The Four Risks Of A Real Estate Investment

There is a reason why you don’t see many investors get interested in physical ownership of real estate until they can ensure that they can afford a property management company to run the day-to-day operations and the size of the family wealth is substantial enough that a single apartment complex won’t consume most of the family’s assets. In effect, this means that outright physical real estate ownership in the portfolios of investors with less than $1,000,000 in investable assets but takes off quickly once you study the assets of investors that have over $2,500,000 to invest. So why don’t you see a lot of real estate investments from the wealthy before that $2.5 million net worth point?

First, it requires a large amount of capital. If you buy a $250,000 house that you want to rent out, you are going to need at least $50,000 in cash to make the down payment, and plus an additional $3,000-$6,000 as part of the transaction costs necessary to acquire the property. It also requires an ongoing amount of capital. There is insurance for the property, maintenance for the property, taxes on the property, and advertisement expenses required to seek out a tenant.

Second, it is an illiquid asset with limited marketability. If someone buys a stock or a real estate investment trust (REIT), you can enter and exit your position online just about anytime you want Monday through Friday. Your asset converts to cash instantly. Not so with real estate. Between the date a home is listed for sale and payment from the sale occurs, almost 130 days come to pass. And this is contingent upon you actually finding a bidder. Furthermore, while you can enter and exit stock positions for $8 per trade, the cost of entering and exiting a real estate position is thousands of dollars.

Third, a real estate investment obviously has a fixed location. If the surrounding environment deteriorates, you are helpless. Even though the property is under your control, you cannot control the surrounding area which is a great input into the value that you charge for rent.

And Fourth, people always assume that they won’t go more than a month or two without a tenant. Just shy of 30% of first-time landlords have to endure four months or more without receiving rent in their first year. If you’re expecting $1,200 per month in rental income that doesn’t materialize, you could be hit with $5,000 in mortgage payments that weren’t part of your initial projections.

My view is that the markets are pretty rational about when to take on a real estate investment. It seems to me that wealthy families move into real estate once their wealth level reaches a point where the property investment takes up an insubstantial amount of their net worth and they have the funds to hire a property manager. If you don’t have the funds to do that, you have a bought yourself a job with an ownership interest rather than investment. Also, the transaction costs associated that precede the tenant’s first payment are far more substantial than real estate investors initially think. My view is that passive real estate investment trusts are the way to go before you’re a millionaire, and then the purchase of a physical property run by a property management group is the way to go after that. The exception would be if you’re a handyman who enjoys making property improvements and the liquidity and gumption to withstand the initial hussle.