After years of financial education, I have become a fairly simple guy when it comes to making investments. I simply want to maximize my return while mitigating my risk. I do not try to pick individual companies due to their product, story, or financial valuation. I do not try to pretend that I know which sector of the economy is going to boom next. Finally, I do not invest in areas that would require a time commitment to earn comparable returns to the S&P 500, if that time commitment would be a distraction from other, more meaningful areas I could spend that time in.
Today, I am alluding to real estate investing. After years of running the numbers in the Portland, Boston, and Los Angeles markets, I have found that it simply is not for me, and I would argue that purchasing individual rental properties is not meant for most. Many go down this path because the appeal is easy to understand: if I can buy a $300,000 multi-family home with a $1,400 monthly mortgage, then rent it out for a total of $2,000, I am clearing $600 per month. I also can historically achieve a 3 to 5 percent annualized return on the home's value, slightly outpacing inflation. Certain cultures prefer to hold these types of investments because they can at least feel like they own a physical asset, while an investment account does not provide the same satisfaction.
What does not typically get factored into a real estate investment analysis, or most investments for that matter, is what can go wrong, or what the unintended consequences will be. If you are just entering the arena, how steep will your learning curve be? How much money will you lose along the way due to a vacated unit, an unexpected repair, or simple bad luck of buying at the wrong time? When will you need to sell the property? Since real estate is not easily liquidated, could you lose money having to sell quickly due to a divorce or medical emergency?
Who should become a real estate investor of individual properties?
Let's first remember that you are competing with commercial companies whose full time job is to purchase, remodel, and rent out properties. They live and breathe the business and have exponentially more resources than you due to the time they have spent in your market. That does not mean you cannot pluck off an undervalued property, it just means you should be doing your due diligence. If your 9 to 5 job is simply unsatisfying and you're ready to get your hands dirty taking on some of the roles I will mention in a minute, there may be a fit.
I would highly recommend reading a book called The Millionaire Real Estate Investor for anyone considering the plunge. Though written prior to the 2008 housing crisis, the fundamentals remain the same. I am happy to share my notes from this book, but one of the bigger takeaways I had involved just how large of a network you would need to build in order to be successful. Here is a quick excerpt from my notes:
1) Inner Circle: consultants, partners, mentors.
2) Support Circle: property managers, attorneys, lenders, real estate agents, investors, accountants, contractors
3) Service Circle: appraisers, inspectors, leasing agents, builders, appliance rentals, cleaning services, lawn service, flooring and carpet, carpenter, electrician, painter, maintenance technician, courthouse clerks, masons, plumbers, roofers, concrete companies, insurance agents, financial planners, developers, landscapers, title companies
-frequency of engagement
1) inner circle: each month
2) support circle: each transaction
3) service circle: as needed
-The right people in the three circles will provide you with: 1) leadership and advocacy, 2) advice and management, 3) work and results
- asking for help and getting the right relationships BEFORE you need them is key
I would recommend taking a long, hard look at that vast list of professionals and ask yourself: which of these roles am I capable of taking on myself? Be honest; if you do not have experience in the arena, don't assume it will be easy.
Having said that, if you are willing to invest time, you will be saving the hourly rate that you would otherwise be paying someone else. This can certainly increase your profit potential. But how much do you currently make at your full time job? Assuming a 2,000 hour work year, a $100,000 earner should be valuing their time at $50 per hour. If we set aside the lost time for family and leisure and assume you are looking for a way to increase your earning potential, are your Saturdays better spent working on your investment property, or increasing your earning potential in your profession? Remember, "increasing your earning potential" could directly mean overtime, or taking on educational programs to improve your value and capabilities.
The turning point for me was reading that list and realizing that I would not enjoy trying to pick out five of those professions to learn and complete myself. Additionally, hiring a property management company to complete many of those tasks for 4-8% of the property's value defeats the purpose of doing this on your own. Luckily, I love the work I currently do and would much rather invest time in expanding my capabilities as a financial advisor.
What are REITs and why should I have any real estate in my portfolio?
A real estate investment trust is a company that owns, develops and redevelops real estate assets. You essentially provide the capital for the company to invest and reap the profits and losses of that company. Publicly traded REITs and REIT funds offer liquidity and low investment minimums. You could also explore the riskier world of public, non-traded REITs and private REITs.
REITs recently became the 11th sector to be added to the S&P 500, pulling them out of the shadows of banks and insurance companies. REITs have been the best performing asset class over the last 20 years, achieving an annualized 10.32% return, beating small/mid caps at 9.53% (as of 2016).
REITs are required by law to maintain dividend payout ratios of at least 90%, making them a favorite for income-seeking investors. REITs can deduct these dividends and avoid most or all tax liabilities, though investors still pay income tax on the payouts they receive. Many REITs have dividend reinvestment plans (DRIPs), allowing returns to compound over time. They are tied to almost all aspects of the economy, including apartments, hospitals, hotels, nursing homes, offices, shopping malls, etc.
The main benefits include diversification, performance, and liquidity. For the casual investor, purchasing a fund will take zero time, guaranteeing you less headaches while likely providing better returns than if you had tried to purchase a property on your own. The Vanguard and iShares funds listed below are a great starting point for any investor. Before you commit to a second or third mortgage that locks you into a world you may not fully understand, consider these viable alternatives.