The idea of owning real estate is appealing for many investors. In this piece, we’re particularly referring to the direct ownership of residential real estate, such as single-family homes, condominiums and apartments. These are properties held for rent, so we usually do not include a personal residence in this discussion.
There are many potential benefits of owning a real estate investment property. First, it is typically a good inflation hedge, producing income that keeps pace with cost of living. Rents received help the owner build equity as debt is paid down over time. Our tax laws currently provide favorable treatment on income received, which is often attractive to those in higher tax brackets.1 Certain real estate investments might even have higher expected returns than a passive equity portfolio. Finally, some people simply like owning tangible assets – things they can see and touch.
That said, it’s important to remember there is no “free lunch” in investing. If an excess return can be expected from real estate, there are good reasons for that. Part of the return comes from leverage, labor and various other risks of owning properties. Let’s explore some of these risks and considerations.
1. Leverage: In most cases, real estate investors acquire properties using debt and carry a mortgage on the property. For example, let’s say you purchase a $500,000 rental property with a 20 percent down payment while borrowing the remaining 80 percent. Your starting equity is only $100,000, but the leverage gives you an extra $400,000 to be put to (hopefully) productive work. Higher expected returns from real estate are often directly related to the amount of debt carried.2 If your property produces returns that exceed the cost of servicing the debt, the risk may be worth the reward. However, it’s important to remember that debt can also magnify your losses as well.
2. Labor: Owning real estate can be time consuming. Finding tenants, collecting rent and dealing with maintenance issues are just a few of the things that take time and effort. You could hire a property manager, but that will detract from your returns as they typically charge a percentage of rent received (7 to 10 percent).3 Furthermore, there’s the risk a management company won’t be as focused on keeping the properties fully rented throughout the year as you would be.
3. Investment opportunity cost: Real estate investors are usually familiar with calculating the net operating income (NOI) from a property.4 One point often overlooked is that even if your NOI is positive, your cash flow could be negative. This is mainly due to the additional cost of servicing debt. The result is you must continue contributing money for many years to keep the property running. This can be true even if you have full occupancy and a reliable income stream. The situation worsens when there are vacancies or large expenses for repairs or replacements. The opportunity cost should be considered because this same cash flow could be redirected to other productive investments.
4. Concentration risk: By owning real estate, you implicitly agree to take on some form of concentration risk.5 You’re owning a property in a particular geographic area with its own unique source of risk and return. It can take successful real estate investors years before their real estate portfolio is diversified enough to mitigate this risk. Like any investment, buying properties when they are inexpensive is wise, but it is no trivial matter knowing when those opportunities are available. It is often said that location is everything with real estate. This is true because every location has its own unique supply and demand dynamics and economic fundamentals. The more reliable you perceive the income stream to be from a property, the more likely you must pay a premium price and lower your future expected return. Again, no free lunch.
5. Liability: The last thing investors want to worry about is the risk of one investment impacting another area of their investment portfolio or personal assets. But that’s precisely what can happen with real estate. Suppose you own a rental property in your own name, which is a common occurrence when a primary residence is converted into a rental. Then someone unfortunately gets injured on your property and files a lawsuit against you. There are ways to mitigate this risk through liability insurance and/or owning property in a separate legal entity, such as a Limited Liability Company (LLC)6, but this adds another layer of complexity and cost to your investment decision.
While valuations are beyond the scope of this piece, we can make some generalizations. If you have a long-term expected return of 7 to 10 percent on a passive equity portfolio, you may want to target a return of 9 to 12 percent (or higher) on directly owned real estate to compensate for the risks previously described. I’ve worked with many clients where we take an honest, conservative look at financial projections on properties they own and we often find the investment potential is either more speculative than they thought or not high enough to offset the risks and time commitment.
It’s worth noting there are reasonable passive alternatives to the direct ownership of real estate. Most common are real estate investment trusts (REITs).7 Recently, our Chief Financial Officer and Tax Director, Derek Northup, described some of the possible tax advantages to REITs under the new tax law.8 Additionally, it’s possible to own limited partnership (LP) interests in real estate. This is essentially where you pool your capital with another group of investors. LPs can also be accessed at an institutional level. For the latter, Exencial’s investment team has vetted a few solutions as potential fits for some clients.
Before making rental real estate a meaningful part of your wealth accumulation or retirement income plan, we suggest thoroughly evaluating both the primary benefits and risks associated with such an investment. Your Exencial advisor is here to help you assess and measure the impact of your real estate investment plan to ensure it makes sense for your financial situation.
Sources:
1. Zillow – Tax savings: Rental property depreciation explained
2. RealtyShares – How you can use debt to boost your real estate returns
3. Forbes – The value and cost of property management vs. self-management
4. Fit Small Business – NOI for real estate investors
5. Investopedia – Concentrated vs. diversified portfolios: Comparing the pros and cons
6. Legalzoom – Forming an LLC for real estate investments: Pros & cons
7. Investopedia – Real estate investment trust – REIT
8. Exencial Weekly Commentary – REIT dividends and Sec 199A QBI deduction
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