With the real estate market sizzling in many parts of the country, I am increasingly asked if it makes sense as an investment. Full disclosure: I’ve invested in real estate in the past, but my opinion of real estate investing has evolved based on my experience and the experience of others. So, I will unequivocally state that real estate is rarely a good investment.
To be clear, I am not against purchasing real estate. For people who have the money and have always dreamed of having a vacation house on the beach to use a few times a year, I say go for it. People who can afford to buy that “experience” without it interfering with their financial goals have earned the right to do so. However, people who view their vacation home or any real property as an investment and as an integral part of their wealth creation may be in for some disappointment.
That’s not necessarily true if you have the discretionary cash to buy a property with no leverage and have the financial ability to use it or sit on it for a few decades with plans to convert it back to cash. Though, from an investment perspective, there are far better ways to put your money to work. Sitting on real estate is not cheap when considering property taxes, insurance, and maintenance.
Crossing the Line into Speculation
But where people cross the line is when they use other people’s money to buy a property, hoping to cash in on its capital appreciation. Most, if not all, real estate investing is premised on borrowing money to make the purchase. Most people don’t have the cash to buy a property outright. So they piece together a deal where they can borrow 80% of the money and justify it as an investment because they have skin (20%) in the game.
They buy a $500,000 property with a $100,000 down payment with the expectation that they can cover their expenses while waiting for the property to go up in value over time. In my view, once debt is involved, whether it’s for purchasing stocks or real estate, you’ve crossed the line from investing to speculation. Again, that’s fine if you can afford to lose your investment, but you should be under no illusion that you are investing.
Guaranteed Liability with No Guarantee of Returns
Think of it this way: When you borrow money, you have a guaranteed liability; meaning there is an iron-clad guarantee you have to repay that mortgage. Yet, there is no guarantee that property will perform the way you hope over the next three, five, or ten years. That creates a very definite imbalance between what you hope will happen and what is guaranteed to happen, which is the repayment of the debt.
That may not seem particularly problematic because everyone does it, right? That’s precisely why the financial crash of 2008 impacted so many people. Nearly 8 million people took on a guaranteed liability, assuming that real estate would perform a certain way, but they tragically ended up underwater. The financial crisis resulted from a speculative housing bubble that burst when people least expected it. But the damage wasn’t caused by falling real estate prices—though that did contribute—instead, it was caused by the massive amount of debt held by homeowners and speculators. We can’t forget the lessons learned from that horrible experience.
What About Speculation in Stocks?
Unquestionably, there is rampant speculation in stocks. I’ve written extensively on the difference between stock investing and speculation. People who buy into a stock to capitalize on a short-term trend in hopes of a quick turnaround are speculating. People who borrow money to do so are definitely speculating. They face the same imbalance of guaranteed liability and what they hope will happen.
However, people who purchase stocks with cash on hand for investing have no such imbalance. They have the time to allow that investment to play out, and if it doesn’t perform as expected, they don’t have to match it up with a guaranteed liability.
So, my problem with real estate is around the leverage or debt that you have to incur to invest in it. Many people don’t understand the risks involved or are not financially prepared to withstand them. Not only does debt increase the cost of the investment, but it also increases the risk of owning it if the property doesn’t perform as hoped. And, in investing, hope is never a strategy.
