No. of Recommendations: 2
Real estate is a productive asset, but the returns are worse than what you would get from taking the rental yield and assuming capital gains a percent above inflation. If one assumes rental yields averaging 4% that we have a real long term return of about 5% per year. At first this appears not far below the real returns from common stock of 7% or so.
We have done very well with real estate, but make no mistake, there is nothing passive about it as an investment. IMO the key to doing well in real estate is being a small investor who can take advantage of the inefficiencies of the market, with many mistakes made by the listing agent who underprices the home for a quick sale. (More than once I have sold a property for 20%+ higher than the agents I interviewed felt I should START the listing at, with anticipation for decreasing the listing price.) Other than for cookie cutter homes, which we avoid, pricing a home takes effort and training that most agents just don't have. Or I guess you can be one of the real estate investor vultures that prey on mostly the elderly by reaching out to them to take the in need of improvement house off their hands, for a fraction of their current value, "without any real estate commissions", but that has never been our approach. Instead we look(ed) for homes in areas that have barriers to competition and new builds, multiple industries for employment, and dazzle factors that eliminate price only based rentals and encourage tenants to fight over the privilege to pay over market rents to live there. This allows us to require higher than typical credit scores for our market, which gives more protection for our investment, as they have something they value to lose in default.
I use the past tense, as I have concerns about investing in real estate these days, beyond no longer wanting to do the work required, though I will always consider my fall back positions in any personal residence I buy. (These concerns would apply to investments in REITS as well.) One is not always presented with a sellers market when needing to leave and area, so we like to reserve the right to hold on to it with it paying for itself. Some of the problems going forward include:
1. Climate changes: While area selection is still an option, I have no control over what seems to be an increasingly extreme climate that can put your property at risk and increase maintenance costs. Note that I automatically budget 10% of rents towards maintenance in my 10 year profit projection spreadsheet. While it could be a separate category, the climate changes have triggered insurance increases, even for areas that have not been subject to extreme conditions, which describes our area. Insurance doubled in 2023, up another 40% in 2024. One cannot account for these kinds of unexpected expense increases in a spreadsheet projection.
2. Property taxes: Similar to insurance, with the escalating prices of real estate, our taxes have skyrocketed. One year was over 30% increase, with all but one year in the double digits! This will vary based on location, but our area insists on re-assessing your property each year to reflect current value. No doubt, they will be slow to reduce that expense should the value go down.
3. Taking profits: If one wishes to take profit in the investment property, unlike a stock one cannot sell off a few shares and thus control the taxes. The whole property must be sold. While $500K capital gains exclusion for a couple used to be unimaginable outside of CA, it comes fast these days. Yes, first world problem.
4. Step up in basis after death: Given that this is constantly considered for elimination, and we have learned from the changes in how Traditional IRAs are to be inherited that the Gov't is happy to eliminate tax benefits, having to sell the entire property upon inheritance would trigger a huge tax bill for our kids and trigger a huge reduction in investment profitability. Our kids have no desire to own real estate investments.
5. Higher Gov't interference: Risks from increased Gov't regulation became clear with the elimination of the ability to evict for non-payment of rent during Covid. A friend nearly lost her property when her tenants refused to pay, while she of course still needed to pay the mortgage on that property. She still has not recovered financially from that. Now our area is talking about rent controls....
Yes, in the past the small real estate investor could do well, and it made a great diversification from stocks. I always considered real estate the bond portion of our portfolio, however, and did not measure it against the stock market. It slayed bonds. We are down to two properties now, neither of which are rentals, with our primary residence being on the market. Given today's market it looks as though we will continue to have two properties for the foreseeable future, but that's OK, as I have back up options for it. Never be forced to sell.
IP
