Updated: Aug 24, 2020
I'll be the first to say, that real estate is a great investment. If you know what you are doing, you can make a lot of money in real estate.
Everyone and their dog loves real estate. Many people don't consider the risk of real estate investing. As a society, we have put the idea of real estate on such a high pedestal, that the reality of investing in real estate could never live up to. For that reason, real estate is the most overrated asset in history.
Real estate has become a cultural obsession in North America.
In 2018, there were more than 13 billion Google search queries for real estate.
If you’re an American between the age of 50–64, there is a 31% chance you have watched at least one Home & Garden Television (HGTV) show in the past month.
55% of Millennials surveyed said they wanted to invest in real estate.
Nearly everyone I know seems to love the idea of investing in real estate. I include myself in that statement. I am the son of two real estate agents and have long been obsessed with the idea of owning real estate.
I’ll say at the top that I have invested in real estate and I have made money doing so.
I am not making the case that real estate investing is bad. Real estate is a very solid asset class that has a place in many investment portfolios.
However, real estate is the most overrated asset in history. Our cultural obsession with real estate has put the asset class on a pedestal it could never live up to.
In this article, I will review why real estate obsession may be holding you back financially.
The media has glorified real estate investing
On HGTV alone, there are well over 100 TV shows centered around real estate. These shows cover every possible real estate niche.
Building custom decks
Buying real estate in foreign countries
Summer homes and cottages
Buying income properties
Real estate agent shows
Within each of these niches, there are multiple shows centered in different real estate markets.
If you want a show about flipping houses in Las Vegas, it’s there.
If you want a show about DIY home repairs in Chicago, it’s there too.
Do you know why a single network has over 100 real estate related TV shows? Because people love these shows. Whether you live in a big city or rural community, liberal or conservative, young or old, we are all united by our obsession with real estate.
I’ll say it again, this applies to me too. I have probably watched at least a dozen real estate related shows with my wife over the past few years.
Whenever I watch one of these shows I can’t help but have the same thought that everyone else has; “I should be doing this”.
How the stock market is portrayed in the media
Unlike HGTV, there is nothing “fun” about stock market coverage.
Few people have ever binge-watched three hours of stock market coverage and thought to themselves; “I should be doing this”.
There are several popular movies centered around the stock market. Three movies, in particular, come to mind.
2013’s “The Wolf of Wall Street” which highlights how depraved and sleazy some Wall Street traders can be.
2015’s “The Big Short” which recounts how fraudulent practices within the mortgage securities industry nearly brought the world into another great depression.
If you watch stock market coverage on TV you will be bored out of your mind.
If you watch movies centered around Wall Street and the stock market you are likely to come away with the feeling that investing in the stock market is dirty and perhaps even immoral.
Contrast that with the feeling you get when you watch real estate shows on HGTV and you can understand why everyone is obsessed with real estate and why so few people are invested in the stock market.
But here’s the truth.
Stocks are a better investment than real estate
When you adjust for risk, effort and time investing in the stock market is hands down a better option for most people than investing in physical real estate.
To illustrate why I will compare investing in physical real estate to investing in Vanguards Total World Stock Market Index Fund. This fund tracks the global stock market. It’s not an endorsement to invest in this particular fund but I’ll use it to illustrate the simplicity of investing in stocks compared to real estate.
It’s impossible to properly diversify with real estate
In each of the markets I own property in, it would cost you upwards of $500,000 to acquire a single property.
Spending hundreds of thousands of dollars on a single property, in a single neighborhood, in a single city, in a single state or province, in a single country makes it impossible to diversify your real estate portfolio.
By contrast, with a total world stock market index fund, I can invest in more than 8,400 companies across the planet. The cost per unit? $64.
Investing in real estate is the definition of putting all your eggs in one basket.
If you own a single property and something happens to that property or your tenants are not able to pay the rent, the income will stop coming in but the mortgage still needs to get paid.
Real estate has a lot of operational costs
Unlike investing in stocks, real estate is an investment that you have to continue throwing money at.
When you buy a property, be prepared to pay between 2%-5% of the purchase price of the property in closing costs.
Every year you will need to pay property taxes which as a rule of thumb are about 1% of the value of the property.
You also need to budget for constant maintenance costs. Another rule of thumb is to budget for at least 1% of the value of the property in annual maintenance costs.
If you own a property you also need to pay for insurance, which can run about $1,500 per year.
Vacancy costs. Your rental property is not going to be occupied with a tenant every single month you own it. There will be months where you have no tenant paying you rent, but you still need to pay the bills associated with the property.
If you choose to have a property manager, be prepared to fork over between 8%-12% of the monthly rent.
Don’t forget the mortgage. If you buy the property using debt, you’ll need to pay the principal and interest each month.
Ideally, the tenant would cover all of these costs through the monthly rent. However, all of these costs eat into the income generated from the property.
By contrast, investing $100,000 in the global index fund would cost about $80 per year in investment management costs.
Residential real estate is a highly regulated industry
Regulatory risk is one of the greatest risks facing a landlord. To you, real estate is an investment. To your tenant, it is their home. That comes with a lot of responsibility; if you are a bad landlord it makes life hard for your tenants.
Since this is such an important responsibility, the government often steps in with laws and regulations surrounding the landlord-tenant relationship.
If you currently live in a city where the laws and regulations favor the tenant the greater the risk to you as a landlord. You could find yourself in a situation where your tenant is not paying rent and you aren’t able to get a new tenant for months.
Even if you live in a city where laws and regulations favor the landlord, that is something that could change at any time.
These types of regulatory risks are not something that you need to worry about investing in the stock market.
Real estate investing is not passive
Unless you are using a property manager, investing in real estate requires a lot of work.
Finding a property you want to invest in.
Finding an agent and mortgage broker you can trust.
Negotiating an offer to purchase the property.
Obtain financing at a rate that will allow you to produce positive cash-flow.
Inspecting the property before closing.
Dealing with lawyers before closing.
Finding a contractor that you can trust to take care of any rehabs and repairs required.
Advertising that the property is available for rent.
Screening tenants and running credit checks.
Collecting rent every month.
Evicting tenants if need be (something nobody wants to do).
Call plumbers and contractors when maintenance is required.
Pay the property tax bills.
The list goes on and on, but I think you get the point.
If you are self-managing your Real Estate portfolio you don’t have a passive investment, you have a business. Your return on investment with Real Estate is directly linked to your skill at finding deals, finding tenants and managing the property.
Compare that to investing in a globally diversified index fund; You invest and then you do nothing.
It’s probably a good idea to not even check your investment account or follow the day to day movements in the stock market. When you invest for the long term using index funds, the less involved you are, the better your returns are likely to be.
That is a passive investment.
So, why are so many real estate investors rich?
I often hear real estate investors say that “millionaires are created through investing in real estate”.
I’m not going to dispute that claim. Many real estate investors have a high net worth.
Part of the reason many real estate investors are wealthy is that real estate is a solid investment. Despite all of the shortcomings I’ve highlighted real estate can help build wealth both through the monthly rent collected and the long term increase in real estate prices.
However, the real reason real estate investors might have more wealth than the average stock market investor is because they use leverage.
Leverage means you used debt to invest. In the case of real estate, this often means getting a mortgage. Real estate investors might put down 20% of the purchase price of a property and borrow the other 80%.
Each year the mortgage balance declines and (hopefully) real estate prices increase. The difference between the value of a property and the outstanding mortgage balance is the equity in the property.
For every dollar increase in a properties equity, the investor’s net worth increases by a dollar.
The same logic of leverage applies when investing in the stock market.
It happens to be the case that investors are much more comfortable using leverage to invest in real estate compared to other asset classes like stocks.
Leverage increases an investor’s expected return but it also increases the amount of risk they take on.
Risk and expected returns go hand in hand. The more risk you take, the higher your expected return will be. The expected return is not a guaranteed return though. Plenty of real estate investors have taken on too much leverage and lost their shirts as a result.
Keep an objective view when evaluating real estate or any other investment opportunity
Most people invest in what they feel comfortable with.
Due to our cultural obsession with real estate, many more people feel comfortable investing in real estate than they do investing in the stock market.
The ironic truth is that investing in real estate requires taking on more risk by taking out a mortgage and going into debt to invest in a property.
Real estate investing also requires a lot more effort and has a lot more ongoing expenses compared to investing in a low-cost index fund.
The takeaway for investors is that we should not fall in love with any particular asset class. A lot of people have “passion” for real estate. Passion is an essential human quality and serves us well in many areas of our lives.
Passion has no place in your investment portfolio. When making financial decisions that impact you and your family’s financial future, it’s important to make dispassionate decisions. Use all available information and make a cold, calculated decision based on the numbers and your risk tolerance.
If you’re going to invest in real estate do so based on the facts available to you.
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This article is for informational purposes only, it should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions