Hey real estate overinvestors. I hear you. You can’t build more land. You like investing in what you can understand. Maybe you even got burned by the stock market in that short window where you tried to trust it. Whatever your reasons, you’re more comfortable with trusting buildings and tenants than you are the income streams of thousands of businesses you know nothing about.
But hear me out. I’d like to gently argue why at least one-third of your wealth should be in businesses – more specifically, the good old-fashioned, low-cost stock mutual funds that hold them.
What’s to Like About Real Estate
I’m a fan of many forms of real estate investing. And if you treat it as a serious part-time or full-time profession, it may be fine to hold a larger percentage of your wealth in real estate than financial planners typically recommend. Including one’s home, I’ve never seen an advisor recommend more than 50% of total net worth. But my guess is you will creep well past that threshold (if you aren’t already).
Real estate is often easier for the average person to trust and understand than the stock market. You buy a building and charge someone to use the space. Compare that to buying shares in a company operating thousands of miles away, that’s run by a board you know nothing about, through a system with no shortage of headlines involving corruption. Hollywood has made countless (fantastic) movies showing why you should be leery of the system: Wall Street, Boiler Room, American Psycho, The Big Short, Wolf of Wall Street, etc. There aren’t too many films about dodgy renters conspiring against landlords.
As a real estate investor, you also enjoy significant tax deductions. It’s quite normal to have positive cash flows but pay very little tax because you’re able to deduct all out-of-pocket expenses as well as depreciation.
Some of you may feel less stress as a landlord than as a stock market participant. For starters, there aren’t ticker symbols scrolling across countless TVs telling you how much the value of your property has gone up (or dropped). While you can get a rough estimate of your building’s value online, it won’t feel as scary as seeing a statement showing you lost 10% of your money during a short-term correction. And if your rental property does dip in value, you’re more understanding because you still have paying tenants. Even if you were stressed about the drop (don’t be) you can’t just push a “sell” button and convert your investment to cash in a matter of minutes.
With all that’s right about real estate investing, why not just start with one building, save the income up to buy another one, then rinse and repeat until you have a real estate portfolio large enough to cover your needs for the rest of your life? One day, you’ll be sitting pretty with a six-figure rental property income stream and never have to go anywhere near stocks. When you die, some lucky heirs will get all of your real estate and can sell some or all of it tax free!
So what’s my hangup with this plan? For the sake of this article, I’ll make five key assumptions:
- Your ultimate goal is to maximize the growth of your wealth so you can eventually maximize your spending from that wealth.
- While you take pleasure in knowing your heirs will inherit something, it’s not a high priority to leave anyone a minimum amount of wealth (i.e. they’ll get whatever they get after you live your best life). In other words, you don’t have kids or don’t wish to spoil the ones you have.
- The types of rental properties you’re buying, inheriting, converting, or considering to buy are single-family dwellings and duplexes. (Meaning, I’m not referring to you bigwig real estate developers or the investment in large, high-grade commercial properties.)
- As a landlord, your net income will average out to about 3% (cap rate) and you’ll experience an average annual appreciation rate of 3% per year. (I know, both could be much higher, but they can also be lower in some years.)
- There’s no way to know which investment “wins” over the long haul, due to variables that are unique to each owner (i.e. mortgage rate, geographic location, vacancy periods, surprise expenses, involvement of property management company, etc.).
So what’s wrong with going all-in on real estate? Let’s go through a short list of my biggest concerns.
Diversification is Harder in Real Estate
If you only own a handful of rental properties, who’s to say one of these won’t end up being the Enron, Pan Am, Polaroid, Blockbuster Video, Texaco, Sears, or Netscape of rental properties. This could happen due to holdover tenants, squatters, earthquakes, neighborhood problems – any number of surprises – which is one key advantage of buying real estate through a Real Estate Investment Trust (REIT) (basically, a fund that owns many properties).
Real estate is a single asset class that comes with its own unique risks, even if you own multiple properties in different locations. As I write this, Los Angeles landlords are not allowed to raise rents on nearly three-quarters of their apartments until 2023 (possibly longer). While you may celebrate that as a win for tenants’ rights, it can greatly impact the return achieved after factoring in inflation. The unexpected pandemic created a perfect storm for landlords: the struggle to maintain or increase rents, all while rental property expenses rose with higher prices for building repairs.
Leverage in Real Estate is a Double-Edged Sword
One of the most attractive components of real estate investing is the leverage. A highly leveraged real estate investor (small down payment, big mortgage) can earn an internal rate of return higher than what “the stock market” should deliver. But this can backfire if your entry point is bad relative to a real estate market cycle, especially if you don’t have large cash reserves.
Imagine buying a $2M building with a down payment of $600,000, then having your building lose 30% of its value in the first year. Oh, then your tenants move out at the end of their 1-year lease. On paper, you have lost 100% of your investment and you’re still on the hook for the mortgage, taxes, and other essential expenses (until you replace your tenant). With a traditional stock portfolio, you can just take a breath and wait out a short-term market correction with no expenses to worry about.
Time is Money in Real Estate Investing
If you’ve owned even one home, especially with a mortgage, you know there’s paperwork (then more paperwork) with the buy and sell transactions, not to mention hair-pulling moments dealing with lenders, appraisers, and the escrow company.
Owning rentals likely means tending to tenants, repairs, and even a management company. If you value your time, you should factor this as an expense when determining how the whole experience is working out for you. In other words, if you could choose between two investments where each provided the same return – but one requires 40 hours per year of your life, and the other requires 1 hour per year – the latter should be the more attractive option (unless you categorize this work as a fun hobby that brings you joy).
Principal Invasion Isn’t a Bad Thing
You might see it as a positive to know your buildings can kick out income for life without ever having to sell them (which results in a large tax bill). But if it isn’t a priority to maximize someone’s inheritance, wouldn’t you want the option to access some of the nest egg you’ve spent decades building up?
People commonly share the goal to “die broke,” which refers to maximizing your spending in the retirement years but not to the point of outliving your portfolio. You can’t take it with you, right? If all of your net worth is tied up in real estate in your last few decades of life, your spending will be limited to whatever dividend you happen to get off your buildings each year.
Many of my clients have cash flow needs that change dramatically between age 60 and 80. They want the flexibility of drawing their portfolio down in their 60s so they can travel more, but are more than happy to reduce their spending between ages 80 and 100 (i.e. no more cars to buy, done with international travel, etc.). Right now, can you say for sure what your wants and needs will be 10 to 30 years in the future?
Retirement Years Cash Flow Crunch
A key disadvantage with real estate overinvesting as a way to generate cash flows in retirement is that those cash flows will likely be lower than what you could draw from a traditional portfolio of mutual funds. Why?
At the start of a retirement phase, I suggest a spending rate of 4% to 5% of a retiree’s (well diversified) nest egg balance. Each year after, the retiree can give themselves cash flow raises to keep pace with inflation – much like you, as a landlord, can raise rents at the start of each lease period (though, you probably aren’t doing that).
For example, this means someone with a $2M portfolio could set up recurring monthly distributions of approximately $6,700 per month and continue doing so even if their portfolio experiences a year or two with negative returns. It requires a touch of trust in the capital market system over the long run, but we have decades and decades of performance data to support why that’s a smart, calculated risk.
If that same $2M portfolio was a rental property, and your cap rate is 3%, you’ll receive $5,000 per month. Any months with higher than expected expenses or tenant turnover could reduce this cash flow stream. It’s not that you aren’t getting a decent return on paper, it’s that the return is hiding in the building and you can’t just ATM that appreciation. Your only option, if you need more cash flow than what’s coming in, is to borrow against it (mortgage, line of credit, etc.) or to sell a property or two (assuming you have more than one).
Selling a property after years, or even decades, becomes less than ideal as you get older. You’re well aware that all of the depreciation you’ve written off, combined with the appreciation, means one very large tax bill if you sell – a tax bill that goes away for your heirs if you can hang on until your death. If you get stuck in this situation, you’ll likely need to explore a 1031 exchange into some kind of commercial property investment to boost your net income. That will reduce your liquidity even more, but is probably a more attractive option than paying huge capital gains taxes.
Your 2-Step Plan to Not Becoming a Real Estate Overinvestor
Here’s my 2-step plan to prevent becoming a real estate overinvestor:
- Max Out to a Retirement Account
Take advantage of one of the biggest free lunches in the investment world – the 401(k) plan. If you are self-employed (in the business of real estate or otherwise), you may be eligible to make a deductible contribution as high as $64,500 (if you’re over 50). If you are employed by someone else, put as much as you can into their employer-sponsored plan if they offer one, including after-tax contributions (if permitted). This will ensure you’re at least building up a modest, but totally liquid, nest egg for the final few decades of your life.
If you don’t trust the stock market, dial the risk down so you can handle the volatility, and just leave it alone. Invest in a diversified pool of low-cost mutual funds that exposes you to stocks, bonds, and commercial real estate, all around the world. If your income also allows for you to contribute to a ROTH IRA, do that as well! If you want a financial planner to help you with that and other general planning help, hire a fee-only advisor who acts as a fiduciary.
- Set a Real Estate Ceiling
If you’ve maxed out all possible retirement plans, and you have surplus income to start buying buildings, set a ceiling for how much of your overall investment portfolio can be consumed by real estate (excluding your primary residence). For example, you might set it at 50%. If your Solo K has a balance of $500,000 and your equity stake in your properties was 50%, you could own $1M of real estate before you shift your investing back to mutual funds.
You can also follow the rules of the Talmud Portfolio (the Talmud is a collection of Jewish texts), which uses a rule that dates back more than 1,000 years. The rule basically states one should invest 1/3rd of their wealth in land, 1/3rd in business, and 1/3rd in reserves. Interpreted for modern times, let’s call it 1/3rd in stock, 1/3rd in real estate, and 1/3rd in bonds and cash. Frankly, I think 1/3rd in cash and bonds is too high for most people in the wealth-accumulation phase of life, but it may be a suitable ratio for a retiree.
A Boost To Your Glory Decade (or Two)
If you see real estate as the key to a stable income stream that lives in perpetuity, your mutual fund nest egg can function as a top-off cash flow vehicle. In years where your rental income is lower because of tenant turnover or large surprise expenses, you can draw from your mutual funds.
You can also view the mutual fund portfolio as the vehicle to fund your wants between the ages of 60 to 80. That would allow you to increase your spending in the years many people wish to do so (hello travel!). Most of us just don’t keep leasing fancy cars and traveling to far away places once we hit our 80s. But you will need reliable cash flows for your basic needs.
As a final example, let’s say you add $20,000 per year to a brokerage account between ages 35 to 60 and it grows to a worth of $1.2M. If your goal is to spend this bucket down to zero on lifestyle enhancement between age 60 and 80, that’s about $30,000 per year (in today’s dollars) for expenses you don’t expect to have beyond the age of 80.
Lastly, don’t forget the possibility of surprise nursing costs, assuming you don’t have a long-term care insurance policy. Those costs can hit six figures pretty quick. Instead of being forced to sell a property at the worst possible time (close to death), your liquid investments can save the day.
Again, using a financial advisor to help you navigate these decisions can make a genuine difference in the quality of your financial and emotional life in your glory decades. Reach out to an advisor today to help shape the future that’s most meaningful to you.