Why Consider Real Estate Investing in an Index Fund World?

Soon after discovering Mr. Money Mustache, I somehow found myself on Jim Collins’ stock series, immersed in the beautiful simplicity of index investing.

He even went on to write an entire book about it, which is arguably the greatest homage to Jack Bogle known to man. I think it is fair to say that a majority of the FI community has rallied behind index investing

And so have I! I love knowing that a portion of my paycheck goes directly into my 401(k) and IRA every month. Just thinking about the tax savings and current bull market makes me feel all warm and fuzzy inside.

But then I did the math. In order to meet our 10 year FI timeline, we would need to keep expenses under a tight wrap. The cost of tuition for our two master’s degrees definitely throws a wrench into the mix.

We needed something more. Side hustles? I had a few ideas, but they were honestly doomed to fail from the beginning. Day trading? HA…just kidding. Uber frugality? There’s only so much I’m willing to give up. Sell my car? Sell plasma? I guess I only need one kidney…

I was out of ideas. So I consider it divine intervention when I first read Chad Carson’s post about the tax advantages of real estate on the Mad Fientist.

A shift to real estate investing

That post marked a pivot in my view of real estate. Before then, all I pictured when I thought of real estate was sleazy snake oil salesmen trying to make a quick buck. I hadn’t been able to shake Jim Collins’ mantra of your house being a bad investment to the point that it was basically etched into the inside of my head. I had decided quite firmly that we would be renters for the foreseeable future.

Chad_teaching_640x427Coach Carson showed me that real estate can be a logical approach to FI and not just a get rich quick scheme. Here was a guy who had built up wealth through real estate in the pursuit of financial independence, not greed, and that had a HUGE impact on my perception of the industry.

Real estate investing (specifically rental properties) is now a key part of our FI strategy for two important reasons:

  • Leverage: financing a large portion of the price of a property will allow us to obtain assets quickly.
  • Cash flow: we plan to use the cash flow from the eventually paid-off properties as our primary income in early retirement.

And the real estate investing approach to FI seems to be catching on, thanks to people like Coach Carson, Paula Pant (Afford Anything), and Guy on FIRE.

But maybe you still aren’t convinced. You’ve heard the horror stories of dealing with bad tenants, the neverending maintenance, and just overall headache. If that’s you, I would like to share my own reasons for real estate investing. While I haven’t yet purchased an investment property, these are the reasons that have convinced me it is a good choice.

Leverage (a.k.a. Using Other People’s Money!!!)

Why invest your own money when you can just use someone else’s money and still enjoy the rewards of the investment? That’s exactly what real estate allows you to do!

Property carries inherent value and its value typically increases. Because of this, markets have emerged to lend people money for purchasing properties. Compared to consumer lending (credit cards), real estate lending is less risky for lenders. If the borrower defaults on the loan, the lender can recover most of their losses by selling the real estate.

Because of lenders’ easy access to a valuable asset, interest rates for real estate loans are considerably lower than they are for non-tangible loans, like credit cards. In the context of real estate investing, the low-interest loans make it cost effective to borrow a large portion of a building’s purchase price.

For example, imagine that you have $100,000 to invest. You have three options:

  1. Invest all $100,000 in index funds
  2. Buy one house worth $100,000 (no mortgage)
  3. Buy five houses each worth $100,000 with the typical 20% down payment ($20,000 x 5 = $100,000)

In all three options, you invest the same amount: $100,000. BUT – how well does each one perform? Let’s take a look at the value of the investments after 30 years. (*see my assumptions at the end of the article)

 Cash InvestedInitial Asset ValueNet Worth after 30 Years
1. Index Fund (i.e. VTSAX) $100,000 $100,000 $761,225
2. Real Estate (1 property, no leverage) $100,000 $100,000 $345,581
3. Real Estate (5 properties, leveraged) $100,000 $500,000 $947,289

The leveraged real estate option blew the others out of the water! Why?

Because from the very beginning, you own an appreciating asset worth $500,000, when all you had to come up with is $100,000. After 30 years, the property value alone has increased to $674,000 (at 1% annual appreciation), and that doesn’t even consider the icing on the cake: cash flow.

Cash flow

In the example above, the net annual rent before mortgage amounts to a whopping $30,000 (again, this is from 5 different rental properties, so each property nets $6,000 per year). So if you didn’t have to pay the mortgage, you would have a nice paycheck sent straight to your bank account. And yes, that even accounts for taxes, maintenance, and capital expenses.

Using some rules of thumb, namely the 1% rule and the 50% rule, the net income from a rental property pays 6% of the property’s values annually. Good luck finding a dividend stock that reliably pays that much!

1% Rule

However, just because you buy a $100,000 property doesn’t mean you will necessarily be able to charge $1,000 per month in rent. It’s up to you to find the right property that fits the 1% rule.

Real estate isn’t exactly smooth sailing. Unlike index funds, real estate requires some form of attention, but if you’re like me, that might not be a problem.

Involvement

“Wow! Real estate investing sounds great! Why even consider index funds if you end up with more money going the real estate route?”

This can be explained through a simple tenet of economics: if you want high returns, you have to accept high risk.

There can be A LOT of risk in real estate.

  • Tenants can trash your property.
  • You can get sued.
  • Your property could get destroyed by flooding.

While the idea of repairing roofs and replacing old windows might scare a lot of people off, I see this as a great opportunity to make my mark on the investment.

With index funds, you have no control over the performance of your investments. You are completely at the mercy of the markets, for better or for worse (mostly better).

With real estate, your own decisions have a profound effect on the success of your investment. From things like how you market your property to renters, to choosing which capital improvements to focus on (or ignore), a lot is in control.

Some things like rent and the price of a property follow market conditions, but you can do everything in your power to find a low priced property or command an above average rent. If you are willing to put the effort into real estate, you will experience higher returns than from the stock market.

Tax advantages

I won’t pretend to know much about the tax side of real estate, so I will defer to Coach Carson! You can read more about his discussion of the tax benefits of real estate investing here.

Here are my favorites:

  • Depreciation: While a property overall will probably increase in value, the building itself is a depreciating asset. The IRS allows you to claim depreciation on real estate to offset income taxes.
  • Appreciation: Unlike index funds, the increasing value of real estate isn’t taxed until you sell.
  • Capital Gains: When you do sell real estate, it is possible to minimize your tax on the capital gains by reducing your income, like through depreciation.

There you have it! I know real estate investing probably isn’t for everyone, but for us it makes sense. We have plenty of time to acquire assets and pay off any debt that accompanies them so that we will have flexible income in early retirement.

What do you think of real estate investing? Are you going to stick with index funds? Let me know your thoughts in the comments!

*This is just a simple illustration, so your results may vary. Here are my assumptions:

  1. 7% stock market return
  2. monthly rent is worth 1% of the property value (a.k.a. the 1% rule)
  3. monthly expenses are 50% of the gross rent (a.k.a. the 50% rule)
  4. annual property appreciation is 1% (so rent also escalates at a rate of 1%)
  5. 30-year mortgage, with interest rate of 5%

 

10 thoughts on “Why Consider Real Estate Investing in an Index Fund World?

  • October 20, 2017 at 12:11 pm
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    Well explained arguments for why to invest in real estate! I agree that involvement is not a bad thing. You can influence the success of your investment, and that is more attractive to many people (including me) than sitting there stressed about ups and downs you can’t control. And in the end, once the rental is set up and occupied, there is VERY little time required – even if you self-manage.

    Thank you also for including me in the article!

    1.

    Reply
    • October 20, 2017 at 2:05 pm
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      Thanks, Chad! There aren’t many investments that allow you to affect their success. I think that if you are comfortable with it, you should use that to your advantage and just own it – don’t shy away from the work.

      Reply
  • October 22, 2017 at 5:32 am
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    Fantastic summary, Dylan! These are all the reasons we choose to invest in properties. It sure doens’t hurt that we don’t mind applying some elbow grease to spiff up and repair.

    Love the concept of other people’s money. It’s the Rich Dad, Poor Dad mantra, and leverage is what really wealthy folks often use to build their net worth.

    Reply
    • October 22, 2017 at 8:47 am
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      Thanks, Cubert! I’m really itching to get started. I’ll probably have a load of questions for you in a few months!

      Reply
  • October 23, 2017 at 8:04 am
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    Very nice write up Mr. Dylan. We are of the same opinion, albeit we also see the benefits of ETF’s. Guess a combination is really the best way to go, for us at least!
    Best of luck (and keep enjoying those good beers from Belgium!).
    Team CF recently posted…Real Estate Report – September 2017My Profile

    Reply
    • October 23, 2017 at 2:12 pm
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      Thank you! Definitely – I’m all about index funds. There is not beating their simplicity, and they are quite good for building wealth. I am interested in real estate for its ability to not only build wealth, but also provide cash flow.

      And I always love a good Belgian! (beer, that is)

      Reply
  • November 6, 2017 at 1:57 pm
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    I had some investment properties in the past; it didn’t suit my lifestyle all that well. So I’m 100% in funds now.

    I love the cash flow and tax advantage of real estate investing. I’m not a fan at all of the leveraged options – because I know too many people who got “hurt” leveraging. Sure, it can make a lot of money, but it can also lose a lot of money.
    Brad – MaximizeYourMoney.com recently posted…How To Make Sense Of Tax BracketsMy Profile

    Reply
    • November 6, 2017 at 5:38 pm
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      Yes, over-leveraging can lead to unnecessary risk, but the same can be said for any investment. I personally consider a 30-year mortgage to be a very low cost, low-risk way of investing in real estate. The “buy low, sell high” idea obviously applies even more in real estate, so it is rather necessary to put in the extra effort of finding a good deal.

      Reply
  • November 9, 2017 at 8:42 pm
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    So I’m all for real estate and am kinda in the “have too much in index funds, time to get me some real estate” boat. What I realized is that most non-portfolio lenders will require 25% down for investment property so you kinda end up with 4 leveraged properties instead of 5 in your example. Second, being self-employed brings up a challenge where its not ‘easy’ to get approved for mortgages, especially if you are starting out and don’t have existing rental property income to show. Curious if you’ve come across any challenges in your RE journey from a financing perspective?

    Reply
    • November 10, 2017 at 3:56 pm
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      Hmm. I hadn’t heard the 25% down. I thought it was 20%. I have not officially started investing since I haven’t made any purchases yet, so I’m not the best one to speak about the specifics of financing. My strategy will be to target distressed/out of date properties and use short term private lenders to fund the purchase and renovation, then refinance to a mortgage or portfolio lender within a year. The idea is that the renovation will increase the value of the property enough to cover the 20% down payment.

      Reply

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