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I have a friend who plans to retire by putting all of his money in local real estate. He makes a huge return on investment on the property he has now - something like 25%. Fundamentally, I think there is a tradeoff between risk and reward, which makes me think that this strategy must be extremely risky. However, I can't put my finger on exactly where the risk is and how high it is.

I will spell out more of the details below, but can someone either explain to me why the standard risk-reward paradigm doesn't apply, or point out where the risks are and how risky they are?

This friend is buying property in Lincoln Nebraska. He took out a mortgage for a $100,000 duplex with $30000 down 10 years ago. He charges $600 per side. The mortgage, insurance, and taxes on the duplex are about $600/month, so the other $600/month is pure profit. Per year that is $7,200 on a $30,000 investment, which is 24%. That is not to mention the equity he is building by paying off his mortgage and the rise in price of his property, which is now worth $150,000.

He tells me he works about 4 hours a month on average making repairs, collecting rent, looking for renters, etc.

Is this a normal scenario? If so, where is the risk? If there isn't much, why doesn't the standard risk-reward paradigm apply?

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    From another perspective, he's getting $7,200/yr on $150,000 in capital. That's less than 5%, significantly below than what he could get selling the duplex and putting the money in an S&P fund.
    – Kevin
    Jun 20, 2019 at 0:07
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    You assume that the market will always go up. 2000 to 2009 was a lost decade. The SPY with dividend reinvestment lost 11+ pct.
    – Bob Baerker
    Jun 20, 2019 at 1:32
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    "so the other $600/month is pure profit" He's owned it for 10 years. It's probably going to need a new roof soon. Maybe siding, windows, flooring, kitchen/bath remodels, appliances, or other work. Maybe he's gone 10 years without a major cost, but these things will catch up to him. When you plan for all the cap ex involved in the long term, I bet that $600/month gets much smaller!
    – dwizum
    Jun 20, 2019 at 13:11
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    If he's doing 4 hours a month of work, that's 48 hours a year. Suddenly the $7200 is no longer "pure profit".
    – ChrisInEdmonton
    Jun 20, 2019 at 14:00
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    Is this friend planning to buy real estate using mortgages? If so this is a form of margin trading, and if the real estate market goes down the losses may be much larger than the initial investment.
    – le3th4x0rbot
    Jun 20, 2019 at 20:00

6 Answers 6

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Where is the risk? The short answer is...

Property damage from weather, termites, tenants, whatever.

How about tenants who stop paying the rent and you need to go through legal channels to evict them? It doesn't cost a fortune but you had better not need that rent to make the mortgage.

How about another GFC (Global Financial Crisis) like 2008 when home prices collapsed. How do you think that your friend got that $100k home for only $30k? Think about owning when going from $150k down to whatever. Contact local realtors and find out how much the average property value loss was back then. I didn't read the stories but I search on Lincoln Real Estate and the first article was "Lincoln home sales level off after years of big gains". The average home price ratio to rent ratio increases when that happens and it makes it harder to achieve a positive cash flow.

Long before 2008, I had a rental property that lost 25% of its value during a bad period. Not as bad as 2008 but still not fun. Make sure that you can withstand that.

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    A malicious tenant can be far more expensive than a simple deadbeat. eg one who runs a methlab and leaves the property a toxic waste dump; or one whose response to being evicted is to destroy the place (rip wire out of the walls, flush concrete down the drains and then leave the sinks running). That sort of damage can easily dwarf the safety deposit and cost of eviction; and that sort of low-life is unlikely to have assets able to cover the repair costs even if you do take them to court.
    – Dan Is Fiddling By Firelight
    Jun 20, 2019 at 15:56
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    @DanNeely I was just talking with a friend yesterday who's going through this. A tenant who looked perfectly normal and harmless turned out to have contaminated my friend's rental property with meth, and now he needs to literally rip everything out to four bare walls and rebuild in order to decontaminate the house.
    – Mason Wheeler
    Jun 20, 2019 at 16:38
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    About 30 years ago, my significant other and I bought a cannibalized repossession for 2/3 of the going rate of similar models in normal condition. Everything that could be unscrewed was taken by the former tenants who coincidentally were low level local drug dealers in a nice residential neighborhood. Everything else was broken (sledge hammer decor). It took a month of sweat equity to get it livable for us and another month or so to finish off non essential renovations. It was a fun project and a good way to buy well under the market.
    – Bob Baerker
    Jun 20, 2019 at 16:59
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    @MasonWheeler People using rentals as grow-houses can also create lots of issues: illegal/unsafe electrical connections and mold from heat and humidity being common.
    – JimmyJames
    Jun 20, 2019 at 19:39
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    @iheanyi: "The rest is the same". Source? Where I live in Canada, townhouses rent for about 70% what they were rented 8 years ago, more or less the same as the decrease in property value.
    – Martin Argerami
    Jun 20, 2019 at 23:17
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where is the risk?

  • Losing renters
  • Damage done by renters
  • Unexpected maintenance
  • Legal liability
  • Capital losses

Other factors that should be included in expenses:

  • Routine maintenance
  • Paying the landlord (essentially a part time job for him)

I'm not saying it's a bad investment - and it sounds like he has a decent property for an amazingly cheap price, but those are some of the risks involved. I assume he didn't charge $600 for rent ten years ago, so using today's rent to calculate return is not accurate. You'd have to look at the average return over the 10 years based on the rent collected and the capital gains (which is extraordinary).

Also note that with a mortgage, the property is leveraged, which multiplies the rewards, but also the downside if something goes bad. If the property were bought today with cash at market value, the return would be less than 5%, but it would have no risk of foreclosure. Without a mortgage, he could be more choosy with renters by letting it sit vacant for a few months.

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    Unexpected maintenance? OP shows zero set aside ongoing repairs. Painting outside/inside. A new roof. New HVAC, or at least heating and hot water, if no AC. Also look at the numbers, current return is less than 5%.
    – JTP - Apologise to Monica ♦
    Jun 20, 2019 at 13:05
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    Return is calculated on current value, not purchase price. Else, I’d claim my Apple share are giving me a 100%+ dividend.
    – JTP - Apologise to Monica ♦
    Jun 20, 2019 at 17:12
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    You need to answer my rhetorical question. My basis for my Apple shares is about $1.50. But the annual dividend is $3.08. Is my dividend 1.56% (as is everyone else’s) or is it over 200%? The owner may have $30K invested, but decisions should be made today. If 30 year treasuries spike to 10%, how do you propose he do the math? I’d suggest he compare his 5% current return and not use his cost in the math, except to estimate future price rise.
    – JTP - Apologise to Monica ♦
    Jun 20, 2019 at 18:12
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    @perennial_noob - ROI uses investment cost. Yield use current value.
    – Bob Baerker
    Jun 20, 2019 at 19:43
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    @iheanyi - I am open to your view that I am not clear in my comment above. The fact remains that an investment return should not be viewed today based on original cost. OP has a $150K asset. Its current return is less than 5%.
    – JTP - Apologise to Monica ♦
    Jun 20, 2019 at 22:03
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The biggest problem your friend has isn't the risks associated with real estate per se, and the existing answers have covered those pretty well.

The problem is that your friend is about to sink their entire net worth (or some appreciable fraction thereof) into a single asset class.

Not a great plan.

The problem is systemic risk: for example in this case what happens during a housing crisis like the one we all lived through in the last decade? What happens when all your money is in stocks and the S&P 500 goes down 20%? All your money is in the bonds of some group of countries that all default at the same time?

If you don't need the money/income then a lot of times you can weather the storm, but it only takes one forced sale during a downturn (or complete destruction of an asset) to wipe out years of growth.

People usually think of diversification within an asset class (like buying a bunch of stocks instead of just one) but it's arguably as or more important to diversify across asset classes.

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    And Enron. Many employees had all their assets in company stock.
    – RonJohn
    Jun 20, 2019 at 16:38
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    +1. And even within the asset class of real estate, you'd be holding a single residential home in a single neighborhood and city. You'd be in bad shape if the city goes through bad economic times or a natural disaster, even if the rest of the real estate market is doing well elsewhere. That's not to say that the current house is not a good investment, but I'd try to diversify the portfolio as soon as feasible (e.g. buying stocks+bonds with the profits, rather than paying the mortgage early, for example).
    – Earth
    Jun 20, 2019 at 17:11
  • @JaredSmith - I understand the essence of what you said but I am confused about the downturn part of it. So let's put aside destruction of the property itself for the sake of discussion. If the real estate value of the property goes down even 50%, selling it off would fetch the investor $75k which is still a profit (considering it was bought for $30k).
    – perennial_noob
    Jun 20, 2019 at 18:08
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    In 2008+, whether rent remained the same or dropped depended on how hard the local housing market dropped. Nevada and Florida housing was trashed and rentals in many areas dropped significantly. In other areas, it rose" Location, location, location.
    – Bob Baerker
    Jun 20, 2019 at 21:54
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    @iheanyi it just depends on if you end up having to sell either because of the downturn (cover other losses) or for any reason at all: medical emergency, paying out shares to estate claimants, lawsuits, whatever. Stuff like that tends to go wrong at the worst possible times, and as I said in my answer it only has to happen once to really put the hurt on. The value dropping is only irrelevant if you're lucky enough to weather the downturn, and crucially the area bounces back afterwards.
    – Jared Smith
    Jun 20, 2019 at 21:58
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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.

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    One thing the 5.6% return number doesn't account for is that property is often leveraged, especially by those using it as an income source/investment. Making 5.6% on five times your investment (using the standard 20% down) is a lot higher return than the 9% from the equity markets, especially if you can get renters to cover even just mortgage interest + costs—anything on top of that is icing on the cake. That said, I agree with the thesis that RE investment is more complex and involved than an index fund, and is certainly not for everybody.
    – Kevin
    Jun 20, 2019 at 19:48
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    It may depend on the legislation, but in some places the landlord is legally required to keep the property in a good state, so by not setting aside money for repairs, not only does he depreciate the property, he may be in violation of the law.
    – gerrit
    Jun 21, 2019 at 8:08
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    To come to my friend's defense: He puts in repairs and makes improvements. I neglected to put this in the description.
    – Josh Brown Kramer
    Jun 21, 2019 at 14:27
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    Also, this is a terrific answer.
    – Josh Brown Kramer
    Jun 21, 2019 at 14:45
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    Yeah, not to disparage your friend. I did not mean to suggest he's a grifter or a slumlord. Just that it's easy to forget these maintenance and upgrade costs and focus too much on the rental flow. Uber/Lyft drivers have the same problem - they might remember to account for gas and tolls, but some forget to account for faster depreciation of the car resulting in higher repair costs. Lots of landlords will upgrade their properties, repaint, buy new appliances, etc., but forget to account for these costs when comparing to other investment options.
    – NL7
    Jun 21, 2019 at 15:33
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I can jump in on this as a family with a lot of property.

First off, I personally wouldn't mortgage an investment like this. He got lucky with this duplex but it can still go south.

Over the years, we have seen a wealth of horrors like you wouldn't dream of from tenants who have destroyed our properties over and over again. Everything from dead sea snakes, to whole rooms that look like their only goal over their tenancy was to fill it with dog poo. We had the SWAT team raid one of our houses to arrest our tenant who had refused to pay rent for 3 years and nobody could track him down to collect. The swat was unrelated to rent, by the way, and they didn't get him. Next day the entire house was ripped to pieces and all the copper was stolen from the walls. This was the handy work of our tenant who is finally gone from our lives. Our part was $15k in damages. Insurance took care of the rest.

And that's the house in a good neighborhood.

One of our houses has the water main run 10 feet below a paved driveway. Didn't know about that when it was bought. How much do you think a rupture costs to fix in that case?

Point being, 24% is not 24%. It is stashed away for as long as necessary because at some point one of the properties will hit you with something hard and if you don't have the reserves to cover it without credit, you are then stockpiling empty, unrentable spaces. Guess what a joy getting rid of squatters who have discovered a vacant property is.

One of our neighborhoods was recently overhauled by some rich group. They turned every conceivable piece of land into mini-dorms which are far more appealing to the people who rent in our neighborhood. This changes the rentability of those properties. One has been vacant for 6 years. A lot of that has to do with personal management and risk, but it is a factor.

I could go on forever on this subject, but the point I'm trying to make is that property always sounds like a good idea and definitely can be. It is a venture that even amateurs can get into without losing everything but is not as safe as one might think just by looking at the numbers. If one were to put everything they have into property, I would advise to diversify first and ensure your real estate ventures are not going to be problematic if you cannot rent or flip the properties within a reasonable time frame.

As for why the normal risk/reward paradigm doesn't apply... it does. But it is a much more involved calculation than something much easier like normal bank investments. For the sake of conversation, buying and selling textiles can generate thousands of percent in profits. You wouldn't get into that market without research. I would advise the same thing about real estate.

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  • I sold a long time rental property some time back. The buyer wanted to rent it out as well. The water connection from the street ran under the driveway, under the garage and then under the kitchen to get to the kitchen sink. A week after closing, water started bubbling up through the concrete garage floor. Corroded pipes. Not pretty. The repair Involved cutting through 50+ feet of concrete to replace the entire pipe. It would have cost 4 months of rent gross, maybe double that when you consider cash flow after expenses. Like on my keyboard, SHIFT happens.
    – Bob Baerker
    Jun 21, 2019 at 18:57
  • +1 on this. I've also thought about getting into the rental real estate business but after talking with many coworkers who are landlords on the side, it's very risky based on their experiences with past tenants. Many of the points were mentioned above. The eviction process for tenants is a nightmare too (even if you have a serious case to evict a tenant) - there are a lot of laws that protect renters.
    – robjob27
    Jun 21, 2019 at 20:30
  • @robjob27 - renters and squatters both. It should be noted we have NEVER been able to successfully evict a tenant. They always vanish on their own eventually. There are loopholes everywhere. One changed a lightbulb and that was considered active development on the property. No eviction granted. The water line 10 feet beneath the earth under pavement was quoted at $8,000. Or we can do it ourselves but we'd have to rent like $2k worth of equipment to do it and it's currently creeping over 100 degrees these days. Plus, who knows what we'll find. That's happening right now.
    – Kai Qing
    Jun 21, 2019 at 21:33
  • I should also add that as a whole the properties do return a profit and sometimes we even feel like we can spend some of the money. We do own them outright so as far as paper wealth goes, we're still pretty solid on the whole gamut. But if one is just getting into it, they better be in it for the long haul and not really go in thinking they will no longer have to work. Even all our properties wouldn't sustain us all. They're just supplement and like... family legacy or something. I'm glad we have them but woo wee they just kill us sometimes.
    – Kai Qing
    Jun 21, 2019 at 21:36
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Per year that is $7,200 on a $30,000 investment, which is 24%.

That's not the way to calculate the yield. If I spend $1 on a lottery ticket which wins me $100, then I deposit the $100 in a bank account which earns $5 per year, then that bank account is earning me 5%, not 500%.

Let's look at the numbers again:

This friend is buying property in Lincoln Nebraska. He bought a roughly $100,000 duplex for about $30,000 10 years ago. He charges $600 per side. The mortgage, insurance, and taxes on the duplex are about $600/month, so the other $600/month is pure profit. Per year that is $7,200 on a $30,000 investment, which is 24%. That is not to mention the equity he is building by paying off his mortgage and the rise in price of his property, which is now worth $150,000.

So, he bought the property for $30,000 and it's now worth $150,000. That's a 17.5% gain per year. Pretty nice, but will the property continue to appreciate at that rate?

Meanwhile, if it's now worth $150,000, and he's earning $7,200 per year, the yield is 4.8%. That's not "a huge return on investment" at all.

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    deposit the $100 in a bank account which earns $5 per year,, where in the world? I'd be lucky at 0.5%!
    – gerrit
    Jun 21, 2019 at 8:12
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    One thing I wasn't clear about initially is that it was $30000 down on the purchase of a $100000 property. Your return on investment should be calculated on the equity in the property, which was $30000 that first year.
    – Josh Brown Kramer
    Jun 21, 2019 at 14:32

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