The Truth About Real Estate
January 2, 2024
10
min. read
Throughout the last several years we've received more calls and questions about real estate than any other time in my 20-year career. Buy? Rent? Invest? Here are our thoughts…
Before we get started, we want to be clear. We are not talking about full-time real estate professionals here. We define a real estate professional as anyone whose primary income, cash flow, and lifestyle is derived from buying, selling, or managing their personally owned real estate portfolio.
This article is for the vast majority of people whose primary income is from their current job/career or through a combination of their portfolio cash flow, pension, and social security (i.e. not personally owned real estate).
Whether you should buy, rent, or invest in real estate is a loaded question with very different risks and rewards. Let’s dive in…
We've all heard the trope from financial experts and the generations before us that “renting is throwing money away.” However, we believe this is a misplaced view and could not be further from the truth. America’s obsession with ownership has practically become a religion to the detriment of many.
In fact, sometimes renting may be a much better solution than buying, especially in today’s climate of sky-high prices and increased financing costs.
In general, if you’re looking for a short-term solution (less than 5 years) or want more flexibility and free time, renting is almost always the preferred option. Renting has a wide variety of benefits, some of which include:
However, if you're looking for a long-term solution (> 5 years), desire more control, customization, and stability, owning may be a great option. Owning has a host of benefits some of which include:
Where home ownership is most valuable, ironically in our opinion, is in its intangible benefits which include autonomy, a sense of community, and the ultimate arbiter return on life (more on this below).
One reason we advise ownership being a benefit after 5 years is in the first 5 years, only about 20% of payments go toward the principal (the rest is interest). If you sell at the end of the 5th year, taking into account realtor commissions, the only equity built during that time is through potential price appreciation. The equity from the payments over those 5 years is entirely eaten up by commissions.
However, the interest paid over the life of a traditional 30-year loan may surprise you.
Interest and finance-related expenses are obvious. But in order to properly evaluate the decision around real estate, we first want to compare the unrecoverable costs of renting to those of owning.
Unrecoverable costs are any expenses you pay with no associated residual value. In other words, its money spent, never to be seen again, in exchange for renting or owning real estate.
Determining the total unrecoverable costs of renting is easy: It’s the amount you are paying in rent. For an owner, the unrecoverable costs are harder to identify.
Unrecoverable costs include property taxes, maintenance, insurance, cost of capital, and opportunity cost to name a few.
Owning real estate comes with a multitude of expenses and added responsibilities. Studies show that owning a home has estimated unrecoverable costs of approximately 5% per year. So, for a $1M home, on average, you're likely to spend $50,000 per year that you're never going to get back.
So, what makes up these unrecoverable costs?
For starters, there are financing related costs referenced above, as well as the obvious taxes and insurance costs. But there's a litany of additional maintenance related costs for repairs such as painting, staining, plumbing, electrical, water heater, roof repairs, HVAC, gutters, deck repairs, moisture mitigation and water damage, sewers and septic tanks, and foundation and structural repairs.
Then there are the routine monthly maintenance costs including homeowner dues, pest control, landscaping, housekeeping, tree trimming, gutter cleaning, HVAC service, pool care, etc.
In addition to repairs and routine maintenance, there are the big-ticket replacement items that loom large over ownership such as land improvements, structural preservations, new/refinished patio/deck/porch, furniture, flooring, remodeling, windows, and roof replacements. The lists go on and on.
Real estate has long been viewed as a simple, passive investment. Buy, hold, and sell at a massively higher price down the road.
Simple right?
As any owner of real estate can tell you, owning real estate is not a passive activity.
Whether it's your own home or an investment property, one of the biggest hidden costs of ownership is the impact on your time (aka the Hassle Factor).
Maintenance and improvement tasks add up quickly. It’s estimated the average homeowner spends about 23 hours a month, almost 280 hours a year, taking care of their house (True Cost of Homeownership). While this time commitment varies significantly depending on the individual owner, research shows nearly all homeowners spend at least five hours a month on maintenance and improvements.
In addition to the items above if you are renting the property, you’ll need to make additional time for paying bills, record-keeping/documentation, scheduling, repairing, and managing various contractors.
When investing in real estate, the old adage "location, location, location" still reigns supreme. But the reality is the vast majority of the money is made through leverage. Leverage is a double-edged sword that magnifies outcomes, but doesn't add value.
When prices and interest rates are low, leverage supersizes potential returns, however, when prices and interest rates are high the reverse is true, and leverage can and will wipe equity (and people) out.
Unlike a business that gets better with time through improved efficiencies, processes and people, real estate is a decaying asset, literally. The structure itself and everything inside is constantly wearing down and will need to be replaced at some point. It requires constant care, time, and money to replace, update and refresh.
When people look at the profit on a real estate investment, they calculate the purchase and the sale price, but many fail to consider the litany of hidden expenses and time that goes into the property over time.
Investment real estate has many of the same maintenance responsibilities plus added issues like advertising, vetting tenants, lease agreements, complaints, potential liability risk as well as professional service costs for the management, tax, and record-keeping. You can outsource some of these, but it eats into potential profit.
Low financing costs and massive leverage were a dream come true for real estate investors for the last several years. That is certainly not the case right now.
Many who invest in real estate receive no actual cash flow benefit from their investment. In other words, the payments received from rent go to debt service and maintenance, but never make it to their checking account for real life spending. It is essentially a long-term growth vehicle for the future that has no monetary benefit on current or future cash flows.
To make matters worse, in many cases, the assets sold to make the investment in real estate provide crucial cash flow and growth needed for day to day living. Not only is the growth and liquidity lost from the asset being sold, but the purchase and subsequent ownership of the real estate may produce a negative real life cash flow.
For example, let's say you sell $1 million from the S&P 500 to buy a second home (primarily for investment). You swap the growth, liquidity, and diversification of the S&P for that of a single second home.
In addition to the lost growth, liquidity and reduced diversification, you also lose the $40,000 in cash flow you can receive annually from the S&P 500. Based on the 5% rule, this second home will likely cost you approximately $50,000 a year on average. Therefore the cumulative real cash flow impact of this transaction on your life is actually a negative $90,000 or nearly 10% of your original capital.
From a purely financial perspective, this is not a great trade off.
For the average non-professional, just like attempting to pick individual stocks or trade options, investing in real estate is generally not on our list of recommended financial decisions.
Everything in life is a trade-off. Choosing to do one thing is making a choice to not do something else. Same thing goes when it comes to real estate. If you rent, you’re committing a minimal amount of cost versus when you decide to own, you are choosing to commit a substantial amount of capital to this asset at the expense of something else.
Many people view an investment property as a portfolio diversifier when it’s actually a portfolio concentrator. Taking a sizable portion of liquid assets and investing into a single illiquid asset automatically concentrates a percentage of a portfolio into a specific asset, in a specific location, with a specific tenant(s).
The financial opportunity cost is the dollars that could be invested elsewhere.
What else could you be doing with your money?
Over the last 35 years from 1988 to 2023, the US house price has increased 366%.
Not too bad.
Now let’s compare that to what it would be like if you had invested in the S&P 500.
For the same period, the total return for the S&P 500 was $3,753% (InflationChart.com).
This US house price data does not even take into account the hassle factor or the unrecoverable costs of ownership over that time.
But what if you look out over a longer period of time?
When you zoom out 100 years it's even worse.
The real return (after inflation) on housing over the last 100 years is...1% per year.
You read that correctly.
The S&P 500 during that same period is up more than 7x that (after inflation) per year.
It’s not even close.
From a financial perspective, you earn a substantially better long-term return at a fraction of the cost (with no leverage) and literally nothing required from you except patience, discipline and faith in the future by owning the S&P vs. real estate.
So, it's easy to understand why our financial advice for the non-professional is to own a diversified portfolio of real businesses over physical real estate.
While none of the above are reasons not to own or invest in real estate, they should all be considered when deciding.
However, opportunity cost is much more than just financial.
Let's look at the last (and most important) factor when it comes to real estate...
Ultimately our advice comes down to what makes the most financial sense combined with what provides you with the best Return on Life (ROL).
As Thoreau famously said, "The price of anything is the amount of life you exchange for it."
When you are making a decision involving real estate, it’s not just the time and money spent on upkeep, but the life and experiences gained by living there or sacrifice by what else you could or would be doing if you had more time and money to do so.
If you buy a bigger home, you may be able to entertain and build countless memories with family, but if it’s more than you can afford you may become financially strapped resulting in less travel, less spent on yourself for health and wellness, and possibility even limit kids activities or school choices.
If you live in a reasonable home and have a rental home as an investment, you may be unable to fully utilize that equity to buy the house of your dreams right now.
If you buy a second home, but only spend a few weeks a year there, you're committing a lot of capital, increased hassle, and risk for a slice of your life.
On the other hand, if you and your family spend every weekend of the summer at your lake or beach house, it’s likely one of the best life investments you can make.
We're huge advocates for real estate when it provides a big return on life.
In general, our philosophy on buying real estate is a solid "yes" if it provides a clearly identifiable return on your life for you and your family. If the reason for buying is a need for unique customization or tailoring the property to fit a specific purpose, we suggest walking through the pros and cons before making a decision. If you are purchasing real estate for the sole purpose of an investment, we almost always advise against that decision.
Andrea and I have personally invested a lot into our home. It's a terrible financial investment, we know this. It takes a ton of time and requires a lot of maintenance. There is always something breaking and always something to fix.
But it's where our family lives.
It's where we are raising our kids.
It's where we entertain friends and build countless memories.
Our return on life here is priceless.
Not everything can be a strictly financial decision.
Everything has a trade-off.
So, what’s the best decision for you?
Let’s find out.
Together, we’ll look at your financial life, crunch the numbers, and clarify what gives you the best ROL helping you make the best choice for you and your family.
