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Real Estate Investing Versus Index Fund Investing

When Deciding Where To Invest Your Money – Real Estate vs. Index Funds

Hopefully in a few years there will be many more physician specific blogs so that we can read more opinions on various physician related issues. One of the issues that physicians face is whether to invest in real estate or invest in index funds. This post will superficially cover what each is exactly in terms of an investment and how it relates to the healthcare professional.

Let’s start by defining our vocabulary..

 

Real estate

This is a great entity because almost all of us are familiar with it. We have rented them, bought them, gotten foreclosed on in them, had to deal with problematic ones and some of us have made mad money selling our primary residence.

There is residential real estate and there are investment properties. These are almost always confused so let’s address that briefly.

Residential Real Estate

If you bought a house or condo which you are living in yourself, with your family or a herd of cats, without generating any other income from it then you are living in a residential property. It’s not an investment in any shape or form.

If the value of the house goes up when you sell it then it’s still not an investment. It was a liability (not an asset) which happened to have a positive fluctuation instead of the more common negative depreciation.

Most who have made money on their residential property have done so because they lived in there for some time and sold when the market demanded a higher price for the same unit. I would go as far as to say that most of those individuals will claim that they “made money” on the property without knowing the facts. There are so many costs involved in buying and maintaining a home that they can be easily overlooked.

The home buyer puts their money down to buy that condo/house but did they calculate the opportunity cost of what that money could have earned them in another investment? Did they calculate the risk of losing that property to a fire/earthquake? Did they calculate the extra money they paid for their reliable cars and the commuting costs to live in this property? What about the interest payments to the bank? What about the closing costs and the time they spent working on the house or even finding it? Did they account for inflation when determining whether the higher price of the house 2 decades later is a profit or simply compounding inflation? What about HOA dues and property taxes?

Investment Real Estate

Real estate, as an investment, has a sexy reputation. Millionaires and billionaires routinely have real estate as one of the main assets in their portfolio.

There are stories of amassing wealth through real estate; we hear of our grandparents who bought $20,000 homes that are now worth $1 million. There are stories circulating of couples who bought their home in some dinky town for $100k and now are selling it for $800k.

Currently, in 2017, peer-to-peer real estate investing is as sexy as peer-to-peer lending was back in 2008. Every blogger is talking about it and everyone is touting the impressive 15% returns.

A real estate investment is anything purchased for the purpose of generating an income now or in the future. It could be speculative as in buying tons of land and hoping that it will become valuable enough in the future to sell it for a profit. It could be income-generating such as a large industrial complex with tenants. It might be a property that’s leased for short-term or long-term rent in order to generate an income. Finally, the buyer may see a hidden value in the property for which they have the ability to uncover it through their talent such adding bedrooms, repairing the foundation or adding a second story.

Hybrid Real Estate

There now seems to be a 3rd category, a hybrid real estate, one that the physician household lives in and is able to generate income from. It could be renting a spare room, renting an ADU, farming the backyard, renting out your parking space, or running a business out of your home, Huxtable style.

My mom ran a family day care out of the home I grew up in. She earned somewhere in the $7,500/month range while the mortgage and tax were around $3,200/month. Was her home a residential property or an income property or a hybrid? She certainly worked more than 40 hours a week to run that business.

 

Index Funds

These are easier to discuss. Index funds are mutual funds, a kind of securities investment where you hold a conglomeration of stocks or bonds or other similar asset in a large portfolio.

Index funds can be active or passive. They can be based on a very specific market such as precious metals or real estate or they can represent a broad market such as the aggregate of large cap stocks in the USA.

These have come a long way in terms of transparency in fees. Just 4 years ago I was invested in an index fund which was costing me 5.25% per year. You see, the fees in index funds is what can ruin the investor.

The next argument in index funds is whether it’s better to hold passive ones or active ones. The latter are managed by an investment lead who makes decisions how to direct the investment – not as bad as a hedge fund but once we account for fees there may not be much left for the average investor.

 

Where to Invest?

Now onto which investment is better suited for which investor. The personality of the investor will have a lot to do with it.

These are some good questions to ask yourself and are the ones that I ask myself a few times a year:

  1. Is that a lump on my testicle?
  2. How much time do I want to spend on the investment?
  3. How much risk am I willing to take on?
  4. Am I willing to put in a lot of upfront work to learn the ins and outs of the investment?
  5. Could any major regulatory or economic waves upset my income?
  6. What resources are available to me to succeed in that investment?
  7. How much return do I expect?
  8. Do I understand this investment and its various costs/fees?

 

An Overview Of Investing In Index Funds

Index funds can be really simple to get into and quite easy to get out of. Their cost structure and fees are incredibly transparent. You know that you’re buying and you can check the value and cost of the ticker symbol as often as you like.

Index funds can be selected based on the security sector which they represent. To select the right index funds for your portfolio, it’s necessary to spend time learning about the various ones out there and maybe consult a few books or a good financial adviser.

Once you’re in an index fund you still need to maintain your continued financial education in order to make sure that you react properly to any major market changes. Most will be noise and can be ignored but some may require some sort of action on your part.

For the record, the “web” says that index funds can be bought into and are a ‘set-it-and-forget-it’ investment. Though Ron Popeil would endorse such as investment, I don’t think anything is really that simple and that’s why you should either always stay on top of those hard-earned investments or hire a professional to guide you along the way.

I don’t know anyone or have read about anyone who has gotten wealthy off of investing in index funds. They got wealthy because they saved a ton of money which they invested, but it wasn’t because of super high returns in securities.

The future of index funds

Index funds will fluctuate in value, often in the positive territory, while dropping from time to time, somewhere in the 15% range. Every few decades you may have to clench that sphincter as you see a 35-50% drop. And there will be ample years of 10-15% returns as well.

There isn’t much in terms of ongoing work that you have to put into an index fund. You will rebalance according to your asset allocation from time to time and maybe adjust your ratio as you get older and your risk tolerance changes.

There is a possibility that investment income will be taxed at higher percentages in the future. But it’s unlikely that index funds will disappear and it’s even more unlikely that they will be ever taxed as intensely as earned income.

An Overview of Investing In Real Estate

Some will make the argument that if you buy a house in a highly desired neighborhood then there is a very good chance it will appreciate in value and therefore be a really good investment.

I agree with that, as long as it’s bought in cash. If you are using conventional lending to purchase a multi million dollar house near the beach, you will likely lose any possible profit by the time you are done paying the interest and maintenance and property taxes.

Fees, Fees, More Fees… And Regulations

Any industry that has so many players involved, is likely not going to leave much room for profits. Taxes, insurance, mortgage interest, repairs, city ordinances, realtors, appraisers, and escrow fees, all will take a bite out of potential profits.

Of course it’s still a viable investment strategy but it’s not as mainstream as it’s made out to be. You can’t just go buy a condo and rent it out. In my neighborhood, for example, there are rent control regulations. A unit which might make for a great rental cannot be rented until the property come up on a waitlist for rentals.

Commercial Units

One area where the profit margins are still attractive is in commercial real estate. The barrier here is gaining entry. The lending for such properties is done through commercial loans which don’t really take your credit history into consideration but your experience with real estate and your cash reserves.

A multiplex unit or industrial complex is considered a commercial piece of real estate. Just because the word ‘commercial’ is in there, doesn’t mean that these are more expensive than traditional residential real estate investments.

I wrote about my interest in commercial real estate in this previous post.

Rich Doctors Who Invest In Real Estate

Docs shouldn’t have much trouble reaching a net worth of somewhere in the $4-10 million if they are willing to follow a traditional medical career timeline, without investing in real estate. So the question is, why would they want to invest in real estate?

Maybe they want to reach those multi-millions sooner. It’s possible to do that with real estate but not when doing it on the side, a part-time real estate gig can only earn you so much in a short period of time. If tenants are supposed to pay off the mortgage for you then you are looking at taking on 30-year mortgages in order for the properties to be cashflow positive.

I know frugal physicians who invest in real estate but I don’t know any doctors who have become noticeably rich from investing in real estate.

Some of the older docs I have met along the way have a few properties to their name. They accumulated these over time, slowly, and have renters who are paying down their mortgage. Never have I heard that these are hands-off investments – there are plenty of stories of divorcing tenants, evictions, and refinancing troubles.

 

In Summary

I recognize that either investment strategy has those who are strong proponents of each and yet I dismiss the idea that beyond a shadow of a doubt that one option is far more superior to the other.

Indexing is a valid strategy which offers milder risks, smaller returns, less upfront and ongoing work and is fairly easy to get in and out of.

Real estate has its own risks but has the advantage that with some skill or leg-work, the investor could achieve better returns. Finding the ideal deals isn’t achieved by typing in a ticker symbol into the web browser.

Take a realistic approach to either path. Currently, it appears as though index funds can return somewhere in the 3-6% range, depending on your tax situation and portfolio. Real estate appears to return somewhere in the 5-10% range from what people are claiming – but, it really depends on expertise and choosing the right property is critical.

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