Is Real Estate A Better Investment Than My Mutual Funds?
It’s 1 AM In the morning and you are up late. You know that you should be in bed; but for some reason, you are still awake. So you say to yourself that if you watch a little late night television, you will eventually fall asleep. You know there is typically not much worth your time at this time of night, yet you watch anyway. You flip through the channels, and come across what looks to be the same live program on three different channels. Your curiosity gets the best of you, you decide to watch this evidently popular program, and you put the remote down. This program, you think, will be the one that will finally put you to sleep.
And of course, you realize that you have seen this program before. The talking head says, “Buy my $300 course, and you can invest in real estate, set your own hours and retire early.” There are lots of ‘real people’ saying that they, too, bought the course and made money hand over fist and now they have the life that they dreamed of. But you know in your head that it can’t be that easy.
If it was that easy, everyone would be doing it and it would not cost $300. But there must be, you surmise, something that you don’t fundamentally understand. Who would want to use their extra money to buy a headache? I can probably make just as much if not more in my company’s 401K or even my own mutual funds, you think to yourself. And then I don’t work nearly as hard. As a matter of fact, some of these ‘real estate’ folks are probably on their way to “fix someone’s toilet at 1 in the morning. Is it really worth it?”
The answer of course is yes and no. But there are some fundamentals about real estate that you need to understand before you decide that it is not worth what might be a little extra work. While there are different methods to use real estate as an investment, it will be helpful to clarify one which is typically the sticking point with most people. That is, to purchase a piece of real estate for the purpose of renting it to someone in order for them to live in it. The question then is, if you were to do that, how could that be better than just hanging on to your mutual fund? There are three advantages:
1.) The first is access to cash. When people are paying rents to you in cash, once you have paid the mortgage and related expenses, you have more cash to reinvest. Depending on what you r payments are, you can use the cash to fund more investments. Having cash allows you to place a significant down payment on your next property to grow your income even more.
2.) The second is shared expenses. If you actually live in one of the units that you are renting, you are sharing some of bills, maintenance and upkeep costs with your renters. Additionally, at least a portion of your bills for your housing will be tax deductable.
3.) The third is favorable taxation. You are allowed to deduct depreciation expense from the income you make from renting the property. This deduction lowers your net income and lowers your overall tax liability. Moreover, you don’t have to pay the social security or self employment tax associated with income earned in a Small Business or salary income.
This third factor is significant, because, under ordinary circumstances, you are likely to pay about $500,000 in total taxes over the course of your lifetime. If you pay those taxes as a result of what you earned in salary income, you will have given up a sizable portion of what could have been your wealth. In other words, $100,000 in earned income from payroll is taxed much heavier than the same $100,000 earned from real estate.
A portion of the $100,000 earned will be paid in income taxes, social security taxes and Medicare taxes if earned in salary. Taxes on the $100,000 earned in real estate income will also be paid, but after operating expenses and depreciation are deducted first. As mentioned before, social security and Medicare tax is not part of the equation. This is that fundamental understanding that was mentioned earlier that you must take into consideration.
What you are doing, regardless of what kind of real estate investment you make (renting apartments, flipping houses, buying and holding land), is that you are choosing to manage your own investment (of course, you could always pay to have someone manage your real estate). The price of doing it yourself is both time and risk. You will have to spend your leisure time (and leisure money) working to maintain and upgrade your real estate. Managing your own investment in real estate will also carry with it the risk that tenants or buyers might be hard to come by.
But at least one of those factors (risk) you are going to have irrespective of what you invest in. Think about those who lost significant portions of their wealth during 2007 and 2008 during the recessionary crash. There are no guarantees that, if your money rests with a fund manager, your investment is without risk of loss. Those of us who thought so were rudely awakened.
So is a real estate investment better than your mutual fund? The answer is still yes and no. One thing is clear, it is worth your attention. Depending on what your returns are, you might want to be out fixing a toilet than up watching late night television. In the long run, fixing that toilet will pay you more…even if it’s one in the morning.
Chances are, you will be up anyway.
Charles T. Harper is an Adjunct Professor of Business at Eastern University.
