Many docs think about real estate when it comes to investing their money. It’s generally an endeavor that requires a bit of organizational skills, a good credit history, cash reserves and a decent income. There are some commonly overlooked facts when it comes to real estate investing, a few of which I have come across as I consider this endeavor.
I know a few successful docs who are in the real estate business. Not a single one of them thinks it’s easy and they are generally fairly preoccupied with it. And that’s what this post is about – the misconceptions of real estate and how a some docs are doing it wrong.
Before I consider an investment option I first want to understand all the terms, then figure out how many parties will have their hands in my pocket and finally I want to make sure that the math makes sense. No investment should be too complex for me to comprehend and in some aspects it should be fun, encouraging me to want to learn more and invest more.
Investing in mutual funds is easy, requiring a very small time-commitment.
The securities market, which I call Wall Street, is often easier to understand because of the many regulations requiring companies to be much more transparent with fees. Think of buying stocks or bonds or mutual funds. Even though it’s easy to comprehend the concept you still have to understand what kind of risk you’re taking, how taxes affect your profits and what the cost is when it comes to owning the asset.
With any investment type you should have enough interest to want to stay on top of the trends, keep up with some basic literature and have a basic understanding of how it works. You can farm this out to a competent financial adviser but not without you having a basic understanding.
Real estate comes in many different flavors. My colleagues generally invest in either single family homes or condos/townhomes. Most will have put down some sort of down-payment and will have tenants paying rent.
Interesting fact, in this seller’s market (7/2016) none of my real estate friends are buying any new property and yet many of my non-savvy friends are desperately looking to acquire one.
I’ve given real estate investing quite a bit of thought so I’ve spent time with those who invest in it for a living and I’ve spoken to many colleagues who invest in it or are thinking about investing in it. What is it about real estate investing that attracts some of the most broke of doctors? It’s perhaps why so many so-called gurus tried to advertise their real estate investing courses to doctors.
Let me get right into why I believe a good number of doctors are doing it incorrectly. This is coming from several recent conversations with fellow docs and from a couple of my doc friends who are actively investing in real estate.
One thinks that as long as there is a tenants in her/his property then some money is being made. The investor is more than happy to cover a little cost every month if it means that the property will be paid off in 30 years in hopes of selling it for profit down the road. This is the ‘forced-savings’ investment strategy – lacking the resolve to save money, the would-be investor creates a financial commitment for themselves forcing them to save.
Okay, I get the logic but let’s think about it. If this doc bought a $500k single family home with 20%-$100,000 down then there is quite a bit of math beyond how much rent the tenant pays. First of all what could that $100k make if invested in something else, after all that money will be tied up for a potentially long time.
Next we have to calculate how much it costs to own and maintain that piece of property. Let’s say 1% a year for repairs and maintenance. And 1% for property taxes and then there are fees paid when purchasing the home, at least 1-2%. On top of that we must consider the actual mortgage payments, the principal and interest.
Don’t underestimate maintenance & repairs. You might be okay not using your A/C for a few weeks if it breaks down but your tenant won’t. The water heater that’s past its prime could go another 5 years, but should it fail it will go out in a blaze of glory. No doubt that most homes do just fine but if we’re trying to romanticize real estate income let’s all go open Bed & Breakfasts – dreamy!
Next take into account the loss of value of your down-payment year-after-year due to inflation, let’s assume 3% – this is an average, inflation has been quite low recently which means eventually it will be quite high and back-and-forth. If the property is fully paid off you still need to take inflation into account. Take this little bit of math into consideration… a home bought for $500k and sold 20 years later for $900k would have LOST money.
My neighbor was sort of bragging to me that she bought her condo in 1990 for $45k and now (2016) it’s worth $140k… in my mind I was chuckling because I assumed it really wasn’t that much but then I went home and did the math – yea, you go girl! She actually did quite well, assuming no major expenses and disregarding HOA/Taxes then she definitely would make a profit if she sold.
Back to the $500k home. So let’s assume all that math has been calculated. We must also take into account vacancy and turning over the home for new renters. Sure, you might get lucky and get the renter who stays in your home for 5-7 years. But you might also have to turn it over every year which means paying someone to clean it, paint it and fix things & update fixtures to make it marketable. It might sit empty for 1-2 months and much longer in a less desirable neighborhood.
The point is that these are costs which must be added into the math. If no repair is needed in one year that’s great, but rest assured that you will have to make some repairs, eventually. Faucets leak, windows break, washer/dryers fail, sewer pipes get clogged and bugs will find their way into your structure. If all you do is to look at the mortgage payment and deduct that from the rent you’re going to be way off.
More than 1 of my colleagues owns rental properties where the rent doesn’t actually cover the mortgage payments – which means their investment is losing them money every month. Their justification is that they are more than willing to pay a couple hundred every month to own this piece of property because they are convinced that it will go up in value. Granted, it probably will go up in value but will it be enough to cover all the costs mentioned above?
I have owned 2 condos in the past 5 years and both I sold for more than I bought. I lost money on both of them. Sure, I could brag and say that I sold it for more but I’m not in the business of screwing my finances over.
This is a good time to discuss the state of your personal finances. If you are interested in getting into the real estate business it’s critical that you have your personal finances in order. If you’re the sort that doesn’t know exactly how much is in what account, or you aren’t quite sure how your 401k investments are doing or what the tax implications are when you withdraw them then you might find yourself in a similar situation with your real estate investments.
Wall Street investing is incredibly easy compared to real estate. So if the former is complex or hard to decipher then I would guess that you will give yourself an even bigger headache with real estate. Then again, real estate is incredibly more transparent and easier to predict than securities.
Next, let’s discuss return on your investment. You might buy your real estate investment in cash or with 5-10-20% down. Either way you put up some of your very hard-earned money. Then you will put in some effort to run that investment (or have a property manager do it for you at a rate of 10%) which is time you could enjoy with friends instead. If that investment returned 5% would you be happy? How about 8%? Perhaps you would be happier with 15-20%.
The toughest thing is finding a piece of real estate that’s cash-flow positive, meaning that after all is said and done you actually get to pocket some money every month. If you accomplished that you still need to deal with maintaining that property and paying a realtor 6% to sell it and someone to stage it or at the very least touch it up before the final sale. Unfortunately I haven’t heard of many real estate investors taking home 15-20% on their investments. 8-10% is what is often claimed and I suppose it’s possible but these are the same people who like me to believe that they spend just 1-2 hours a month on their real estate portfolio. I spend quite a bit more than that on my mutual fund investments.
My friend’s mother invests in real estate in Southern California and China. When she started she was putting in 8 hours a day. After nearly 2 decades of doing this she tells me that she no longer has to look for deals, that people come to her with them. She spends just a few hours a week now managing her properties after having built a very strong network of subcontractors.
So what does this supposed 8-10% actually look like? Well, if you put down $100k it would mean you are taking home $833/mo. Which would mean that the $500k single family home would have to rent for well more than $3,000/mo to make any profit. If you put down all cash and owned the home outright you could pocket as much as $4k/mo according to that 10% rate of return. I suppose that’s possible but how many half million dollar homes do you see renting for $4k+ per month?
Most likely these investors claiming the 8-10% range have 3-4 properties worth $150k each, in which case the math makes a bit more sense. Then again you are no longer managing 1 single family home in a decent neighborhood, you’re now managing 3-4 in much more interesting parts of town. My brother-in-law told me a great story of when he and his mom had to go knocking on a door to collect rent from a delinquent tenant – I’ll spare you the details but gunshots were exchanged.
I realize this post is a bit of a downer for the could-be real estate investor but I have no doubt that there are plenty of investors making money in real estate. Just be aware of all the costs involved, some of the finer details are easy to overlook. And if you are going to invest in real estate don’t go into it just focusing on the end-value of the property when you sell it. There is no way you can predict what the value will be in the future so it should at the very least be cash-flow positive.
Oh by the way, based on that 8-10% annual return you would end up with $10 million after 30 years with just an upfront $500k investment without adding another dime to it.