Real estate has often been touted as one of the most accessible ways to grow real wealth. Who among us ambitious haven’t heard the platitudinous claims passed off as conventional wisdom or perhaps as an arcane right of passage into occult upper echelons of society?
“Real estate makes more millionaires than any other industry.”
We have heard it in forums, self-help books, and from passing snake oil peddlers trying to get you to sign up for their educational seminar so you too can get rich.
As an engineer fortunate enough to not be living pay check to pay check as many Americans do, I also found this promise alluring. After all the basic principle that you can own a second home and collect a sizable and secure supplemental income certainly seems like a good deal at first approximation and so when me and my wife moved out of our first home for new jobs, we decided to keep it as a rental property rather than sell it.
We had purchased the property for only $130,000 dollars in 2017 and after living there for about five years the value had doubled. It was also located in an above average area of growth in South Carolina that had seen explosive growth going from Hicksville, USA to having two Starbucks by the time we moved out (of course the number of Starbucks is the proper measure of affluence). We were able to rent the house out with ease for two years for $1,800 a month while all of the recurring costs amounted to only $1,000 a month.
Indeed on paper it was an excellent investment. But when a difficult tenant started to stress us out we began to wonder if having a rental was worth all the hype in comparison to less stressful alternative investments.
So I decided that rather than scouring the internet for advice from likely unqualified faceless charlatans, I would conduct my own analysis of owning a rental home vs. simply investing in the stock market. After all, at one point in the not so distant past relying on your own mind rather than the top 10 Google search results to reach your own conclusions was considered desirable.
The Calculation
My methodology was to calculate the total net benefit over the next 22 years (the time until the house would be paid off) in today’s dollars of keeping the rental vs. the total net benefit in today’s dollars of selling it and investing the proceeds in an index fund for 22 years and compare the two results. Although seemingly simple, the reality is that the financials of rentals are convoluted and comparing them to neat investments is actually kind of difficult. There are a lot of assumptions and extrapolations that must be made about both benefits and expenses.
The total net benefit for market investing was actually pretty simple. I estimated that the total proceeds from a sale after everything was said and done would be $100,000. So simply applied compounding interest to calculate the value I’d have in 22 years.
For this I assumed the historical average market return of 10% (7% accounting for inflation) as well as a few other higher returns to see how I would fare if things went well.
Because I will not be retired in 22 years and this money would be growing in a traditional taxed brokerage account, I made the assumption that if I wanted to derive regular income from the final capital I would have to sell everything and take the fat 15% long-term capital gains tax in order to move the money from an index fund into a high yield fund providing a yield of 5%. I then further assumed that as income I would have to pay 29% of those earnings in federal and state taxes. This yielded the total income I could expect in my pocket every month after investing for 22 years.
Total derived benefit and possible income for investing $100,000 in index funds after 22 years.
The calculation for the house was much more tenuous, but as I mentioned earlier, you do have to make some big assumptions to make a comprehensive assessment of the total net benefit of renting a house for 22 years. I started by calculating the total positive factors:
Total rent — Assuming that I will increase rent at 3% to keep up with inflation, I assumed an average rent value for a total present day value of all collected rents over 22 years of $468,600. I then adjusted this value for an assumed vacancy rate of 8% to yield $431,112 (A).
Appreciation — Of course one of the benefits of real estate is that it generally appreciates at a rate that is commensurate with the desirability of the location. Before things exploded circa 2022 and houses got crazy expensive, the rate of appreciation in my area was just under 5%. This is a good bit better than the historical national average of 3.5%. Since it is a higher growth area in South Carolina where I’ll used the higher number. At 5% appreciation (2% after accounting for inflation) I can expect the house value to grow from the present value of $250,000 to about $386,494 or an increase of $136,494 (B) in today’s dollars.
Although there are many other potential benefits of renting a house, at the basic level, the benefits are from rent and appreciation. So the total gross benefit can be calculated simply by adding A+B for a total of $567,606.
However, the story doesn’t stop there. There are also negatives or expenses associated with owning a rental property. The total negative factors were calculated as:
Capital gains tax on sale- It turns out that when you sell your house after many years of appreciation you have to pay long-term capital gains tax on the profit. There actually are ways around this but as we will discuss later they probably are pretty useless to the average one-off real estate investor. So since I paid $130,000 for the house and expect it to be worth $386,494 when I ultimately sell it 22 years from now, the net profit is $256,494 which is taxed at 15% costing $38,474 (A).
Depreciation recapture tax- When you rent out a house you get to depreciate it’s value every year like any other large capital assett in a business. This means you can kind of say you “lost” a certain amount of value every year from use. That depreciation ultimately helps lower your taxes every year and so it is a benefit….kind of.
When the time comes to sell your house, you actually have to pay the government back for all the asset depreciation you claimed. You could try to figure this out yourself, but I just used an online calculator and figured that I would have to pay about $31,200 (B) in depreciation recapture tax.
Sales cost — There are also significant costs associated with actually selling your house. Things like real estate agent commissions and repairs can really add up. Based on some internet research I saw that 8% is a reasonable number for sales cost. It could be more if there are many repairs needed. At 8% it would cost $30,920 (C) to sell a house for $386,494.
The total future expenses at time of sale can be calculated as A+B+C or $100,594. However, this is in 2046 dollars (22 years from 2024). This has to be adjusted to be in present 2024 dollars for the purpose of comparison. The adjusted number in 2024 dollars works out to $58,432 (D).
Maintenance — There are also repairs to consider. Any repairs that are not covered by the rent payments come out of your pocket. There are a lot of assumptions that you have to make here. I was actually pretty light on repairs assuming that the tenant wouldn’t trash the place and that only predictable things would need to get done. This included things like replacing the roof once, changing the carpet out three times in 22 years, and painting the place several times, and replacing the wooden privacy fence once. I also made the assumption that most of the repairs would be sooner rather than later. I browsed the internet to get estimated repair costs and life expectancy numbers. For 22 years I estimated $75,000 (E) (in today’s dollars). Honestly, I think this number is very light and could easily see it being twice that.
So everything said and done, the total gross expense in present money can be found by adding D and E for a total of $133,432.
The total net benefit can finally be calculated by subtracting the total expenses from the total benefits, or $434,174 ($567,606 — $133,432 ).
When we compare this with the estimated stock market returns, we see that it is on par with the 11% return (8% after inflation) which is slightly better than the more conservative 7% often quoted. So at that it looks like real estate wins! … however there is still more to consider.
Other Considerations
Remember why I started looking at this in the first place? I said that having a rental property was beginning to stress me out. Even with a property management company “running things” the reality is that it is impossible for them to take care of your property the way you would want to. They aren’t there day in and day out noticing the slow degradation of condition. Yes, they will catch the big things and hopefully boot tenants that are trashing the place, but the insidious decay will be left un-noticed until it becomes a big enough problem.
For me, being emotionally attached to the house, I find this to be incredibly stressful. It is fair to say that not everyone feels that way about their properties, some are able to treat them strictly as business assets that require repair when they stop working. However, you really can’t discount the psychological affects of dealing with someone who doesn’t care about your home the way you do.
So now we are talking about 22 years of stress. That is 22 years of worrying if you are going to go in to sell the place and find that the house should be condemned and repairs would take a tremendous chunk out of what you expected (possible A LOT more than that $75k we estimated). That is 22 years of stress dealing with tenants and having to watch their ridiculous and rude maintenance tickets come through your email where they call you a “slum lord” and tell you that the carpet looks like someone “took a shit on it” (mind you this is who is living in the house you once loved).
Is it still worth the difference?
That is a personal determination that everyone in this situation must make on their own. In my case, I am leaning towards ‘no.’
But why does everyone make a bid deal out of real estate? If the actual returns are comparable to the market, why is it so special?
Now that is the question, and I think that we are ready to answer it given the context of the above analysis.
If the total net benefit really is comparable to the market then why in the hell would anyone want to dabble in real estate let alone claim it is “the way?”
I am hardly the Supreme Overlord Barron Lord Admiral of real estate investing, but I know enough to tell you that the reasons have to do with those secondary benefits we deferred from earlier.
The primary benefit of real estate is leverage. Leverage is the idea that you can own a house using primarily someone else’s money (i.e., the bank’s through a mortgage). This means you get the full benefit of owning a house and renting it (full appreciation, equity, and rent proceeds) with minimal investment of your own. You are taking out a loan to buy an asset and having someone else pay for it. Leverage is possible for stock investing, but houses are much more secure investments and banks realize this and so the rates and terms are much more reasonable than taking out a loan to buy stocks. So why would you ever want to give that up?
The reality is that you are only leveraged while you are …. well, leveraged. As your equity in the house increases (either by paying down the mortgage or through appreciation) you become less leveraged. That is to say that magical benefit of real estate decreases with the less you owe.
Look at it this way. Say you only owe the bank one more dollar on your mortgage; while you still don’t own the house outright, you have nearly 100% equity. That equity is effectively your money (not the bank’s) that can be applied to anything and thus it carries an opportunity cost. That is, you have to compare what it is doing for you tied up in the house to what you could get from the market or other investments. If the situation were flipped and you only had one dollar of equity, it is a much better deal… you couldn’t do much else with that single dollar. The more equity you have in your house, the less leveraged it is, and the more it acts like a traditional stock.
What you’ll find, is that houses perform very much like high dividend, low growth stocks. That is, they provide good income, but appreciate less than the market. When we do the comparison (as we did above) it really does come out as more of a wash than many burgeoning real estate investors might think.
There are other benefits to owning a home. For example, it is real and has an intrinsic value; when the next great depression happens, people will still need a place to live. Plus, since mortgages don’t change with time (that is they get cheaper with time due to inflation) you could live there during difficult times, probably for much less than your current rent or mortgage.
Although these are secondary considerations, there are also creative financial mechanisms available for homes. For example, home equity loans or lines of credit can give you a better rate when you need money compared to a private loan. There are also mechanisms to avoid having to pay taxes on your gains (possibly until you die) such as 1031 exchanges, however these are very complicated and are really only designed for real estate investors to turn one property into another. They are nearly useless for the average Joe with maybe one rental (big surprise).
We also hear a lot about the tax benefits of owning rental property. What are those? Well you can claim depreciation. Depreciation is the government’s way of acknowledging that large capital business assets (think a large factory machine) lose value over time as they are used. So you are generally allowed to claim back the full purchase price of your home over the course of 30 years which helps to offset taxes on the rental income. However, you do have to pay it all back when you sell the house in a process called depreciation recapture tax. So maybe it isn’t that much of a benefit after all….the real benefit is that since you pay it back later it is worth less due to inflation. Not a huge benefit… You can also claim business operating expenses to also help offset your rental income (think new roof, new windows, repairs, project management fees etc.).
So now seeing the whole picture it is obvious that there are some benefits to owning a rental home over investing in the stock market. However, they may not be what you thought. Let’s recap:
- The total net benefit from renting a house, vs. investing in the market is likely comparable.
- Renting a house is much more stressful (even with a management company) than investing in the stock market. You have to have the right kind of personality to not be affected by people trashing your place, being rude to you, and, if this was a home you lived in, the steady decay of a home you once loved (because no, management companies do not maintain houses like you did when you lived there). There is also (i’d argue) a lot more variability in how you’ll fare with real estate (assumptions about vacancy rate, long-term repairs, etc.)
- The primary benefit of owning rentals is the ability to leverage into a stable investment on favorable terms. The more of your house you own, the more they perform like traditional stocks and the less argument there is for keeping it due to the opportunity cost of your tied up equity.
- There are some secondary benefits, pertaining to taxes, the actual utility of the home, and some creative financing opportunities.
So in conclusion: what does this mean? It means in an apple to apple comparison houses are good investments that rival stock markets but they are much more stressful. However, with leverage being the primary benefit there is a real advantage here if you are willing to maximize your leverage in the real estate market.
If you are going to have one house and pay it off and keep it for income, I’d advise you to consider other options if it is stressing you out as (1) it won’t make you rich and (2) it may not be better than the markets. However, if you are going to go big and leverage leverage (no not a typo) there is a possibility to do well.
So what does that mean? Money is made in real estate at the front end by making good investments and using (and I mean USING leverage). If you are willing to maximize your credit and home equity usage as much as possible to buy more and more houses putting as little of your own money into each one as possible and you are willing to have a part or full-time job dealing with managing them all and it won’t stress you out, it is a path to wealth. Of course, you could also do well just dropping that $100k into the S&P 500 and call it a day.
