Updated: Nov 5, 2020
Let me tell you from experience. Over time, it's a lot harder than you expect.
I bought this property in 2009 for $43,500. At the time, I thought it was the steal of my career. It was in a "B" neighborhood that was popular for rentals, and I thought that I would at least double my money on it. I put about $20,000 into it to get it rent-ready, and held it for the next 8 years as a rental, expecting it to appreciate.
Except it never did. I sold it in 2017 for $45,000. Why did I not make any money on it, you ask? There are several reasons why rental properties generally don't appreciate as well as more expensive properties.
The biggest advantage to real estate ownership is appreciation. Because real estate investors own their properties, they participate in the growth of its value. They can realize the profits from this growth by selling the property for a higher price than they purchased it for or by pulling cash out through loans. How significant an advantage is this?
Well, between 1969 and 2016, the average appreciation rate was 5.4 percent. During the eleven-year period of January 2009 and January 2019, the average home price appreciated more than 50 percent.
The problem with counting on appreciation, besides the fact that you don’t know the property will have appreciated by the time you want to sell it (just ask investors who retired and wanted to sell property in 2009), is that leverage makes potential appreciation look way better on paper than it is in real life.
Let’s look at an example. An investor purchases a six-unit building for $500,000, making a 25 percent down payment of $125,000. Leverage allows the investor to count on the $500,000 purchase price as the basis for the asset’s appreciation, not just their down payment.
If that $500,000 building appreciates at 3 percent per year, then in ten years, it should be worth $650,000. Because the investor has only invested 25 percent of the purchase price as the down payment, in theory the asset can produce a cash-on-cash return of over 100 percent ($125,000 costs, $150,000 profit).
On paper, it seems like a no-brainer, right? Especially when you compare it to a similar mortgage loan investment, which has a cash-on-cash return of 10 percent.
But wait—not so fast. This example doesn’t take into consideration any of the following potential losses absorbed by the investor:
● large capital expenditures
● routine maintenance/repairs
● pest control
● unit rehab between tenants
● overcharging contractors/property managers
● fires/floods/natural disasters
● increasing costs for property taxes
● Increasing costs for hazard, liability, and umbrella insurance
● increasing competition flattening rent increases
● city fines/inspections
● closing costs
● Agent/property management fees
All these expenses can massively derail profits during that ten-year period, offsetting any appreciation. They drive down the net gain and impact the investor’s liquidity along the way.
Let’s face it—owning property comes with huge liability risks. In order to profit, most landlords are forced to manage their properties at a substandard level, which devalues the property over time and increases the risk of lawsuits. Speaking of which, the amount of insurance landlords require is staggering. From hazard to liability to umbrella to workers’ compensation, it’s not just about protecting the property but also tenants, guests, and workers.
In a very serious event, such as a fire, there is a high likelihood the owner’s coverage won’t be enough to pay out the totality of claims. Since most investors underinsure to maximize profits, they face the risk of attorneys going after their personal possessions and accounts, which a simple LLC won’t prevent.
What if a tenant brings something onto the property—a pit bull or a trampoline, for instance—and someone is seriously injured? Who is the attorney going to recoup damages from? The tenant? Or the property owner? Even if the owner didn’t know about the dog or the trampoline and didn’t give the tenant permission to have them, the owner is still liable for the damages.
Or, what if the handyman the landlord uses frequently for repairs gets hurt while working on the property? An investor may think the handyman is an independent contractor, but a judge will likely rule under workers’ compensation laws that the property owner is responsible for the injuries and/or disability.
And, as I briefly mentioned, none of this considers the risk that the property will lose value either because of mismanagement, vacancy, neighborhood, or economic factors. Remember, only investors purchase commercial buildings, not homeowners, so the purchasers don’t fall in love with room sizes or colors or appliances. They only fall in love with the numbers and cap rate, and only buy when they can get a deal. It’s no secret that tenants are hard on rentals, and owners must project very generously for ongoing building repairs.
Furthermore, not all properties appreciate equally. I held single-family rentals for over ten years that actually depreciated in value from what I invested into them, between acquisition and rehab costs.
Many investors choose lower-value (under $150,000), single-family rentals because of the cash flow and perceived stability, like I did. Yet, in my experience, these are speculative investments, mainly driven by investor demand during real estate market upswings. Unfortunately, markets with numerous single-family rentals are considered less desirable, tend not to be well maintained by the investor owners, and attract fewer homeowners.
I have also watched investors move into markets betting on gentrification, only to see those markets drop in value during market corrections. In some cases, the investors have trusted city- or county-wide plans for improvement that seemed to be pointing the area in one economic direction, only to see plans change, funding fall through, and improvement projects scrapped.
Leverage is helpful to real estate investors who want to grow a portfolio quickly, but it still takes time to make a portfolio of rental buildings appreciate. During this time, investors are exposed to a multitude of risks that just grow, which for me, at least, begs the question: Is it worth it?
For mortgage loan investors, however, the value of the loans we purchase slowly decrease over time as we collect payments and the loan is paid back, because there is no underlying physical asset.
This definitely represents a difference compared to real estate investing, but remember that we determined our minimum yield when we purchased the loan. Since loans are usually paid off prior to the maturity date and we purchased at a discount, we will get a nice additional return on our investment when that happens.
In addition, rather than pay interest on a loan to extract value out of a property, like a real estate investor must do if they don’t want to sell, we get capital back every month that we can continue to reinvest, allowing us to increase our cash flow dramatically over time.
While we all like to focus on the appreciation of real estate, which is certainly a benefit for real estate investors, it’s also important to consider that there is a real risk of values dropping during a recession. That is a risk real estate investors are exposed to, but mortgage loan investors are not. During the 2008 recession, home prices fell 33 percent. In 2020, we’re seeing real estate values falling in some markets due to the financial pressures brought on by the pandemic. And, as I’ll discuss in the Weighing Traditional Investments against Mortgage Loans chapter, while economic downturns almost certainly contribute to falling home values, they do not necessarily trigger high rates of foreclosure, which is good news for mortgage loan investors.
Personally, I would much rather buy a set number of payments from a mortgage loan and not have the responsibilities and headaches of property ownership, even if I miss out on the potential property appreciation. While appreciation is nice—when it happens—it usually requires a decade or more, and for investors with rental properties, it’s always offset by large capital expenditure requirements.
I hear stories of investors buying rental properties with cash flows of only $100 after fixed monthly expenses. I shudder when I hear that because I can guarantee that person they will lose money over time due to all the variables involved with real estate investment. Whether it’s a new roof, foundation, concrete, porches, sewer, plumbing, electrical, HVAC, tuckpointing, siding, and/or windows, you can always count on properties breaking down, ultimately offsetting gains in appreciation.
For me, going into an investment knowing exactly what I’m buying, what I’m getting, and what my expenses will be has proven to be a much faster route to financial freedom than dealing with tenants, toilets, termites, and trash.
https://escholarship.org/content/qt31q9h8m0/qt31q9h8m0.pdf https://fred.stlouisfed.org/series/MSPUS https://www.washingtonpost.com/news/business/wp/2018/10/04/feature/10-years-later-how-the-housing-market-has-changed-since-the-crash/