There’s no doubt about it—real estate can help you fast-track your way to financial freedom. It’s a powerful tool, especially when combined with leverage, that millions of people have used to dramatically accelerate wealth creation.
Every week, we hear new stories about investors who start with little to nothing and build a sizable position that propels them not just to financial freedom but beyond—into “should I buy a small private plane?” territory.
What we don’t get a ton of, however, is the story of the guy or gal who was already a self-made millionaire and then took up real estate investing. I’m sure they are out there, but I bet that there’s not much flashiness and their returns aren’t really that great.
In this article, I want to write about a concept that I think will impact many people who are well along on their journey towards financial independence. People who might be in the $500,000 to $1,000,000 or more in net worth range. People who are rich (even if they don’t feel that way).
If you are in this bucket—the bucket where you earn a good to great income, you spend little, and you invest passively—you probably don’t want to invest in real estate. Yes, I am the CEO of BiggerPockets.com, and I am telling you that buying real estate as we typically like to discuss here on BiggerPockets is probably not the move for you if you are already at the high end of upper-middle-class in terms of earnings power, or if you are approaching $1M in net worth, seeking early financial freedom.
Read on to find out why.
The Risk/Reward Concept
Investing in general is all about this notion of risk-adjusted returns. The higher your expected return, the better. The lower your risk, the better.
Risk-Adjusted Returns in Stocks
When we invest in something totally passive, like a total stock market index fund, for example, we take on a relatively easy to understand risk-adjusted return.
Many of us in the financial independence and real estate community are familiar with this example—we invest in index funds expecting the long-term returns to be in the ballpark of 8 to 10 percent (before inflation), and we understand that the stock market can be extremely volatile—it’s possible we go through a period where the value of our portfolio declines by 50 percent or more.
The index fund is comprised of hundreds or thousands of companies that are publicly traded. By investing in an index fund, we diversify away the risk of investing in just one company and assume the market risk. No one company can make us rich, but no one company can wipe out our investment, either. We assume only the risk of the market our fund covers.
This is the risk/reward profile that an investor with 100 percent of his/her portfolio in a stock market index fund assumes. There is little the investor can do to change this risk profile—which is why index fund investing is so attractive. A huge chunk of the risk associated with investing is diversified away besides market risk—there is no selection of companies, fund managers, etc.
Risk-Adjusted Returns in Real Estate
When we invest in real estate, it is because we want to put in work to get a better or different risk/return profile than an alternative, like stocks, or to diversify.
A real estate investor assumes the same types of market risks that an index fund investor assumes (although many, like myself, feel that real estate is likely to experience fewer and less extreme periods of volatility in general than the equity markets). They also assume local risk and risks inherent to the property itself—like getting a bad tenant, damage, etc.
On the upside, investors like myself feel that we can get a better risk-adjusted return in real estate, often because real estate enables us to more safely and reasonably use leverage, and at much better interest rates, than we can use investing in stocks.
How Investors Reduce Risk in Real Estate
Because so much real estate risk is local and subjective, it is really hard for a new investor to accurately assess a deal for it’s risk profile and even harder for that person to manage the property effectively during the hold period.
This means that the uneducated newbie will not get a good risk-adjusted return. Their risk of making a mistake in analyzing the deal, the market, or in operating poorly is just too high. They might do well in an up market as a rising tide lifts all boats, but they will get crushed in mediocre or down markets.
In order to get a good risk-adjusted return, the newbie will have to self-educate. They will have to read books, take free courses, listen to podcasts, read blogs like this one. They will have to network. They will have to learn from the school of hard knocks over a period of years.
After a period of self-education, the new investor will learn the basics about how to analyze cash flow, how to project rents, the local landlord/tenant laws, the zoning rules for property in their area, how to screen tenants, how to manage contractors, and the many other models that lead to success in purchasing and managing rental property investments.
After that price has been paid, the investor can simply maintain their knowledge base and go on to reap a lifetime of excellent risk-adjusted returns in real estate.
What Is the Price?
There is no way to adequately pin down exactly how many hours of self-education, networking, and experience are needed for an investor to cross the chasm of knowledge needed to get solid risk-adjusted returns. So, I’ll just offer up my opinion:
1 hour: You’ll get hosed
10 hours: You’ll get hosed
100 hours: You might be OK
1,000 hours: You’ll probably get great returns over time
10,000 hours: Please call me if you need to raise money for your next deal
Where is the inflection point? I think that’s up to the individual to decide. But the point is that the price must be paid, and I think that many investors here on BiggerPockets would agree that the minimum price is between 100 and 1,000 hours of your time. For the purpose of discussion in this article, I’ll call it 500 hours before the new investor has invested enough time to have a great shot at getting excellent returns in real estate.
Who Should Pay This Price?
This is really the question being explored in this article. Five hundred hours is a lot of hours. If your time is valuable—for example, you can earn $200,000 per year or are a self-made millionaire—this is an extremely expensive investment.
On the other hand, if you make $50,000 per year and have a net worth of $5,000, then 500 hours is a much smaller relative investment.
When I was 23, I was making $50,000 per year and had about $5,000 to my name. I had absolutely no trouble putting in 500 hours to learn about real estate investing. Heck—I put up 168 hours just to get my agent’s license!
Nowadays, my time is far more valuable, and my income and net worth profile are different—in part because of that self-study. I would think long and hard before taking on a new field of study that required 500 hours of my time. I certainly wouldn’t put in that investment if I felt that I was just a year or two away from being able to FIRE with or without real estate!
If we agree with the arguments I present above about the price, in time, that must be paid to get a fair risk/reward profile from real estate investing, then we reach two conclusions:
First, investing the buy-in price of approximately 500 hours of networking, self-education, and practical experience is absolutely worthwhile for the relatively young person starting with relatively few assets (perhaps less than $500K) and a median to upper-middle-class income (perhaps less than $200K). The person with this profile will pay the price when their time is relatively less valuable and reap the rewards of great returns with a comfortable risk profile for the majority of their life.
Second, investing this price is probably not worthwhile for the person who is already very well off, has little free time, or has very strong earnings potential. This person will probably coast to financial freedom with a reasonable lifestyle. simply by continuing to generate their huge income and investing passively.
If you are already wealthy or close to financial freedom, you might want to rethink whether you should invest the hundreds and hundreds of hours needed to become comfortable with this line of business. It may only be worthwhile if you plan to use what you learn to go on to generate significant generational wealth over your career—perhaps a net worth in the upper seven figures, eight figures, or more.
Of course, you may also just be an investing nerd and approach real estate investing as your next hobby. In that case, go nuts!
Do you agree or disagree with my arguments? Why?
Let me know in the comment section below.
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.