Should I be investing in real estate?

The other day a friend asked me this question. He told me “Everyone I know seems to be trying to invest in real estate. So I am having FOMO (fear of missing out). Should I be investing in real estate?” My answer to him was not a simple one as you can imagine. But let me give you the short and simple answer before you read further – don’t invest in real estate if it’s FOMO that’s driving you. Real estate is not for everyone. Today, I want to talk about what you should keep in mind when considering investing in real estate and give you some fundamental reasons why real estate may or may not make sense for you. My hope is that you walk away with a more realistic view on this. 

Begin with asset allocation and an understanding how active or passive you want to be

To begin with, the first step to answer whether real estate should have a place in your portfolio begins with an understanding of your asset allocation as I have explained in this earlier article. But the fundamental question of whether real estate is something you personally want to invest in comes down to how active or passive you want it to be. The article helps lay out the different forms of real estate investing based on that. Long story short – if you want this to be a 100% passive and don’t want any kind of active involvement, you are left with essentially investing in REITs or through some crowdsourced platforms like Fundrise. Any other form of real estate investing involves some level of active involvement from your end. 

With this basic understanding, let me offer more color on what is actually involved in the more active forms of real estate investing so you can then decide if this is something you want to do or not. My personal “expertise” (I don’t call myself an expert by any means just someone with some experience so take it for what it’s worth) is in direct single family residential housing investing. So I am going to talk about that mostly in this article. One more thing – there is no such thing as a national or international real estate market. Real estate is local. So each market is very different and it’s important to not make broad generalizations. Before I dig into what is going to be involved, let me walk you through a bit of the why should you consider investing in real estate. 

Why active real estate investing?

There are many reasons that make real-estate investing interesting and attractive. Let me lay out a few that I am familiar with:

• Diversification – I fundamentally looked to real estate because I wanted to diversify our assets from being entirely in the stock market. Simple portfolio theory tells you that one way to spread the risk is to diversify your portfolio between asset classes. Real estate generally has very limited correlation with the stock market and can offer the much-needed diversity for your portfolio to spread the risk. 
• Bond-like characteristics – This is an interesting one and something I have come to understand and appreciate more. Most people may be surprised to read this. Done right, real estate cash flow can have the same characteristics of providing fixed income like a bond does. What I mean is if you do your due diligence and find properties that cash flow with rent after all expenses are paid, you can make a good 4% – 6% minimum returns that don’t have the same volatility of the stock  market. Note that there can be different types of volatility with rental properties which I will talk about later in this article.
• Strategy for financial independence / early retirement – so the outcome of the previous bullet is that this fixed income can be your way to cover most or all of your living expenses to become financially independent and/or potentially explore early retirement. This is part of the strategy for a lot of early retirees because a lot of their savings tend to get locked up in retirement vehicles like 401Ks which cannot get accessed until the age of 59.5. With the right amount of rental properties and cash flow, this is very doable. This is very much part of my strategy. Given how this deems more explanation, I have written a companion article to go into more detail on financial independence through real estate investing. 
• Wealth creation – the other side of the coin of rental passive income is of course the value of the underlying asset which is the property itself. Wealth creation happens in two ways – when you pay down principal you gain equity in the property and of course through appreciation in the value of the asset. But do not ever buy property assuming appreciation because as my mentor and real estate guru Paula Pant likes to say “Appreciation is speculation”. Buy real estate for cash flow and wealth creation will be an automatic by-product of that. 
• Tax advantages – most people love to talk about this but I keep it to the end. This is because you should never buy real estate because of the tax advantages but really do it for the reasons above and then take advantage of the tax advantages. Simply put, you are able to reduce your taxable income through real estate by taking deductions on certain expenses you incur and through depreciation (think of this as an amount the government allows as a non-cash deduction that reduces your tax liability). So you could legally show losses in your rental properties and reduce your tax burden on these. Ultimately, uncle Sam will come knocking when you do try to sell the asset because all of the appreciation in the asset will be fully taxable. However, there is a way to eliminate that too – by way of what is called a 1031 exchange. Without going into details, it’s simply a way to use the proceeds from sale of a property to buy a similar property within a given amount of time without having to pay any taxes on the gains. I am sure there are other ways to gain tax advantages through real estate but these are the most common. 

So how active is real estate investing?

As I mentioned earlier, real estate investing (outside of investing in REITs and crowdsourced platforms) is active investing. So let me explain to you what all is involved in single family residential investing. A lot of these can be similar for other forms of real estate investing too. 

• Finding and analyzing deals – This is the first and fundamental step in active real estate investing. 
  • Finding deals – If you do turnkey investing, the ‘finding’ part of it can be outsourced but the ‘analyzing’ part should never be outsourced. You should always know how to analyze a deal and figure out whether it makes sense to invest your hard earned money in it. Finding deals can be as straightforward as working with a realtor to go see properties that are listed on the MLS, make offers and close on them – similar to how you go about finding your personal residence. But this can also involve finding off market deals through active networking, directly contacting folks in neighborhoods through mail/email marketing or simply walking up to houses and asking them if they are interested in selling. Fundamentally all of this involves a key element – you need to be persistent and disciplined. You will likely need to make multiple offers before one gets accepted. I personally have found all my deals so far by working with an agent and finding them on the MLS. 
  • Analyzing deals involves understanding what your expected returns on the property will be. I won’t go into the detail here but just touch on this at a high level as this warrants a separate article by itself. Typically it involves understanding the CAP rate (it’s a calculation to understand your returns on the property without including your principal and interest portion of your mortgage). In order to do the math, you will need to understand how much rent you can get from the property, understand all the possible costs involved (taxes, insurance, any HOA fees, estimated maintenance and repair costs, estimate for vacancy and property management). Ultimately, you should have an expectation of certain returns and only go after deals if it meets your criterion. Note: A lot of folks simply think – if I can cover my mortgage, I am going to have an asset that is being paid off by renters in 30 years. While that is true, you are not truly thinking of it as an investment then because the opportunity cost of using that money in some other investment could be high. So understand the returns you will get.  

• Finding a tenant – now this is something that can be outsourced if you use a property manager but if you do, you will need to pay a fee (typically one month’s rent) to the property manager. So far, I have done all this myself. It involves some good old marketing on online portals like Zillow, Craigslist and Facebook marketplace to name a few. You then have to do showings and also screen the prospective tenants based on some basic criteria you may have. All of this can be done using online tools these days. You do have to make sure when you do this you don’t violate any Fair Housing laws in the US. Finding the right tenant is very critical especially if you are going to be managing the property yourself or you will find yourself dealing with problems. This is the single biggest reason why many people absolutely won’t go anywhere near real estate investing. But I personally enjoy this – I love meeting new people and ‘selling’ my property to different folks. But I will admit that during this process, I have met some interesting people who I may not normally meet. 

• Managing the tenant and the property – If you did the first 2 steps well and thoroughly, this step can be an absolute breeze. Of course, this can entirely be outsourced to a property manager for a monthly fee. But I have systems in place to ensure this is done with very limited effort at my end. I have an online rent collection system to collect rent. I have a handyman who deals with any tenant maintenance issues and I trust him completely. So as I said, for me this has not taken up a lot of time so far. As you increase the number of properties, you should assume this can consume some more time. Of course, you should not expect everything to be perfect. You will have issues with the property you need to address, you may have problem tenants that you need to deal with. I am not trying to downplay the role of this but want to simply impress upon you that this does not need to be a huge time suck if you do it right. 

• Having the cash cushion to weather the bumps – You can read a lot of stories of people who talk about investing in real estate with no money and while I acknowledge that is possible, I don’t personally subscribe to those approaches. I am fairly conservative and like to keep it simple. Just like I have talked about having a personal emergency fund to cover 6 months of living expenses, you need to have an emergency fund to cover 6 months of expenses on the properties. Now, if you have 10 properties, you may not need 6 months of expenses sitting in a bank for each of the 10 properties. But know that there can be sizable capital repairs every now and then and you should simply budget for that and keep a cash cushion. During the 2020 pandemic, a lot of landlords found that their tenants were out of jobs and unable to pay rent and there were eviction moratoriums. You would need extra cash to weather those types of storms. 

So as you read all that and if it scared you, don’t worry. That’s exactly how I felt too. Most people after reading that list simply say this is not for them and walk away. However, if the why behind real estate investing motivates you strongly to try it, then maybe this is something for you. For me, that motivation was very strong to want to try it out and once I got in, there was no looking back. 

How do I learn about all this?

Ultimately, the best way to learn is on the job by doing it. But let me tell you what I did. First, I went ahead and signed up for a real estate investing course. Now i will be the first to tell you that there are a LOT of scammy courses out there. So if you are skeptical about it, I don’t blame you. I have no qualms (and gain no benefit in doing so) in sharing that my real estate mentor is Paula Pant who runs a company called Afford Anything. She has a 10 week online course that I took and it helped give me the confidence to get me going.  But formal learning can only get you so far. Find mentors who can give you guidance. I joined a local real estate investing group and met some interesting folks, I talked to some friends and family who had been doing this, and finally I was able to leverage Paula Pant herself as part of the course. But then, as you get into it, you will learn so many things. Actual experience is the best teacher. 

So is real estate investing for me?

I want to close this article by going back to the very question with which we started this article. I have walked you through a lot of detail. Here is what I will tell you to consider as you decide:

• Are you strongly motivated by some of the reasons behind real estate investing that I laid out? This is fundamental – because if those reasons don’t resonate with you, you are not going to want to do this. 
• Are you willing to learn and try new things? More importantly, are you willing to commit to some time and effort to do all this? If you are not, then this is going to be hard. 

I don’t say all this to discourage people from doing this but I want to offer a balanced and nuanced view of what this involves. None of this stuff is rocket science. You don’t have to be a numbers geek or a handy person to be a real estate investor – you just need the motivation and right attitude. Everything else will follow. 

Ultimately, I am someone who has a full time job, a family and so it’s not like I have a ton of extra time on my hands. But I was super motivated by the financial independence possibilities and I just loved learning about real estate. As I mentioned, after some up front time and investment in each deal, the income after that has been pretty passive with limited work from my end. So it has worked out well for me so far. 

Thank you for reading and I hope this article gave you a bit more insight into the world of real estate investing. I wish you success in your financial journey.

Disclaimer: I am not a financial advisor and all the information in my articles are from my personal experience and are for informational and educational purposes only. Please consult with a financial advisor or CPA for professional advice.