My last post discussed investing in
- Real Estate Investment Trusts (REITs), which I covered in my last post
- Traditional
real estate , which I’ll cover in this post.
“Traditional
- Main home (buying outright, buying with a loan, rent-to-own, etc.)
- Vacation property
- Long-term rental property
- Short-term rental property (such as AirBnB)
- Real-estate investment groups
- Timeshares
- Flipping houses
- Crowdfunded
real estate (such as Fundrise or Realty Mogul) - Commercial/industrial property
For this post, I’m going to focus on the most common
Is Home Ownership an Investment?
As I noted in my last post, home ownership fits the common sense definition of an investment. But it’s probably unwise to decide whether to buy a home based purely on the math of investing. Home ownership is a decision supercharged with emotion and sentimentality. We bought our home almost 15 years ago, and the market price has hardly gone up in that time, which makes it a bad investment. However, we’ve reaped so many non-financial benefits from owning a quiet rural house with a lovely garden, fruit trees, a big yard for our kiddo, and easy access to the local ski area. For many people, their home brings a sense of enjoyment and security that’s priceless. But I argued in my last post that once you’ve decided to buy a home, it makes the most sense to consider it part of your long-term investing portfolio, along with all your other investments.
The Good and Bad of Leverage
Many people see an inherent advantage in traditional
However, leverage is a two-edged sword, whether you use it for
Traditional Real Estate as An Investment
I found in my last post that investing in REITs is pretty similar to investing in the overall stock market. Does traditional
Correlations – I searched for several different ways to examine correlations between traditional
Returns and Volatility – What about returns and volatility? I used Federal Reserve Bank of St. Louis (FRED) data on median U.S. house prices dating back to 1963 to compare the historical returns for
Of course, price changes are only one source of long-term returns from traditional
It’s a vast understatement to say that opinions vary on the ratio of rental income to property value that you can expect. One common rule is that real estate investors should shoot for monthly rent that is 1% of the house price, which equates to 12% in annual rent. Another common rule is that you should expect about 50% of the collected rent will go to expenses (not including mortgage payments) such as property taxes, insurance, maintenance, vacant periods, etc. So, I applied these rules and estimated net rental income as 6% per year (half of 12% per year).
You’ll also see widely varied opinions about the realism of the 1% and 50% rules. One variable, among many, is that 1% monthly rent is pretty reasonable for low-cost-of-living regions, like the rural mid-west and south, but completely unreasonable for high-cost-of-living areas in big cities and coastal states. My experience with rental properties in coastal and more rural Washington State is that netting 6% rent per year is a pipe-dream. Consequently, I also calculated total return based on netting 4% rent per year, which for Seattle (and I suspect many other high-cost-of-living cities) is still very optimistic.
Here are two graphs of total returns from 1963 through 2017, assuming that $10,000 was initially invested in:
- A main home or vacation property that is not rented (the “House Price” scenario)
- A rental property with 4% net rent (“House Price + 4% Rent”)
- A rental property with 6% net rent (“House Price + 6% Rent”)
- Bonds represented by 10-Year government bonds.
- U.S. stocks as represented by the S&P 500
To better show both the early and late growth trajectories of each scenario, the first graph uses a log vertical scale and the second uses a standard vertical scale.
And here are some key metrics for these same scenarios.
| Scenario | Final Value | Annualized Return (CAGR) | Best Year | Worst Year | No. of Houses Acquired |
| House Price | $189,831 | 5.42% | 17.37% | -9.2% | 1 |
| House Price + 4% Rent | $766,629 | 8.06% | 16.55% | -3.5% | 4 |
| House Price + 6% Rent | $1,406,094 | 9.22% | 20.33% | -1.5% | 8 |
| 10 Year Bond | $282,884 | 6.23% | 32.81% | -11.1% | NA |
| Stocks – S&P500 | $2,249,405 | 9.93% | 38.46% | -37.2% | NA |
Stocks are the clear winner in terms of final value, at least in this period from 1963 through 2017. But the difference in annualized return between stocks and
I couldn’t generate detailed volatility statistics with the frequency of data used here, but the best- and worst-year statistics show that traditional
The “house price” scenario is analogous to the return on your main home, and this analysis shows that the median U.S. home was a much worse investment than even government bonds, at least in this period. The same conclusion applies to a vacation home that’s never used as a rental. For the two rental scenarios, compounded rent contributes between 75% and 86% of the final value coming from rental income, for net rent between 4% and 6%**.
Considering the particulars of this analysis and the results for both returns and volatility, I conclude that a carefully selected and operated rental property investment is nearly as good an investment as stocks.
Qualitative Factors
For me, more qualitative factors break the tie between investing in stocks versus traditional
- You have to constantly monitor and control rent expenses to achieve the net rent you projected.
- You have to save the net income consistently and find the best available cash interest rates.
- Once you’ve saved enough income, you have to quickly find a good next rental house to buy, regardless of the prevailing market conditions. (Biding your time slows down the rate of compounding.)
- Meanwhile you have to keep up on the maintenance and steady occupancy of your ever-growing fleet of rental houses.
- You need to avoid acquiring too many poor-performing rentals. But you can’t swap out poor performers too much, because the added process costs will further erode your returns.
And you have to do all this consistently year after year, house after house, until you have a pretty remarkable
I’m willing to agree that many
- Are a small minority among traditional
real estate investors. - Work in regions of the country or local areas with high rent ratios.
- Are extremely knowledgeable and savvy about
real estate investing, having learned from earlier mistakes and money lost. - Are using leverage in very controlled and specific circumstances, which requires even more savvy.
- Enjoy running a full-time business in rental
real estate , which is anything but passive.
One way to make rental property income more passive is to hire a rental property manager, who will typically take at least 10% of the rent in addition to other specific costs that can arise. But given the virtual tie between traditional
It’s also worth noting that the government taxes
Conclusion
Traditional
- A bad investment in the case of a main home or non-rental vacation home,
- A good investment that’s a considerable hassle in the case of do-it-yourself rental properties, or
- A decent investment with some hassles in the case of rental properties with a manager.
That’s not a ringing endorsement.
On the other hand, the mindful perspective on diversification is that we can never predict the future. Because no one knows what will happen next, moderate amounts of diversification across relatively high-return investments, like stocks and traditional
Personally, I never want so much traditional
*I assumed the cash earned a return consistent with a high-interest bank savings account by applying the average annualized return of 3-month T-bills over the period 1963 to 2017, which was 3.38%. To some degree this confounds
**If I exclude interest paid on the saved cash, rent accounts for 59% to 68% of the total return.
