Is "Investing" in Real Estate a Good Idea?

In the previous blog I outlined why our personal homes are an under-performing investment.. With the unpredictable ups and downs which all asset classes experience, we are left being “market-timers”, which history has shown humans are not good at. So, for our personal homes the best time to buy is when you want to buy and the best time to sell is when you want to sell. Life trumps money, so do what is best for you and your family when it needs to be done. Everyone will be just fine never buying a home (sacrilege coming from a real estate agent, don't tell on me). There is absolutely nothing wrong with renting, its' just weighing out what your priorities are. If it's all about money, renting makes better financial sense as the return on investment of a personal home is barely positive, and that's specualtive.

BUT… what about all the millionaires on infomercials and all of my friends who made a killing “investing” in real estate??? Flat out, it is not true. I’ve never met a real estate investor who “lost money”; they all won somehow, except for me. I personally lost 130 homes (including my own), $400,000 in cash and my mind in the last crash. My goal here is to help “investors” make educated, informed decisions and avoid common pitfalls. Many times I tell people not to buy or invest in real estate, which personally makes me zero income. I don't care, if telling someone 'no' is the correct answer then I tell them that, I don't need or want $1,000 by bullshitting someone.  

There are only a few things we can do with our money:

1. Spend Money

2. Save Money

3. Invest Money

4. Gamble

Most people confuse numbers 2, 3 and 4 as the same acts.

Saving money is keeping it in a safe place, with as minimal a risk of loss as possible. Investing money is committing money to an endeavor with the expectation of return of that money and more. Investing has higher risk of loss and should also have a corresponding higher return.

We cannot “save” money in a stock, mutual fund or any asset which could potentially be worth zero, because the inherent downside risk outweighs the benefit of any or all potential gain. The stock market is purely speculative (unless a stock pays a dividend), because the price of a stock is based on the markets expectation of it’s future performance. Many people believe buying a stock is an investment, when it is truly a speculative purchase with the hope of the price being higher in the future.

I do not believe Speculation is Investing, it is gambling. It is not “bad”, it is just not for most people, especially those that cannot afford the losses. If you think you are investing in real estate by purchasing a home and hoping to sell it for more later, you are simply speculating you know what the future conditions will be. Just like a stock, the winner of the Super Bowl, the next Blackjack card and well, most anything else in life.

So… the only way to “Invest” in real estate then is for passive cash flow, just as we would receive passive cash flow from a dividend paying stock. The upside is that the chance of the house being worth $0 at some point is very, very low. If it is destroyed by fire or natural disaster, you should have insurance to cover the losses. Now, just because it most likely will never be worth zero, it could be worth $100 or $1000 at some point in the future. The main reason is the location, which is a risk we can try to mitigate, but there is always that and other Macro-Economic Risks we do not control (think housing bubble).

When Investing in Real Estate for passive cash flow we determine the Return On Investment (ROI) as the Net Profit over the Cost Basis. This is both a very simple calculation and very complicated set of data. What we choose to factor into this calculation, pre and post investment, makes a huge difference. I have seen many ways to do this over the years and 99% of them are poor, at best.

Most ROI calculations are provided by the sellers’, trying to tempt someone to invest in real estate and buy their product. These are the worst sets of data and also normally leave out some critical data:

Cost Basis – $50,000
Rental Income – $11,400
ROI = 22.8% (divide rental income by cost basis)

Holy crap, that’s an awesome return! No, it’s simply crap data, which does not take into account any operating expenses. Remember, investing in real estate is really creating a business, which will have both general and property expenses. Here is a slightly “better” ROI calculation:

Cost Basis – $50,000
Rental Income – $11,400
Management Cost – ($1,140)
Property Taxes – ($1,200)
Prop Insurance – ($500)
Cash Flow – $8,560 (subtract rental income from all of the expenses)
ROI = 17.1%

Hey, that’s still awesome and those expenses didn’t dent the ROI much! No, this is still Bad Data. Remember that homes & people are not perfect, tenants do break stuff, houses do age and need repairs and tenants do not live there forever… Duh right! Yeah, but I’ve met hundreds of investors who did not think about this… they were blinded by the infomercial!

Cost Basis – $50,000
Rental Income – $11,400
Management Cost – ($1,140)
Property Taxes – ($1,200)
Prop Insurance – ($500)
Vacancy Factor – ($946) – I like to use 8.3% = 1 month vacant
Maintenance – ($720) – I like to use 5.0% of the square footage of the home
CAPEX – ($1,440) – I like to use 10.0% of the square footage of the home
Cash Flow – $5,454
ROI = 10.9%

Well, 10.9% isn’t too shabby, especially when interest rates are sooo low. That is correct, but we need to add one more piece of data – the Probability you will get that ROI. The Probability is necessary because tenants do not always pay their rent and some will need to be evicted. For this you will need to determine your own numbers based on the areas you invest in. Some really cheap properties in less desirable areas have great ROI numbers on paper, but if you cannot find a tenant who will pay rent, then your ROI is negative. More expensive homes in better areas have lower ROI’s on paper, but if there is a 99% chance the tenant will always pay, then it could generate a higher actual ROI.

To do the math, multiple your Paper ROI by the probability you believe you have of getting that return. Hint, the probability is never 100%, ever. Take our 10.9% ROI from above and assume this is a good area, so we believe we have a 90% probability of getting that return (10.9% * 90% = 9.8%). That 9.8% is what you would use to compare different properties in the same or different locations. It is also what you should use as a base comparison for year-over-year investment performance.

If you want more information or to talk about investing in real estate or anything else, feel free to email me at douglashilbert@yahoo.com

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