Summary: In this article we will discuss, is real estate a good investment? Topics also include the pros and cons of real estate investing and if real estate investing is right for you.
How To Determine If Real Estate is a Good Investment
Real estate can be a great investment for building tremendous wealth. But it can also empty an investors bank account and leave them with a pile of debt. As with any type of investment there are risks associated with real estate. That’s why it’s so important to look at both sides and weigh the pros and cons before deciding if real estate is a good investment for you..
8 Pros of Real Estate Investing
The benefits of real estate investing are many–from earning monthly cash flow to building equity. There are a number of great reasons to invest in real estate and next we’ll share our list of pros.
Pro #1: Leverage
One of the things that sets real estate apart from other types of investments is that you can use other people’s money (OPM) to buy it. Investors have the ability to borrow money or finance a property or multiple properties for a fraction of the total cost. Whereas stocks and bonds don’t offer this benefit.
For example, let’s say you want to buy a $200,000 investment property to rent out to tenants. With financing, you would only need to put down 20 percent or $20,000 plus closing costs. You’re basically leveraging OPM (like a bank) to buy rental property with the goal of earning money through long-term appreciation and equity. Ideally, rent should cover your entire mortgage and then some.
Real estate investors can also leverage the equity in their own rental properties to pay for improvements and upgrades or to buy additional properties. Investors also have the option to do a 1031 Exchange, where you can essentially swap one property for another like-kind property to avoid capital gains taxes.
Pro #2: Potential For Appreciation
Historically, home values have increased (along with inflation) over time. So unlike vehicles, which are depreciating assets, real estate is considered an appreciating asset. That said, appreciation potential will largely depend on where your rental property is located and that markets potential for growth.
Picture this: You leave a store and hold the door open for a stranger walking in. This person proceeds to walk past you, without any acknowledgement of your gesture. Would this lack of appreciation make you pause? If yes, why…? In my own experience, people will generally say thank you. So when someone doesn’t show some sort of acknowledgement, it can kind of bum you out. But if you didn’t expect a thank you in the first place, then receiving one would just be a bonus.
In real estate, think of appreciation as a BONUS for buying an investment property in a good market. Smart investors will pay close attention to local market conditions and trends. If you buy in a market that’s about to see big growth in jobs, population, infrastructure, home values will certainly follow suit.
There are other ways for investors to “force” appreciation. This could be as simple as keeping the property well-maintained by consistently performing repairs and updates. For even more appreciation, you can make bigger improvements over several years that add long-term value and produce solid appreciation.
Pro #3: Rental Property Tax Benefits
Real estate is a good investment when it comes to tax deductions. There’s a long list of tax benefits that rental property owners can take advantage of and these investment property tax deductions can include:
- Mortgage interest
- Repair and maintenance costs
- Property management expenses
- Rental property losses
- Capital expenditures
- Appreciation taxes – when the property is passed down or inherited it will get a “step up” to fair market value and won’t be taxed on appreciation.
Pro #4: Cash Flow / Passive Income
Real estate is a good long-term investment. But that doesn’t always mean a property won’t start producing cash flow in the short-term. As soon as the rental is filled with tenants, it’s totally possible to receive passive income from rents every month.
The key to buying a property that will cash flow is to run the numbers. Meticulously analyze and calculate all associated costs and expenses, including the mortgage. Check out average rental rates in the area for properties similar to yours. This will give you an idea of how much you can realistically charge tenants for rent.
If your mortgage and total monthly expenses are less than your rental income, you’ve got a cash flowing investment property!
If mortgage interest rates decrease down the road, refinancing the property at a lower rate will add to your monthly margins.
Pro #5: Builds Equity
Another pro that makes real estate a good investment is when your tenants pay your mortgage. This is basically free money, just in the form of equity. You may not have cash in your hand right now, but you’ll get the big pay off long-term. Think: retirement fund.
Real estate equity is unique because as your tenants pay down the principal mortgage amount over time, your property’s value should also be increasing. AND if you went with a fixed-rate mortgage, your monthly payments will stay the same for the lifetime of the loan.
Pro #6: More Stability & Control
Anyone who has invested in the stock market knows it can fluctuate day-to-day. There’s much more volatility in the stock market because it’s impacted by a number of different economical factors and varying markets.
On the other hand, the real estate market is much less vulnerable to significant fluctuations. Plus, real estate is a long-term investment, so short-term dips in the market won’t affect the property’s overall profit.
COVID-19 is a perfect example of how real estate has more stability than stocks. When the Coronavirus hit the U.S. full force, we watched the stock market drop suddenly and a number of other markets and industries followed suit. The real estate market didn’t go entirely unscathed, with the number of home sales declining dramatically since the declared pandemic. However, home values continued to rise per usual and home sales in many markets across the country have already rebounded.
With the Federal Reserve lowering interest rates again (~3%), people that are buying or refinancing homes are getting insanely low rates.
Pro #7: Inflation Buster
Inflation raises the cost of goods and services and decreases the value of the dollar over time. Consider this: in 1987-1988, the average cost of tuition at a public four-year university was just over $3,000 per year (in-state residents). Fast forward to 2019-2020 where the average cost of tuition is now $10,440 per year (in-state residents).
While inflation may seem like a bad thing overall, property owners actually benefit from it. Real estate is a physical asset, so it will appreciate along with the rate of inflation. A rental property is considered both a “good” and a service. Which means as inflation rises, so do monthly rents.
Borrowing money to buy real estate can be an excellent way to make inflation work for you. If you finance a property with a 30 year fixed-rate loan, your monthly mortgage payment will always stay the same. Over the next several years, your property will have appreciated in value and your mortgage will have depreciated. Essentially, inflation eats away at debt–which makes real estate a great inflation-fighting investment strategy.
Pro #8: Diversification Lowers Risk
One of the fundamental rules of investing is to diversify. A well-balanced portfolio is key to minimizing overall risk and should include a variety of investments across multiple industries. Real estate is an asset class that isn’t directly impacted by stock market fluctuations. So having a mix of both will is a great way to lower your risk.
8 Cons of Real Estate Investing
All types of investments come with a certain amount of risk, including real estate. While there are almost risk-free investments, like some bonds and CDs, their returns are very low. Before you decide if real estate is a good investment or not, let’s weigh the potential cons.
Con #1: A Chunk of Money (Usually)
While financing an investment property makes it easier to buy, you’ll still need a good amount of cash up front. To even throw your hat into the real estate game, you need enough money for a down payment (20% of the purchase price), closing costs and initial repairs and updates to the property. Also take into account that there will be ongoing expenses including insurance, mortgage payments, property taxes and maintenance. For many investors, that may be too much money to put into a single investment.
Con #2: Time / Learning Curve
Learning the ins and outs of real estate investing can take a lot of time and work.
I’ve been working in real estate for several years, and there is still plenty to learn. Before pouring a whole bunch of money into an investment property, it’s important to understand real estate terminology and become somewhat knowledgeable in basic investment strategies.
To expedite your learning process, reach out to real estate experts and your financial advisor for advice. Finding a quality real estate mentor might take some time, but it’ll be well worth it in the long run.
Con #3: Longer Wait For Returns
Buying rental property is generally a long-term investment. For those looking for short-term returns or the option to access cash quickly, real estate might not be the best option for you. Like I said before, it is possible to start seeing returns in the form of rental income sooner than later. But it’s fairly uncommon for a rental property to see big gains in a short period of time.
There are short-term real estate investment strategies, but they are usually more difficult to execute successfully, especially for newer investors. These types of short-term strategies inherently come with unique risks and challenges.
Con #4: Tenant Challenges & Vacancies
Whether you’re personally managing the rental property or not, tenants can bring their own set of challenges and added costs. Experienced landlords and real estate investors know the importance of finding and keeping quality tenants. Quality tenants are worth their weight in gold because they tend to stay long-term and take pride in your property as if it were their own, but they can be hard to come by.
Vacancies are another risk factor with owning rental property. Every month your property sits empty, you are losing money out of your own pocket. Additionally, the average cost of tenant turnover is around $2,000 per rental until.
Hiring a property management company can save investors a lot of time, stress and money.
Con #5: You May Not Qualify for All Tax Benefits
Depending on your annual income, you may not qualify for all the real estate tax breaks. High net worth investors fall into a higher tax bracket, which limits their ability to make certain deductions. Before investing, it’s always wise to consult a CPA to make sure you know exactly what deductions you can apply.
Con #6: More Liability
Owning an asset that people live in creates more liability risks. In the event that an accident occurs on your rental property, you will be held liable. Rental property insurance will mitigate a lot of that risk, but won’t eliminate it entirely. Shop around before deciding on which insurance policy works best with your risk tolerance.
Con #7: Over-leveraging
A common mistake that many real estate investors fall victim to is getting over leveraged. An investor will become over leveraged when they over-borrow or carry too much debt compared to a property’s cash flow and equity.
Even if a market drops, property owners are still responsible for paying the mortgage and the ongoing associated expenses. Investors that are over-leveraged for a long period of time are exposing themselves to potentially huge losses.
It’s important to avoid over-borrowing and have a hefty emergency fund to offset some of the risk.
Con #8: Fewer Exit Strategies
Selling an investment property takes both time and money, making real estate one of the least liquid investments out there. The transaction costs and fees to sell a property can get expensive, and unless you get a cash offer, the financing process can take between 30 and 60 days.
There’s always a chance that the market will be slow when you decide to sell, making it harder to do so–at least at the price you want. Owning a property that you can’t sell and that isn’t producing income is a big risk and can quickly drain your nest egg.
If you’re looking for flexible and fast investing options, you might consider sticking with stocks. These days we can buy and sell stocks with a simple click of a button.
Should I Invest in Real Estate?
If I haven’t scared you off and you’re still thinking real estate is a good investment for you, here are some quick tips for how to get started.
Decide Which Type of Properties You Want to Invest In
New real estate investors should generally stick to smaller deals. A great way to get into real estate is to buy a duplex, live in one side and rent out the other. This investment strategy is known as House Hacking and is totally doable for beginners. House Hacking has a few major advantages including lower housing costs and growing equity. The idea is that tenants would pay all or a portion of your mortgage, while helping build equity in your property at the same time.
Check Out Your Financing Options
If you are considering buying an investment property with cash, I would recommend thinking long and hard about whether you really want to put that amount of money into one asset. Even if you are able to buy a property outright, that’s not always the smartest investment strategy.
Financing a real estate investment at a super low interest rate should steadily increase your monthly cash flow and profit margin. And because we know that inflation eats away at debt, it often makes more sense to take out a low interest, fixed-rate mortgage.
Look at Local Housing Markets
The health of local housing markets across the country varies greatly so it’s important to research and analyze markets you want to invest in. Be sure to look at local markets and trends–not just national trends.
Learn From Others–Educate Yourself!
There is an endless supply of free real estate education available online. Educate yourself and learn from others by reading articles, listening to podcasts, watching webinars or attending investing groups.
Is real estate a good investment? For many investors, real estate can be an incredible way to generate passive income and build wealth. Whether your financial goals are to save for retirement, a college fund or become financially independent, investing in real estate has proven to be an excellent vehicle to get there.