The Myth of Passive Real Estate Investing
Owning income-producing rental property may sound like an easy way to earn returns to many investors, but the reality can be very different from the dream.
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In my financial planning firm, we focus on serving clients in their 30s to their 50s — and we see firsthand how popular the idea that real estate is a way to get rich (relatively) quick is. That would be fine if real estate was a no-brainer passive-income maker the way so many people think it is. The problem is that narrative doesn’t line up with reality.
While real estate can be a good investment, that statement comes with a laundry list of caveats. All the “ifs” and “buts” that surround it mean that investing in real estate (especially with the goal of generating passive income) is more of a myth than a viable strategy for most people who simply want an easier or more exciting way to grow wealth than investing in the stock market for the long term (opens in new tab) using a diversified portfolio.
Before you join the ranks of rookie real estate “investors” who realize how much skill and luck are required just to break even — never mind actually turn a profit — consider the following realities associated with real estate investing first.
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1. Managing Rental Properties Takes a Lot of Work
When people tell me they want to invest in real estate, here’s the scenario they typically envision: They receive a rent check on the first of the month, every month, which is much bigger than the mortgage payment on the property. They then use the check to pay the mortgage, cover all costs of homeownership, and then pocket the profits.
It is possible to locate, buy and manage a rental property that allows this dream scenario to come true. But it is not for everyone, and it is not nearly so passive an endeavor as many people imagine.
Unless you’re prepared to:
- Advertise to find tenants and avoid vacancies.
- Show the property to interested parties when seeking new renters, and help maintain it for current occupants.
- Vet applicants to ensure you have qualified, reliable tenants.
- Consistently update and improve the property so you can continue attracting high-paying renters.
- Respond to maintenance requests and coordinate repairs (or do them yourself) in a timely manner.
- Manage all the financial obligations, from paying bills to handling security deposits and more.
… then playing landlord might not be the ideal role for you. All of this takes serious time and effort, and this is just what you can plan for. Ask any seasoned real estate investor who manages properties with tenants about their unexpected list of duties, and they will tell you about repairs going massively over budget, evictions and entanglements with the court system, or other rentals-gone-wrong horror stories.
Of course, you could just outsource the headache and use a licensed property management company. That’s a viable option and one that many serious real estate investors use. But that leaves even less room for profit, considering standard property management fees can run 10% of your monthly rent (opens in new tab).
Compare all this to investing in the market, where you may not have to do any work at all if you set up an automated contribution to your investment accounts that runs on the same day of the month, every month.
2. Just Because It’s a House Doesn’t Mean It’s a Good Rental
Again, none of this is to say you can’t make money by purchasing real estate and then renting out the property to earn rental income. That’s not the myth. The myth is that anyone can do this with any property they buy and offer for rent.
Unfortunately, it’s not quite so simple. Learning to evaluate the investment potential of a rental property is far more involved than most people who simply want to buy a single-family home they’d personally enjoy living in tend to think.
While there are some simplified formulas, such as the 1% rule (opens in new tab) — which suggests the rent you could collect from a rental property needs to equal 1% of the purchase price of that property for it to be a good deal — they are too generalized to be hard-and-fast rules for success.
That’s especially true in unusual real estate markets like we’ve seen over the past two years. Bloomberg recently reported that in the third quarter of 2021, the median price of real estate investment properties was $438,770 (opens in new tab). Using that 1% rule means you’d need to charge $4,400 per month in rent on that property. Most markets won’t support that kind of rent for a midsize, single-family home.
And that’s just a simplified calculation. It doesn’t take into account any of the other factors you need to properly evaluate before you can determine whether a specific property is a good candidate for investment. So yes, you could buy a $400,000+ home and rent it out. But if the whole idea of real estate investing is that you earn a return, you might face an uphill battle to make that happen. Again, this underscores the fact that buying real estate is not the ticket to fast, easy cash.
3. If You Really Want to Invest in Real Estate, You Probably Don’t Want to Live There Yourself
That back-of-the-napkin math for determining what can work for a rental also doesn’t account for the scenario we see a lot of people talk about when they say they want to invest in real estate: What they actually want is to buy a vacation property, use it themselves for a portion of the year, then rent it out when they are not personally using it.
What they don’t consider is the fact that a home they personally want to live in or use is likely going to be much more upmarket than a home an actual real estate investor will consider for purchase. The higher the price of the home, the harder it is to actually realize a positive return.
And while vacation rentals can do brisk business, if you want to use the house for yourself during peak seasons, you’re going to have a hard time renting out the home for a prime price, filling vacancies during off-seasons, or both.
Remember, seeing rental payments come in does not equate to automatic profit. To determine if you’re truly earning a return on a property that is equivalent to or higher than what you could expect through a diversified portfolio invested in an array of mutual funds and ETFs (opens in new tab), you’d have to calculate your total internal rate of return — which requires you take into account all costs of homeownership, not just the top-line numbers on your mortgage statement.
4. Buying Real Estate Could Be a Distraction from Your Actual Goals
Many clients tell me they want to explore buying real estate as a way to grow their wealth, until I ask a very simple question: Is managing a portfolio of rental properties something you actually want to do?
With demanding careers and growing families, the last thing most of our clients have is an abundance of time, energy and hundreds of thousands of dollars floating around begging to be used to buy another house. Managing either the landlord role or handling a relationship with a property management company is typically not what most people want to take on, because that has nothing to do with their stated values, priorities and goals.
In fact, because buying real estate requires significant capital, it often detracts from the other goals they have. It can also take away from an overall, long-term investment strategy if it leaves you cash-strapped and unable to invest in the market. Remember, you can invest in real estate through the market via REITs, or real estate investment trusts.
Only you can answer if committing to a real estate portfolio is a good use of your time and money, and if it’s worth taking money away from other goals in order to fund this endeavor.
5. Real Estate Investing Requires a Team of Good Professionals
Bloggers and podcasters tend to make real estate investing sound deceptively simple, so it’s easy to think you can handle it all on your own. But the reality is that real estate investing is complicated. There are legal and financial dynamics at play that will likely require a team of trusted professionals to help you protect yourself and your investment.
We live in a lawsuit-happy society, which makes it critical to protect yourself and your assets from potential liability. A knowledgeable insurance broker and trusted real estate attorney are non-negotiables for real estate investors. If something goes wrong with your tenants or your property, you want these folks in your corner.
The financial landscape in real estate investing is not the same as in your personal finances. So having an accountant, tax professional and financial adviser who are skilled in the terrain are also critical components of a well-oiled real estate investing machine. It’s important to the success of a new real estate investor to build and nurture these kinds of relationships.
Real Estate Investing as Passive Income: Know What You’re Getting Into
Yes, real estate investing can be profitable, and after putting a lot of hard work in on the front end, it may be able to provide some passive income at some point in the future. But that is a very far cry from a guarantee, and it requires a significant amount of luck and skill to achieve that outcome.
What real estate investing is not is a quick, surefire, easy and foolproof method to earning huge return on your initial purchase.
Unless you feel very passionate about investing in real estate and are willing to devote time, energy and money to such a massive project, you are probably better off building your assets through other avenues. Otherwise, it’s too easy to find yourself working hard to break even at best.
With all big financial undertakings, it’s best to be fully informed. Maybe the trade-offs are worth it to you. That’s great — as long as those trade-offs fit into your big picture. Either way, when you know the truth that real estate investing is rarely passive, you’ll at least know what you’re getting into.
This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.
Eric Roberge, CFP®, is the founder of Beyond Your Hammock (opens in new tab), a financial planning firm working in Boston, Massachusetts and virtually across the country. BYH specializes in helping professionals in their 30s and 40s use their money as a tool to enjoy life today while planning responsibly for tomorrow.
Eric has been named one of Investopedia's Top 100 most influential financial advisers since 2017 and is a member of Investment News' 40 Under 40 class of 2016 and Think Advisor's Luminaries class of 2021.
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