Updated: Nov 24, 2020
Real Estate's Biggest Risks are sometimes less obvious
Real estate investment wasn’t on my radar until 2001 when I read Rich Dad, Poor Dad. The book’s message convinced me that the secret to financial freedom was cash flow obtainable through real estate investing: owning rental properties that would bring in stable monthly income.
Every real estate investing book I read told me that cash flow from real estate ownership was the number one path to wealth in America. I took that to heart and earnestly learned everything that I could about rental investing. I found a mentor who was an attorney, became a licensed real estate broker, and started my own single-person brokerage. I scaled a real estate business that allowed me to purchase and flip homes for profit while accumulating thirty-eight rental properties in the Chicagoland market.
Dream come true, right? Wrong. Because after thirteen years, my fantasy of leaving my teaching job and being financially free seemed even further away than when I was investing in mutual funds.
I learned the hard way that being a real estate investor was a grueling business, even more volatile than the stock market. There’s an old expression in real estate: You make your money when you buy, not when you sell. Unfortunately, purchasing discounted properties was even harder than picking winning lottery numbers. The ever-growing number of real estate investors, many inexperienced, increased competition and drove up prices for properties to irrational levels. It was not uncommon for discounted properties to have over thirty bids from investors. Rehabbing older properties revealed latent defects and hard-to-estimate expenses. Tenants were especially hard on the properties, and every tenant turnover cost an average of $5,000. This would include often-forgotten costs such as vacancy expenses and advertising for and finding a qualified tenant. I even hired several property management companies to help me with my business, only to see my problems, costs, and oversight increase.
The downturn of 2008 proved especially challenging. Many of my tenants lost their jobs and couldn’t pay their rent. Spreading risk between more units failed to provide any type of hedge against loss; it just amplified the risk. As a landlord, I found there weren’t really any laws working in my favor. Laws were overwhelmingly designed to protect tenants (and they should be), but they created an untenable model for me. Trying to create a stable, passive income from tenants who are frequently struggling from paycheck to paycheck in an environment that views landlords as the enemy isn’t a practical business model.
Then there was the interpersonal aspect of the job. I’ve never met anyone who enjoys dealing with tenant drama, demands, excuses, and problems. I loathed it.
I tried everything I could to trim expenses and run a nimble business, but in thirteen years, I never made anywhere near what I projected. I could not support my family as a full-time investor when I was always just one roof replacement, trashed unit, or lawsuit away from insolvency. While everyone thinks that landlords make tons of money, I sure didn’t. The bank, the county, the contractors, and the attorneys all got paid before I did, and there was very little left over each month for me to reliably count on.
Expenses went up every year, and because of the stiff competition locking area rent rates in place, there was no way to recoup those higher costs. A single major setback (which I discovered over time was pretty much guaranteed) could blow up my entire cash flow for that year and sometimes even the next.
The National Apartment Association’s research supports what a low-margin business rental housing is. According to their 2019 findings, each dollar in rent received is broken down the following ways:
$0.39 Mortgage payment
$0.10 Capital expenditures
$0.27 Maintenance, utilities, insurance
$0.14 Property taxes
I remember sharing the details of my business with a financial analyst who was interested in real estate investing. He asked me if I could quit my teaching job and rely on my properties for income. My lack of an answer made it crystal clear to both of us that it was time to accept the obvious: this was not the business I had been hoping for.
Looking back on those years as a real estate investor, the biggest and most expensive lesson I learned was real estate investment wasn’t worth the constant stress. You can’t put a dollar amount on being interrupted every holiday with a repair catastrophe or a furnace failure when you are trying to enjoy time with your family. I began feeling like I was on call twenty-four hours a day, providing high-quality housing to tenants, but receiving very little financial incentive in return.
None of the gurus that promoted real estate investment as the secret to financial independence ever addressed any of these issues, drawbacks, or the guaranteed burnout that comes with landlording. They were too busy convincing me how I would be a multimillionaire within ten years. It made me wonder if the gurus gained much more from the promotion of real estate investment rather than the actual practice.
There is no question that serious wealth is made in real estate. However, based on my own experiences, I wouldn’t be surprised to learn that much of that wealth is skewed toward large investment companies rather than mom-and-pop organizations like mine. Either way, being a landlord or running a vacation rental is not going to be a good fit for every investor, which is why we need to consider a new way of making money in real estate—a way that’s truly passive and truly profitable.
Recovery through Mortgage Loan Investing
Needless to say, after more than a decade, I realized real estate investing and landlording weren’t going to get me the financial success and independence I wanted. Still, I thought that real estate might hold the key to realizing my future goals, but how?
I discovered the answer to this question in 2016, during a chance meeting at a real estate conference. An investor I met had transitioned out of rental investing and into mortgage loan investing. His story, which was very similar to mine, blew my mind. The difference was that as a mortgage loan investor, he ran a profitable, low-stress business from anywhere in the world. Payment collection and borrower communication were handled by a third-party loan servicer. Best of all, he was able to invest in loans secured by real estate without the myriad risks and complications that came with owning the property. It sounded too good to be true—but in this case, it wasn’t.
Soon after I began purchasing mortgage loans as investments, I started selling my rental units, most of them at a loss from what I paid a decade earlier. I was so glad to walk away from the stress and headaches, I was willing to accept the loss.
With mortgage loan investing, I found I was better able to expand and grow in diverse markets across the country, without having to spend my weekends inspecting rentals and paying contractors, without the worry of flooded basements during every heavy rainstorm. Mortgage loan investing gave me a manageable way to enjoy the inflation resistance of real estate while ensuring I received regular distributions, rather than having appreciation locked up in equity. Even better, the distributions were ongoing, which meant I could live on or reinvest the income steadily, at the buying power of today’s dollar.
As a real estate investor, I felt like I earned every dollar I ever made by dealing with stressful situations every day. This is not the case with mortgage loan investing, a truly passive method of secured lien holding with predictable payments. Part of the reason for this is that mortgage loans allow investors to leverage the traditional banking model—and if there’s one thing banks are experts at, it’s making money passively, without the headaches that come with real estate ownership and being a landlord.