is real estate investing profitable

March 19th, 2008

Is Real Estate Investing Profitable?

My post Someone Had To Buy The House You Rent, asking how people can own rentals in markets that it is much cheaper to rent in than to buy, garnered tons of reactions in the comments as well as a few around the blogosphere. Mike from Quest For Four Pillars contacted me that evening and asked if he could write a guest post response to my post and I agreed. Here is his take. If you like what you see, consider subscribing the the Quest For Four Pillars feed! For a completely different view from a real estate investor, visit the response post written by Wise Bread’s Catherine Shaffer.

Last week, Paid Twice asked a very good question which I’ve paraphrased as “Why would someone own a rental property if it’s cheaper to rent than buy?” In other words, if you can’t collect enough rent to pay for your expenses (including mortgage) then why wouldn’t you sell the rental house and put the money into something more productive?

I’m not a real estate expert by any means but I do have some ideas about why this situation occurs and why it might not always be as illogical as it seems:

Irrational exuberance for owning property

My theory about this phenomenon is that some house owners are irrational and attach great significance to ‘owning property’ and are willing to take lower returns in return. Real estate by itself is not necessarily more or less profitable than any other kind of investment for a given time period – over the long haul it has gone up by inflation plus 1 or 2% – but many people feel a strong connection with owning property that they don’t feel with any other kind of investment. Conceptually real estate is easier to understand than a stock or a mutual fund so some real estate investors just assume their rental houses are doing well and sometimes don’t do the proper accounting.

Reluctance to let go

The recent decrease in real estate values has meant that people who moved in the last year or so often had to take a loss (or sell for less than they wanted) on their house so many of them decided to rent and “wait it out”. This may or may not work out for the home owner but it indicates that the owner is using their heart and not their mind when making a financial decision. This also increases the supply of rental properties which will lower the rents.

Return on investment – not return on equity

The example of someone who has a paid for house is a perfect example of where the owner might be better off selling the house and investing the money into dividend stocks or reits (like a real estate mutual fund) but they like the idea of owning and renting out a house. Because of the huge run up in real estate prices over the last ten years, there are undoubtedly a lot of owners who have done very well with their investment and are reluctant to let something go which has done so well for them. Logically you need to look at the current value of the house when evaluating the cash flow but a lot of real estate investors will think in terms of what they paid for it – which in some cases is so far out of date that it’s meaningless. ie if someone who paid $150k for a house 10 years ago and is getting $15k in rent per year might think they are doing well because the $15k is 10% of their original house price. Fast forward to today and if the house is now worth $350k then the $15k in rent is only 4% which is not enough to make it worthwhile. On the other hand, if you own a rental house outright – it’s easy to think you are doing well if the revenue is greater than your costs.

Investment time frame

Real estate is a somewhat volatile investment so there are periods where there are significant increases or drops in the house value, but that doesn’t mean the home owner is going to sell just because they are doing poorly for a few years. Rental rates are set by supply and demand – not house price, so if there are too many rentals available in a city, then rents might not keep up with purchase prices. This situation has occurred in some areas over the last several years because interest rates were very low and lending standards were relaxed so in many cases it was cheaper to buy rather than rent so a lot of the potential rental pool became home owners which drove up the house prices and drove down (or kept steady) the rents. A real estate investor has to live through good times and bad if they are in it for the long run.

Houses are illiquid

Selling a house is expensive and can be a lot of work – even in a hot market you are still looking at huge transaction fees of 5% or more which means that you can’t treat a rental house the same way you can treat a mutual fund or stock that you can sell very cheaply with a few clicks.

Selective accounting

Very few home owners (rentals or otherwise) know how much their house costs them. We know what are various bills are and the mortgage and tax payments, but do we add them up over the years? Do we add up the various remodels? Do we consider the potential lost income or capital gains we could have gotten from investing the money in the stock market?

Some considerations which help the rental owner

If there is a mortgage on the property then the portion of the mortgage payment that goes toward equity is not a cost since it is balanced with the increase in equity of the house. Another consideration is tax write offs – the rental owner gets tax write offs for maintenance, repairs, losses etc so that has to be factored in as well. Leverage is another tool which helps the homeowner if the house value rises in the long run. Because they are borrowing a portion of the house price, even a small rise in house value will get a larger return for the investor.

Recent history and complacency

Prior to 2007, real estate values in most of the country had a pretty good run – 10% annual increases or more for at least five years which is way above the long term average. If you were a rental home owner during that time, you were probably too busy celebrating your new found wealth to do any kind of analysis to determine if the income generated by the rental property was high enough to justify ownership of the property.
Remember that with investment properties, you can’t just look at your cost of ownership – you also have to consider the potential income if you put the money into another investment like dividend stocks.

Eventually things revert to the mean

Whether owning a house is a better deal in your area or if rent is the preferable choice, you should keep in mind that over the long run it may not make much difference which you choose as long as you handle your finances properly. Many renters feel like they are going to be left behind because they don’t own a home but there are some steps they can take to make sure that doesn’t happen.

Conclusion

There are many reasons why there are rental houses in areas where it doesn’t seem to make a lot of sense – owners who don’t care, don’t know or are riding it out and hoping the rental market gets better – reasons abound. Remember that if you are considering buying a rental property yourself then do as much research as possible and whatever you do, don’t trust your real estate agent!

Feel free to check out the Quest For Four Pillars blog or click on the big orange icon to subscribe to the feed.

If you enjoyed this post, make sure you subscribe to my RSS feed!

You can also: Stumble It!  
Bookmark  
Submit to Reddit  
Submit to Tip’d


19 Responses to “Is Real Estate Investing Profitable?”

  1. There is one major concept in rental property that you missed. *someone else is paying for your investment.*

    Simple as that. I currently own my own home and rent out two bedrooms. The rent I charge pays for the house payment and part of the utilities.

    This means that in effect, I have a *much* higher amount of disposable income available.

    I admit I don’t really think I’ll see a huge return on my homes value. It may go up, may go down. To be honest, that part doesn’t concern me. The supplemental income of a rental house is really what concerns me.

    Of course, if someone has a home that they’re renting which does not cover the mortgage (Very probable, considering the housing bubble we’ve been in these past few years) then they’re in trouble.

    Keep in mind, however, that not everyone bought their rental property this year. You also don’t know the terms of the loan, the down payment, interest rate, life span of loan, if they refinanced once they got the mortgage paid down (and hence were able to lower their rent) or any number of factors.

  2. I only have one rental property, and it is my former home. I kept it not because of sentimental value or because it had dropped in value, but because I thought it would be easier to rent than to sell, and I didn’t want to be stuck with two mortgage payments while it sat on the market.

    My rent ($895) barely covers the mortgage ($828) and certainly doesn’t cover repairs, advertising for new tenants, vacancies, etc. But I have to admit, even if I have to pour a little of my earned income into the property each year, it’s still a pretty good investment. Let me tell you why.

    I currently owe about $90,500 on the house, and it last appraised (before the fall of the housing market) at about $120,000. That puts my equity at $29,500. However, I know that I will pay about 6% in commissions when it sells so that brings me down to approximately $22,000 in equity. What rate of return am I currently getting on my $22,000?

    Of the $828 monthly payment, $253 (as of my last statement) is going toward principle. So the mortgage is only costing me $573/mo. for interest, insurance and taxes. Take that from my rental income of $895 and I’m clearing $328/mo. Multiply that time 12 to get my annual income of $3,936. If you divide that figure by my equity of $22,000 you get a rate of return around 17.9%. Of course, if it sits vacant for a month, that figure drops rather quickly. But even if it drops to 10%, where else am I going to earn that on $22,000? And that’s assuming I’d even clear $22,000 if I sold. In this market it would likely be much less, which means the return on investment (equity) is even a bit higher.

  3. Zach – I didn’t miss that scenario because it doesn’t exist – as you mention yourself if the revenue doesn’t cover the costs then the tenants are clearly not paying for your investment. In your case YOU have already paid for your property so it’s not an issue for you.

    Mike – I think your math is way off. You mention that you aren’t counting repairs, maintenance or vacancies which pretty much invalidates the numbers. The time you spend on the rental is also a cost in my opinion.
    That said would you be looking at capital gains tax if you sold it? If so (as it would be in Canada) then that would be more motivation to keep it.

  4. I hope you get a chance to check out my post at Wise Bread, which breaks all of this down in some detail. You mention at the beginning that you’re not an expert and have no experience in real estate investment, so you might consider that, well, you’re not an expert and you don’t have any experience. Your basic thesis is that landlords are stupid. You can believe that if you want, but most landlords tend to believe the same thing of their tenants.

  5. Catherine, did you even bother reading the post? You might want to read the part where I explain that the point of this post was address the question of why a rental house owner would be owing a rental house in a situation where it would appear not to be profitable.

    Yes, in some cases there are stupid landlords but in a lot of other cases (which I covered had you read the post) there are other factors which help explain why a landlord owns a rental house that is losing money even though the house overall might be a great investment.

    As for expertise, clearly a lack of real estate expertise hasn’t stopped you from writing about the topic – which is the point of blogs – you don’t have to be an expert.

    Mike

  6. Strictly speaking, renting is usually more profitable than owning your own home … BUT for most people the only path to wealth starts by owning your own home.

    Why?

    The key is to invest in income-producing rental property long-term (with BOTH interest rates and Property prices so low right now … a 30 years fixed mortgage will produce wonders for your long-term financial well being), for many people that means buying a home and waiting for their equity to break my 20% Rule …

    … then using that ‘spare equity’ to fund an investment property – repeating the above process as often as possible (ideally, yearly).

    This is a slow-but-sure-way to wealth, and MUCH quicker and better than simply plonking money in your 401k and hoping for the best.

  7. If I sell it right now there would not be any Capital Gains tax. In the US a married couple can sell a house they have lived in for two of the last five years and not incur any Capital Gains tax (up to $500K). Unmarried individuals can do the same, but the cap is $250K. That means I have to sell it within three years of moving out to avoid the tax.

    We moved out in the summer of 96, so I have until the summer of 99 to sell it without incurring a tax liability. I had planned to put it on the market in the Spring of 99, but with this dip in housing prices I’ll have to weigh then whether it makes sense to sell to avoid the tax, or hold it and let the price come back up.

    As for the math being bad, I don’t think so. Yes there is some cost I didn’t figure in, but there are also tax savings I didn’t figure in either. With the depreciation allowance it actually reduces my tax bill. And as I said before, with the market down I’d get much less than $22K if I sold it right now, so I’d have less to invest elsewhere. I can’t see even clearing $2K a year if I sold it and invested the proceeds. Much less $2K tax free.

  8. I own four single family rental properties. I can say that there are many good reasons to own rental properties even if the expenses (mortgage, repairs, taxes, insurance) are greater than the rent. One of my four properties falls into that category, but it’s on a 20 year note and we financed 100% of the purchase price and rehab costs. We could have put 20% down and financed over 30 years, and then our rent would have greatly exceeded our monthly costs. Would that have made it a better investment? I don’t think so. Perhaps less risky, although I have plenty of cash reserves in case of an emergency. I do agree, however, that folks can become emotionally attached to real estate. But I’ve seen that more from homeowners in relation to their own home, not real estate investors.

  9. Mike – thanks for the clarification.

    It’s clear from your comment that you have the tools and ability to properly analyze your situation which I think is the important thing. It drives me nuts when people have “one size fits all” bits of advice like “real estate is a great investment” or “real estate is a bad investment” when there are so many different factors to consider.

    Mike

  10. Personally I got out of real estate investing because it wasn’t profitable. You end up dealing with tenants losing their jobs and not paying, turning into idiots when they meet a boyfriend or girlfriend, tenants fighting with each other, etc. The maintenance is the easy part…The only thing that hurt here is when you hit a major repair that needs to be done and it costs a significant amount of cash.

    My business partner and I are posting all about the scenarios we encountered through our ownership of a combined 11 units. This is titled our Real Estate Profits and Losses series on our blog “The Money Kings”. Check it out at themoneykings.com

    Our latest post deals with the transition to warmer weather, and how that time period seems to bring all the freaks of the neighborhood out!

    Tim

  11. erm…I don’t think Four Pillars is saying that landlords are stupid. According to Catherine Schaffer’s Wise Bread article it is okay to lose over $500 a month to be a landlord. I don’t know what to call that.

  12. I am about to buy a house for investment , after reading your article , it gave a lot of tips to consideration .

    Thanks a lot ,

    Tracy Ho
    wisdomgettingloaded

Trackbacks:

  1. Carnivals Around The Web | I’ve Paid For This Twice Already…
  2. 5 Ways I Plan To Survive The Recession | The Wisdom Journal
  3. Saturday Weight and Links
  4. The Patch » Blog Archive » Real Estate Investing?
  5. Thicken My Wallet » Blog Archive » What is the True Rate of Return on Real Estate?
  6. L0Q.com – Life’s Quest » 5 Ways I Plan To Survive The Recession
  7. Real Estate Investing: Return On Investment and Leverage | Moolanomy