits.
Of course both investments are different types of investments, fundamentally, so comparing them is difficult. RE has more control, but takes more work. Equities are more passive, but much less control.
They're tailored for different people.
But still, we try and compare, and have to do the best we can to align the variables as close as possible to do so. :)
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Very interesting post. I will say that, as far as I can tell, it's completely impossible to come anywhere near the 1% rule in the condo market in Chicago. An "alright" condo will run $250k or so in the downtown area, and you're not going to get $2,500/month for rent on a $250k unit (probably closer to $1,400-$1,600). Expenses also seem to be higher because of ubiquitous condo association fees that can tack on a few hundred per month and very high property taxes. It's a shame, honestly, because I'd really like to put some of my cash to work somewhere other than index funds, but so it goes.
Spouse would also kill me if I tried to get into RE investing...
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My biggest disagreement with Arebelspy is the 1% rule and perhaps more specifically his characterizing investing properties cash flow positive as being investing and investing in areas where you get say less than 1% as being speculating.
If never lived in an area where you could get close to 1%. The only time I even saw it was buying properties in Vegas in 2011,2012. The current property I'm buying there has .83% (10%/year) rent.
Rental Property #1: Purchase and rehab price: $45,000. Immediate property appreciation due to repairs: $35,000.
Year 1 rent: $750 / month 1.67% of purchase price.
Year 2 rent: $765 / month 1.70%.
Year 3 rent: $780 / month 1.73%. (Hopefully, we'll see, it's going vacant in a month.).
Rental Property #2: Purchase and rehab price: $50,000. Immediate property appreciation due to repairs: $30,000.
Year 1 rent: $820 / month 1.64%
Year 2 rent: $850 / month 1.70%
Rental Property #3: Purchase and expected rehab price: $45,000. Immediate property appreciation due to repairs: $40,000
Expected Year 1 rent: $800 to $900: 1.78% to 2.00%.
Yet it is still possible that it's a great investment. You put $300K down on $1.5Mill house lose $30K/year in cash flow, but you are making $150K or even 100K/year in appreciation that is a terrific cash on cash return.
It's not a CASH on cash return each year. It's a CASH on cash loss each year.
Once you sell it, THEN you'll see the appreciation provide a CASH on cash return.
Until then, it's a pile of bricks and lumber on the ground that you toss cash into. :)
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In your assumptions, I think you are factoring in getting the same rents (1% or original purchase price) the entire 30 or 50 years. I think you need to factor in a growth rate for rental appreciation. It would seem that if you are increasing the value 3% a year, the ongoing 1% of rental income would be 1% of the new property value as opposed to a consistent 1% of the original purchase price.
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In the original post by Arebelspy, he said "I'm ignoring taxes for simplicity's sake..." He also didn't add 3% appreciation in rents.
Has anyone figured out the real return by actually including Taxes and Depreciation? I think it's important because you are getting cash flow AFTER TAXES and Depreciation.
Let's assume
6% Rental Yield first year, after All Expenses including Management Fees, Cap Ex, Repairs, Taxes.
3% Increase in House Price, Rent, and Expenses each year
25% Tax Rate
Using Depreciation
Assuming reinvesting the Cash Flow AFTER Taxes/Depreciation into S and P, and getting 10% Return a year.
25% down payment
5% Rate for 30 years.
The calculators online don't include cash flow after taxes, or Depreciation.
Anyone have a real number return or compound % return?
Thanks!
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I think what's "best" really depends on the individual situation and personal investing style.
For an investing with a large net worth, I think it's good to have both - they grow in different ways and adds to diversification.
For someone who has to choose between one or the other, it depends.
The major advantage of real estate is leverage (and possibly taxes depending on your country/situation).
- Leverage is a great thing if your making money, but an awful thing if you are losing money/can't stay solvent, so you need a lot more of a safety net.
- You are highly exposed to interest rate risk (which may not be so relevant in the last few years, but could be in the future.
- You are usually dependent on the market you are living in (no point in buying into a ridiculous local market) as most people do not have the capacity to manage an investment income in a city far from where they live.
- Large transaction costs (realtor fees) and operational costs (maintenance, renovations)
- Generally more work (finding tenants, etc.)
- Difficult to buy and sell - it takes more time and effort to do this.
The major advantage of stocks:
- Easy to buy and sell
- Has a higher rate of return (not including leverage), but less ability for most normal people to get leverage (theoretically, if you could obtain a "mortgage" for stocks with same amount of leverage, you would be better off).
- You can buy stocks anywhere in the world (no geopolitical risk) and you can buy into cheaper markets globally if your local market is expensive.
- Generally takes less time/effort
- More volatile, which can be hard emotionally for some people.
- But may be less "tangible" for people to understand.
I don't think either asset class is inherently better or "safer". It depends on your local market, whether you are comfortable with leverage and interest rate risk, whether you prefer liquidity+volatility vs. less liquidity+more tangible asset, and whether you prefer the "work" required to purchase and rent out real estate.
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In order to make a fair comparison one needs to know what the projected long term return is for a particular RE investment. S and P is historically 10% long term.
Does anyone have a good spreadsheet to calculate the compounded return of RE that includes Taxes, Depreciation AND cash flow reinvestment?
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I am still curious about this because it seems to me that there are several variables in RE that are brutally difficult to calculate.
Stocks are easy. Pick your (few) assumptions and spit out a number between 9-12% over 30 years.
Real estate is much more like buying a single stock and going all-in on it. Also, you agree to a massive hassle to sell it. You're hoping your "company" remains relevant for a very, very long time. You have basically no idea what your local RE market will look like in 5 years, never mind 10 or 20. The costs of really bad tenants who can't afford to pay for damages they cause is a big risk you have to also assume. That your local RE market will go up is not the safest assumption either.
And yet, delicious, instant leverage...
I wonder if anyone who has managed a large number of properties could tell us about their average "major property-related setbacks per year" and how they would inflict themselves on the formulas here. No tenants for 3 months, or having to switch property managers, or major tenant neglect issue, etc. would dramatically affect the numbers.
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In the original post by Arebelspy, he said "I'm ignoring taxes for simplicity's sake..." He also didn't add 3% appreciation in rents.
Has anyone figured out the real return by actually including Taxes and Depreciation? I think it's important because you are getting cash flow AFTER TAXES and Depreciation.
I have acquired my 7th property this year and have yet to pay taxes on any of the cash flow. Depreciation has offset all my earnings. Long term, eventually, taxes will impact me as each property seasons, but I will still not being paying my full income tax rate on these earnings. Also, buying more properties adds to my depreciation pool and offsets income on older properties. This past year, I have cash flowed approximately $25,000 with zero effect on my AGI.
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In the original post by Arebelspy, he said "I'm ignoring taxes for simplicity's sake..." He also didn't add 3% appreciation in rents.
Has anyone figured out the real return by actually including Taxes and Depreciation? I think it's important because you are getting cash flow AFTER TAXES and Depreciation.
I have acquired my 7th property this year and have yet to pay taxes on any of the cash flow. Depreciation has offset all my earnings. Long term, eventually, taxes will impact me as each property seasons, but I will still not being paying my full income tax rate on these earnings. Also, buying more properties adds to my depreciation pool and offsets income on older properties. This past year, I have cash flowed approximately $25,000 with zero effect on my AGI.
Well keep in mind it's only your 7th year, and you may have 23 years left. In your later years, you Interest payments will be smaller, therefore you will be paying more Taxes.
I really think the best way to analyze is input your own numbers into a spreadsheet that can show Returns after 5,10,20 and 30 years. Then you can really make a good comparison to Stocks.
Anyone have a good spreadsheet that shows Cash Flow after Taxes/depreciation and Cash Flow reinvestment?
I really want to see the Math that Arebelspy was trying to show in his original post.
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I have built that spreadsheet several different ways, and in my case the stock market always wins out over long enough time frames. You just can't beat 9.5 CAGR over 30 years.
Real estate can be more predictable in the short term, though.
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Quibbles with assumptions?
- Inflation runs 3%, and the house appreciates at the rate of inflation.
How often does a particular piece of real estate appreciate at 3% for 30-50+ years? This is one hell of an assumption.
Here's another assumption - you buy a house for $100k (which is a very cheap house in probably not a good neighborhood) and appreciates 20% over 10 years (120k value). Then the neighborhood starts to decline as all the people start ageing and not taking care of their homes. This results in the home being worth only $90k 20 years after the initial purchase.
The problem with real estate is that you have to know how a neighborhood will be in 10, 30, or 50 years. Also, a $100k house is likely to be a junker. If it's not a junker, then it's likely in an area where prices haven't appreciated 3% annually and probably won't in the future.
Likely, you would have to at least buy a $200k+ house in an established neighborhood to ensure you get close to the 3% appreciation your scenario needs.
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Why would you only be able to invest $1,135.8 per year for years 31-50 if you have already paid off the mortgage by that point?
I understand the net profits would be ($1,000-$500-$405.35)*12=$1,135.8 profit per year to invest, but that should only be the case for the first 30 years.
So I think your you are shorting yourself on the 50 year return.
After the mortgage is paid off you would have an extra $4,864.20 per year (for a total of $6,000 per year) to invest for the next 20 years.
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Pretty easy to beat the 1% rule where we invest. The last 2 houses we bought we paid 60k for each one, had less than 1k in repairs and one rents for 875 and the other rents for 900. The first two we bought we paid 44k for 2 years ago, about 3k each in repairs and and each of them now rents for 800. I wont even look at a house that only rents at 1%.
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Pretty easy to beat the 1% rule where we invest. The last 2 houses we bought we paid 60k for each one, had less than 1k in repairs and one rents for 875 and the other rents for 900. The first two we bought we paid 44k for 2 years ago, about 3k each in repairs and and each of them now rents for 800. I wont even look at a house that only rents at 1%.
And this is why the 1% rule just doesn't work for everybody. REAL ESTATE IS LOCAL. LOCATION, LOCATION, LOCATION! It works for you because you live in an area with cheap houses. There are no houses within a hundred miles of me that sell for $60K. A very cheap house in my area is $200K, and it is going to rent for less than $2000/month. The 1% rule is reasonable for cheaper properties, but you won't generally find higher priced properties that meet the 1% rule. Also cheaper properties are more work in general, and a lot of times just aren't worth it. I wouldn't want most really cheap houses even if they met the 1% rule because they just wouldn't provide enough cash flow to make it worth my while. $100 per month in cashflow is just not worth the headache of owning a cheap house. I would rather have a $350K house that provides $500 in cashflow even if it doesn't meet the 1% rule.
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OK, can we stop calling it the 1% rule since Expenses vary widely by location and price point? 1% was created assuming 50% would go to Expenses.
How about it calling it the 6% Rule. You need a minimum of 6% Rental Yield for the year after ALL expenses.
All expenses include Vacancies, Capex, Repairs, Condo Fees, RE Tax, Management Fees, and others.
Since the OP title is "RE Returns vs Stock Returns: The Maths", can we get some numbers for the Return after 30 years, that includes Cash Flow AFTER Taxes, Depreciation, Reinvesting the Cash Flow, and finally Closing/commission Costs?
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Pretty easy to beat the 1% rule where we invest. The last 2 houses we bought we paid 60k for each one, had less than 1k in repairs and one rents for 875 and the other rents for 900. The first two we bought we paid 44k for 2 years ago, about 3k each in repairs and and each of them now rents for 800. I wont even look at a house that only rents at 1%.
And this is why the 1% rule just doesn't work for everybody. REAL ESTATE IS LOCAL. LOCATION, LOCATION, LOCATION! It works for you because you live in an area with cheap houses. There are no houses within a hundred miles of me that sell for $60K. A very cheap house in my area is $200K, and it is going to rent for less than $2000/month. The 1% rule is reasonable for cheaper properties, but you won't generally find higher priced properties that meet the 1% rule. Also cheaper properties are more work in general, and a lot of times just aren't worth it. I wouldn't want most really cheap houses even if they met the 1% rule because they just wouldn't provide enough cash flow to make it worth my while. $100 per month in cashflow is just not worth the headache of owning a cheap house. I would rather have a $350K house that provides $500 in cashflow even if it doesn't meet the 1% rule.
I understand the assumption that cheaper houses are more work and that the cash flow may be less, but that hasn't been the case for us. So far anyway. People assume maintenance is more, but I really don't think it is. The roof is smaller, there's only one water heater, the AC units are smaller and less costly, it takes less new flooring and paint.
I also like that my cash on cash return is much higher than it would be on a 350k house that flows 500 dollars.
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OK, can we stop calling it the 1% rule since Expenses vary widely by location and price point? 1% was created assuming 50% would go to Expenses.
How about it calling it the 6% Rule. You need a minimum of 6% Rental Yield for the year after ALL expenses.
All expenses include Vacancies, Capex, Repairs, Condo Fees, RE Tax, Management Fees, and others.
Since the OP title is "RE Returns vs Stock Returns: The Maths", can we get some numbers for the Return after 30 years, that includes Cash Flow AFTER Taxes, Depreciation, Reinvesting the Cash Flow, and finally Closing/commission Costs?
Andy, I don't think this dataset exists. And realistically, we'd need data from multiple time periods in multiple real estate markets in order to do a mathematical comparison to stock market returns.
Some markets would have rapid price appreciation (sometimes rents would grow with property values, sometimes they wouldn't). Some would appreciate with inflation. Some would see rents drop. Some would see populations decline to the point where many houses became essentially worthless (like some towns in the rust belt). Some would see rent control laws introduced (Pacifica City introduced a new rent control law earlier this year). Some will see significant cuts in property taxes that increase the profitability of rentals (see Prop 13 in CA).
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OK, I had a friend make a spreadsheet that included 25% Tax Bracket, Depreciation, 5% Brokers Fee, Recapture Tax, Capital Gains Tax, and Closing Costs.
Let's assume 25% down, 30 Year at 5% rate. 3% appreciation for Home price, Rents, and Expenses.
Rent is 6% yearly yield after All Expenses including Management Fees, Cap Ex, Vacancies etc.
Let's assume Reinvesting the Cash flow into a Bond/Investment that gives 3% compounded return each year.
If you sell after 30 years the Return is 8.88% compounded. Not too good.
If you sell after 15 years, the Return is 10.52% compounded. OK, but not worth the RE work.
If you sell after 10 years, the Return is 11.12% compounded. Not bad.
So it seems the longer you hold RE, the compounded Return gets smaller and smaller.
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As previously stated, it's hard to beat the stock markets CAGR over sufficiently long time periods.
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The thing I really dislike about real estate is that it is an inherently riskier investment.
The risk of total loss is far more real for a single home than for a diversified portfolio of stocks.
The rental market can change, a neighborhood can worsen, an earthquake or flood can happen.
And leverage only increases your downside exposure.
You can insure against some of this of course, but if you insure against all of it, your returns will be severely effected.
Add on to that poor liquidity, the hassle of having to deal with tenants, finding competent managers, vacancies, etc, and I would take on a well diversified investment portfolio any day of the week.
It's just so much less work for a better return long term.
Agreed. Being a landlord is a lot of work and you have to have the right personality for it or else you will begin to begrudge it like any "Service Worker" job with more complex and expensive transactions. We found out the hard way that for us, personality wise, we thought it an absolute pain in the ars and did not enjoy it despite the money. Any phone call from the PM Company or tenant is rarely ever a good thing. If you can assemble a good maintenance team for things you can't do or don't want to do yourself, that is a plus or find good tenants that are HONEST and don't mind being handy once in a while but finding that for any length of time is just lucky.
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...and that would be a learning curve... how would someone who never owned a rental to know this? because he read it online as a rule?
Well, I read it in books and online. Then I did the math to double check it.
Then I read some more.
Then I looked around for properties online and did the math to see if they might be workable, based upon some assumptions about what repairs might cost.
If the properties looked possible, we checked them out by walking around outside them and looking in the windows. We dropped the ones that were in too much disrepair and then shopped for estimates. Not official estimates, but estimates like "How much for a new roof, simple roofline, 1200sq foot of roof?" Or, "How much for 1000 sq ft of this carpet, installed, assuming a regular plywood floor that's in decent shape?"
It took us about a calendar year before we were ready to commit to a property.
We're doing great on it.
I already had basic carpentry skills and had owned a home for some decades, so I had some idea of repair costs. A 22 yr old, as in the original scenario, would have to get more estimates and do a bit more reading.
This is well within the ability of regular folks to do if they set their minds to it - and do the research, the math, and the work it requires.
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The thing I really dislike about real estate is that it is an inherently riskier investment.
The risk of total loss is far more real for a single home than for a diversified portfolio of stocks.
The rental market can change, a neighborhood can worsen, an earthquake or flood can happen.
And leverage only increases your downside exposure.
You can insure against some of this of course, but if you insure against all of it, your returns will be severely effected.
Add on to that poor liquidity, the hassle of having to deal with tenants, finding competent managers, vacancies, etc, and I would take on a well diversified investment portfolio any day of the week.
It's just so much less work for a better return long term.
But the reason we have this thread is because the long-term return is demonstrably not better with a balanced equity portfolio. ARS did the math and showed his work.
My experience backs this up, FTR.
I'm a complete ass-clown n00b in real estate and I'm pulling roughly 25% return on equity in my typical investment. That's with high vacancy rates and excessive maintenance costs due to crappy management (soon to be fired), a few delinquencies, and lots of catch-up work from years of prior neglect.
I'm not sure where you get the idea that the risk of total loss cannot be effectively insured. My company just bought four properties, 6 units total, $40K GSR, purchase price $260K but rebuild cost over $500K, and we paid $2800 up front for an entire year's insurance with fairly low deductibles.
Agreed. Being a landlord is a lot of work and you have to have the right personality for it or else you will begin to begrudge it like any "Service Worker" job with more complex and expensive transactions. We found out the hard way that for us, personality wise, we thought it an absolute pain in the ars and did not enjoy it despite the money. Any phone call from the PM Company or tenant is rarely ever a good thing. If you can assemble a good maintenance team for things you can't do or don't want to do yourself, that is a plus or find good tenants that are HONEST and don't mind being handy once in a while but finding that for any length of time is just lucky.
If you're buying the right stuff at the right price, and we are all in agreement that this is a big "if", almost all of that hassle is handled by someone else and you still beat the market. However, I don't deny that there is still an element of personal choice here.
And of course, the hassles you've decided to avoid are exactly what we're being compensated for, in the form of higher returns - "we" being those who choose to accept the ass-pain. :)
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But the reason we have this thread is because the long-term return is demonstrably not better with a balanced equity portfolio. ARS did the math and showed his work.
Yeah, I was hoping someone would double check my math and find any problems.
None of the responses found anything wrong with the OP, other than disputing premises (e.g. "you can't get 1% in my area" or whatever).
If the premises of the OP hold, and I think there's plenty of times they do, as I made them fairly conservative/average scenarios in all directions, I think it's correct.
RE is more work. A bit more risk (that can be mitigated when you understand the risks). But much higher return.
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The thing I really dislike about real estate is that it is an inherently riskier investment.
The risk of total loss is far more real for a single home than for a diversified portfolio of stocks.
The rental market can change, a neighborhood can worsen, an earthquake or flood can happen.
And leverage only increases your downside exposure.
You can insure against some of this of course, but if you insure against all of it, your returns will be severely effected.
Add on to that poor liquidity, the hassle of having to deal with tenants, finding competent managers, vacancies, etc, and I would take on a well diversified investment portfolio any day of the week.
It's just so much less work for a better return long term.
But the reason we have this thread is because the long-term return is demonstrably not better with a balanced equity portfolio. ARS did the math and showed his work.
My experience backs this up, FTR.
I'm a complete ass-clown n00b in real estate and I'm pulling roughly 25% return on equity in my typical investment. That's with high vacancy rates and excessive maintenance costs due to crappy management (soon to be fired), a few delinquencies, and lots of catch-up work from years of prior neglect.
I'm not sure where you get the idea that the risk of total loss cannot be effectively insured. My company just bought four properties, 6 units total, $40K GSR, purchase price $260K but rebuild cost over $500K, and we paid $2800 up front for an entire year's insurance with fairly low deductibles.
Agreed. Being a landlord is a lot of work and you have to have the right personality for it or else you will begin to begrudge it like any "Service Worker" job with more complex and expensive transactions. We found out the hard way that for us, personality wise, we thought it an absolute pain in the ars and did not enjoy it despite the money. Any phone call from the PM Company or tenant is rarely ever a good thing. If you can assemble a good maintenance team for things you can't do or don't want to do yourself, that is a plus or find good tenants that are HONEST and don't mind being handy once in a while but finding that for any length of time is just lucky.
If you're buying the right stuff at the right price, and we are all in agreement that this is a big "if", almost all of that hassle is handled by someone else and you still beat the market. However, I don't deny that there is still an element of personal choice here.
And of course, the hassles you've decided to avoid are exactly what we're being compensated for, in the form of higher returns - "we" being those who choose to accept the ass-pain. :)
A quick RE note for great deals that are remote to your personal situation.
Nightmare scenarios happen, even when deals look bullet proof. Buy a foreclosure home and instantly hit positive cash flow? Great.
However, what happens if your target market suddenly decays as part of a national or local crisis? Floods or economy crash, plant closing, for example. Perhaps to the point where the supply of banks (for leverage), property managers, and tenants (economy) dry up at the same time? This is the RE equivalent to a market crash. It happens, it happened to me. I personally had this happen in one of the most promising cities, in terms of cash flow and lost pretty much 100% of an investment in mutiple homes. In times of stress, local governments will be desperate for cash and rob you. Local business managers may also cheat and steal. They may have started out honest, but while the house of cards is falling locally, good men and women often go bad (they may send statements that look great, while they are spending your reserves and filing to declare personal bankruptsy). Good luck collecting your past due rents from your defunct property manager via the courts.
Meanwhile, at the same time they are killing rental subsidies, your local govt will likely be looking at you to balance their books. Their tax collectors msy raise rates or will likely deny applications for reassessments. So you may not get any tax relief for vacant units, perhaps a notice of a bill to remove blight left behind by a squatter. Realtors may not even be willing to list properties for sale, especially those that fall too low in value. Need to replace your manager? Good local managers may not be able or willing to rent your properties for you. Your local partners may start stealing the rent and then dissappear (not to mention selling your copper pipes).
Just saying it is not a sure thing. People lie in real estate all the time. Overall we have done ok, as some big wins balanced out the 100% loss scenario. But big lessons learned by many in 2008-9.
If there was a real estate crash and people started losing their homes, wouldn't there be a stronger rental market for the people who can no longer afford their home?
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If there was a real estate crash and people started losing their homes, wouldn't there be a stronger rental market for the people who can no longer afford their home?
This was indeed the case in 08-11.
His points about bad managers, rising costs, etc. are all valid, and worth having a plan for (and higher vacancies as well; I wouldn't count on a stronger rental market in a crash, though it very well may happen).
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If there was a real estate crash and people started losing their homes, wouldn't there be a stronger rental market for the people who can no longer afford their home?
This was indeed the case in 08-11.
It's also possible for rents to collapse in an area. That would happen if people start to leave the area in droves to find a job elsewhere.
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OK, I had a friend make a spreadsheet that included 25% Tax Bracket, Depreciation, 5% Brokers Fee, Recapture Tax, Capital Gains Tax, and Closing Costs.
Let's assume 25% down, 30 Year at 5% rate. 3% appreciation for Home price, Rents, and Expenses.
Rent is 6% yearly yield after All Expenses including Management Fees, Cap Ex, Vacancies etc.
Let's assume Reinvesting the Cash flow into a Bond/Investment that gives 3% compounded return each year.
If you sell after 30 years the Return is 8.88% compounded. Not too good.
If you sell after 15 years, the Return is 10.52% compounded. OK, but not worth the RE work.
If you sell after 10 years, the Return is 11.12% compounded. Not bad.
So it seems the longer you hold RE, the compounded Return gets smaller and smaller.
Chiming in because it does not seem that anyone addressed this post.
With all due respect, Andy, I think you're ignoring the fact that in a long-term buy-and-hold real estate purchase scenario as you have outlined above, the purchaser is also receiving principal paydown on his loan (e.g., he's getting a paid-off asset). Yes, as stated previously in the thread, the return on rents will converge back to 6% as you essentially delever by paying off more and more of the principal on the loan (and subsequently having more and more of your money locked up in equity in the rental)... but you also have a paid off rental with some massive equity, which you can either re-lever, keeping your rental returns at those higher rates, or you can just sell the rental after it is completely delevered (read: paid off), and use the proceeds to buy stocks. All the while you will have been collecting rents, too.
RE makes money in one of four ways
1) rents;
2) appreciation;
3) principal paydown;
4) preferential tax treatment.
In your example above, it seems - to me - that you're ignoring 3-4. Factor in the principal paydown and appreciation (even at inflation rates) and you come out way, way ahead with RE versus stocks.
Something nobody has noted (I think) explicitly in the thread is the inherent effect of cheap leverage on the gains you enjoy from even modest appreciation. In ARS' example above, if you have a 100k house on which you've put down 20k, and the house appreciates even a piddling 2k per year, due to the magic of leverage, you are rewarded by an additional 10% return on your original investment just from that appreciation alone (2k in appreciation / your original 20k investment = 10%, completely independent of rents received).
Uncallable, relatively-cheap leverage is - IMHO - the best reason to consider RE versus stocks. Caveat emptor, of course, that it bites both ways, and if your house starts depreciating in value (due to Detroit style breakdown of the market), then the leverage will absolutely crush your returns. If your house loses 2k per year, you're losing 2k/20k = 10% right there. Ouch. So ideally pick an area that will stay flat/increase at pace with inflation.
Now let's all go get filthy rich.
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Something nobody has noted (I think) explicitly in the thread is the inherent effect of cheap leverage on the gains you enjoy from even modest appreciation. In ARS' example above, if you have a 100k house on which you've put down 20k, and the house appreciates even a piddling 2k per year, due to the magic of leverage, you are rewarded by an additional 10% return on your original investment just from that appreciation alone (2k in appreciation / your original 20k investment = 10%, completely independent of rents received).
i've always wondered about this, but isn't your leverage being eroded by the fact you are paying interest? is your $20k initial investment not accumulating each month due to interest payments?
further, i have also always felt the perceived tax 'benefits' of home ownership is overblow. sure, rentals and schedule E works out fine, but for your primary, you need to pay a lot of interest to exceed the standard deduction amount.
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Something nobody has noted (I think) explicitly in the thread is the inherent effect of cheap leverage on the gains you enjoy from even modest appreciation. In ARS' example above, if you have a 100k house on which you've put down 20k, and the house appreciates even a piddling 2k per year, due to the magic of leverage, you are rewarded by an additional 10% return on your original investment just from that appreciation alone (2k in appreciation / your original 20k investment = 10%, completely independent of rents received).
i've always wondered about this, but isn't your leverage being eroded by the fact you are paying interest? is your $20k initial investment not accumulating each month due to interest payments?
further, i have also always felt the perceived tax 'benefits' of home ownership is overblow. sure, rentals and schedule E works out fine, but for your primary, you need to pay a lot of interest to exceed the standard deduction amount.
Hey bro, I'm not entirely sure what you meant by "leverage being eroded by the fact that you are paying interest." Yes, you are paying interest, but you're making more in rents (on a percentage basis) than it costs you to borrow the money - this is the definition of leverage, and frankly, one of the sexiest reasons to do real estate to begin with. I can't think of anywhere else where you get a cheap, long-term, non-callable leverage. If someone would give me 4% money - and no option to call the loan in - for 30 years, I would take out a kazillion dollars and put it in the stock market today for good.
To keep it simple, here's some back of the envelope math.
You buy a 100k house that rents for 1k monthly. You put down 20k. The bank loans you 80k at 5% - let's assume it is interest only for ease of the maths. After one year, the house has appreciated to 102k. What was your return overall?
First, your cost. You had to pay the bank 5% interest on the 80k they have so graciously loaned you, or 4k, for the privilege of holding their money. Boo, hiss. You are down 4k. (-4k)
Your house cranked out rents, though, on the order of 12k! Let's say you lost half of that in expenses, so you profited 6k in rents. (+6k)
...But the house also appreciated in value at inflation rates (of 2%) for a 2k net gain! (+2k)
Ergo, your total return for the one year would be... -4 + 6 + 2, or 4k. On a 20k investment, this is pretty darn good, no?
If you wanted to factor in inflation, the simple math would be something like: your 20k has sat around doing nothing for you (boo, hiss), so it has eroded by the 2% that we brought up above. Stuff that previously cost $100 now costs $102. Your 20k is now only worth... $19607 . So technically, if we are accounting for your stale-ass 20k sitting around and losing value, your net gain of $4k above would probably more accurate be described as a net gain of $3607, still a pretty solid return on 20k.
Most people I have talked to seem to take appreciation as an "icing on the cake scenario," meaning that in the example above, you'd "only" profit $1607 on your initial 20k investment. Still not bad... and that's assuming that the house doesn't even appreciate with inflation, which should proooobably not happen.
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Something nobody has noted (I think) explicitly in the thread is the inherent effect of cheap leverage on the gains you enjoy from even modest appreciation. In ARS' example above, if you have a 100k house on which you've put down 20k, and the house appreciates even a piddling 2k per year, due to the magic of leverage, you are rewarded by an additional 10% return on your original investment just from that appreciation alone (2k in appreciation / your original 20k investment = 10%, completely independent of rents received).
i've always wondered about this, but isn't your leverage being eroded by the fact you are paying interest? is your $20k initial investment not accumulating each month due to interest payments?
No, your leverage is eroded by the fact that you're paying PRINCIPAL. :)
further, i have also always felt the perceived tax 'benefits' of home ownership is overblow. sure, rentals and schedule E works out fine, but for your primary, you need to pay a lot of interest to exceed the standard deduction amount.
Yep, the tax code is more advantageous to rental property, where those costs come straight off the top of your business income, than it is to homeownership, where qualifying costs (which are fewer to begin with) in the amount of your standard deduction are effectively excluded from consideration.
For some people, this means the majority of qualifying costs are excluded. If you pick a small, affordable home in a LCOL area like I did, it might not even benefit you at all (itemized deductions < standard deduction). But that's OK with me. The only thing better than getting a tax deduction for an expense is not having that expense to begin with.
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OK, I had a friend make a spreadsheet that included 25% Tax Bracket, Depreciation, 5% Brokers Fee, Recapture Tax, Capital Gains Tax, and Closing Costs.
Let's assume 25% down, 30 Year at 5% rate. 3% appreciation for Home price, Rents, and Expenses.
Rent is 6% yearly yield after All Expenses including Management Fees, Cap Ex, Vacancies etc.
Let's assume Reinvesting the Cash flow into a Bond/Investment that gives 3% compounded return each year.
If you sell after 30 years the Return is 8.88% compounded. Not too good.
If you sell after 15 years, the Return is 10.52% compounded. OK, but not worth the RE work.
If you sell after 10 years, the Return is 11.12% compounded. Not bad.
So it seems the longer you hold RE, the compounded Return gets smaller and smaller.
Chiming in because it does not seem that anyone addressed this post.
With all due respect, Andy, I think you're ignoring the fact that in a long-term buy-and-hold real estate purchase scenario as you have outlined above, the purchaser is also receiving principal paydown on his loan (e.g., he's getting a paid-off asset). Yes, as stated previously in the thread, the return on rents will converge back to 6% as you essentially delever by paying off more and more of the principal on the loan (and subsequently having more and more of your money locked up in equity in the rental)... but you also have a paid off rental with some massive equity, which you can either re-lever, keeping your rental returns at those higher rates, or you can just sell the rental after it is completely delevered (read: paid off), and use the proceeds to buy stocks. All the while you will have been collecting rents, too.
RE makes money in one of four ways
1) rents;
2) appreciation;
3) principal paydown;
4) preferential tax treatment.
In your example above, it seems - to me - that you're ignoring 3-4. Factor in the principal paydown and appreciation (even at inflation rates) and you come out way, way ahead with RE versus stocks.
Something nobody has noted (I think) explicitly in the thread is the inherent effect of cheap leverage on the gains you enjoy from even modest appreciation. In ARS' example above, if you have a 100k house on which you've put down 20k, and the house appreciates even a piddling 2k per year, due to the magic of leverage, you are rewarded by an additional 10% return on your original investment just from that appreciation alone (2k in appreciation / your original 20k investment = 10%, completely independent of rents received).
Uncallable, relatively-cheap leverage is - IMHO - the best reason to consider RE versus stocks. Caveat emptor, of course, that it bites both ways, and if your house starts depreciating in value (due to Detroit style breakdown of the market), then the leverage will absolutely crush your returns. If your house loses 2k per year, you're losing 2k/20k = 10% right there. Ouch. So ideally pick an area that will stay flat/increase at pace with inflation.
Now let's all go get filthy rich.
Makinbutter,
The return numbers does include principal paydown, tax benefits and Depreciation. It even includes reinvesting the excess rent after mortgage and all Expenses! It includes 3% appreciation each year for Rent and Property Sale price. How does Real Estate in this example come way ahead of Stocks? After 30 years you have a 8.8% Compounded Return for all the work. Then the return will be even lower when you no longer have a Mortgage after 30 years.
Does anyone else have a spreadsheet to input the numbers and come with the same conclusion?
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I would propose the following:
a) Figure in the cost of a full time manager
or
b) Do it yourself.
If "a", then the costs of rentals vs stock investment is relatively easy and straight forward.
If "b", then since managing rentals takes time and effort (work), something similar should be added to holding stock to make this an even comparison. I came up with a paid position as a volunteer fire fighter. Like being a landlord, you don't know when you're going to be called to fix something. You can go long periods with nothing and then get one problem after another.
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OK, I had a friend make a spreadsheet that included 25% Tax Bracket, Depreciation, 5% Brokers Fee, Recapture Tax, Capital Gains Tax, and Closing Costs.
Let's assume 25% down, 30 Year at 5% rate. 3% appreciation for Home price, Rents, and Expenses.
Rent is 6% yearly yield after All Expenses including Management Fees, Cap Ex, Vacancies etc.
Let's assume Reinvesting the Cash flow into a Bond/Investment that gives 3% compounded return each year.
If you sell after 30 years the Return is 8.88% compounded. Not too good.
If you sell after 15 years, the Return is 10.52% compounded. OK, but not worth the RE work.
If you sell after 10 years, the Return is 11.12% compounded. Not bad.
So it seems the longer you hold RE, the compounded Return gets smaller and smaller.
Chiming in because it does not seem that anyone addressed this post.
With all due respect, Andy, I think you're ignoring the fact that in a long-term buy-and-hold real estate purchase scenario as you have outlined above, the purchaser is also receiving principal paydown on his loan (e.g., he's getting a paid-off asset). Yes, as stated previously in the thread, the return on rents will converge back to 6% as you essentially delever by paying off more and more of the principal on the loan (and subsequently having more and more of your money locked up in equity in the rental)... but you also have a paid off rental with some massive equity, which you can either re-lever, keeping your rental returns at those higher rates, or you can just sell the rental after it is completely delevered (read: paid off), and use the proceeds to buy stocks. All the while you will have been collecting rents, too.
RE makes money in one of four ways
1) rents;
2) appreciation;
3) principal paydown;
4) preferential tax treatment.
In your example above, it seems - to me - that you're ignoring 3-4. Factor in the principal paydown and appreciation (even at inflation rates) and you come out way, way ahead with RE versus stocks.
Something nobody has noted (I think) explicitly in the thread is the inherent effect of cheap leverage on the gains you enjoy from even modest appreciation. In ARS' example above, if you have a 100k house on which you've put down 20k, and the house appreciates even a piddling 2k per year, due to the magic of leverage, you are rewarded by an additional 10% return on your original investment just from that appreciation alone (2k in appreciation / your original 20k investment = 10%, completely independent of rents received).
Uncallable, relatively-cheap leverage is - IMHO - the best reason to consider RE versus stocks. Caveat emptor, of course, that it bites both ways, and if your house starts depreciating in value (due to Detroit style breakdown of the market), then the leverage will absolutely crush your returns. If your house loses 2k per year, you're losing 2k/20k = 10% right there. Ouch. So ideally pick an area that will stay flat/increase at pace with inflation.
Now let's all go get filthy rich.
Makinbutter,
The return numbers does include principal paydown, tax benefits and Depreciation. It even includes reinvesting the excess rent after mortgage and all Expenses! It includes 3% appreciation each year for Rent and Property Sale price. How does Real Estate in this example come way ahead of Stocks? After 30 years you have a 8.8% Compounded Return for all the work. Then the return will be even lower when you no longer have a Mortgage after 30 years.
Does anyone else have a spreadsheet to input the numbers and come with the same conclusion?
So let me get this right - you're assuming that all of the rents earned from the RE purchase are reinvested... in a stock/bond investment that returns 3% (!) yearly... and you're surprised that the long-term returns of the RE option in your spreadsheet are lagging?
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OK, I had a friend make a spreadsheet that included 25% Tax Bracket, Depreciation, 5% Brokers Fee, Recapture Tax, Capital Gains Tax, and Closing Costs.
Let's assume 25% down, 30 Year at 5% rate. 3% appreciation for Home price, Rents, and Expenses.
Rent is 6% yearly yield after All Expenses including Management Fees, Cap Ex, Vacancies etc.
Let's assume Reinvesting the Cash flow into a Bond/Investment that gives 3% compounded return each year.
If you sell after 30 years the Return is 8.88% compounded. Not too good.
If you sell after 15 years, the Return is 10.52% compounded. OK, but not worth the RE work.
If you sell after 10 years, the Return is 11.12% compounded. Not bad.
So it seems the longer you hold RE, the compounded Return gets smaller and smaller.
Chiming in because it does not seem that anyone addressed this post.
With all due respect, Andy, I think you're ignoring the fact that in a long-term buy-and-hold real estate purchase scenario as you have outlined above, the purchaser is also receiving principal paydown on his loan (e.g., he's getting a paid-off asset). Yes, as stated previously in the thread, the return on rents will converge back to 6% as you essentially delever by paying off more and more of the principal on the loan (and subsequently having more and more of your money locked up in equity in the rental)... but you also have a paid off rental with some massive equity, which you can either re-lever, keeping your rental returns at those higher rates, or you can just sell the rental after it is completely delevered (read: paid off), and use the proceeds to buy stocks. All the while you will have been collecting rents, too.
RE makes money in one of four ways
1) rents;
2) appreciation;
3) principal paydown;
4) preferential tax treatment.
In your example above, it seems - to me - that you're ignoring 3-4. Factor in the principal paydown and appreciation (even at inflation rates) and you come out way, way ahead with RE versus stocks.
Something nobody has noted (I think) explicitly in the thread is the inherent effect of cheap leverage on the gains you enjoy from even modest appreciation. In ARS' example above, if you have a 100k house on which you've put down 20k, and the house appreciates even a piddling 2k per year, due to the magic of leverage, you are rewarded by an additional 10% return on your original investment just from that appreciation alone (2k in appreciation / your original 20k investment = 10%, completely independent of rents received).
Uncallable, relatively-cheap leverage is - IMHO - the best reason to consider RE versus stocks. Caveat emptor, of course, that it bites both ways, and if your house starts depreciating in value (due to Detroit style breakdown of the market), then the leverage will absolutely crush your returns. If your house loses 2k per year, you're losing 2k/20k = 10% right there. Ouch. So ideally pick an area that will stay flat/increase at pace with inflation.
Now let's all go get filthy rich.
Makinbutter,
The return numbers does include principal paydown, tax benefits and Depreciation. It even includes reinvesting the excess rent after mortgage and all Expenses! It includes 3% appreciation each year for Rent and Property Sale price. How does Real Estate in this example come way ahead of Stocks? After 30 years you have a 8.8% Compounded Return for all the work. Then the return will be even lower when you no longer have a Mortgage after 30 years.
Does anyone else have a spreadsheet to input the numbers and come with the same conclusion?
So let me get this right - you're assuming that all of the rents earned from the RE purchase are reinvested... in a stock/bond investment that returns 3% (!) yearly... and you're surprised that the long-term returns of the RE option in your spreadsheet are lagging?
Makinbutter, I used 3% for reinvestment returns because I figured a lot of people in Real Estate don't want to put their excess cash flow into 100% Stocks. The OP was assuming you don't buy another Investment Property, so you will have to put it into Bonds/Stocks.
Let's use the Arebelspy original numbers with 10% reinvestment from Stock return to see what the projected return will be.
He said
$100,000 Purchase Price
20% downpayment
$2000 Closing Costs
4.5% 30 Year Mortgage
$1000 a month for Rent
$500 a month for all Expenses including Real Estate Tax and Cap Ex and Management Fees
3% Appreciation each year for Rents and Real Estate House Price
10% for reinvesting the extra Cash Flow after paying Mortgage and Expenses (Assuming owner puts 100% into S and P Index)
5% Brokers Fee
$2000 Closing Costs
Includes Depreciation Tax benefits and Principal pay down.
Includes being in the 25% Tax Bracket.
After 30 years you would have 11.93% Compounded Return.
It's pretty good, but not amazing for the amount of work and risk. At least for me.
What are your thoughts?
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PTF. I need to read this thread from the beginning.
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The original post was great. Unfortunately, I can’t find real estate that pays 1%+ in my local area (Northern California) and don’t like the idea of being a long distance real estate investor.
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$100,000 Purchase Price
20% downpayment
$2000 Closing Costs
4.5% 30 Year Mortgage
$1000 a month for Rent
$500 a month for all Expenses including Real Estate Tax and Cap Ex and Management Fees
3% Appreciation each year for Rents and Real Estate House Price
10% for reinvesting the extra Cash Flow after paying Mortgage and Expenses (Assuming owner puts 100% into S and P Index)
5% Brokers Fee
$2000 Closing Costs
Includes Depreciation Tax benefits and Principal pay down.
Includes being in the 25% Tax Bracket.
After 30 years you would have 11.93% Compounded Return.
It's pretty good, but not amazing for the amount of work and risk. At least for me.
What are your thoughts?
Well, cancel the 5% broker's fee and you have a "get one property and pay it down" strategy which some people stick with on something like an owner-occupied duplex or quad. But that's not the "make your fortune in RE" strategy.
Over long horizons, RE is not worth the effort on a "buy it and pay it down" method for a lot of people. But that's why RE is a leverage game. You get in and are making money magnified by leverage (money borrowed). The people who make the big money just keep releveraging. Risk is actually highest on your first property, and decreases on subsequent properties, providing you're not buying in the same city or neighborhood and you're picking properties well. So it's more a calculation of the value of a property in the first few years (what new leverage it provides you), because that leverage can keep getting magnified. These RE investors can replace their jobs by leveraging up to enough properties to simply become property managers.
Once you stop playing the leverage game and just pay things down, you turn back towards sub-stock levels over time. RE long-term is about repeatedly leveraged gains, not paying down one property. You can't borrow 250k tomorrow to drop into the S&P like you can to drop into your first quad (then your second, and so on). If your RE empire appreciates, you can just sell everything and be done. If it doesn't, you can still collect rent and either keep leveraging or wait until what you have appreciates, but keep in mind you're calculating the value of RE investment only according to the slowest strategy.
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Makinbutter, I used 3% for reinvestment returns because I figured a lot of people in Real Estate don't want to put their excess cash flow into 100% Stocks. The OP was assuming you don't buy another Investment Property, so you will have to put it into Bonds/Stocks.
Let's use the Arebelspy original numbers with 10% reinvestment from Stock return to see what the projected return will be.
He said
$100,000 Purchase Price
20% downpayment
$2000 Closing Costs
4.5% 30 Year Mortgage
$1000 a month for Rent
$500 a month for all Expenses including Real Estate Tax and Cap Ex and Management Fees
3% Appreciation each year for Rents and Real Estate House Price
10% for reinvesting the extra Cash Flow after paying Mortgage and Expenses (Assuming owner puts 100% into S and P Index)
5% Brokers Fee
$2000 Closing Costs
Includes Depreciation Tax benefits and Principal pay down.
Includes being in the 25% Tax Bracket.
After 30 years you would have 11.93% Compounded Return.
It's pretty good, but not amazing for the amount of work and risk. At least for me.
What are your thoughts?
Hey brother, I only point out that it seems prima facie obvious that if you assume all of your rents will return 3% in perpetuity that your overall return will converge on a much, much lower number. I can absolutely appreciate that you may not want to go 100% stocks, but it's pretty bad investing to stuff things into any vehicle that gives you 3% returns over the long run. If you do that, it seems that you're intentionally hamstringing the real estate side of this equation to make a closer comparison between real-estate-versus-index fund. A more realistic number would be to probably use the same projected return on rents received that you are using for the stock portfolio to do the comparison in the first place (say, 6-9% [?] above inflation).
I haven't number-checked for you, but yes, a +/- 12% compounded return does sound somewhat reasonable... with the inputs you have outlined above.
Spelling out some of those inputs:
1) You buy a house at market value of 100k.
2) The house only rents at 1k/month.
3) You lose a full 50% to expenses (e.g., you do not achieve economy of scale, get cheaper PM costs, find a system that allows you to get cheaper maintenance inputs in bulk, etc.)
4) You buy a property that appreciates exactly at inflation rates over the long-term.
Let's be clear: this is by no means a 'home run' deal (or even a 'good' deal - check over at BiggerPockets for a kazillion examples of people who are either finding houses that rent at 2% of purchase price monthly, or are wildly undervalued, or they appreciate wildly, etc.). This is just one work-horse property. Nothing fancy here.
You still beat stocks over the long-term, and by a multiple-percentage point margin.
Whether or not that is worth it TO YOU is another question - there is certainly some extra risk involved, but again, with a tiny bit of effort you can widen that delta in a major way by purchasing... better properties. :)
To tell you where I am coming from, I am a n00b real estate investor and I'm ball-parking a return somewhere in the low teens for my properties (even accounting for a very healthy/conservative buffer for outlandish maintenance costs). Is this worth it to me, compared to a relatively pain-free return from an index fund? Absolutely. Will I definitely win out of an all-stock portfolio? Who knows, let's check back in 30 years and drink a beer and throw piles of money at each other.
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Makinbutter, I think your approach to running the numbers is a good one. I find it best to not use one set of assumptions but rather several scenarios, some likely and others not. Weigh these as you decide. I did not expect 5 rented homes cash flowing 15+% in a major downtown city (purchased at well below rebuilding cost) to become effectively worthless 3 years later, as both renters and property managers dissappeared and a desperate city govt started charging taxes at values 20x market (and refusing to reassess). These properties became valueless, as cash flows for taxes and for the costs to address dumped junk & squatter tenants became unreasonable (who stopped paying rents, because they depended on eliminated rent subsidy/guarantees from local govt.). Effectively the govt was foreclosing on homes unless people were willing to carry high negative cash flows on temporarily unsellable properties. Sure, someone could have go in with a shotgun and managed tenants directly, but the neighborhood had collapsed.
This happened all over the country during the RE crisis. Empty subdivisions in Arizona, Vegas...downtowns of large cities with super distressed properties, banks going under and pulling lines of credit. Fortunately, after losing 100% on one deal I found a local home at a bargain price and it has made me back all I lost on those properties. I would be very cautious about betting my future on a few RE deals.
Will it happen again? I can't say. Newbie investors should realize that the stable spreadsheet assumptions may or may not happen. I see RE much more like buying individual stocks than index investing. Higher upside, higher risk and volatility of results.
Holy shit - mind explaining what metro this was in? Has to be Detroit, no...?
I do agree with your last point (bolded above), and if you don't *need* to make the extra bucks, you should probably weigh whether or not the juice is worth the squeeze, so to speak.
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Forgive me for pulling up an older thread but this has been on my mind recently and a search turned up this thread.
I just skimmed this thread and have a question:
In the OPs comparison it seems like we are comparing after tax stock investing to RE investing. In reality most human beings are not maxing out their tax advantaged accounts: 401k/403b, t-ira, roth, HSA. So, my question is how do real estate returns compare to first $32,000ish (depending on employer contributions) of tax advantaged retirement account stock market investing?
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After you max 401k/back door Roth space. Real estate is a fine investment, it is also one where if you know the market well, your returns can be great. Real estate is not an efficient market and a small amount of education goes very far. Like anything else, the more you do, the more you know. Investing in the rust belt can give mind blowing cash flow that is tax advantaged. It is also an investment that scales well. It is hard to pull in 250-300K gross a year on 2 million in properties in a HCOL area. In a LCOL area it is not that hard to do, especially if you bought houses when nobody was buying. Deep in the great housing crisis, Warren Buffet said he would buy a million SFRs if he could. -Smart dude
I would rather invest in a SFR or small apartment building at 5-6x gross right now than index funds at PE=30 at this point. It is more of a risk management move than anything. If stocks are several SD away from the mean, buy some RE with extra money. Reversion to the mean will most likely happen in the future as it has in the past. If houses are too expensive, do not buy them. If RE does not make good money after repairs either as a rental or a flip, do not buy it! If you do not have the temperment for individual properties, stay away from them. If you have the patience and a long term plan RE can be good. If you use Mara Salvatrucha to collect your debts, your collection rate will be really solid. :)
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Forgive me for pulling up an older thread but this has been on my mind recently and a search turned up this thread.
I just skimmed this thread and have a question:
In the OPs comparison it seems like we are comparing after tax stock investing to RE investing. In reality most human beings are not maxing out their tax advantaged accounts: 401k/403b, t-ira, roth, HSA. So, my question is how do real estate returns compare to first $32,000ish (depending on employer contributions) of tax advantaged retirement account stock market investing?
1+ This is what I was wondering as well.
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only you can do that math yourself since the tax deferment is based on your income level now vs post FIRE
ARS the OP of this was a teacher as was his wife so the tax benefits of those accounts were not as good to him as the RE investing was. He also hit the market at an excellent time for this right around the financial crisis.
in general if you're lower income RE leveraging is probably an excellent use of your free time to learn and start doing - if you're higher income the more hours you spend to increase your income in your line of work are probably more valuable.
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Yeah to get a truly accurate number, but ars was using a case study with a fairly generic setup if I remember the first post well.
Why do you say the tax benefits were useful due to him being a teacher? Are taxes better for lower income peeps in real estate?
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The assuming a low marginal tax rate in retirement (probably a safe assumption for most MMMers), the benefit of saving in save deferred vehicles like 401k, 403b and 457 plans are greatest if you're in an extremely high marginal tax bracket, and much lower if you're in a low one (which is generally where teachers are going to end up).
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Ahh gotcha =]
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A simple way to calculate your tax savings for tax deferred retirement accounts (403b, 401k, T-ira) is to take the amount you contribute and multipley it by your effective tax rate (your final tax rate not including FICA taxes). Average effective tax rate for americans is 13%, using that number:
401k/403b annual tax savigns on $18,500 contribution: $2,405
Tradional IRA annual tax savings on $5,500 contribution: $715
For an HSA the amount saved is the above plus about 8% savings for no FICA taxes.
Of course the "income earned" on the investment in the form of an increase in their value is also tax free but that is harder to quantify. For RE we pay tax on the income earned minus our expense to run the business (depreciation, qualified expenses, etc)
Of course, any employer contributions are free money and not counted in the above.
In my case after running the numbers on RE investment options vs. pre tax retirement accounts it is very hard to find a RE investment that out-performs the tax advantaged retirement accounts. I do invest in RE but only after maxing out all of these accounts.
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A simple way to calculate your tax savings for tax deferred retirement accounts (403b, 401k, T-ira) is to take the amount you contribute and multipley it by your effective tax rate
We normally use the marginal rate, not the effective rate, because it's the marginal dollar that is either going into the tax sheltered account or not going in to the tax sheltered account. You have to calculate the savings difference between those two scenarios in particular, since that's what you're deciding on.
Example: An average American worker earning $50k/year in 2018 is firmly in the 24% 22% tax bracket, but is likely to pay more like 10% or less effective tax, after deductions and such. If he puts $10k into his 401k he has $40k of income, and if he doesn't put in anything he has $50k of income, the last ten thousand dollars of which will be taxed at 24% 22%. His tax bill is $2400$2200 different between these two scenarios, so he "saves" $2400 $2200 by contributing to his 401k.
I prefer to think of tax sheltered accounts as mandatory. Any time you fail to max one out, you are voluntarily paying extra money to the government for the sole pleasure of spending less money in your lifetime (but slightly more money in the immediate short term). From that perspective, tax sheltered accounts are like inverse lottery tickets, a tax on people who are bad at math. If you're bad at math you buy lottery tickets and don't max your tax sheltered accounts. If you're good at math you max the accounts and skip the lotto. In both cases there is a mathematically optimal decision to be made, but millions of Americans choose otherwise.
edited for misreading the 2018 tax bracket table.
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Sol, that last paragraph is spot on. Amazingly these points appear to have been completely missed in the first 4 pages of this thread. Anyone that is earning income and not maxing out their pre-tax retirement accounts must compare RE returns vs. stock returns in pre-tax account to the extent which they can do so.
Im trying to understand the math you used to calculate the tax savings in your example of the 50k earner with a 10k pre-tax contribution. I understand that only the portion of income in the highest bracket is taxed at the highest bracket but the effective tax rate seems to take this into account. The last 10k of income for the 50k earner is taxed at the 24% marginal tax rate but marginal rates are meaningless if we want to know the amount of tax saved vs. scenario 1 and scenario 2 since the marginal rate is not the actual rate charged to the taxpayer. For a sanity check this calculator says that the 50k earner who contributes 10k to the pre-tax account will save only $1200 on their taxes, that is only half of what you said, so is it possible that there is an error in how you are calculating the tax savings or am I missing something?
https://ffcalcs.com/pretax_savings
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this calculator says that the 50k earner who contributes 10k to the pre-tax account will save only $1200 on their taxes, that is only half of what you said, so is it possible that there is an error in how you are calculating the tax savings or am I missing something?
https://ffcalcs.com/pretax_savings
That calculator is using a 12% marginal rate, exactly half of the 24% marginal rate you would pay if you had a 24% marginal rate.
For the 2018 tax year the brackets will all change. For a single filer, the 12% rate goes up to $38,700 of taxable income, not $50k, but it's taking off the $12k standard deduction first to get your taxable income down under $38,700. The effective rate would drop from 8.74 to 7.92%, in that case. My example above only applies to taxable income after the deduction, so you can replace $50k with $62k (https://ffcalcs.com/yjJxN) to add the deduction back in if that makes it clearer. I should have been more precise about separating income from taxable income.
Note that you are still realizing a tax savings equal to your marginal rate, whatever that is, not your effective rate.
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Okay Sol, you are really helping me out here, appreciate it!
I understand what you are saying now. It was tough to compare numbers since I was using 2017, you were using 2018 and you were using AGI and I was using gross income. Nevertheless I have been missing the point all along that the tax savings for the pre-tax contribution are in fact computed using the highest marginal rate (or several rates if the contributions span several AGI brackets). So, I have been underestimating the tax savings of the pre-tax contributions. This means that it will be even harder to find a RE investment that outperforms 401k,T-IRA,403b. I think this is important because for the vast majority of folks the choice is not a RE investment vs. post tax stock investment. In practice the choice is nearly always between a RE investment vs. tax deferred stock investment.
I found this article which explains this better than either of us can: https://www.kitces.com/blog/understanding-marginal-tax-rate-vs-effective-tax-rate-and-when-to-use-each/
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I think this is important because for the vast majority of folks the choice is not a RE investment vs. post tax stock investment. In practice the choice is nearly always between a RE investment vs. tax deferred stock investment.
Do you mean the majority of people generally or the majority of people in this forum? In the general population I agree with you. In the forum, lots of folks with savings rates up in the 40-60% range (or even higher) have already run out of tax deferred savings space, so they would be comparing taxable stock investments to real estate investments.
But if you are comparing these investments, shouldn't you be comparing it after adding the tax at your FIRE marginal rate back in? You're still paying the tax, it's just deferred.
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I think this is important because for the vast majority of folks the choice is not a RE investment vs. post tax stock investment. In practice the choice is nearly always between a RE investment vs. tax deferred stock investment.
Do you mean the majority of people generally or the majority of people in this forum? In the general population I agree with you. In the forum, lots of folks with savings rates up in the 40-60% range (or even higher) have already run out of tax deferred savings space, so they would be comparing taxable stock investments to real estate investments.
But if you are comparing these investments, shouldn't you be comparing it after adding the tax at your FIRE marginal rate back in? You're still paying the tax, it's just deferred.
No, we are talking about the tax savings which are not tax deferments, these are an actual discount that is never paid back to the IRS. In essence this is "free money" There is no equivalent for RE investments that I am aware of. And, you dont pay income tax on the tax discounts, so as other scenarios you are better off saving $1 than making $1 extra because you only get $.80 of the $1 extra you made while you keep the whole $1 you saved.
I have no idea how many forum people are maxing out their tax deferred accounts. None of the active RE investors I know in real life do. Tax deferred is a bit of a misnomer since these are actually tax discount + tax deferred accounts.
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I think this is important because for the vast majority of folks the choice is not a RE investment vs. post tax stock investment. In practice the choice is nearly always between a RE investment vs. tax deferred stock investment.
Do you mean the majority of people generally or the majority of people in this forum? In the general population I agree with you. In the forum, lots of folks with savings rates up in the 40-60% range (or even higher) have already run out of tax deferred savings space, so they would be comparing taxable stock investments to real estate investments.
But if you are comparing these investments, shouldn't you be comparing it after adding the tax at your FIRE marginal rate back in? You're still paying the tax, it's just deferred.
No, we are talking about the tax savings which are not tax deferments, these are an actual discount that is never paid back to the IRS. In essence this is "free money" There is no equivalent for RE investments that I am aware of. And, you dont pay income tax on the tax discounts, so as other scenarios you are better off saving $1 than making $1 extra because you only get $.80 of the $1 extra you made while you keep the whole $1 you saved.
I have no idea how many forum people are maxing out their tax deferred accounts. None of the active RE investors I know in real life do. Tax deferred is a bit of a misnomer since these are actually tax discount + tax deferred accounts.
Until next month, my wife and I have both been maxing our 401Ks and we are real estate investors. So there are two of us.
(To be accurate, though, we both FIRE in May so that's going to be harder this year (and in years following). We're looking into setting up a self-employed 401K for me. We have to figure out if the tax savings from 401K employer/employee contributions (or as close to max as we can get it) is worth doing or not. Lots of rules to look up, because I don't want to take rental property income and convert it to wages and thus cause it to to be subject to SS and Medicare taxes in addition to the income tax it's already subject to. Trying to find out if I can minimize my "employee" contribution and maximize the "employer" contribution.
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No, we are talking about the tax savings which are not tax deferments, these are an actual discount that is never paid back to the IRS.
Well, it's a little bit of both. Yes you are deferring taxes until later, and yes you are saving by paying less taxes, but it's not like the money you put into a 401k is automatically untaxed forever. You do have to pay taxes on it when it comes back out.
But the advantage is that when you make the contribution you are avoiding paying taxes at your (usually high) marginal rate, off the top of your total income, and then when you withdraw you are paying taxes on it from the bottom of your income (including in the 0% tax bracket, aka the standard deduction).
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No, we are talking about the tax savings which are not tax deferments, these are an actual discount that is never paid back to the IRS. In essence this is "free money" There is no equivalent for RE investments that I am aware of. And, you dont pay income tax on the tax discounts, so as other scenarios you are better off saving $1 than making $1 extra because you only get $.80 of the $1 extra you made while you keep the whole $1 you saved.
I have no idea how many forum people are maxing out their tax deferred accounts. None of the active RE investors I know in real life do. Tax deferred is a bit of a misnomer since these are actually tax discount + tax deferred accounts.
3/3 Mustachian real estate investors who fill their tax deferred accounts before adding to the down payment kitty.
Well, real estate does have tax advantages. Paper losses via depreciation that you get to take against your rental income, which the majority of the time brings the taxable rental income to ~=<0. Like tax deferred accounts, those will come back as income in the future if you decide to sell but hopefully that would be at a point when your marginally tax bracket is lower. If your investments are profitable enough that you do have positive income, then 20% of that is deductible.
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(including in the 0% tax bracket, aka the standard deduction).
To be pedantic, the 0% tax bracket isn't the same as the standard deduction (nor is it the same as the personal exemption [may it RIP *]).
https://taxfoundation.org/2018-tax-brackets/
* Until it (possibly) returns.
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(including in the 0% tax bracket, aka the standard deduction).
To be pedantic, the 0% tax bracket isn't the same as the standard deduction (nor is it the same as the personal exemption [may it RIP *]).
https://taxfoundation.org/2018-tax-brackets/
* Until it (possibly) returns.
You may notice that in the table you linked, there is no 0% tax bracket.
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You may notice that in the table you linked, there is no 0% tax bracket.
Sigh. How embarrassing. Please ignore my previous post.
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Sigh. How embarrassing. Please ignore my previous post.
No problem, this stuff is super confusing.
There used to be large options for declaring tax-free income, through the standard deduction, the personal exemptions, the dependent exemptions, deductible accounts like 401ks, and (in some cases) by offsetting income above the 0% tax rate with tax credits, for example the EITC, child tax credit, or the various savers credits. Together, these made it pretty easy for a family with a couple of kids to have up to ~$60k of income and still pay zero taxes without even itemizing!
Things are a little harder now, and this impacts mustachians who are planning on drawing relatively low incomes from their 401k accounts in retirement because it looks like we will face higher tax burdens under the new law than we did under the old one (but lower tax burdens while still working and earning money). These are exactly the sorts of complications that make it so hard to compare real estate returns to stock returns. The tax treatments are very different, not just in percentages but in what amounts count as income at what times.
For example, I make more money in property price appreciation than I do in rental cash flow. If I pocket $10k in cash from excess rents this year, that amount is not taxed as income until after I deduct depreciation and expenses from my gross rents (making my net rents, the most important part, kind of an afterthought in the taxation process). If the value of the home goes up by $20k in the same year, I pay zero taxes on that increase until I sell the house, at which point I pay either capital gains (which depends on my income level) or depreciation recapture or both. But those taxes are only due in the future, and are potentially avoidable if I hold the property until death and pass it on as an inheritance. The whole system is just loopholes on top of loopholes and exceptions to exceptions.
Income tax, by contrast, seems relatively straightforward despite the myriad of deductions and credits you can get. At least there's a form to walk you through the process, unlike RE taxes which are just a black box to most people.
edit: there IS a zero percent tax bracket for capital gains income, if your total income is in the 10 or 15% income tax bracket. That makes total sense, right?
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Forgive me if someone already pointed this out. But to me, the biggest argument against real estate as an investment is not the maths....its that owning rental RE is not "passive" income like stock ownership is.
Owning, maintaining, cleaning, repairing, managing real estate for 30-50 years vs enjoying life while your stocks grind away without you doing a thing???
Having said that, I own just such a rental property. It returns around 10% a year....but with a good deal of effort on my part.
BUT - I also get to enjoy that property by staying in it or having a great place for guests to stay. Hard to apply "the maths" to that.
See the MMM article on being a lazy landlord....
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Hey guys,
Sorry if I just missed it but I'm curious about the variability/risk comparison. Leverage should increase risk but it feels like real estate returns would vary less overtime than stocks right? I am not sure how to do this analysis since mass data isn't available like it is for stocks but if stocks and real estate earned relatively the same return BUT the variability in that return from year to year was greatly reduced that would still make real estate a worthwhile investment.
FYI-i currently have no real estate holdings, but have been considering this question recently. If risk and return is relatively similar, I'll take the passive route.
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If you look at real estate as a class, yes the volatility is lower than the stock market. However, to get the volatility and returns of the whole class of real estate you'd need to own a significant numbers of properties in a substantial number of markets without incurring substantial management costs. (REITs give you geographic diversification, but at the cost of significant management expenses and a lot more exposure to interest rate/credit risks than you'd have as an individual investor with 30 year fixed rate mortgages.)
As an individual investor with less than 10 units, individual events -- rather than market conditions -- are going to produce a lot of your volatility in personal rate of return. Maybe one year everything goes right and you match or beat the "real estate market" return. In another year, you find out you unexpectedly need to replace the roof on one unit, two others sit vacant for a while as it takes an extra month or two to secure new tenants when your old one leaves, and you're also forced to evict a tenant from a fourth unit when they lose their job and stop paying rent and you end up with well below the average returns for a real estate investor.
For single real estate investors, second biggest source of volatility after individual events might be regional ones in the city where you are buying the rental units. A major employer leaves town. Amazon opens a new headquarters ("head-eighth" now that it's split?) in your neighborhood. A new freeway cuts the neighborhood with your rentals off from the rest of the city and rents drop. A new Trader Joes/Whole Foods opens three blocks away and rents rise (apparently this actually makes a significant difference).
If I could invest in an index fund of real estate across the USA or world that utilized 30 year fixed rate mortgages and had a total expense ratio similar to what we might see from Vanguard/Fidelity I would do it in a heart beat. It's the non-passive involvement required and volatility of real estate returns for individual small sets of properties that have convinced me that real estate is not for me (even though it does great things for other people).
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Forgive me if someone already pointed this out. But to me, the biggest argument against real estate as an investment is not the maths....its that owning rental RE is not "passive" income like stock ownership is.
Owning, maintaining, cleaning, repairing, managing real estate for 30-50 years vs enjoying life while your stocks grind away without you doing a thing???
Having said that, I own just such a rental property. It returns around 10% a year....but with a good deal of effort on my part.
BUT - I also get to enjoy that property by staying in it or having a great place for guests to stay. Hard to apply "the maths" to that.
See the MMM article on being a lazy landlord....
I own 3 properties that are rented out. I buy them for cash in distressed state, so getting them up to snuff using sweat equity is a non-trivial investment of my time.
BUT -- after I have them repaired I hand them over to a property management company and have little to do with them after that. The property management company inspects them, rents them, deals with the tenants, dispatches repair staff and even goes to court on my behalf if need be.
If I had bought a rent-ready unit per the example in this study, I would not even have the big investment in time to renovate them.
So, it's a myth that owning rental homes REQUIRES a huge input of personal time.
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I am not sure how to do this analysis since mass data isn't available like it is for stocks but if stocks and real estate earned relatively the same return BUT the variability in that return from year to year was greatly reduced that would still make real estate a worthwhile investment.
There was no implication that real estate isn't worthwhile. Just a comparison of returns over very long periods of time.