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How many times in your life have you heard “Real estate is always a good investment?” Probably quite a few. I’m here today to tell you that anyone who has said that probably has never owned a home or actually invested in real estate. Most people misunderstand real estate and without a proper understanding, you’re sure to lose money.
Things I’m covering today:
The two ways investments make money
Moving a home from your balance sheet to income statement
Why making cash on rentals isn’t enough
Alternative ways to invest in real estate
Home Ownership ≠ Investment
Let’s start off and consider what an investment is. An investment is something we put money into with the hopes of receiving more money in return based on a certain time horizon and risk factor. You receive returns one of two ways; total return appreciation or a series of money that is generated along the way.
When people saying buying a home is an investment, they’re speaking about the first type of return. They hope that when buying the home, that it will appreciate over the life of your ownership which you can then sell for more at a later time.
This does happen, but there is a glaring issue with home ownership that is regularly overlooked. Consider…
Case study: Let’s say you buy a home in, what you think is, an up and coming neighborhood. You pay $200k for the home and three years later the home is worth $225k (above the 3.8% average appreciation per year).
Did you make $25k? Probably not even half of that.
To sell the home, you need to make any repairs contingent on selling (not to mention any done while living there) and then real estate agent fee to sell.
THEN you need to live somewhere still right? You’re likely upgrading homes so you buy a larger home which entails larger closing costs, another real estate agent transaction, moving costs, and a down payment. Still think you made money?
Let’s say in a good scenario all of that only cost $10k. The fifteen thousand you made would equate to a 7.5% gain over three years which is typically what the market returns in one.
Lesson here is that there are many side costs associated with buying and selling a home that should be accounted for. Also, it’s important to look at things in terms of percentages and not dollars.
Owning a home generally costs you more money over time than what you’re likely to make when it comes time to sell it. The good news is that that’s okay - you need somewhere to live! A different approach should be taken when thinking about investing your money in real estate.
While owning a home is an expense to you, putting your money in a money producing asset moves something like a home from your “personal balance sheet” to your “personal income statement”.
Making Money Investing in Real Estate
One of the most popular ways to consider getting into real estate is buying a rental property. The whole idea with owning a rental is to charge more for rent than your monthly mortgage payment on the house.
Example: The easiest, most popular example of this is a house hack. You buy a duplex and your monthly mortgage on it is $1000. You charge $1000 for the other half of your duplex to be rented meaning you live for free.
This example misses out on what makes investing in real estate through rentals extremely powerful; depreciation. Depreciation is a tax advantage you gain by owning an investment property (a home you don’t live in). The tax advantage allows you to write off the costs of the rental against the income you gain by renting.
Depreciation is one of the many advantages you get of investing in real estate. Some of the wealthiest people in America have made their fortunes by taking advantage of how real estate tax and laws work.
I’ll never miss a chance to talk about the wealth inequality gap so here’s my chance. There is a massive divergence in how the wealthy and how the middle class view real estate. The follow chart shows that the bottom 80% of wealth class in America has their wealth tied up in their primary residence. Remember how I’ve said your home is not an investment? This is why.
Real estate is a great asset class to be invested in, it just needs to be viewed through the correct lense. Understanding that your home is not an investment is the first step of that. While I’m all about buying rental, there are other easier ways to be invest in real estate that require less money and won’t require you to unclog any toilets at 3am.
Alternative Real Estate Investments
The first way you can easily invest in real estate is by buying individual REITs or real estate investment trusts. REITs are a tax advantaged security that trades like a stock that you can purchase in an individual brokerage account or a retirement account. What makes these unique is by law, REITs are required to pay out 90% of their earnings back to shareholders. That means that you as a holder/investor will be distributed dividends from the company’s earnings.
One example of a REIT is American Tower (NYSE: AMT) which owns properties that are leased to cell phone service providers. AMT, due to its operational excellence and niche offering, has performed very well. Not only have owners been distributed dividends, but the stock price has appreciated and beaten the SP500 over the last 5 years.
The second way you can add real estate to your personal portfolio is by owning an ETF or exchange traded fund which is just a basket of multiple REITs. An example of this is Vanguard Real Estate Index Fund ETF (NYSE: VNQ) which is the largest real estate ETF. ETFs are a great way to own one thing that diversifies you across many areas
Picture below is a photo of the holdings of VNQ based on different sectors.
A last, and relatively new way to invest in real estate is something called crowdfunding. With websites like Fundrise and Crowdstreet, you can pool your money with other investors and take part in different projects around the country. The platform does all the work, sourcing the deals which range from commercial to residential and then collecting money from all investors that want to take part based on their risk profile.
Understanding the difference between something that takes your money and something that creates you money is the differentiator in tackling real estate. If a home you own is sitting on your personal balance sheet and not on your income statement, don’t plan to make money off of it.
Let me know how I did this week? Choose your response so I can improve!
Talk next week