According to a recent Forbes article, approximately 10% of the world’s 2,100 or so billionaires made their wealth in real estate. What’s even more intriguing, according to some estimates, over the last two centuries, approximately 90% of the world’s Millionaires either made or grew their wealth by investing in real estate.
So, this begs the question, is investing in real estate a good idea for the average investor?
I think in order to answer this question, one is well-advised to consider the benefits and the risks of real estate investing. There are actually five major benefits and five pretty significant draw backs that I can think of. Let’s go through them one at a time.
Benefits of Investing in Real Estate
No. 1 – Appreciation
Appreciation is the increase in value, over time, of the real estate that you own. There are two general types of Appreciation: one is what I call “Organic Appreciation” and the other is “Forced Appreciation.”
Organic Appreciation is where the value of your property grows over time without you having to do anything to the property other than maintaining its present condition.
While this growth varies from time to time and location to location within the United States, it has generally kept pace with inflation at somewhere between 2 and 3% per year.
By contrast, Forced Appreciation, is where you improve the property after purchasing it, thereby increasing its value. Forced Appreciation is one of the major X-factors that can make real estate investing extremely profitable. That’s because, Forced Appreciation is entirely within the investor’s control.
If you buy a property for 100,000 dollars and you know that with some key improvements, that property will increase in value by 50,000 dollars, you have just “Forced” the property to appreciate in value. The key with this, of course, is that you have to spend less on improvements than 50,000 dollars in order to actually create a profit.
This Forced Appreciation, if done on a large scale, for example with an apartment complex, can create real, life-changing wealth with just one deal, even for an average investor.
The thing that makes real estate Appreciation, a near certainty given a sufficiently long time horizon, is the concept of “Scarcity.” Scarcity exists where the supply of something is smaller than the demand for that thing.
And, it just so happens that we live on a planet that has a finite amount of land. In other words, the “supply” of real estate is limited.
However, the human population has grown from 1.6 billion in the year 1900 to just around 6 billion in the year 2000, to over 7.7 billion as of the date of this recording. And it continues to rise by 1% or more every year.
So, unless humanity comes up with a way to upload our minds into some kind of virtual reality where a physical existence will no longer be necessary (a la the Matrix) or unless there is some kind of cataclysmic event that drastically reduces the human population (think Terminator or World War Z), all these people new people entering the world are going to need a place to live.
Now, it is true that colonization of other planets can become a thing. But, judging by the pace of our current space exploration — I mean, the last time a human set foot on another celestial body was 1972 — we are centuries away from anything resembling large-scale space colonization.
So, with a limited supply of earth and an ever-increasing demand spurred on by the rise in human population, the only place for real estate prices to go in the foreseeable future is up.
No. 2 – Leverage
Benefit number two is “leverage.” There are actually a number of different types of “leverage” which are possible with real estate investing. But, I’ll focus on the one that is primarily referred to when this term is used, and that is, the ability to buy real estate without having to use your own funds to fund the entire purchase.
In other words, when you buy real estate, you have the ability to use other people’s money. You borrow money from those people (or entities such as banks), use it to buy the real estate, and in exchange you pay those lenders a percentage return for a set period of time.
The reason leverage in this form is more readily available for real estate, as opposed to for example stocks, is because real estate is considered a safer asset. Real estate is tangible and, well, “real,” unlike crypto-currency or stock valuations supported by inflated price and earnings ratios.
For this reason, you can pretty easily get a loan to buy real estate. The same is not true for other types of investments. This gives real estate a distinct advantage.
You can buy $100,000 worth of real estate for just $20,000 or $10,000 or possibly even $0 dollars of your own money. How much real estate can you buy if you never had to spend any of your own money to do so? The answer is a LOT.
Over time, as you make payments to your lenders, you also pay down the loan, reducing the leverage, while at the same time increasing your equity in the property. Any equity that is created after the loan is paid down, is money in your pocket when you go to sell the property.
No. 3 – Insider Trading is Allowed
Unlike stocks, real estate can be traded on insider information.
In stock investing, it is illegal to trade on insider information. The current laws require the investing public to be provided with the same information on which to base their decision whether to buy or sell. Stock trading is designed to be an equal playing field. No one has an unfair advantage. At least they are legally not supposed to.
Yes, you can make stock trades based on better market research and better predictions than your fellow investors. But, you can’t trade on specific insider information known only to you.
This is not the case with real estate investing. In real estate, you can absolutely trade on insider information.
Let’s say for example that you learned that a 4-plex in a good part of town, that you have had your eye on for quite some time, has just been transferred upon the death of the owner to an heir who wants nothing to do with it. The heir would much rather get quick cash for the building than continuing to operate it and dealing with tenants.
Because you had an inside connection to the deceased owner, you are the only one who knows this about the heir’s situation. You also know that the property in its current condition could sell for $200,000 if it were to be listed on the market. But, because of the heir’s dis-interest, you know that you can probably get it for a lot less if you make them a cash offer. So, before the heir gets around to putting the property on the market, you offer them $150,000 for the property and they accept.
You just made a great deal, simply because you knew something that other, potentially interested investors didn’t know. Gold star for real estate!
No. 4 – Scalable Cash Flow
Not only will real estate likely appreciate in value, not only will your equity increase both from the loan pay-down and appreciation, and not only can you buy property at a discount if you know the relevant facts, but if you purchase the right property correctly, you can also expect continuous cash flow.
Cash flow is the difference between the property’s ongoing expenses and its income. If that difference is a positive number, that is dollars in your pocket. If the property produces a $1,000 per month in income, but costs just $750 per month in expenses, the $250 per month difference is your cash flow profit.
As long as you can find properties like this and have the funds to purchase them, you can continue increasing your monthly cash flow, thereby multiplying your wealth.
No. 5 – Tax Advantages
The last major benefit of real estate investing is the tax advantages afforded by the current American tax laws. These include various deductions and depreciation of real estate assets. They also include exemptions from taxes under certain circumstances.
The U.S. tax code continues to favor real estate investing because it sees it as a public benefit to encourage people to develop real estate. As I mentioned, more and more people need a place to live and more and more businesses need a place to run from which to run their business. If the U.S. government stops encouraging real estate investing through the tax code, fewer people will want to invest, leading to a shortage of housing and a shortage of commercial buildings.
For these reasons, it has been a long-standing policy of our government to give certain tax advantages to real estate investors. This benefit is of course not guaranteed as government policy is only as prudent as the politicians who implement it. So, if certain politicians end up getting elected, some or all of these tax benefits may go away.
Disadvantages of Investing in Real Estate
I am a huge believer in real estate as a primary vehicle to serious wealth for the average investor. However, there are some very serious disadvantages to real estate that you should definitely consider before deciding to invest. The top five disadvantages are listed below.
No. 1 – Real Estate Investing is Not Really Passive
Disadvantage number one is that real estate investing is not really passive. In fact, real estate investing is only “semi-passive” at best.
The level of non-passivity will depend on a number of different factors. One of the main factors is the type of real estate investing strategy you choose. Flipping houses and wholesaling are probably two of the most non-passive real estate investing strategies. They require a lot of personal involvement from the investor.
Their level of non-passivity, in my opinion, is rivaled only by the short-term rental business, such as Air BnB and similar business models. With those, you are essentially in the hospitality business — in other words, you are operating a hotel with daily operational headaches.
Purchasing and managing rental properties can also be pretty involved. There are a lot of moving parts, especially as you begin to scale and purchase more investment properties.
All of these strategies can be made more passive by implementing systems and outsourcing tasks. However, it is hard to reach a point where they become truly passive.
The truly passive real estate investing strategies are where you only invest your money, such as investing in REITs, syndication deals, or by becoming a private lender for other real estate investors. But, of course the downside with these is that you need a LOT of money to make any kind of real returns.
No. 2 – Real Estate Investing Requires a LOT of Education
Disadvantage number two is that successful real estate investing requires a LOT of education. I don’t mean classroom education or formal degrees. But, rather education in real estate. Because the world of real estate investing has so many nuances and because margins of error are so small and competition is so high, the only way to consistently outperform is to be more knowledgeable than your peers.
In order to be more knowledgeable, you have to spend time educating yourself about real estate. Some scientists say that in order to become an expert at something, you need to spend 10,000 hours practicing. I am not sure if this is true for real estate, but I can tell you that I have spent a lot of time studying and learning about real estate over the last 9 years and I still feel like I have a lot to learn.
Real estate investing in my opinion is very much a knowledge-intensive game that requires a lot of effort and self-discipline to do well.
No. 3 – Real Estate Wealth is Slow
Disadvantage number three is that growing wealth through real estate is a slow process. It is not a get rich quick scheme. You need to be willing to dedicate years and sometimes even decades to reach meaningful levels of wealth through real estate.
Yes, you can get lucky and hit some home runs right away, but this is not typical. Rather, you should expecting a 5 to 10 year time frame for reaching significant financial milestones.
By contrast, if you were to, for example, create a popular mobile app you could make a million dollars in a matter of a few months. So, if app development or some other type of business is more your thing, then you may want to focus on that instead of real estate investing.
No. 4 – Financial Risk
Disadvantage number four is the substantial financial risk that comes with real estate investing. When you invest in real estate, you likely put your credit and your current and future finances on the line. When you borrow money, you pledge to pay that money back whether your investment succeeds or not.
If you borrow in your own name or personally guarantee loans made through your entities, which is almost always required, you are taking a substantial financial risk. The bigger the deal you do, the higher the risk.
But, in addition to the defined risk of loss that comes with borrowing or investing your own funds, you also face a less defined risk of being sued. Unlike investing in stocks or other passive asset classes, when you invest in real estate, there is a possibility that you can lose more money than the investment itself.
For example, let’s say you buy a property for a $100,000. You invest $20,000 of your own money and borrow the additional $80,000 from a lender. Let’s also say that something tragic happens at the property and a family dies in a fire. Their estate sues you for $5 million. You lose the lawsuit because a jury determines that you were negligent in maintaining the electrical system. After your insurance pays $1 million — your policy limit — you are still personally on the hook for the remaining $4 million, which will probably take you the rest of your life to pay.
This is a very grim scenario and also a very unlikely one if you do things the right way and if you have sufficient insurance and take the appropriate steps to protect your personal assets. But, it can happen. This is a serious downside to real estate investing that does not exist with other asset classes.
No. 5 – Physical Risk
The last disadvantage that I will mention is the physical risk of harm that may exist with real estate.
This can take the form of getting injured as a result of some unsafe condition at the property, such as an environmental hazard or a defect in construction. It can also take the form of getting injured while performing manual labor — such as where you decide to take on repairs or maintenance yourself rather than hiring that work out to someone else.
It can also take the form of being harmed through the criminal actions of others. One common example could be if you go door to door to your tenants to collect their rent in cash and as a result walk around a less-than-safe neighborhood with large amounts of cash in your pockets.
Do me a favor guys and DO NOT do that! There are so many better and safer ways to collect rent these days, from apps, to direct electronic transfers, to having tenants go directly to your bank and deposit rent there, to good old fashioned snail mail, that there is really NO reason to EVER go to the property to collect rent.
So, I personally think that real estate is still one of the best, if not the best investment class out there. It has been one of the best for thousands of years and I think it will continue to be one of the best for the foreseeable future. But, every investor has to make that decision for themselves taking into account all of the pros and the cons that I just listed.
Comment on this blog post and let me know if you agree or disagree with my conclusion. Also, let me know if you think I missed any benefits or disadvantages that should be on this list.