Risks and Tradeoffs of Real Estate Investing
In my past post, 6 Reasons Why I Invest In Real Estate to Build Wealth, I talked about the many benefits of investing in real estate. However, it’s important to highlight the risks and tradeoffs, too. So what are they, and are you willing to accept those risks anyways?
Diversification.. or is it?
Diversifying outside stocks, great. But just as buying individual stocks is frowned upon because investors lose out on diversification via ETFs and/or index funds, buying an individual piece of property is arguably the same. After all, a single, physical rental property requires tens, if not hundreds, of thousands of dollars.
Opportunity cost
I always have my real estate partners looking for deals and sending them my way. So oftentimes, I have idle cash sitting on the sidelines earning a fraction of a percent in a HYSA (high-yield savings account) because I know that that next deal may come my way at any moment. Unfortunately, that results in low-to-no returns on that idle cash that could otherwise be invested in the stock market, which is arguably quite a high opportunity cost.
Appreciation
If you’re looking for appreciation, real estate has historically underperformed the stock market. But it really depends on timing and the local market you invest in. In my opinion, my primary reasons to invest in real estate is for cash flow and incredible tax benefits. I invest in stocks for growth.
Debt is debt
There are many ways to think about debt. Personally, I think that there’s a spectrum of debt, where high-interest consumer debt is “bad,” and low-interest mortgage debt is “better.” No form of debt is necessarily “good” since debt is always working against you.
That said, there’s also a concept of “overleveraging.” I don’t think there’s a particular way to quantify it, but it happens when someone simply takes on too much debt. When an investor is overleveraged and can no longer cover their expenses, they tend to go into a downward spiral where they have to borrow even more to cover prior debts, etc.
Additionally, if the real estate market takes a significant hit, it’s possible that your properties go “underwater.” A property is considered “underwater” when the market value of the home drops below the loan itself. Coupled with being overleveraged, you may be forced to sell your home(s) with very unfavorable terms.
High barrier to entry
Unlike stocks where you can very easily invest double-digit dollar amounts at a time, buying physical real estate often requires tens or hundreds of thousands of dollars just for a 20-25% down payment! And for most people, it can take years to save enough. That equates to years of lost investment time, unless you’re willing to take the risk of investing it in the short-term and watching its value fluctuate. And it’s always possible that your investment loses value by the time you’re ready to purchase a home. If it does, you’d have to postpone your home purchase before you have enough for a down payment, while watching home values potentially increase during that additional waiting period!
Lots of traps if you don’t do your due diligence
Over the past decade of investing in real estate, in just about every deal I’ve participated in, there’s at least one person who’s a shark. There are so many parties who have skin in every real estate transaction, so it should not come as a big surprise that they all want to profit on it in every way they possibly can. That’s why if you don’t know what you’re doing and you haven’t done your due diligence, your investment just became very risky (possibly speculative). And you will likely lose money in some way, shape, or form, whether it’s in one-time fees you’re unaware of or on a major line item like the overall purchase price or realtor commissions. To quote Warren Buffet, “If you’ve been playing poker for half an hour and you still don’t know who the patsy is, you’re the patsy.”
It can be very complex and time-consuming
Real estate can be very complex. Here’s a small list of complexities that I can rattle off:
Learning all the different tax benefits
Knowing which tax laws to apply to each unique deal
Understanding how to determine the value of a property
Understanding how to determine the market rent
Deciding if you should flip or buy-and-hold a property
Being able to run the numbers on deals quickly
Building a network of real estate partners you love to work with
Learning how to negotiate
Figuring out all the real estate terminology
Knowing the roles and responsibilities of everyone involved in a real estate transaction
In addition to all the complexity, you have to make sure you stay organized and keep thorough documentation of all your expenses and transactions, not only for tax purposes but also for liability.
Liability
If you own rental properties under your own name, without LLCs, your personal assets may be susceptible to lawsuits, should anyone come after you. Now, does it happen often? Probably not, but the prospect of a lawsuit certainly is terrifying. So I think it’s best to prepare for the worst and create a boundary between your real estate business and your personal assets. You do this by working with a real estate attorney and creating an LLC for your rental(s).
Owning rentals under a business also helps to increase your anonymity if done properly by masking who the owner is and where the owner resides. This may sound petty, but if someone is considering suing you and can identify who you are and what personal assets you may have, they may discover how wealthy (or not) you are. And if you’re wealthy, a lawsuit becomes more appealing.
Lastly, if you’re disorganized and frequently mix your personal assets with your real estate business, that can really increase your liability. Even if you keep your rentals in proper LLCs, by mixing your personal assets with your business, you’re piercing the corporate veil. When that happens, the personal assets you mixed in with your business just became vulnerable to a lawsuit.
Conclusion
All that said, while there are many downsides to real estate investing, I still believe the positives outweigh the negatives. If you haven’t already read my past posts on the many reasons I love investing in both stocks and real estate, be sure to read them to get a better understanding of why and how they can be such powerful investment vehicles to grow your nest egg.
As all decision-making goes, you have to weigh the pros & cons of real estate investing with other investment alternatives. Which asset classes work best for your personality and financial goals? For me, I use a combination of both stocks and real estate to build out my portfolio over the years leading up to my $10M fat FIRE goal.
