[This real estate investing post was originally published as part of my monthly columns with Physician's Money Digest and can be found here. It sprang off many of the real estate discussions that have been taking place on this site recently.]
Individually Owned Property
Many physicians invest directly in rental real estate, whether residential or commercial. This can provide a great return thanks to appreciation of the property, tax benefits such as depreciation, amortization of the loan, and cash flow after all expenses are paid. Individual properties provide very low correlation with the rest of your portfolio and may provide quite stable value and cash flow. The real estate market is also much less efficient than the stock market, making it much easier to find deals that boost your returns.
5 Issues Owning Real Estate Directly.
1. It is difficult to diversify.
Even on a physician’s income, most investors can only purchase a few properties in their entire career. A REIT owns hundreds of properties all over the country, and a REIT mutual fund may hold dozens of REITs.
2. Property management can be a major hassle.
Real estate author John T. Reed points out that it is very difficult to hire a good property manager due to the nature of the property management business. Since they only make a few dollars a month from each property they manage, there is little incentive to manage a property well, but a great deal of incentive to spread themselves thin by managing as many properties as possible and accept kick-backs from contractors. He recommends that a real estate investor manage his own properties or, if he has enough properties, hire his own employee as the manager.
Physicians tend to be busy and neither interested nor adept at property management. They also have a job where they can trade their time for money at a very high rate, far higher than they could do managing properties. It’s bad enough to get a call at 3 a.m. to take care of someone who needs your help to save their life. It’s far worse to get a call at 3 a.m. about a leaky roof or a clogged toilet.
Owning only one, or a few properties, also doesn’t provide much economy of scale for management, maintenance, and other necessary chores.
3. It is difficult to be a long distance landlord.
This causes most investors in individually owned properties to invest primarily in their home town. It is unlikely that your town is among the best in the country for real estate investing at any given time. The desire to keep your investment close enough to check on may keep you from getting the best purchase price or the best rate of appreciation.
4. Financing for individually owned investment can be problematic.
Ideally, an investment is financed with a non-recourse loan — meaning if it does poorly and is foreclosed on the lender cannot come after you for the difference. However, it is very unusual for an individual property owner to be able to acquire non-recourse financing.
5. Transaction costs for real estate tend to be very high.
Five percent of the value at the time of purchase and 10% at the time of sale are not unusual, necessitating a long holding period to spread these costs out over many years. Since it can take months to sell a property, liquidity is also a serious issue.
Fractional Ownership of Commercial Real Estate
Some physicians advocate using a private syndicator to buy a fraction of a larger property rather than individual properties. Instead of buying a $250,000 house with $50,000 down, you could get together with 20 other investors and buy a $5 million property with $1 million down. There are a number of advantages to doing this.
First, you get a professional team doing the acquiring, managing, and liquidating of the property, allowing you to focus on your practice, your family and your hobbies. Second, you are no longer limited to investing in your home town. Third, non-recourse financing is generally available. Last, since you now own perhaps 100 apartments instead of just one house, there are management and maintenance economies of scale available and a vacancy has much less effect.
There are also downsides to investing in real estate this way. First, the minimums can often be quite high: $50,00 to $100,000 is typical. Second, fees can be quite high, with an acquisition fee as high as 5% of the value of the property and ongoing fees as high as 1% of the value of your property. The private syndicator may also take 20% to 33% of the appreciation of the property and amortization of the loan, depending on how the deal is structured. Third, it will cost you time and money if you actually want to go out and inspect the property, since it is unlikely to be in your home town. Fourth, just as with owning properties individually, liquidity may be difficult and you may have to wait months or even years to get your principle back. Last, since these tend to be small, private companies, there is risk that you’ll end up investing with incompetent, or even unscrupulous, folks. Doing appropriate due diligence and perhaps even background checks on the principals can be time consuming and expensive.
Pros and cons
Real estate can provide high returns and wonderful diversification to your portfolio. There are many ways to invest in real estate, but each method comes with its own downsides. Carefully weigh the pluses and minuses prior to adding this asset class to your portfolio.
Nice discussion.
Correction for you. R-squared is NOT correlation but coefficient of determination and can not be negative. You mean “r”.
You’re right. Thanks for pointing that out.
Sigh. You have both flubbed this basic statistics lesson. R^2 can be negative.
Interesting. You’re right. I always assumed since it was squared it couldn’t be negative. More details here for anyone that cares: http://stats.stackexchange.com/questions/12900/when-is-r-squared-negative
Nice article.
Would love an article re “real estate professional tax status”. esp in regards to a non working spouse applying for the status. Details like what activities are counted/allowed by irs, making election to aggregate all real estate. Dont know if that article would fit with the aims of this blog..but hoping.
Thanks
Sounds like an interesting article….any guest posters interested? It’ll require some research if I write it.
I’d suggest looking over on BiggerPockets for someone to guest author. They have a lot of good real estate content over there.
Hi, I’ve invested in real estate full-time for 14 years, and I grew up in a household with a high-earning Dentist mother and full-time real estate investor father. So I can add a few things to this conversation for those who stumble upon this topic like I did.
First, here’s a good BiggerPockets article on the basics of being a professional in real estate: https://www.biggerpockets.com/renewsblog/2010/08/04/basics-of-real-estate-professional-status-tax-irs/
Second, matching high earnings to large paper rental losses during their highest earning years saved an enormous amount of taxes for my parents. But the non-medical spouse must be sure to document 50% or more of their time professional hours to material participation in real estate. If you can’t do this, you can’t prove their professional status in case of an audit. Paying those taxes back later would be ugly.
Third, even if your spouse is not a professional, you might benefit from passive losses anyway through a strategy that includes 1) cost segregation, 2) accelerated depreciation 3) selling properties every 5 years. This is an advanced real estate strategy that requires expert assistance, but it might be a fun read for some of you:
https://www.biggerpockets.com/renewsblog/2010/08/04/basics-of-real-estate-professional-status-tax-irs/
Dr. Dahle, I enjoy your site! I’m definitely recommending it to dentists/doctors/lawyers in my family. I’d be interested in providing a guest post at some point should you want a real estate investing perspective. I’ll read through the archives and come up with some ideas.
Thanks!
My second link was a duplicate. Here’s the correct one for the advanced real estate strategy: https://www.biggerpockets.com/renewsblog/2015/12/18/cost-segregation-case-study/
Thanks for the links. Here’s the guest post policy:
https://www.whitecoatinvestor.com/contact/guest-post-policy/
Got it. Thank you. I can see you’ve been through the guest post spam cycle as well:) I look forward to submitting something of value for your review.
Not sure why you would want your non-working spouse to take this option. It almost always increases his/her tax rate by changing all real estate income into ordinary income versus capital gains or installment tax rates.
http://www.ustaxaid.com/ustaxaid-blog/big-loss-for-real-estate-professional-tax-status/
Excellent tips. I always say that real estate is one of the wisest investments that someone can make. I specialize in matching Wellesley real estate listings with interested home buyers, and the way the real estate market is taking off is a very encouraging sign for the next 24-36 months.
Tracy
I’ve been reading your blog for the past several weeks and I wanted to say thanks for all the fantastic advice!
The link to the original article no longer works; is the text still available somewhere? Thanks!
We’re still working on fixing those bad links. They’re all PMDs fault.
http://www.mdmag.com/physicians-money-digest/investing/4-ways-to-add-real-estate-to-your-portfolio-dahle
Thank you!
Nice informative post, thanks for sharing this.