No dice for this real-life Monopoly.
The below is not financial advice, these are just my opinions.
I’ve always had a passion for money, and I spend a lot of time learning about the ways I can improve my financial circumstances. Something that I’ve always been drawn to is investing in property. When I was younger, I had no doubt that my future assets would include a few rental properties (likely spurred on by the fact that this was a path my parents took).
There was something enchanting about the idea of buying a property, renting it out and having the rent pay the mortgage. But now that I’m in a position to actually invest my money in property, I’ve looked deeper into the reality of it and I don’t think it’s quite the golden child of investing that it’s made out to be.
What’s The Appeal
Let’s look at why buying a rental property is attractive in the first place.
It’s (seemingly) a no-brainer: As mentioned above, the idea that the rental income pays for the mortgage on the property makes it seem like a no-brainer — almost as though it’s free money. While it isn’t as simple as that, the idea helps many overcome a large mental barrier to investing.
It’s tangible: A rental property is something real that you can see and touch, compared to shares in the stock market which seem almost theoretical.
It’s understandable: Property, and how it makes you money, aren’t difficult concepts to grasp — you get income from rent, and the property itself increases in value over time. It’s part of our everyday lives, unlike the stock market which is unfamiliar and complex.
It’s exciting: The idea of buying a rental property is really exciting; as though you’re building your empire. And it’s also exciting to see others talk about their property investment success too (the number of videos on YouTube on the topic are testament to that). You don’t get that same level of excitement when talking about a buy-and-hold strategy with low-cost index funds.
It seems safe: Historically property has performed well as an investment. People always need somewhere to live, even in an economic downturn.
It’s familiar: For many millennials who grew up in a middle class family, it’s likely your parents, or someone they knew, dabbled in real estate investment, or at the very least talked about it. It’s something people are open with, whereas shares and the stock market are only talked about on the news.
All of this is to say that I understand why many, including myself, are drawn to the idea of buying a rental property. But none of these points touch on the messy reality of property investment.
Below I explore the reasons why I won’t be buying a rental property as part of my wealth building. For simplicity’s sake, I’m going to compare buying a rental property with investing in the stock market— specifically a low-cost index fund. I will also exclude the taxation side of this, both to simplify and to make it more globally accessible.
Barrier To Entry
Buying an investment property has a huge barrier to entry. While it can vary, on average you need to have at least a 25% deposit, as well as additional money for the various fees and costs associated with buying a property. Compare that to investing in shares, which you can start with as little as $100 in many cases.
In the process of saving a deposit there’s an opportunity cost saving the money vs. investing that money in shares. While saving you’re likely to have little to no interest from a savings account, but if you were investing that money in a low-cost index fund you could get a much better return on your money.
As an illustration of this, let’s say you‘re planning on buying a rental property for $200,000. A 25% deposit is $50,000 and you’ll save another $5,000 for closing costs. That’s $55,000 needed in total. If you’re able to save $1,000 a month, you’ll have the amount needed in just over 4.5 years.
But if you were to instead invest that $1,000 a month in a low-cost index fund with an average 7% annual return, at the end of the 4.5 years you could have $65,000 — that’s $10,000 more. Even with a much more conservative 4% annual return, you’d still be ahead by nearly $5,500.
You might be thinking “Why not invest the money in shares and then sell when you’re ready to buy the rental property?”, and you could do that. But the general consensus is that you shouldn’t invest in the shares in the short term due to the potential risk. At best you could find a high interest savings account which could make up some of the difference, but it wouldn’t outweigh the opportunity cost.
Starting On The Back Foot
Putting the above point aside, let’s say that you have the $55,000 needed and you’re ready to buy that property.
The bulk of that money ($50,000) is your deposit. That money goes from being cash to equity in the property. This means the money is still an asset of yours, it’s just in a different form.
But you also need to pay closing costs when buying a house. This is money that you need to pay which, unlike the deposit, is a cost of the investment. The total can vary from between 2–5% of the property value, and so for this example I’m staying on the lower side and basing it on 2.5% — so for a $200,000 property that’s $5,000.
So right away, you’re on the back foot, $5,000 down on the investment. You need to make a 10% return on the $50,000 you’ve invested just to break-even — to get back to zero.
Compare that with investing in a low-cost index fund where there’s usually no fee to put your money in and get started. There are fees (that’s covered later) but not usually an initial ‘buy-in’ fee.
As well as the initial costs incurred to make the purchase, there are also ongoing costs you need to pay to keep it going. The costs broadly fall into the following categories.
Maintenance and Repairs: The suggested rule of thumb for maintenance and repairs is about 1% of the property value per year — so in this case, $2,000 a year to start with, but increasing slightly each year as the property value increases. The longer you own the property, the more likely you’ll also need to do renovations, beyond just general maintenance, to ensure that you can optimise the property value and rental return. If you’re handy (and qualified) you could do much of the maintenance and repairs yourself, but the cost is then your time.
Insurance and Legal Fees: You’ll need to have insurance; at the very least building and liability insurance. You may also want to take out landlord insurance. You’ll also likely have legal fees, especially if you have issues with the property or a tenant.
Property Management: This cost covers finding and managing tenants, and dealing with issues on your behalf. Again, it may be possible to manage this directly yourself to save on cost, but at a certain point it becomes more like a second job rather than an investment. If you were to manage the property yourself it would likely restrict where you can buy your rental property as you’d need to be close by.
Property Taxes and HOA/Condo Fees: Property taxes can vary depending on where you live, but can be a significant cost you need to cover. On average in the US it’s 1.1% of the property value. It is possible to avoid buying a condo or a property in an HOA, but condos in particular are generally cheaper and are a more accessible option to many investors.
Mortgage: The biggest cost of all is the mortgage. In reality the mortgage payment is made up of two parts. The first part goes towards the principal, and therefore isn’t really a “cost” to you, as that money turns into equity in the property (similar to the initial deposit). But the other part is the interest, and that is a cost to you. At the beginning of the mortgage most of your payment goes towards interest, with a very small amount actually going towards the principal.
The rental income you’re paid would need to ideally cover these costs, with some money left over as profit. Some of these costs are known, but you’ll need to be confident that it’s enough to cover the costs that can vary, plus unexpected costs.
I touched on this in the examples, but for most of the costs there’s a financial aspect and a time aspect. Even if you outsource everything there’s still a time element involved to a degree.
When investing in a low-cost index fund, there are also fees involved. This can include a platform fee (to have the account itself) which is usually less than 0.5% of the balance, and then specific fees for your investments which are known as expense ratios. In a low-cost index fund, these fees are usually less than 0.1% of the investment per year — so for $55,000 invested, that would be $275 for the platform fee+ $55 for the fee for the investment. A key difference is that the costs here are entirely known up front — there’s nothing left up to chance.
One final point on cost. When investing in shares, the costs associated are directly related to the value of the investment (as a percentage). That is to say that if there was a dip in the market and the value of your investment went down, so would the fees. However, that’s not the case for a property investment — if there was a housing crash, the costs listed above would largely remain the same.
There is risk involved in all investments — particularly the stock market which can plummet or rally depending on the day. I’m not going to say one investment is more or less risky than the other — there’s no way to really know. Ultimately investing in any asset is a risk.
However for a rental property there are risks beyond that of investing in a traditional asset. The biggest of all is that you take out a debt in order to make the investment. I can’t imagine many people would feel comfortable taking out a loan the size of a mortgage and putting it into the stock market — I know I wouldn’t. And yet many don’t think twice when it’s for a rental property.
The entire investment is balanced on the premise that you have consistent rent payments to cover the costs. But all it would take is a small set-back to leave you exposed with a large cost each month.
This could include:
- Non-payment by tenant (which could also result in a costly eviction)
- Property damage, either from the tenant or from natural disaster.
- Economic challenges where it’s difficult to find a new tenant at the desired rental amount.
- Just a gap between tenants.
All of these factors are entirely outside anyone’s control, but each could mean months of costs with no rental payments to cover them. Once the situation is resolved, you’d likely need years of profits to make up for the losses you experienced — again, to bring you back to zero.
As I said above, all investments have risk associated with them. But there’s a difference between losing value in your investment, and being in debt and on the hook for thousands of dollars each month as well.
There are a number of basic principles all investors should follow, and one of the most important is diversification: spreading your investments across different types of investment classes (shares, property etc.), countries and industries.
When it comes to property investment, not only is a huge amount of your money in one asset class (property), but it’s in a single property in a single town or city, and with a single tenant as your source of income. And it’s likely a considerable amount of your wealth is already tied up within your own home. That’s the exact opposite of diversification.
Conversely, low-cost index funds are by definition diversified as they track whole markets, and it’s easy to spread your money over multiple funds to further spread your risk.
Obviously it is possible to achieve diversification with rental properties in your investments, but that’s achieved through a combination of having multiple properties and ensuring that property makes up a smaller amount of your total investment portfolio — but both of these things are largely out of reach for a regular person.
Don’t Let The Door Hit You
The final step is selling the asset. And just like every other step in the journey, there are costs involved when selling a rental property.
In order to get the best price for your property you may need to invest some money doing some final maintenance or renovation work. But even without that you’ll have legal fees plus the commission for the selling agent. All in, the fees could come to 10% of the total property price which is a huge hit on any return you’ve made on the property value itself.
When it comes to investing in index funds generally there is no fee when it comes to selling. Additionally, you have the benefit of being able to part-sell over time, rather than having to sell as one transaction.
Running The Numbers
When I had the idea for this article I planned on demonstrating the difference in returns for property investment compared to index funds. But after spending a considerable time trying to do so I have come to the conclusion that there is no clear cut way to do this.
For the index funds it’s easy. We can see the inflation-adjusted return for the stock market, with and without dividend investment (though past performance isn’t guarantee of future performance).
But with property, looking through all the data I could just showed that it’s impossible to put a number on it. House price increases vary by state, city and street. Similarly, rental income and associated costs vary wildly depending on location. On top of this, there doesn’t seem to be a consistent way of recording and reporting on the data, which means some of the numbers can be very misleading.
It would be very easy to cherry-pick numbers to tell whatever narrative you wanted. But I don’t want to do that. What I will say is that in the various scenarios I ran using the example numbers above, over a 30 or so year period it seems very possible to get a similar return from money invested into property as you could from money invested in low-cost index funds, or the stock market generally.
And that’s not really a surprise. Property investment is popular, and people wouldn’t do it if the returns weren’t at least comparable. My resistance to investing in property isn’t because of the returns, but the environment in which it happens. There are many factors and complexities that you need to consider and manage to make sure it’s a success, and there’s a lot at stake if you don’t manage to do so.
Is Property Out?
Coming to the end of this article you might think I’m ruling out investing in property entirely. But that would go against my earlier point about diversification — it would be almost as foolish to exclude property investment entirely as it would be to only invest in property.
Thankfully, there’s a way to invest in property without having to buy a house. REITs (Real Estate Investment Trusts) allow you to invest in property without any of the property-specific costs and risks I’ve detailed above.
A REIT is, for all intents and purposes, a stock like any other. But it’s one that’s in a company that owns, and in most cases operates, income-producing real estate. You invest in them as you would shares, and get the benefits of low barrier to entry, low ongoing costs and liquidity. This way you achieve diversification and the benefits of property value increases and rental returns, but at scale and without the risks of buying your own investment property.
In all investing, it’s a case of risk vs. reward, and that’s definitely heightened when it comes to property investing. But there comes a point where investment risk gets close to gambling, and I’m not willing to take that bet.