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My LinkedIn feed and YouTube suggestions are full of rental property stuff, presumably because the robots know I browse Zillow sometimes when I’m bored. Seems like a lot of people view and pitch owning rental properties as a passive cash flow machine.
When I hear “rental property,” I think illiquidity, leverage, concentration, idiosyncratic risk, fees, stress, time, sweat equity, taxes, paperwork, and headache from things like repairs and bad tenants, all for returns not too different from just buying comparable exposure to a low-cost stock market index fund.
Of course, this must necessarily be true in aggregate because if real estate markets were inefficient enough to allow for easy and consistent alpha, money would pour into real estate from lower-returning assets until those risk-adjusted returns reached equilibrium. Heck, even T-bills – quite literally the “risk-free asset” – are paying nearly 5% right now. Some specific local markets may be inherently juicier and/or more insulated, at least temporarily, but that’s the idiosyncratic risk I mentioned.
A friend of mine constantly complains about having to evict people and repair or replace things like holes in walls, plumbing, appliances, etc. Sounds exhausting to me. Using a property management company solves some of that headache but massively lowers returns.
I have no interest in being a landlord. I also probably wouldn’t have the heart to continually raise rents or evict people, so I’m not cut out for it anyway. But if I wanted more real estate exposure, I’d also rather diversify by just using REITs or even something like Fundrise (shared fractional ownership; not an endorsement) to be completely hands-off after a few clicks on my computer. A REIT index fund won't call me in the middle of the night about a busted pipe.
The only special dimension real estate seems to offer is leverage (borrowing money for exposure greater than the capital outlay), and specifically a degree of leverage that is admittedly somewhat difficult to obtain elsewhere for the average person. And that aspect is indeed special. Purely looking at home prices over time, U.S. real estate has returned a pretty paltry 4% annualized over roughly the past century, with most of that coming in just the last 30 years. That’s not even 1% higher than inflation. For comparison, over the same period, U.S. T-bills have returned roughly 3.3%, U.S. bonds about 5%, and U.S. stocks about 10%.
But just because leverage is available doesn’t necessarily mean it’s wise to take it. Chances are you’re already levered up plenty with a mortgage on your own home and/or a car loan. Many people are arguably over-leveraged already. If you want more, cash out your home equity and buy other assets (or study up on options and futures contracts). Callability aside (not insignificant, to be sure), you can also find margin rates cheaper than a typical mortgage, and required collateral on futures is lower than a downpayment on a mortgage. Moreover, if your time horizon and tolerance for risk allow for the use of leverage, why not boost capital efficiency by diversifying across multiple asset types with that enhanced exposure rather than concentrating further in a single one?
Maybe you enjoy and are proficient at the hustle of finding fixer-uppers and doing DIY upgrades, in which case go for it, but know what you’re getting into, and recognize that 5x leverage (20% down) amplifies gains and losses. It only takes a small drop in the housing market to put you underwater. We also know real estate behaves like a mix of small cap value stocks and low credit bonds. So while it's not a perfect analogy, would you rather invest in a diversified index fund with no leverage or a single small cap value stock and a single high yield corporate bond with 5x leverage? Levering up a concentrated position that requires time, effort, and monthly expenses doesn't sound fun to me.
In terms of scalability, building a real estate “empire” also just increases the time and effort you have to expend on what increasingly becomes a hands-on business. Index funds require no more effort at $1M than they do at $1k.
Remember that being a landlord is a job, not a “passive income” source, and anyone who suggests otherwise is either lying to you, has never owned a rental property, and/or has forgotten that another 2008 is possible. There’s a reason all those real estate gurus want to sell you their $299 course instead of just buying up more properties themselves.
The simple point is that owning rentals is not at all as glamorous as it’s made out to be, and you shouldn’t feel any FOMO (fear of missing out) or inadequacy by not owning one. Similarly, buying a rental is probably not going to be your key to financial freedom.
Anyone else? Or anyone from the other side who owns rentals and has somehow made it truly passive who wants to be honest about their returns net of insurance, taxes, upkeep, realtor fees, closing costs, etc.?
Or anyone who had the bravery and timing luck to buy in ‘09 or ‘10 who wants to rub it in my face that they’re rich now?
Disclosures: None.
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You hit the nail on the head with this. Can’t wait to refer people to this article next time they try to convince me to buy an income property.