By Dr. Jim Dahle, WCI FounderThere are a lot of terrible ways to invest in real estate.
Let's go over seven of the worst.
The Worst Ways to Invest in Real Estate
#1 House Hacking as a Student
House hacking means buying a house to live in and then renting out part of it to roommates. It's not the worst way to get started in real estate investing. Lots of people start out with a duplex where they live on one side of it for a while and rent out the other side. But that's not really the case if you're a student without an income.
The sales pitch of house hacking is “someone else pays for your mortgage and you don't have to pay any rent.” The reality is often dramatically different. Now, you're in a position where you have to extract rent from people with whom you're trying to maintain a roommate-like relationship. The tenant is no longer just limited to trashing the house. They can trash your personal stuff, hurt you, or just do all kinds of passive-aggressive mischief.
But the real issue is the financial risk. A typical student doesn't have much in the way of assets or income. They might not have even qualified for the mortgage without a co-signer (and co-signing on this sort of deal may be even worse than being the owner). If a big repair comes up, you don't have any other income to use to fix it. Plus, the lack of assets probably means you didn't put enough money down to have this be cash flow positive, especially if you take the primary bedroom (i.e., the most valuable part of the house to a potential renter) for yourself.
“Feeding the beast” every month using student loans and hoping you make it all back when you sell isn't a very comfortable position. Plus, most people are only in school for a maximum of four years, and whether the property will appreciate enough in that time period to overcome the transaction costs is a gamble.
#2 Accidental Landlord
Many of us have been in this situation. This often happens when someone buys a house in residency. Then, three years later when it's time to move to their attending job in another city, they can't sell their house because they're underwater, because it isn't very desirable, or because they bizarrely choose not to because they think it's a great investment. Now, they need to figure out how to be a landlord and find a renter, and they need to do all this with serious time pressure and/or from a long distance away. It's not going to end well.
The main problem is that we buy houses differently when we're going to live in them vs. when we're going to rent them out. The only benefits of renting out someplace you've already been living in are that you don't have the transaction costs to buy and you can probably get away with using the mortgage you already have (owner-occupied mortgages are generally a little cheaper). Those advantages may not be enough to make up for the fact that the property doesn't pencil out as a cash flow positive rental. Especially if you bought it with little down using an FHA, VA, or doctor mortgage.
More information here:
How We Became Accidental Landlords: Turning a Primary Residence into a Rental Property
6 Reasons We Lost Money on Our First Rental Property
#3 The Vacation Property
The idea here is that you're buying a second property to use that you really can't afford. So, you plan to rent it out part of the time to cover your costs. Again, there is the issue that you're not using your “investor eyes” when you buy it. You're using your homeowner eyes. You're picturing yourself staying in this property with your family and friends, and that doesn't lead to the best investment decisions. You overpay. You overupgrade. You overfurnish. You overpersonalize. Whatever. The better it becomes as a place for your family, the worse it becomes as an investment, and vice versa.
Plus, the times you want to use it are some of the most profitable times to rent it out, so you're always faced with hard decisions and feeling guilty about staying in your own place.
#4 The 1-2 Rental ‘Empire'
Plenty of people get excited about real estate investing and buy a property or maybe two and then stop. It turns out it isn't very fun. It's a lot of work.
The problem with only having 1-2 doors under management is that you're a rookie and you'll remain a rookie. You'll enjoy no economies of scale. There isn't enough income to feel like you can hire out everything, and you feel like there isn't quite enough work that you can't just do it yourself. But you hate doing it. And to avoid hard conversations with tenants, you just give them sweetheart deals on their rent, reducing the profitability of the property.
#5 ‘Nothing Down!' Deals
There are books and seminars teaching methods to invest in real estate despite not having any capital of your own. As a general rule, this is a bad idea. Get a job, earn some money, save a big chunk of it, and use that capital to invest in real estate. As your real estate produces more income and increases in value, use that money to buy more real estate.
The problem with not putting down 25%-40% on each property is that you have little protection in the event that you need to sell the property earlier than anticipated. Plus, minimal down payments make it far more likely that you will be in a cash flow negative situation, which is how all real estate nightmares begin.
#6 Investing with a Syndicator Without a Track Record
Good syndicators can be hard to find. It's not that easy to line up a good property or even a fund to invest in at the exact time you need to invest some money. Maybe you default to someone you know personally or someone who came looking for you. Maybe that person isn't very experienced. Although they've owned a few properties themselves, maybe they've never done a syndication or run a fund. Or perhaps this is just a part-time gig for them. Maybe three years from now, when your syndication is only halfway through its renovation plan, they'll get bored. Or worse, they're actually running a scam. Now, you've invested $50,000 or even $100,000 with them into an illiquid investment, and you can't do a thing about it but hold on and hope.
This is an even bigger issue if that $100,000 was a lot of money to you and you're not buying a diversified portfolio of these things. Don't let someone else learn how to run syndications or funds using your money. Find someone who already knows how to do it well and invest with them.
More information here:
Real Estate Syndications — Who Are They Right For?
A Tale of 2 Sponsors: How My Real Estate Investments Have Had Vastly Different Results
#7 Making an Undiversified Mortgage Loan
I like investing on the debt side of real estate. The returns are usually pretty high, dramatically higher than cash and bonds and rivaling stock market returns. You usually get first position in the capital stack, so when things go bad, you can foreclose and get your capital back. But you don't actually want to foreclose yourself. You want someone else to take care of that for you. And frankly, you don't want to put all of your money into a single mortgage or even five. You want a fund that has 50 or 100 or 5oo of these loans all bundled together and run by someone who has foreclosed on properties under development before and knows how to do it efficiently. Don't run your own mortgage loan fund on the side.
See the End from the Beginning
I think you can see a trend in all of these examples above. If you want to invest in real estate, you need to see the end from the beginning and set up these illiquid investments in a way that you'll still be happy with five or ten years from now. You need to do this in a professional manner, not ad hoc. There are several ways to intelligently, professionally, and profitably invest in real estate. Use one of them instead of the half-cocked, hare-brained ideas above.
While you will certainly meet plenty of real estate investors who “got started” using one of the ideas above, most of them now agree it really wasn't that great of an idea and was probably incredibly risky. Here is how to actually invest in real estate.
#1 The Academically Sound, Diversified, Liquid, and Hassle-Free Way
Perhaps the easiest way to invest is simply to buy something like the Vanguard Real Estate Index Fund. This collection of 120+ publicly traded REITs provides massive diversification, liquidity, and zero hassle. Data also suggests that publicly traded real estate has had better total returns in the past than private real estate. Adding VNQ to an index fund portfolio absolutely is “real estate investing,” but that doesn't mean it has to be complicated.
We cover this option as well as “more advanced” options in our No Hype Real Estate Investing online course and our free monthly real estate newsletter.
More information here:
#2 The Passive Method for Rich People
If you're already wealthy and want to diversify into real estate, you can consider investing in real estate passively via private syndications or, better yet, private funds—which provide more diversification than individual syndications with similar minimum investments. Not only are you legally required to be an accredited investor (income of $200,000+ each of the last two years or at least $1 million in investable assets), but you honestly need more money than that to build a truly diversified portfolio and minimize the associated tax hassle.
If you are not investing at least $500,000 into private real estate (25% of a $2 million portfolio), it is going to be hard for you to meet the minimum investment with the better sponsors while still diversifying adequately between them. Plus, who wants to file eight state tax returns for an investment that only pays a couple of thousand dollars a year in income? With $500,000, you can invest $100,000-$200,000 with each of 3-5 different managers. With $2 million in real estate (20% of a $10 million portfolio), diversification won't be an issue at all, and the tax hassle and cost will be minimal compared to your new passive, tax-advantaged income. What is probably a great idea with $2 million is a terrible idea with $25,000.
You can learn more about investing by checking out our real estate partners.
Featured Real Estate Partners
#3 The Hands-On Method
Another great option is to really get into real estate. This becomes a part-time job, at least for a while, because you're going to need to take a professional approach to this. Whether you choose to run a “hotel business” with short-term rentals or work toward a 20-, 50-, or 100-door long-term real estate empire, this is a serious pathway to wealth.
Use a reasonable amount of leverage (60%-70%) and work toward acquiring Real Estate Professional Status (or at least the 100-hour short-term rental loophole). Done well, the tax breaks and the returns of being a direct real estate investor can be fantastic. After doing this successfully, you may very well look around and wonder why so few others are doing what you're doing. Well, the reason is because it requires a lot of learning, a lot of work, and often a fair amount of risk. Your financial life will be dramatically more complex. But you may also have far more wealth than you ever imagined, and you could free yourself from your 9-5 far earlier than you expected.
You can learn more about buying and managing short and long term rentals by taking our No Hype Real Estate Investing Course.
What do you think? What would you say are the worst methods of real estate investing? How do you invest in real estate?
Inheriting property can be a bad way to own real estate. Older buildings are often full of lead and asbestos. They might even have nob and tube wiring. They might have leaching underground oil tanks not properly disposed of. Old concrete septic tanks where I live are now failing, literally collapsing and have to be remedied according to Code.
Yea, wish I would have thought about that while writing this piece. It would have been a good # 8. I mean, you have those potential problems when you buy too, but an inheritance is harder to walk away from. You can do it though if the property really will cost more to rehab than it is worth.
Inherited property holds all kinds of risks in some states like VA. It’s not unheard of still in VA to find old graves on property, especially where rural property is turning suburban. Or worse, bones in old trash heaps before deaths had to be recorded. Forgotten family graveyards, slave burials, Civil War soldiers, and bones in the cellar, Its an expensive process paid for by the owner to take care of. And there is the problem of Crown Land Patents where VA recognizes these and old encumbrances on rural land are enforced. I disclaimed property, not wanting the drama at this point in my life.
A stock index fund is self-regenerating as new companies replace the old failing one automatically. This doesn’t happen with individual real estate as the properties decay. What was a nice apartment building to rent out may change in 40 years.
How do long term real investment investors that own their properties directly handle this? What might be great property portfolio when one is 45 years old may change at 75. You don’t have this issue with stocks, the only dilemma is whether to increase bonds as you age.
There’s a reason you depreciate the dwelling. It really does become worth less over time and must be maintained, upgraded, and periodically, bulldozed.
Real estate has the potential to be a great investment, but you are absolutely correct that it has to be done wisely. I bought my first RE investment property when I was finishing residency, long before I bought my first personal residence. That was decades ago. The market value of my RE holdings is now around 23M, with around 14M in equity and an almost 7-figure net cash flow each year. RE investing worked out well for us, but it does make our financial life more complex.
If you had to start from scratch in today’s market… where would you invest? Still in RE? If so, how would you go about finding your first properties? How would they cashflow?
Similar to Ziggy, I purchased my first property the year after residency and have purchased 1-3 since (including 2 last year and 1 this year). I’m certainly not at the 7-figure cash flow range, but am comfortably in the mid 6-figure range to where I’ve achieved financial independence comfortably in less than 15 years out of residency.
I generally recommend that if people want to get into real estate they should approach with the intent of truly dollar cost averaging real estate. You cant time the market and if interest rates are high, prices are lower, and vice versa. The real king is cash flow. For a long-term rental you look at zillow and look for the rent for a given property, and then find a sales price of a home that allows you to cash flow a reasonable amount (I generally recommend a 6-10% return on the cash you’re putting in).
Here’s an example – this house for sale currently in Maryland –
https://www.zillow.com/homedetails/10216-Wild-Apple-Cir-Montgomery-Village-MD-20886/37251028_zpid/
Its listed at 350. If you get it for 310, with 25% down (roughtly 90k including closing costs), your monthly payment (PITI) will be 1800. Your rent for that property will be 2600 -ish (other houses in the neighborhood). Your monthly cashflow will be 800 with an annual return of 9600. Assume some vacancy and some misc expenses and you’re at 8000 and getting an 8% cash on cash return.
I’m not saying buy that house, I just quickly zillowed a house to give you some rough numbers. Getting someone to sell for 40k less than asking isnt easy either, but if you’re serious you should throw out 10 offers for 1 to hit.
You keep that house for a few years, if interest rates drop your monthly payment goes down price goes up. If they dont it doesnt matter because you’re still cash flowing.
Keep in mind you’re depreciating the cost of the house on your taxes, you’re paying down the principal, and that house will likely appreciate at some point if you’re getting it 30-40k under asking.
Then save up another 80k and do it again. At some point you’ve got 5-10 houses and it’s much easier to consistently purchase more property as long as you dont touch the cash flow.
PassiveIncomeMD talks a lot about this method (hes actually posted here).
More importantly once you’ve gotten a few long terms under your belt, you feel very comfortable experimenting with short terms and multifamilies which tend to be more lucrative but require more work/expertise.
Good luck!
If rent paid is 2600 and your mortgage is $1800, there’s no way your cash flow is $800 a month consistently. There are other expenses besides PITI. Maintenance, repairs, management, and vacancies to list a few. May still work out great, but there’s a little more to it than that.