Rule #1 Reminder: Why investing in the market can yield better returns than real estate
Originally published 7/22/05 as Real Estate vs. Rule #1.
In response to the Safety Net Nation post, a reader wrote that because real estate lets you leverage your investment, the rate of return is much higher than a business/stock investment and is, therefore, a better place for beginning investors to put their money. This is a commonly held idea that I thought I would discuss for you here because I think, at least for investors who do what I do, that it is completely mistaken. Here's why:
I've owned a lot of real estate. Everything from subdivisions to huge farms to apartments to commercial to single family homes. I've bought into hot real estate markets like Del Mar, CA and Jackson Hole, WY and slow ones like Fairfield, IA.
If we're going to do a comparison we could use the hottest real estate markets vs. the hottest Rule #1 investors, but it seems better to use the average real estate market vs. the average Rule #1 investor.
A reasonably good growth rate in a real estate market over a 30 year period is about 4%.
A reasonably good rate of return for a Rule #1 investor is about 15%.
True, Jackson Hole and Del Mar real estate appreciated at 10% per year for 30 years (in big bursts). And equally true that experienced Rule #1 investors nail 25% per year ROIs for 30 years. But these are exceptional cases. 4% per year growth from now until the year 2035 would mean that my house in Jackson Hole will be worth over $7 million. I'd be happy with that.
So let's look at the difference between investing $50,000 right now in real estate vs. $50,000 right now with Rule #1.
Here are the numbers: You buy a $250,000 house someplace for $50,000 down with a 6% 30 year fixed mortgage. Your payments are $1200 a month but you rent it for $1200 and cover your mortgage payments. You are, however, in the hole for insurance, maintenance, advertising and taxes.On the other hand, let's allow you to never miss a month's rent and you can increase the rent by 4% a year. By your 9th year, you've been able to increase rents enough to cover everything. From there on to the 30th year it's all cash flow.
Then you sell the place. At that point, the house is worth $811,000 and is totally paid for. Plus you've pocketed another $175,000 that you reinvested wisely and made the same return on that as on your house over all - about 10% per year for an additional $440,000. Total return equals $1,251,000. Your compounded ROI for 30 years is 11%.
Quite respectable, although I did not deduct for management, which I expect you will do yourself. This is not an insignificant headache and makes scaling up the investment dollars difficult. Nonetheless, let's compare that to our 15% minimum Rule #1 return.
First, we have no management. We do not have to negotiate. We do not have to drive around neighborhoods looking for a deal. These are not insignificant advantages. What we do have to do is spend about 15 minutes a week managing our few businesses. And we have to know how to do Rule #1 investing, of course, but it's easy to learn once you see the advantages.We buy a business (or a part of a business, i.e., stock) with our $50,000. Since we're going to use leverage in the real estate transaction, we're going to use it here, too. Our online broker will lend 50%. Now we have $100,000 to invest.
We buy a wonderful business at an attractive price and sell it when it gets unattractive and buy another one. We do that for 30 years averaging 15% but paying 8% margin costs on $50,000. (I'm not getting taxed in either case because I'm doing both in an IRA).
After 30 years, my investment is worth $6,500,000 after deducting margin costs. My 30 years compounded ROI is 18%, only 7 points higher than the real estate transaction, but 5.3 million dollars more in my bank account.
Oh, and it gets better. Now you are 60 and retired. You take the $1.2 million and put it into a nice 5% bond that pays you $5000 per month. After tax you keep $4000 a month. That is a whopping $1650 in today's money. Better hope social security is still working.
But if you are a Rule #1 investor, you will continue to invest the $6.5 million at 15% and then live on the 15% increase each year. That means you are receiving about $80,000 a month. That's not a typo. Your income off the 6 mil is almost a million a year. Of course you do have to pay tax on that so you'll end up with about $50,000 a month which is only $20,000 in today's dollars. Do you think you can squeak by on twenty grand a month when you are retired?
So there's how I look at it. You can stay ignorant of The Rule, go exclusively for real estate and try live on the result the rest of your life or become a Rule #1 investor.
Your choice but at least now you know the truth: real estate is nice and I have a lot of it, but it really doesn't begin to compete with a consistent 15% Rule #1 return. My advice: go find a wonderful business at an attractive price and live like a King when you retire.
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