How risky is real estate?

Question

I have a friend who plans to retire by putting all of his money in local real estate. He makes a huge return on investment on the property he has now - something like 25%. Fundamentally, I think there is a tradeoff between risk and reward, which makes me think that this strategy must be extremely risky. However, I can't put my finger on exactly where the risk is and how high it is.

I will spell out more of the details below, but can someone either explain to me why the standard risk-reward paradigm doesn't apply, or point out where the risks are and how risky they are?

This friend is buying property in Lincoln Nebraska. He took out a mortgage for a $100,000 duplex with $30000 down 10 years ago. He charges $600 per side. The mortgage, insurance, and taxes on the duplex are about $600/month, so the other $600/month is pure profit. Per year that is $7,200 on a $30,000 investment, which is 24%. That is not to mention the equity he is building by paying off his mortgage and the rise in price of his property, which is now worth $150,000.

He tells me he works about 4 hours a month on average making repairs, collecting rent, looking for renters, etc.

Is this a normal scenario? If so, where is the risk? If there isn't much, why doesn't the standard risk-reward paradigm apply?

Answer 1

Where is the risk? The short answer is...

Property damage from weather, termites, tenants, whatever.

How about tenants who stop paying the rent and you need to go through legal channels to evict them? It doesn't cost a fortune but you had better not need that rent to make the mortgage.

How about another GFC (Global Financial Crisis) like 2008 when home prices collapsed. How do you think that your friend got that $100k home for only $30k? Think about owning when going from $150k down to whatever. Contact local realtors and find out how much the average property value loss was back then. I didn't read the stories but I search on Lincoln Real Estate and the first article was "Lincoln home sales level off after years of big gains". The average home price ratio to rent ratio increases when that happens and it makes it harder to achieve a positive cash flow.

Long before 2008, I had a rental property that lost 25% of its value during a bad period. Not as bad as 2008 but still not fun. Make sure that you can withstand that.

Answer 2

where is the risk?

• Losing renters
• Damage done by renters
• Unexpected maintenance
• Legal liability
• Capital losses

Other factors that should be included in expenses:

• Routine maintenance
• Paying the landlord (essentially a part time job for him)

I'm not saying it's a bad investment - and it sounds like he has a decent property for an amazingly cheap price, but those are some of the risks involved. I assume he didn't charge $600 for rent ten years ago, so using today's rent to calculate return is not accurate. You'd have to look at the average return over the 10 years based on the rent collected and the capital gains (which is extraordinary).

Also note that with a mortgage, the property is leveraged, which multiplies the rewards, but also the downside if something goes bad. If the property were bought today with cash at market value, the return would be less than 5%, but it would have no risk of foreclosure. Without a mortgage, he could be more choosy with renters by letting it sit vacant for a few months.

Answer 3

The biggest problem your friend has isn't the risks associated with real estate per se, and the existing answers have covered those pretty well.

The problem is that your friend is about to sink their entire net worth (or some appreciable fraction thereof) into a single asset class.

Not a great plan.

The problem is systemic risk: for example in this case what happens during a housing crisis like the one we all lived through in the last decade? What happens when all your money is in stocks and the S&P 500 goes down 20%? All your money is in the bonds of some group of countries that all default at the same time?

If you don't need the money/income then a lot of times you can weather the storm, but it only takes one forced sale during a downturn (or complete destruction of an asset) to wipe out years of growth.

People usually think of diversification within an asset class (like buying a bunch of stocks instead of just one) but it's arguably as or more important to diversify across asset classes.

Answer 4

So the general rule for real estate investment (in North America) is this: only do it if you love the idea of doing it.

If you love the idea of being a landlord and property manager, you think the Monopoly Guy had the right idea, and you think hours spent repairing units and analyzing property spreadsheets and browsing property listings are a really fun hobby, then go ahead and use real property as an investment vehicle and income source. But if you are literally anybody else who does not love the idea of being a landlord or property baron, and you just want reliable passive investments, do not pursue real estate investment.

The costs he is missing are:

• Maintenance and repairs
• Depreciation and/or upgrades
• His own labor costs of management
• Purchasing costs, including lawyer, title, agent (and his own labor again)
• Concentration of risk

There was a great study released 2015 titled The Rate of Return on Everything, 1870–2015 and it found that, for the US, the average rate of return on equities is better than housing. Modern US equities are around 9% returns and modern US housing is around 5.6% returns. This is true if you look at 1950-2015 or at 1980-2015, but US equities outpaced US housing over the whole scope of the period studied.

The study looked at returns from housing including rent net of maintenance and other costs. If you just look at housing as a buy-and-hold asset, like for your personal residence, then the Case-Shiller returns are something like 3-4% on average. While the S&P 500 is more like 9-10%.

So equities are better investment, so long as you can keep your investment costs low and you are appropriately diversified.

Your friend is underestimating repairs and depreciation. Eventually, major appliances will need to be replaced or repaired, the roof or the water heater or the air unit will need work, and other things will need attention. He is not setting aside any money for these costs, so it looks like profit but actually he's depreciating the value of his property. His property may still be worth more than it was in the past, due to general inflation or because the area around it is in demand, but eventually the rent he can demand and the sale price he could expect will be affected by neglecting to upgrade.

He is also underestimating the work he spends on it. Part of the return is for his labor, so property management is not just a true passive asset, it has a big active component. He is earning money for his services and if he stopped doing them, then either he would pay somebody else to do it (increasing his costs) or he would lose tenants and eventually maybe suffer lowered rents due to bad reviews from his neglect. So you need to analyze it as partly a part-time job or business.

The transaction costs are often much higher for real property. You do a lot more browsing to find the right property, you pay agents and lawyers and title companies and inspectors. It takes weeks or months to complete. And you have to go through it again at sale. Whereas it is comparatively painless to buy a few index funds, and the trading fees in some cases are free or very cheap.

Also, real property concentrates your risk. If you own a few index funds, you are heavily diversified in your risk and your investment returns are the same if you check your balance everyday or if you spend 12 months in a coma. You can move across the country and your equities do not care. Whereas the owner of real property can suffer greatly if the areas where they own property are affected by economic downturn, natural disaster, crime, or slumping demand. If you own units in 3 neighborhoods and 2 of them are suffering, you can be hit with lowered rents and lower anticipated sale price - loss of income and loss of stored wealth at the same time. And the owner of active rental property cannot spend months on a beach without paying somebody to manage the properties, collect rents, etc. If the owner wants to retire and move across the country or across the world, then either somebody has to be paid to manage the properties, or the properties have to be sold. Rental property concentrates your wealth in a few major assets and is difficult to diversify, unlike publicly traded equities.

Somebody who loves real estate will do it. They might like the respect of being a landlord, they might appreciate the concrete nature of owning a patch of land, they might like feeling like a burgeoning tycoon. Passive investment in a few index funds will rarely give you any of those things. But it gives more reliable higher returns, requires incredibly little knowledge or work, allows a lot more personal mobility, and involves far fewer costs.

Answer 5

I can jump in on this as a family with a lot of property.

First off, I personally wouldn't mortgage an investment like this. He got lucky with this duplex but it can still go south.

Over the years, we have seen a wealth of horrors like you wouldn't dream of from tenants who have destroyed our properties over and over again. Everything from dead sea snakes, to whole rooms that look like their only goal over their tenancy was to fill it with dog poo. We had the SWAT team raid one of our houses to arrest our tenant who had refused to pay rent for 3 years and nobody could track him down to collect. The swat was unrelated to rent, by the way, and they didn't get him. Next day the entire house was ripped to pieces and all the copper was stolen from the walls. This was the handy work of our tenant who is finally gone from our lives. Our part was $15k in damages. Insurance took care of the rest.

And that's the house in a good neighborhood.

One of our houses has the water main run 10 feet below a paved driveway. Didn't know about that when it was bought. How much do you think a rupture costs to fix in that case?

Point being, 24% is not 24%. It is stashed away for as long as necessary because at some point one of the properties will hit you with something hard and if you don't have the reserves to cover it without credit, you are then stockpiling empty, unrentable spaces. Guess what a joy getting rid of squatters who have discovered a vacant property is.

One of our neighborhoods was recently overhauled by some rich group. They turned every conceivable piece of land into mini-dorms which are far more appealing to the people who rent in our neighborhood. This changes the rentability of those properties. One has been vacant for 6 years. A lot of that has to do with personal management and risk, but it is a factor.

I could go on forever on this subject, but the point I'm trying to make is that property always sounds like a good idea and definitely can be. It is a venture that even amateurs can get into without losing everything but is not as safe as one might think just by looking at the numbers. If one were to put everything they have into property, I would advise to diversify first and ensure your real estate ventures are not going to be problematic if you cannot rent or flip the properties within a reasonable time frame.

As for why the normal risk/reward paradigm doesn't apply... it does. But it is a much more involved calculation than something much easier like normal bank investments. For the sake of conversation, buying and selling textiles can generate thousands of percent in profits. You wouldn't get into that market without research. I would advise the same thing about real estate.

Answer 6

Per year that is $7,200 on a $30,000 investment, which is 24%.

That's not the way to calculate the yield. If I spend $1 on a lottery ticket which wins me $100, then I deposit the $100 in a bank account which earns $5 per year, then that bank account is earning me 5%, not 500%.

Let's look at the numbers again:

This friend is buying property in Lincoln Nebraska. He bought a roughly $100,000 duplex for about $30,000 10 years ago. He charges $600 per side. The mortgage, insurance, and taxes on the duplex are about $600/month, so the other $600/month is pure profit. Per year that is $7,200 on a $30,000 investment, which is 24%. That is not to mention the equity he is building by paying off his mortgage and the rise in price of his property, which is now worth $150,000.

So, he bought the property for $30,000 and it's now worth $150,000. That's a 17.5% gain per year. Pretty nice, but will the property continue to appreciate at that rate?

Meanwhile, if it's now worth $150,000, and he's earning $7,200 per year, the yield is 4.8%. That's not "a huge return on investment" at all.