Diversifying into Real Estate

What this article is not about:

This is not a knock against stock market investing. I've known many people who invested their whole lives in mutual/index funds and have done fantastic. They were consistent in investing and did not waiver when the stock market headed for down turn. The theme with what they did and successful real estate investing is consistency, long term holding, and not quitting when it gets tough. If you want to learn more about the mutual fund/index fund side of investing check out a book called The Wealthy Barber. 

Disclaimer: This is based off my personal experience. Talk with your financial advisor and or CPA before considering investing options.

A Crazy Week for Stocks

It has been another crazy week in the market. Stocks plummeted again Monday almost 8% with fears of Coronavirus and oil prices. The key word in that sentence is fear. When we see wild swings in the market it is usually a key indicator of fear or uncertainty in the current state or short term future of the market.  The American economy is strong but the trading is not reflecting that. People have been saying since 2015 that a correction or recession was on the verge because "we have never seen growth last this long" or "we're due for one". We do not get recessions because we are owed one. Never the less the current market is reflecting fear and bearishness which no one ever knows how long that will last. With the swings in the market it has made me reflect on why I believe in real estate investing. 

Real estate is too risky!

If you ask people what they think about real estate investing many would probably say it is too risky! Just let me reiterate that stocks dropped 8% in ONE DAY not in a year. The Dow Jones lost 2000 points IN A DAY. The stock market is not a bad place to invest. But to invest in a vehicle that can lose 8% IN A DAY then call real estate too risky I think is short sighted. 

When I talk about investing in real estate long term I am referring to buy and hold, CASH FLOWING, properties. The key word is CASH FLOWING. They do not need to make 1000/mo but there should be money above and beyond the reserves for capital expenditures and pay the mortgage, taxes, insurance, and interest. Investing in property that you lose money every month on because you think it will appreciate one day is really speculation and not investing.

Benefits Breakdown:

Cash Flow: It is not hard to find a property that cash flows 200-400 bucks a month  after paying the (PITI) or principal, interest, taxes, and insurance. The more you put down the less of a mortgage payment you have thus more cash flow per month.  I have a property I did an FHA loan on 3.5% down and I still do well on that one. 

Equity: The one everyone forgets about! Each month you gain equity in the property by paying the mortgage. Lets assume you buy a property that is worth 250,000 and put 20% down on thus the loan is 200k (30 year fixed). In the first year each month you gain around 293/month in equity. Or your net worth increases by 293/month. With fixed rate mortgages the principal you gain increases every month and the interest amount generally shrinks. In 30 years (without appreciation) you have an asset worth 250k paid off by your tenants. So you are getting 200-400/mo in cash flow before maintenance, and end up with an asset worth 250k at the end. Over the years rents should be increasing 2-3% per year and of course taxes and insurance will go up as well. 

Appreciation: The growth in value of real estate on an annual basis. The trend in the United States has been 3-5% appreciation of value annually. So now we have three benefits Cash flow/equity pay down/ and appreciation. 

Depreciation: The definition is the reduction of value in an asset with the passage of time , due to wear and tear. Real estate value is made up of the land and structure (home) value. Only the structure can depreciate which for residential real estate is over 27.5 years. Thus divide the value of your home over 27.5 years. Then multiply the depreciation expense by the marginal tax rate to get the property tax savings from real estate depreciation. So why is it important? Depreciation gets written off against your taxable income. (I am not a CPA so talk with one more about this). Depreciation will be recaptured if the property is sold hence part of why the hold is important! So that is 4 benefits (Cashflow, equity, appreciation, and depreciation). 

What About the Housing Crash of 2008:

I'm talking about insulating risk through diversifying into real estate. I have to talk about 2008 right? Before 2008 people always said housing was a safe investment and it will always go up in value. Which over long periods of time I believe to be true generally throughout the country with exception of a black swan (unexpected) event. So what happened in 2008. In 2008 a lot of people over extended and got approved for NINJA (No income No Job) loans. People bought properties they could not afford and a lot of what happened also was real estate speculation. Some were buying properties expecting the value to go up then sell, the values did not go up, and people took losses on these properties until they foreclosed. The industry learned from this event and it is incredibly more regulated today. Not to say that is could not happen again. 

Insulating Against Risk:

Per the above graphic: Philadelphia actually had one of the lowest foreclosure rates in the county (in the 0.1-.5% range). The big insulator against risk is what class of property people invest in. If someone only invests in A Class properties (Luxury homes/apartment buildings) when the economy slows wallets tighten and people cannot afford those places. Thus the rents on A Class properties have to take a hit to stay afloat. Those A class tenants end up moving to B or C class properties. This is why I choose and others I know invest in B or C class properties. The rents are more insulated to risk because the demand for more affordable housing heightens during periods of economic downturn. People may use the term workforce housing interchangeably when referring to B or C class properties. The premise is still the same. 

You Control Your Investment in Real Estate:

When we see dives in the stock market like this week. It is easy for people to feel like they have no control over their investment and can even change life plans for them. Real estate allows you to have full control over your investment which is both a positive and a negative!

Negatives of control:

If you do not have property management (which I do not) you are the one getting the calls Sunday night at 9pm that something broke (the calls are always Sunday at 9pm I don't know why). In addition for the first year you are fixing everything the past homeowner or landlord put off. A good inspector can save you some of these headaches but you will have a lot of surprises that first year. This is a long term play though so have to realize that one year of headaches may provide you a great property for the next 30.

You are the one filling vacancies, writing leases, and dealing with issues. At first this was a big issue for me who do I call to fix a fridge, how do I write a lease, how do I find tenants? I would say I have gotten a decent handle on things now (knock on wood). I have a great network of contractors for any and everything. Washer breaks I know a guy, fridge breaks I know a guy, lease needs to be written I have standard docs that are electronically signed. (I will be writing an article in a few weeks on building systems for rental real estate.)

I used to try to fix everything myself which turned into me watching a YouTube video saying that's easy then wasting time and money on supplies when I couldn't fix it. A big part of this is knowing what you are not good at. For me anything mechanical I just pay someone for now, and plumbing... and electrical. Instead of wasting my time learning to fix a dryer I can be reading a book on investing strategies. 

Positives of Control:

You control your asset completely, you get all the cash flow, you get all the equity in the property, appreciation, and depreciation off your taxes. Did I forget to mention the tax write-off for the interest paid on your mortgage?

When you fix something or pay a contractor to you can do it how you like. So if the bathroom goes in the first month (which it did for me) and you can redo it to your style. Even though you are paying to fix that bathroom you are adding value (forcing appreciation) to your asset by doing a great job and making it look great. This is a whole side of investing research BRRR investing, Flipping, or value add for more info. When a tenant moves out you can choose to raise the rents or build an addition and get more bang for your buck. You could live in one room and rent the rest and live rent free. There are so many opportunities when it comes to real estate investing. 

In conclusion:

Real estate investing has so many benefits but it is more work than mutual fund/index fund investing. It is up to the person investing. There is no magic investment that will make you get rich quick overnight or a perfect stock to pick. The strategy I stick to is consistency, long term investing, and focusing on one or two investment strategies. The more I focus the better I get, the more I know how to deal with issues more cost effectively, the more money I save which I can reinvest.