Thursday, December 13, 2007

My Life In and Out of Real Estate Markets, conclusion

Part III: Lessons Learned

In Part I of this series, I explained why I decided to become a real estate investor, and how I came to own a rental property. In Part II of this series, I described my frustrations with owning a rental property, and how I got out of the real estate market just in time.

In this final post in this series, I will share with you what I learned from my time as a landlord. It is my sincere hope that you learn from my mistakes, and consider carefully whether real estate investing is the right investment for you before taking the plunge.

So, what did I learn from my three and a half years as a landlord?

  • Real estate can pay off big.
  • Owning a rental property can be painful.
  • Real estate has some drawbacks compared to stocks.

Real Estate Can Pay Off Big

By investing in real estate, you can use credit to leverage a down payment into a pricy asset, which generally appreciates over time. This means that you can make big gains, even with only a modest appreciation in the value of a house.

For example, if you make a down payment of 20% on a property that appreciates 3% in the first year, your down payment has netted you a return of 12% in one year - not bad at all, especially if your mortgage payment is close to what you were previously paying for rent. Buying a home with a large down payment and the intention of living in it for a long period of time makes great sense, especially if you don’t overpay for your house, and if you don’t buy more house than you need.

Owning a Rental Property Can be Painful

When you invest in a rental property, on the other hand, you’re not paying a mortgage instead of rent – you’re paying a mortgage in the hope of recovering some or all of your costs by renting to others. Over time, rental inflation will bring your rental income above your costs, assuming that your mortgage payments remain the same.

If your costs exceed what you are able to rent the property for by a wide margin, or if you are using an adjustable-rate mortgage, then you are not really investing; you are speculating: Speculating that interest rates will stay low and so will your payment; Speculating that house prices will go up fast enough to bail you out.

Whether you are a risk-adverse investor like me, or a reckless speculator, you will be on the hook for making mortgage payments when the property is vacant, and unless you pay several thousand dollars a year, you will be responsible for managing the property as well. This may sound fine, but unless you enjoy working on weekends and holidays, you will not be happy about it; take my word for it.

Stocks perform better over long periods of time than most asset classes, including real-estate. Stocks also include built-in management (of admittedly varying quality), so if you can find the right individual stock or fund, you can do as well as you would owning rental properties, especially if you account for the value of the time that you don't have to spend managing the companies that you are invested in.

I could have purchased any number of stocks, including real-estate stocks such as Boston Properties (BXP) or Caterpillar (CAT), and made the same money that I did with my rental in the same period of time, without the same frustrations.

Real Estate Has Some Drawbacks Compared to Stocks

Since we’re on the subject of comparing real estate to stocks, here is my complete list of shortcomings of real estate as an asset class:

  1. Personal Responsibility. You have duties as a landlord, from making timely repairs to spending Saturdays showing the house to prospective tenants. It is a second job, and paying someone to manage your property is not cheap.
  2. Financial Responsibility. You are on the hook for those mortgage payments, whether you have a tenant or not.
  3. Illiquidity or Slippage. You have to find the right buyer. You need to have the house vacant. Houses are not identical (or fungible), and yours could have or develop an attribute that makes it undesirable, such as a neighborhood that becomes blighted by foreclosures.
  4. High transaction costs. 6% in, 6% out, unless you want to try to sell the house yourself, which means even more responsibility and another part-time job.

So, Do You Really Want to Be a Landlord?

So, when a co-worker mentions to me they are thinking of taking advantage of the current downturn in house prices to buy a rental house, I ask them: Are you sure that you want a second job? Are you sure that you can afford to have a vacant rental for several months? Do you enjoy calling people to ask for money that they owe you? Are you good with a hammer and power-tools?

If you are like most people, the answer to one or more of these questions is an emphatic “no”.

So, do you really want to be a landlord?

I don’t.

1 comment:

Payam said...

Nice summary.

Another drawback vs. stocks that I'd like to point out: When you own a single rental property, your return is highly affected by actions of the town or city government, i.e. your return is controlled to a degree. Some cities or towns have, what I might call "capitalist friendly" policies. Other's don't. Worse still, the local government's idea of what policy to employ can change. For example, if Manhattan's zoning policies were to change and more high-rises were allowed, the market clearing price of existing condo and co-ops would drop remarkably. For some background, read this, written in 2003:

Note that today (year end 2007) the price per square foot is upwards of $1,000 for a buyer of a condo in new development.