By Dr. James M. Dahle, WCI Founder
This is one of those posts that I'm writing in hopes that the comments section will be full of bad experiences investors have had with real estate. That's not to say bad experiences are not possible with other asset classes, but obviously people are getting the message somehow that “you can't lose with real estate,” which is obviously not the case.
However, before we get to the comments section, I've got to find something to write, so I thought I'd write a few words about how money can be lost in real estate investing, artfully illustrated by my own personal experiences losing money in real estate!
#1 Property Value Can Decrease
Let's start with this one. Trees don't grow to the sky. The value of real estate goes down from time to time. This is well-illustrated by looking at the share value of the Vanguard REIT Index Fund over the last 20 years or so.
Now, if you look carefully, you'll see something very interesting, right in the middle of the graph. I know, it's subtle and hard to see, but if you really squint you can see that there was a slight decline around the end of 2008. As an investor in this fund during that time period, having originally bought in very close to the preceding peak, I can assure you that decline was very real. 78% from peak to trough actually. But don't just look at the big drop. Look at all the little ones. Real estate goes down in value all the time.
Okay, now I'm sure there are a few of you real estate addicts who are now arguing in your head “but those are paper assets” blah blah blah. Are you seriously arguing that real estate never goes down in value? Maybe you'll pull out a chart showing housing prices going up, up, up all the time. Well, there are a few issues with those charts.
First, they usually don't account for the fact that houses are getting larger and more luxurious.
Second, they're never adjusted for inflation. Let's look at one that is.
As you can see, there are not only times when housing values decline, but they can also remain quite flat for long periods of time. Basically from 1970 to 1998 house prices did not increase on a real basis. Appreciation of the property is a major contributor to your real estate return, especially if you are highly leveraged. Take that away and things look much less rosy.
Robert Shiller adjusted for not only inflation but also the fact that houses are getting nicer. Here's what his data looked like (it's not quite up to date):
Lots of ups and downs there over the last century plus. But that's all housing, you say. I don't invest in residential. Okay, how about this chart?
Anyone still want to argue that real estate doesn't go down in value and that the value can't stay down for many years? I didn't think so.
#2 Individual Properties Do Not Mirror the Overall Market
Just like an individual stock may not track the return of the overall market (thus why you should invest in index funds) an individual property may not track the indices above. Real estate, at least outside of publicly-traded REITs, is a far less efficient market than the stock market. That means your skill, or lack thereof, can have a large impact on your returns. Luck can also be a major factor. (Of course, we call it skill when things go well and luck when things don't.) What are some of the reasons for this? Let's consider a few:
- First, you often don't buy a property as an investment. Many landlords are accidental real estate investors. They're renting out the place they used to live in. When they bought it they did so because they liked the layout and the paint and the neighborhood, not because a cold, calculating analysis showed it was likely to make money. Then they were forced to move before they wanted to or they're underwater or they heard from a friend that real estate is a good investment and so they keep it when they move out. Or they move out in 2010, like we did, and NOBODY wants to buy real estate at anywhere near a reasonable price. After moving out in June 2010, we spent 15 months trying to sell our townhouse accidental rental. We had it under contract within a month, but after that fell through we didn't even have a nibble until we gave up over a year later after multiple price reductions.
- Second, vacancies happen. A lot of times we run our numbers assuming we're actually going to get a rent check each month. That is often not the case. Maybe you account for one or two months a year of vacancies when you run the numbers, but then have three or four. In our case, even after we gave up trying to sell and went looking for renters it took us four more months to get one in!
- Third, unexpected expenses happen. Bathrooms flood, roofs leak, A/C units stop working, etc. These will cost you time, aggravation, and/or money. Experienced investors estimate well for these expenses, but sometimes even they are surprised. Inexperienced investors often hemorrhage all theirs gains paying for expenses and upgrades.
#3 Lack of Cash Flow
Lots of investors get in trouble due to cash flow problems. It simply isn't enough for rent to be higher than the mortgage payment. If your cash flow does not cover all of your expenses, even “one-time” expenses, you are going to have to feed the beast from your other earnings or your savings. Do this long enough and you will go broke. However, if you can keep your cash flow positive, you can ride out fairly dramatic but temporary decreases in value.
Leverage can really boost your returns, but leverage works both ways. Interest never sleeps.
“It is a rule . . . in all the world that interest is to be paid on borrowed money. May I say something about interest? Interest never sleeps nor sickens nor dies; it never goes to the hospital; it works on Sundays and holidays; it never takes a vacation; it never visits nor travels . . . it has no love, no sympathy; it is as hard and soulless as a granite cliff. Once in debt, interest is your companion every minute of the day and night; you cannot shun it or slip away from it; you cannot dismiss it; it yields neither to entreaties, demands nor orders; and whenever you get in its way or cross its course or fail to meet its demands, it crushes you.” –J. Reuben Clark, Jr.
It is impossible to go bankrupt without debt. Most of the really terrible real estate investment disasters that occur result from overleverage. A 20%-40% downpayment not only improves your cash flow, but also gives you the ability to sell a property despite a significant decline immediately after purchase.
#5 Assumptions Were Wrong About Investment Property
When you run the numbers before buying an investment, you must take a certain number of assumptions. You try to be conservative, but sometimes you're just wrong. Maybe you (or your hired manager) can't increase rents like you thought you could. Maybe the property doesn't appreciate like you thought. Maybe vacancies increase. Whatever. But the process of estimating future returns is HIGHLY dependent on inputs. It's a garbage-in, garbage-out process. A number of my syndicated properties are currently underperforming their pro-forma. While you never know the true overall return until the investment is liquidated, and the manager will give you a wonderful sounding excuse for why they're underperforming each quarter, it basically boils down to the fact that you (or your manager) did a poor job of predicting the future.
#6 Property Manager Risk
Many of us (like me) have discovered that not only do we not enjoy buying, managing, and selling our own properties, but that we aren't all that good at it. So we hire someone else to do it. Their credentials sound very impressive when you hire them, but sometimes they just suck at their jobs. That risk is one reason you lose money in real estate.
#7 Crowdfunding Platform Risk
Sometimes we don't go directly through a manager, but instead through a third party like a crowdfunding platform. A good example of this risk showing up can be seen with RealtyShares, one of the largest and fastest-growing of the crowdfunding companies, at least until it wasn't. When they went under, I had one investment left with them, a debt investment backed by a property that the flipper was having trouble finishing and selling. He eventually did get it sold and supposedly paid off the loan. This is what RealtyShares told me:
Yet here I am on June 25th wondering where my last $34.17 in principal is.
My emails go unanswered. That's called manager/platform risk. Yes, I still made money on the investment, but I didn't make as much as I should have.
#8 Products Designed to Be Sold
Sometimes you just get sold an investment, rather than buying one. The classic example of this in real estate is the old broker-sold private REITs. The commissions and expenses were so high on these things that it was always unlikely that the investors were going to do very well. They were promised an 8% yield, which they usually received, at least for a while. The problem was a good chunk of the yield was a return of principal and the value of the investment was dropping while the share price appeared to be quite stable. One prominent example kept share values stable at $10/share. . . until all of a sudden, they were worth $1.50 per share. Ever since the 2012 JOBS Act, real estate is being sold in more and more forms all over the internet. Some of these will undoubtedly eventually show themselves to be products designed to be sold, not bought. Caveat Emptor.
#9 Liability with Rental Properties
A rental property is a toxic asset. Buy plenty of insurance to protect against loss AND liability. Fix problems promptly. The property should usually be placed in a limited liability company. In most states, this provides both internal and external liability protection. One way to lose money on a rental property is when liability risk shows up and you are not prepared for it.
Even successful real estate investors have taken their share of lumps. If you think you, as a new, inexperienced investor, cannot lose money in real estate, you're a fool. Diversify, exercise due diligence, beware of negative cash flow, don't overleverage, buy insurance, be skeptical about your (and anyone else's) ability to predict the future, and be prepared to hold your investment for years longer than you originally planned.
What do you think? How have you lost money in real estate? What's the worst real estate disaster you've heard of? Comment below!