Ask Brian is a weekly column by Real Estate Expert Brian Kline. If you have questions on real estate investing, DIY, home buying/selling, or other housing inquiries please email your questions to [email protected] .
Question from Chelsey in Philly: Hi Brian. I’m a busy 34-year-old professional that bought my first house at age 28. My career is going great, and I have made an offer on a much nicer home that I think I’ll be living in for many years. I count my blessings because I don’t have to sell my first home to get into the new home. I already have a fully funded 401k that is invested in mutual funds. I’m a busy person but I’m seriously thinking about diversifying my investments into real estate by renting out my first house. My knowledge of real estate investing doesn’t go much beyond buying these two houses for my personal use. The other option that I’ve thought about is selling my first house and opening a stock account outside of my 401k. I know how fortunate I am to be in this position. But is real estate a better investment than stocks?
Answer: Hello Chelsey. Congratulations on your success. My first thought is that asking the right questions has probably helped you get to where you are now. I sometimes refer to your way of thinking as “I don’t know, what I don’t know – but I want to find the answers.”
Investing of any kind takes work. There are tradeoffs between investing in stocks and bonds or investing in real estate. Ultimately, it likely depends on how much time and effort you want to put into either one. My opinion is that most real estate investments are more secure than stock and (importantly) you have much more control over real estate. On the other hand, stocks have certain advantages like lots of data at your fingertips and not needing a lot of capital to quickly get in and out of investment scenarios (liquidity). Real estate is nowhere near as liquid as stocks but also not nearly as volatile. On the downside for stocks, despite all the data, you have almost no control over how a particular investment performs.
According to the Motley Fool review that's most recent, many investors try to compare real estate to stocks by comparing returns over several years. Something like comparing 10 years growth of the S&P 500 to the increase in the median value of single-family houses. There is a big problem with this because real estate is a very local investment. Just because the average U.S. median home value goes up 12% doesn’t mean it did the same in your hometown. In the right town, house values might have gone up 18% but in a less fortunate town, values might have declined by 5% (numbers will vary). The same thing can happen if you buy individual stocks rather than mutual funds. Individual stock values can decline at the same time the market average is going higher. So be very careful about making individual investment decisions based on broad averages.
Chelsey, with that said, it appears that converting your first house into a rental property could be another great opportunity for you. With your capital investment already in place, your main goal is generating enough income to pay off whatever remains on the mortgage – using other people’s money. That means keeping your house rented (minimum vacancies) at a dollar amount that pays all your expenses and has a positive cash flow (ROI). Unlike a mutual fund or stocks in an individual company, you are the only manager of your real estate investment. You need to be financially prepared for things like emergency repairs, HOA special assessments or fee increases (if applicable), along with covering the mortgage and utilities if you have a vacancy. Along the way, you may want to make improvements to the house to increase the monthly rent or to keep it competitive in the local market. It’s not unusual to need significant repairs when the time comes to sell your rental. You’ll also probably pay a 6% listing commission to sell it. The bottom line is you are in control and need to do some long-term planning to maximize your ROI. That includes the opportunity cost of keeping cash reserves that otherwise could have been invested elsewhere.
In the end, you will have renters paying the mortgage and expenses on a house that you will one day own free and clear. But it doesn’t come without effort and risk on your part. With only one rental, you are probably going to manage it yourself. That can mean things like responding to a tenant with clogged plumbing at the most inconvenient times. And because real estate is local, it has local risks. Being a landlord has proven to be so profitable that big institutional investors are very active in the market. Even if your rental is in an ideal market, something can happen like a big luxury apartment project going up a few blocks away that undercuts the rent for single-family houses. Another risk is a big employer closing down operations that can lead to vacancies.
Chelsey, you are a busy professional and your time is worth money. From the little I know; I think you will do well with real estate investing and renting out your first house is a great place to start. But it will take more time and effort on your part compared to stock investments. That’s another opportunity cost that you want to put into the equation. There is plenty of money to be made as a real estate investor but along with your career, it might not leave you with much free time.
What is your take on real estate versus stock investments? Please add your comments.
Our weekly Ask Brian column welcomes questions from readers of all experience levels with residential real estate. Please email your questions or inquiries to [email protected].