Financial gurus and Twitter money bros constantly bombard the financial independence space with the same advice: real estate investing is the key to wealth.
Is it True?
The stories all have a similar ring to them. “How I achieved financial independence with real estate investing” and “How I make $200K per year investing in real estate”.
While these stories are mostly true, they don’t tell the whole story. Investing in real estate isn’t a magic button to wealth building.
Here’s the absolute truth about real estate investing so you know what to expect before diving in.
1. Buying a House is Impossible if You’re Poor
The most significant limitation with real estate investing is the lie that anyone can do it. Homeownership is out of reach for millions of Americans. The barriers to entry are too high for many people to overcome.
What it Takes To Buy a Home
To even consider buying your first home, you need a decent credit score and a hefty down payment. You must also show a steady income and have enough cash to pay closing costs. And don’t forget all the extras that come with a mortgage payment: interest, taxes, PMI (primary mortgage insurance), and homeowners’ insurance.
The best option is a conventional loan because you won’t have the additional burden of PMI payments. However, you need a 20% down payment to access a conventional loan. With the average home price in the US reaching nearly $350,000, you’d need $70,000 in cash to obtain a conventional loan – and that’s before considering closing costs!
2. Secret Safety Nets Help More Than You Know
I’m sure you’re wondering, “if buying a house is expensive, how do people afford it? How do they afford to buy more than one?”
I suspect the truth can be found in the media. You’ve seen the stories. “How this millennial used real estate to retire at 30!” and “How I saved 75% of my paycheck, and if I did it, anyone can!”
You know these articles. And you also know what you will find when you read them.
Family Money
Many of the people extolling the virtues of real estate investing have help. Their parents or grandparents gifted them money for a down payment, got them a high-paying job, or even bought them a whole house. While I don’t blame them for taking advantage of the available resources, I think it’s disingenuous to assume everyone has the same kind of support.
While you can still find people who have done it independently, those stories seem scarcer by the day. Generational wealth is a massive component of successful real estate investing. Those with access to it have an enormous head start.
3. Real Estate Investing is Difficult if You Don’t Have Capital
We talked about how hard it is to buy a first home, and that doesn’t begin to scratch the surface of how crucial access to capital is if you want to make good money investing in real estate.
And by capital, I mean cold hard cash.
The old adage it takes money to make money is true. Access to cash for 20% down payments is just the beginning. You will also need cash at closing and funds available to pay for any necessary repairs while you own the property.
How Much Cash Do You Need?
Repairs are difficult to estimate. You never know when an air conditioning will go out, a roof will leak, or an appliance will bug out. My house in Savannah had constant problems with the HVAC. It required repair after repair, costing me upwards of ten thousand dollars.
Unfortunately, I didn’t have the money in my bank account to cover these repairs, so I had to rely on credit. The end result was a lower credit score and increased debt load until I sold the house.
4. It’s Actually Not Passive
Financial advisor Nathan Mueller, owner of Blackbird Financial Planning, often sees clients interested in real estate investing who believe it’s a passive way to build wealth.
Although Mueller acknowledges that a property manager can make things easier, he often has to advise clients that it still isn’t passive.
All the Work
Property managers can’t make decisions on repairs or evictions. The property owner must make every decision regarding the property. Once a property owner has made the decision, the property manager can facilitate the actions if desired.
Without a property manager, you have to do everything yourself, from finding tenants, collecting rent, coordinating repairs, and, if needed, working through the eviction process.
5. There’s So Much Stress
The need for capital and responsibility for all decisions intensifies the stress of real estate investing. I was more stressed out as a landlord than at any other time in my life, including my tour in Iraq.
When you don’t have an emergency fund capable of covering any housing repair, you begin to dread the phone calls. All you can think is, “What’s wrong now” and “What needs repairs next.”
Your entire existence is spent waiting for the other shoe to drop, waiting for the property manager to call you and tell you about the next extensive repair.
Selling my rental property was the most significant stress reliever of my life, followed closely by selling the fixer-upper nightmare I used as a personal residence for three years.
6. DIY is Harder than it Appears
Speaking of the fixer-upper, flipping houses is often hailed as an easy way to make money with real estate.
Home improvement shows make it look easy, but it can become a massive and costly headache if you don’t know what you’re doing.
Problems with DIY
My home in Pennsylvania was a fixer-upper, and I quickly learned I’m not good at DIY. I didn’t have the skills to put in a new floor on my own or to demolish and rebuild a bathroom completely. Installing even a new toilet is beyond my capabilities!
I ended up paying contractors over $20,000 to fix all the problems with the house and couldn’t recoup these losses when I sold.
Though buying a fixer-upper may be an excellent option for those with construction skills, it’s not good for everybody, and don’t let home improvement shows sucker you into thinking it’s easy.
7. Surprise Damage Can be Costly
Although I knew the home I purchased was a fixer-upper, I wasn’t prepared for the scale of the project. I knew that a bathroom was leaking, the kitchen was dated, the carpet needed replacing, and the roof was old.
Unfortunately, I didn’t know that all three bathrooms had plumbing issues, the sewer was backed up, and the kitchen floors were uneven.
Nasty Surprises
Even real estate professionals find nasty surprises while trying to flip houses. Brian Davis, the owner of Spark Rental, bought a seemingly perfect property to flip. He did his due diligence, getting inspections and quotes from contractors before buying.
The deal closed, and the contractors got to work. Upon tearing down the walls, the contractors discovered the entire frame was rotted and needed to be replaced. The repairs cost Davis thousands of dollars more than he had bargained for, so much more that he could no longer sell for a profit.
Davis decided to keep this property as a rental, but he put so much into the renovation that he lost money on it every year.
8. Bills Don’t Stop Coming
No property has a 100% tenancy rate, meaning you will have months without renters if you’re a landlord. The bills don’t stop coming when you don’t have a tenant to help you pay them.
Adam Kol of the Couples Financial Coach Podcast reminds listeners that real estate investing often requires borrowing a large sum of money. Borrowing to invest is called leverage, and it can be a powerful wealth-building tool.
Overleverage
However, Kol advises caution. You will still owe your payments if you can’t find a renter. Although you can decrease your risk by making larger down payments and having a bigger cash cushion, those options can also lower your overall return on investment.
The possibility of overleverage is even more dire in a lousy economy. Just as you still owe on a vacant property, you still owe in a bad economy. If you’ve taken on a lot of debt to acquire properties, you may find that you owe far more than the properties are worth. A decline in real estate values could lead to a financial avalanche that’s difficult to dig out of.
9. Returns Aren’t Always High
If you’re looking to invest in real estate due to the massive returns of the last few years – look again. Current returns are far from ordinary.
Mueller helps his clients make good decisions on real estate investing by looking at the complete data. He found that, on average, real estate tends to provide a 3.5% rate of return. In addition, many people don’t even consider their costs when calculating their returns. Interest payments, inflation, closing costs, and other things can eat into the income.
Of course, the average tracks the entire US, and some areas may have vastly different outcomes. But it’s essential to look at the whole picture before investing and remember that real estate has long been considered a conservative investment vehicle.
10. The Housing Market Doesn’t Always Go Up
Speaking of low returns, you also need to consider that the market doesn’t always go up. Sometimes it goes down slightly, and sometimes, like in 2008, it crashes and burns.
Investing in real estate, like any other investment, comes with risk. Unfortunately, unlike stocks, it can turn into a risk that keeps on risking.
11. Tenants Destroy Things
Another harsh truth about real estate investing is that you must rely on the integrity of others. While most people are good and don’t want to destroy the place they live in, there is no guarantee that you will find great tenants. Even the best credit checks and referrals can’t catch everything, leaving you stuck with a less-than-stellar tenant.
Tenants can trash a property. Some refuse to clean, leaving the landlord a mess when they move out. Others steal anything not bolted to the ground. Others have out-of-control animals or children who destroy walls and carpets.
12. Taxes are Complicated
Don’t get me wrong, the tax benefits of a real estate investment can be fantastic. Many of the expenses we discussed previously (maintenance, insurance, property taxes, etc.) can be written off as business expenses, resulting in a much lower tax burden.
However, the rules regarding what’s deductible and what’s not can get confusing, especially regarding depreciation. Real estate investors should talk with an accountant to ensure they correctly complete their taxes each year.
Depreciation Recapture
The more confusing and sometimes shocking tax burden comes when you sell. Unless you have lived in the house for three of the past five years, you need to pay capital gains tax on the sale of your home. If you rented the property and claimed depreciation over the years, you will also need to pay the depreciation recapture tax.
Depreciation recapture is calculated based on the years you owned the property and the depreciation you claimed each year on your taxes. Although it’s capped at 25%, it may be a nasty shock for small-time landlords unaware of it.
13. Cashflow is More Complex than it Seems
Kevin Lao, a financial planner at Imagine Financial Security, finds that investors often make mistakes when calculating cash flow. Lao advises that it’s not as simple as taking the mortgage and subtracting the rent.
There are many other costs to consider before measuring cash flow, such as taxes, insurance, maintenance, management fees, and possible vacancies. These costs can potentially eat into monthly earnings, depending on the rental value of your property.
It Doesn’t Always Cover Expenses
When I rented my house in savannah, I barely made enough money from rental income to cover the mortgage and property manager fees. I struggled to afford maintenance costs and often relied on credit to fix more significant problems.
My cash flow didn’t cover my expenses.
Although Lao cautions potential investors to understand everything that goes into cash flow, he also reminds us that cash flow isn’t the only way to make money with real estate.
Investors make money with tax breaks, real estate appreciation, and by paying off mortgages. However, these alternative methods of earning money through real estate take more time and are less liquid. If you don’t have enough cash on hand to cover a maintenance issue when it arises, it doesn’t matter that the property is worth 3% more.
14. Illiquid Capital
Even if the property appreciates, you may be unable to pay your bills. The only way to access money made via real estate appreciation is to sell, and real estate sales take time.
In the hot 2021/2022 market, it took approximately 21 days for a home to sell, on average. However, the time to sell doesn’t tell the entire story. Usually, after an offer is accepted, it takes 25-35 more days to close on a property.
Investing in Real Estate Can Help You Build Wealth
Another harsh truth is that financial advisors are right: investing in real estate CAN be a great path to building wealth. Thousands of people have made fortunes with real estate.
I’m one of them.
A very small fortune. Buying a home in Southern California near a market bottom and selling it in a rising market is the number one reason I’m in the financial position I’m in. I’ll be able to quit my full-time job in a year or two, primarily thanks to the sweet payout I received when I sold.
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Melanie Allen is an American journalist and happiness expert. She has bylines on MSN, the AP News Wire, Wealth of Geeks, Media Decision, and numerous media outlets across the nation. She covers a wide range of topics centered around self-actualization and the quest for a fulfilling life.