Why Are Real Estate Cash Returns so Low?

Question

I've been reading a lot lately about investing in real estate. I'm considering transitioning the bond allocation in my portfolio to real estate if I can get a 10% net return on my investment.

My big concern is that I charge a percentage of the value as rent, I hear 1% is solid in a good area. At 50% expenses, I'd keep just 6%.

Learning this whole field of real estate for a 6% return seems ridiculous when you could get better returns via a basic stock index. For lifestyle or flipping as a job, I get it. I personally would love to have my own solid home base so even if I dont invest, I'll still have it as part of my allocation.

But really, why do you invest when the returns are so low? 12% net sounds great but to focus so much of my net worth into a single location seems foolish compared to buying stock that is diversified across many products, continents, and laws. Real estate investing also requires more input of time and energy. Leverage is the only situation in which this makes sense but again, you can leverage stocks quite easily and cheaply.

Joe Villeneuve · Answer

First, the words "only thing that makes REO attractive" and "leverage" should never be used in the same sentence.

Second, the ability to get all of the money you put in (your only cost), out of the REI quickly...and still be making money that is compounding, is another "attractive" advantage.

Third, the fact that your tenant is the one buying the property for you is pretty important too.

...there's more, a lot more, but these three things alone should be enough.

Mark S. · Answer

@Jacob Sampson Can’t disagree at all with those points. When I said I would do something like that, I didn’t really mean for myself. Like you, even though the % returns can be pretty good, the actual dollar amounts are too low for me. But for someone starting out, something like this could be a good learning experience with the opportunity to make some decent returns.

Jacob Sampson · Answer

I understand what you are saying.  Those margins are just to slim for me.  Plus %s aren't as useful on small numbers.  Meaning if $100 is an 8% COC return, who cares.  That is so little money that a single bump in the road will eat it all up and more.   Further, there is some base level of effort involved in this business and $100 cash flow is not sufficient to make it worth that base effort.

And for me, all that matters is the cash flow.  The principal buy down and appreciation don't factor in to my calculations for a couple of reasons.

1.  I can't control appreciation or depreciation so principal buy down and appreciation may or may not be there when I go to sell.  If they are then they made my good investment great.  If they aren't there then my good investment is simply good.

2.  By adding those squishy numbers into the calculation it can make sub par properties look like reasonable investments.  Then in the end when you go to sell if they aren't there your good investment becomes sub-par.

Calvin Ozanick · Answer

I am not sure how you calculate your returns. However, it is not very difficult to find 10% CoC especially in the Janesville and Beloit, WI markets. Let me know if you have any questions.

Joe Villeneuve · Answer

Percentages lie.  You can't compare the returns from the SM with returns from REI.

Here's what it would look like if you took $100k, and invested it in the stock Market with 15% returns (including dividends that was reinvested), and 5% in REI (plus cash flow that was reinvested), over a 5 year period:

Stock Market                         REICash Invested      $100k                               $100kTotal Return        $101k                               $570

...and the difference grows wider with each passing year.  It's the power of leverage, and the power of compounding.

Aaron K. · Answer

Leverage is much more doable in real estate, not to mention you are skipping over the appreciation side of RE, you are much more likely to get margin called in the stock market than to have your RE loans called.

Cameron Tope · Answer

@Felipe R. I was wrestling with this same question a few years ago!

Why would I want to tie up my money in a liquid asset that requires time, energy and leverage, when I could buy a passive index fund and return ~9%?

The reasons I came up with were diversification (I didn't want all my net worth in stocks & regardless what the market returns I still have a tangible asset), tax advantages (I had matched my 401k and maxed out my ROTH IRA), cash flow, leverage (I can get money really cheap) and control (my team and I can increase the value by better operations).

With leverage and effective operations, the rentals are consistently making returns over 15%, with many making an infinite return due to the cash out refi part of the BRRRR strategy.

If you're comfortable in stocks then just do stocks but most of the millionaires have some real estate in their portfolio.

Joe Villeneuve · Answer

Forget the percentages...they lie.  Talk dollars.  They spend.

Mark S. · Answer

@Jacob Sampson I would purchase a $100,000 house for a $100 cash flow if the COC was at least 8% or so and there was a reasonable chance for appreciation. (If capex, vacancy, etc is all accounted for) Plus the principal pay down. $1200 CF, $2500 principal pay down, $2000 appreciation @ 2% equals a 24% annual return on a 20 down payment plus $4k in closing costs. Of course, if the management consumes a lot of time or you could find bigger, better deals I would look somewhere else. But it could be a good way for someone to get started.

Jacob Sampson · Answer

You are correct, nothing about real estate is guaranteed.  Further, a major difference between real estate and the stock market is that in the stock market you can only lose what you put in, in most cases.  In real estate, your losses can be infinite.  So with that greater risk you should require greater possible returns.

To get greater potential returns you cant be using rules of thumb like the 1% rule.  I would never purchase $1000/month of rental income for $100k.  That is a horrible investment to me.

Like any investment there will be people skilled at it and they will make above average returns but most will not be and they will make below average returns.

Why Are Real Estate Cash Returns so Low?

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