So the general rule for real estate investment (in North America) is this: only do it if you love the idea of doing it.
If you love the idea of being a landlord and property manager, you think the Monopoly Guy had the right idea, and you think hours spent repairing units and analyzing property spreadsheets and browsing property listings are a really fun hobby, then go ahead and use real property as an investment vehicle and income source. But if you are literally anybody else who does not love the idea of being a landlord or property baron, and you just want reliable passive investments, do not pursue real estate investment.
The costs he is missing are:
- Maintenance and repairs
- Depreciation and/or upgrades
- His own labor costs of management
- Purchasing costs, including lawyer, title, agent (and his own labor again)
- Concentration of risk
There was a great study released 2015 titled The Rate of Return on Everything, 1870–2015 and it found that, for the US, the average rate of return on equities is better than housing. Modern US equities are around 9% returns and modern US housing is around 5.6% returns. This is true if you look at 1950-2015 or at 1980-2015, but US equities outpaced US housing over the whole scope of the period studied.
The study looked at returns from housing including rent net of maintenance and other costs. If you just look at housing as a buy-and-hold asset, like for your personal residence, then the Case-Shiller returns are something like 3-4% on average. While the S&P 500 is more like 9-10%.
So equities are better investment, so long as you can keep your investment costs low and you are appropriately diversified.
Your friend is underestimating repairs and depreciation. Eventually, major appliances will need to be replaced or repaired, the roof or the water heater or the air unit will need work, and other things will need attention. He is not setting aside any money for these costs, so it looks like profit but actually he's depreciating the value of his property. His property may still be worth more than it was in the past, due to general inflation or because the area around it is in demand, but eventually the rent he can demand and the sale price he could expect will be affected by neglecting to upgrade.
He is also underestimating the work he spends on it. Part of the return is for his labor, so property management is not just a true passive asset, it has a big active component. He is earning money for his services and if he stopped doing them, then either he would pay somebody else to do it (increasing his costs) or he would lose tenants and eventually maybe suffer lowered rents due to bad reviews from his neglect. So you need to analyze it as partly a part-time job or business.
The transaction costs are often much higher for real property. You do a lot more browsing to find the right property, you pay agents and lawyers and title companies and inspectors. It takes weeks or months to complete. And you have to go through it again at sale. Whereas it is comparatively painless to buy a few index funds, and the trading fees in some cases are free or very cheap.
Also, real property concentrates your risk. If you own a few index funds, you are heavily diversified in your risk and your investment returns are the same if you check your balance everyday or if you spend 12 months in a coma. You can move across the country and your equities do not care. Whereas the owner of real property can suffer greatly if the areas where they own property are affected by economic downturn, natural disaster, crime, or slumping demand. If you own units in 3 neighborhoods and 2 of them are suffering, you can be hit with lowered rents and lower anticipated sale price - loss of income and loss of stored wealth at the same time. And the owner of active rental property cannot spend months on a beach without paying somebody to manage the properties, collect rents, etc. If the owner wants to retire and move across the country or across the world, then either somebody has to be paid to manage the properties, or the properties have to be sold. Rental property concentrates your wealth in a few major assets and is difficult to diversify, unlike publicly traded equities.
Somebody who loves real estate will do it. They might like the respect of being a landlord, they might appreciate the concrete nature of owning a patch of land, they might like feeling like a burgeoning tycoon. Passive investment in a few index funds will rarely give you any of those things. But it gives more reliable higher returns, requires incredibly little knowledge or work, allows a lot more personal mobility, and involves far fewer costs.