If any lesson has been made clear during the Covid 19 pandemic, it’s that life brings us the unexpected. Over the last year-plus, we have experienced the devastation of commercial and retail real estate. With so much up in the air, residential real estate can be a safe and solid investment to make—but what does that mean, and why?
Chris Clothier began building his rental portfolio in 2003 as a successful entrepreneur looking to diversify his investments turned to Real Estate Investing
Out of all of the ways to build wealth through investing, why invest in real estate?
To start, I’ll say this: there are a lot of different ways to invest in real estate — all of them with real potential. I would argue, however, that residential real estate — especially single-family rentals — is truly one of the best real estate investments that you can make.
That’s right. Residential real estate may be better than stocks, bonds, flipping, commercial investing, or REITs.
If any lesson has been made clear during the Covid 19 pandemic, it’s that life brings us the unexpected. Over the last year-plus, we have experienced the devastation of commercial and retail real estate. We’ve seen wild stock market fluctuations and a strange war between Reddit and hedge fund short sellers — a saga that puts the true stability of the stock market into question.
With so much up in the air, residential real estate can be a safe and solid investment to make — but what does that mean, and why?
What does it mean to call an investment safe?
Before we get into the meat of the matter, I want to define what a “safe” investment is. With investing, there is always a balance between risk and reward. The higher your risk, the higher the reward should be. Ideally, you can recognize your risk tolerance and make decisions accordingly.
When I call an investment “safe,” I do not mean it is without risk. A safe investment for me is one that I have a reasonably high expectation of return of capital — which means that I get my initial investment back. From there, I try to maximize my return on capital — meaning that I also make money on my initial investment.
One of the reasons I love median priced, single-family homes is that I can have a reasonably high expectation of a return of my capital at almost any time in my investment horizon, which is 7-10 years. They are under-produced, in high demand, and remain a relatively safe investment.
They also meet four criteria that define a safe investment to me:
- A long history of success
- Risk that can be mitigated
- Stable and reliable
- Good returns for its level of managed risk
While there are some investments that are traditionally considered “safe” — such as savings accounts, Treasury securities, and fixed annuities — these do not, on their own, provide the returns necessary for building real wealth and achieving financial freedom.
Investing in real estate is arguably riskier than these methods. But what makes real estate a safe investment has to do with your strategy…and your due diligence.
So what makes investing in SFRs a solid choice for wealth-building? Let’s talk about it.
Investing in single-family rentals
Investing in single-family rentals (SFRs), at least in the context I am referring to, means employing a buy-and-hold strategy to acquire and rent detached single-family homes. This is done as a means of generating passive income and building equity.
The process can vary in some ways, and often depends on whether or not you pursue these investments alone or with the help of a turnkey provider. In general, though, the process follows these four steps:
Over time, an investor will acquire multiple rental properties — likely across multiple markets — as their portfolio grows. This, in turn, mitigates risk through the diversification of your portfolio.
This diversification occurs based on the number of properties you hold and where they are located. As a result, you minimize the financial impact of rental vacancy, major repairs, market downturns, and natural disasters.
You build your wealth through cash flow and equity. While some investors will try to tell you that you should focus on one or the other, both contribute to your overall wealth. You maximize the equity in a home by paying off its mortgage. Investors utilize their cash flow to do this over time, essentially using someone else’s money to pay for the home.
Once a mortgage has been paid, cash flow increases. If and when you decide to sell, you get the most from a property’s equity. Because we are talking about a buy-and-hold strategy, you were already planning on holding the property for a minimum of five years. The longer you hold the property, the more likely you are to see the fruits of cash flow, equity, and appreciation.
This investment strategy has an edge over other real estate investments for a few big reasons, which we’re outlining for you below.
The advantages of buy-and-hold rental investments
Real estate distinguishes itself from other investments like stocks and REITs due to the simple fact that you are buying a tangible asset. The property and land will always be worth something. Even if its value drops, these dips rarely last.
Plus, real estate consistently appreciates over time. Not only does it appreciate but it is an effective hedge against inflation. While other investments suffer during inflation because the dollar becomes less valuable, real estate keeps in time with inflation. Property values rise to meet the difference.
This helps offset the consequences of bumps in the national and global economy. The fact that we are dealing with physical assets like real estate assures us because we own something tangible that will always be worth something — even if the value fluctuates from time to time. That’s not the case with other types of investments, like stocks, which have value that may dry up in an instant — and unlike real estate, it’s value that you have no control over.
Real estate has the big advantage of leverage, which is utilizing someone else’s money to make a purchase. In most cases, this will be a bank lender.
For example, if you are buying a $100,000 property with a $20,000 down payment, you are leveraging $80,000. The idea is that you will pay this back over time, with interest. However, as I mentioned above, investors will utilize their monthly cash flow from their rental properties to pay off their mortgages.
As a result, you have to pony up a lot less of your own money to make the investments happen. That means that you can more quickly and effectively scale your portfolio — buying properties for a fraction of their cost out of your pocket. This is not the case for other types of investments.
Every investment must come with an exit strategy. Buy-and-hold investors have a big advantage here in that they can afford to wait. A flip or a stock sale might come with a certain window of time you must sell within in order to get the most out of your investment.
Buy-and-hold investors, on the other hand, do not rely on the sale of their investment to build wealth. They wait and sell when the time is right for their circumstances while building equity and appreciation in the meantime. In most cases, the longer you wait, the more you have to gain.
Additionally, single-family real estate is easier to sell. While commercial and multifamily properties have a limited pool of potential buyers, just about everyone is in the market for an SFR at one time or another. You could sell to a typical homebuyer, another investor, or a company. That’s because SFRs are always in demand and, as we have seen throughout the COVID-19 pandemic, tend to be more stable during crises than multifamily and commercial property.
Beyond selling the property, a buy-and-hold investor also has the option of performing a 1031 Exchange. This is a strategy that allows you to “trade” your property for one that is like-kind while also deferring capital gains taxes. Investors use the strategy to refine their portfolios, increase diversification, and save significantly on what would otherwise be a heavy tax burden.
Managing risk in real estate investing
While there are advantages to this type of investing, the reality is that investing in real estate, even as a buy-and-hold investor, is not a risk-free experience. And, the risk can be high under certain circumstances. Here are the biggest contributing factors to risk in investing in rental properties:
In real estate investing, having a vacancy is typically your most expensive time. Vacancies mean paying for the mortgage, the upkeep, and the management of a property while not earning any passive income. While vacancies are inevitable, they do not have to be excessively long. Investors minimize their risk by providing a quality property and attentive management to residents. Residents who, by the way, have been properly vetted.
This increases the likelihood of residents renewing their lease — thus avoiding turnover. Even when you do experience a vacancy, having the right team behind you that can fill it with a quality resident is key in preserving your cash flow.
Negative cash flow
Negative cash flow is often — though not always — an investor’s nightmare. In real estate, this can happen for a few reasons, including:
- High vacancy rates
- Excessive overhead costs
- Not competitively priced
- Poor market or location choice
While it is not unusual to have a month here or there with negative cash flow due to unforeseen circumstances, like vacancies or the sudden need for big repairs, chronic negative cash flow is a sign that the investment is not working well for you.
That said, some investors invest in negative cash-flow properties on purpose. They either expect negative cash flow based on the high IRR expectations when they sell the property, or they purposely construct the investment to be break-even or slightly negative on cash flow on purpose to reduce principle quickly and own the asset outright. These investors are usually very experienced and make the investment eyes wide open. They fully understand any risk they are taking.
That said, the potential for negative cash flow can be reduced through due diligence from the start.
Is there a more classic rivalry than that of a landlord and their resident? While this should not be the case — after all, we should be helping each other — it is a common stereotype. The problem of “problem” residents, like many risks in real estate investment, can be solved through due diligence.
Problem residents might be those who consistently fail to pay on time, neglect or damage the property intentionally, ignore maintenance issues, or don’t follow through on their responsibilities as defined in their lease.
This is why screening is so valuable. For many investors, screening is not something that they do personally. Rather, the task is deferred to their management team. I cannot overstate the value of a quality property manager. These are the people who will make sure you get the right residents, that your property is in tip-top condition so that you can get top dollar (and top appreciation), and that you don’t have to worry about the daily minutiae of being a landlord.
Lack of due diligence
Due diligence is a broad term. For real estate investors, however, this refers to doing your homework, so-to-speak. It means running your numbers, looking at the right indicators, having a thorough and proper inspection of the property or properties, analyzing the market or markets, and working with the right people.
If you want to preserve the quality of your investment and the wealth that comes with it, for example, you will need to hire an experienced, high-quality property management team. You need people beside you that you can trust to do the best job possible.
Real estate investors expose themselves to risk when they neglect the details and hard facts about their existing or potential investments.
At this point, you might say “Wow, Chris. That’s a lot of risk for a supposedly safe investment.” And, you wouldn’t be wrong. However, the risk involved in investing in rental properties can be mitigated to the point that many of your would-be risks are so slight that they don’t make an impact on your investing career. Here’s what you can do:
Two ways to effectively mitigate risk with single-family rentals
Method 1: Educate yourself
Investing in real estate is a complicated and daunting prospect for most people. First-time investors are exposed to the most risk simply by way of their inexperience. As such, that inexperience often translates into a lack of capital and connections, which makes those risks that much more, well…risky. A new investor has a lot to lose.
Start by educating yourself. You may choose to find a mentor or just read and read some more so that you are mentally prepared for what to look for in your investments. Ongoing education is key for investors at every level, but it’s especially crucial for new investors.
I often recommend investors look locally for investors who are accomplishing the same goals they have set for themselves. When they find them, invite them for a cup of coffee. Most investors I have met love to share. Many of us had good and bad mentors coming up in the business and we look to pay it forward. Unfortunately, many of us also learn through our own mistakes, so we have plenty to share on that front, too.
If you hope to avoid really painful lessons, you should slow down, be patient, and spend time trying to learn from others as much as you can. Not every investor has the same goals as you, so choose whom you want to learn from wisely.
Now, before sharing the second method, I will say that the two go hand in hand. If you truly want to give yourself the highest likelihood of success and mitigate risk, use method 1 — and if you find that you will make a better passive investor, go to method 2.
In other words, no matter what, invest in your own education and understanding of real estate!
Method 2: Leverage experience and services
The best ways to mitigate your risk are to use either a turnkey provider or build a highly experienced team. While a provider must be investigated like any other service or partner — taking into account testimonials, stats, their track record, and more — they make new investors perform like old pros if they’re worth their salt. The same can be said of building an experienced team, and David Greene gives a fantastic account of how to do that remotely in his BP book.
That said, I want to be clear how much distaste I have for the word turnkey. It is over-used today and has been stripped of its meaning. The only way to mitigate your risk passively is to work with an actual turnkey company that purchases, renovates and manages properties from start to finish. With each variation of the term “turnkey,” including the worst variation in which individuals market the word turnkey to promote their services of telling investors which turnkey company they recommend, the risk an investor faces will rise.
Investors are better off building their own teams before they take advice from anyone promoting their turnkey tell-all services. Those companies have one product and it is not properties. They sell investors to turnkey companies that are willing to pay them and package their message up as experience.
Unfortunately, that is a disservice to passive investors and can cause investors to completely step over the due diligence requirements. The safety is in being able to leverage experience.
When you leverage the right people, whether that be licensed real estate agents, attentive property management teams, skilled portfolio advisors at turnkey companies, consistent and thorough renovations teams, and more, investing in real estate truly becomes one of the safe investments that you can count on now and for generations to come.