In my first article and our recent podcast, my brother and I made the claim that buy and hold real estate is the best investment around. As my father puts it, buy and hold is the best way for a person of modest means to become independently wealthy. Here I would like to defend that claim by addressing some of the thoughtful criticisms I received from the comments section of the first article.
A Reminder and Clarification
I am not saying that flipping or wholesaling are not good businesses. In fact, I think flipping and holding together is the best way to get into buy and hold for someone coming at real estate without a lot of money. Namely, flip one, use that money to live off of. Flip a second, and use that money for a downpayment on a property to hold. Then repeat.
There are also plenty of other great businesses and investments out there. At times, they make more sense to do than real estate. If you could have invested with Warren Buffet when he first started, then yes, you should have done that.
But pound for pound, buy and hold is superior. It is the I.D.E.A.L. investment:
I: Income (cash flow each month)
D: Depreciation (the tax advantages of being able to write off real estate as a depreciating item when it actually appreciates)
E: Equity Pay Down (the principal on the mortgage goes down each month)
A: Appreciation (national average is about 4.6 percent over the last 30 years)
L: Leverage (being able to use other people’s money to finance your acquisition)
I do not mean to say buy and hold is a perfect investment. It is not. If you had bought and held in Detroit, you would have taken a sizeable loss. But nothing is a perfect investment. Buy and hold is simply the best investment around in this author’s humble opinion. Especially when done right.
Now on to the criticisms.
“Stock Market Returns Are Better”
One commenter noted that “research that I see of the US residential prices seem to indicate the real estate prices keeping in line with inflation, and not making much real returns.” Most of what I’ve seen puts the return slightly above inflation, but it really doesn’t matter that much. For one, these returns don’t include cash flow (and I only recommend holding properties that cash flow) and principal paydown. Another commenter noted, “Very little equity accumulates in the early years of a 30 year amortization mortgage.” That’s true as well. In the first five years of a $100,000 loan at 5 percent interest, you’ll only pay off about $8,000. Of course, with a 15 year amortization mortgage, you’d pay off $25,500.
But to show why it’s not hugely important if appreciation doesn’t beat inflation by much, let’s use an example with the 30 year loan and say it doesn’t cash flow one cent and the market appreciates no faster than inflation. You still pay down $8,000 in five years on $100,000 loan, which averages out at about 1.6 percent return per year. Since appreciation and inflation cancel out, you’ve still beaten inflation by 1.6 percent.
But of course, you only put down $20,000. So you need to multiply 1.6 percent by five. Which makes it 8 percent. Now you are beating the market by 8 percent each year, and that’s without cash flow or appreciation. And that doesn’t even account for the benefit of depreciation.
With leverage, you don’t need to beat inflation. Let’s use the same example above and assume there’s three percent inflation. Here’s what you get:
Fifteen percent beats the stock market almost any day. And when you take principal paydown into account, over the long term, you have what amounts to an exponential increase in your equity. Let’s go with the 4.6 percent historical average for appreciation and a 5.5 percent loan amortized over 25 years. Here’s what happens to your equity:
After 15 years, you’ve added $131,000 of equity. Not too shabby.
“Leverage is a Two Edged Blade”
“Leverage is a two-edged blade. While yes, small *increases* in the value of a highly leveraged asset can produce extraordinary returns — small *decreases* in the value of that same highly leveraged asset will generate extraordinary losses and can wipe out the investor’s (borrower’s) equity and have the lender knocking on the door with foreclosure papers.”
Well said. I couldn’t agree more. Indeed, you can buy stocks on margin (with leverage), and it’s for this very reason that I would advise against it.
Leverage is powerful friend and a powerful enemy at the same time. If you have an 80 percent LTV mortgage, then if the market goes up 5 percent, you’ve actually made 25 percent on your money. But if it goes down 5 percent, you’ve lost 25 percent on your money.
But if you can buy a property for 70 percent of its ARV to flip, then you can buy a property for 70 percent of its ARV to hold. As I put it before,
“The real estate market makes no bones about it; it is undeniably an inefficient market. There are no motivated stock sellers out there. If someone wants to sell their stock, they just sell it. Not so with real estate. Selling a house is much more difficult.”
This is the reason that the stock market is efficient (more or less), and the real estate market is inefficient. This is why there are no smoking bargains to be found on the Dow Jones, but plenty down the street. Motivated sellers and value add propositions are all over the place.
By getting great deals (just like you have to if you want to flip or wholesale), you can take advantage of the benefits of leverage while insulating yourself from its risks. So let’s say you bought that property worth $100,000 for $80,000 and put $20,000 down. Now if it goes up five percent, you make an additional $5,000, or a 25 percent return. And if it goes down five percent… well, you can cry yourself to sleep knowing you’ve now only made $15,000 instead of $20,000.
One commenter highlighted this very fact, stating,
“…financial instruments also provided a MAJOR advantage over real estate – Liquidity … the ability to sell (or buy) (or sell then repurchase) the financial instrument with just a phone call or a few mouse clicks AND have the proceeds from that sale available in an instant.”
Liquidity is convenient, but it is real estate’s illiquidity that provides real estate investors the advantage. Illiquidity allows real estate investors to find great deals and thereby dull the other side of leverage’s blade.
“Property Management Sucks”
The final criticism is the only one I agree with. What if the you have to deal with “The Occupants from Hell?” Being a landlord is hard. Perhaps you can find a good property management company, but there are plenty of bad ones out there. Or perhaps you can do it yourself, but that’s a lot of work, and not all of it is pleasant. To quote my brother, “With the buy and hold strategy, you never realize your profits until you manage.”
There is plenty more to be said on property management that I don’t have space for here, but it is one of two major cautions I would give someone regarding buy and hold. The first, as implied above, is you need to make sure you buy and hold in a stable city, preferably the path of progress in a growing city, but at least a stable one. The second is you need to be prepared to either manage yourself or do the work to find a good manager and manage that manager.
If you are willing to do this, then there simply is no better investment around than buy and hold.
Do you think buy and hold real estate is the best investment around? Why or why not?
Let me know with a comment!