There are two parts to any investment – cash flow and equity appreciation. Cash flow refers to how much money the investment generates and equity appreciation is how much the investment itself grows in value. When you look at real estate, cash flow refers to any rents you can earn and equity appreciation refers to any increase, or decrease, in the property’s value.
In the last few years, real estate has taken a huge hit because prices simply grew too quickly, financially incapable people were given loans they couldn’t afford, and the myth that “buying a home is the best investment ever” was finally revealed to be the result of incredible anecdotes and not a statistical look at historical home values.
I’ve never liked the idea of real estate as purely an investment for a variety of reasons.
Diversification
Part of the reason probably has to do with our age and our current nest egg. We have already invested close to $300,000 in real estate with our primary home, that we purchased three years ago for $295,000. When you compare that with our retirement and taxable brokerage accounts, our home already represents a significantly portion of our investment allocation.
To go out and buy another piece of property for the purposes of making it an investment would really put our allocation out of whack. That’s the number one reason why investing in real estate is not appealing to me.
Significant Minimum Investments
You can open a Vanguard account, invest it in their STAR fund, for $1,000. Can you buy a piece of property with only $1,000?
When you invest it in a mutual fund, your liability is limited to $1,000. When you buy property, you’re on the hook for a lot more… even if it only requires a $1,000 down payment. Someone could get hurt on your property, it could burn down or be flooded, or it could seized by the government under eminent domain. Insurance will cover against most of those issues but insurance costs money… which leads up to the next reason.
Holding Costs
When you own property, there are significant holding costs involved. You have to pay property taxes, insurance, interest on the mortgage, local and county taxes, utility costs like electricity and water, and that’s outside of any management fees. When you purchase a home, not only are you getting the liability of the mortgage but also all the weight of monthly carrying costs.
If you’ve ever watched a flipping show on those home improvement channels, you’ll know what kind of pressure these holding costs can have. First time flippers almost never finish their projects on time and see those monthly holding costs cut into their profits. These holding costs will eat into your cash flow or your equity appreciation.
Transaction Costs & Time
When you sell a home, you pay 3% to the seller agent and 3% to the buyer’s agent. So you lose 6% of the total value of your property to the transaction. That also doesn’t include any last minute touch-ups to the house that you may need to make, such as a fresh coat of paint or staging fees to make your house look better.
When you get to the time involved, that’s where it really gets serious. How long does it take for a house to sell these days? If you’re lucky, a couple weeks. If you’re not, it could take a year or two. How will the market be in a year or five? Will it be sizzling hot like five years ago or will it be like today? If you need the money for something, you could find yourself taking a hit just to liquidate quickly.
Stock market? Stocks will trade in seconds (minutes if it’s lightly traded) and it’ll cost you less than ten bucks.
Am I Advocating the Stock Market?
In a way, yes I am. It’s liquid, there are little to no holding costs, and the transaction costs are low. It’s just as difficult an investment arena to understand but the system is a lot easier to manage. For individuals at my age, 20s and 30s, I think real estate is a fools errand and the stock market offers the flexibility we need.
If you already have a lot invested in the stock market, perhaps real estate is the way to go. It’s just not the sure thing people always make it out to be. When your friends tell those stories about how someone sold a house they bought in the 80s for $50,000 and sold it for $500,000, ask them how much was paid in interest, property taxes, and real estate agent commissions.. then think about whether a similar investment in the stock market might have yielded similar or better results.
What are your thoughts about real estate as an investment? I know it is a very popular subject so I’m eager to hear your thoughts!
(Photo: lcd1863)
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