Are you sure? Those words aren’t in the right order to spell FIRE.
OP, if you already own your house in an expensive urban area, you’re probably heavily invested in real estate already. Going out and buying more real estate, from an asset allocation point of view, might not be a good idea.
Also, buying a single property and paying someone to administer it seems riskier than just buying shares in a REIT, and presumably has about the same expected return. If you manage it yourself, you should get a higher return, but in exchange you’re taking on a part-time job as a landlord. Make sure that’s a part-time job that you want to have.
You said that you save or invest about fifteen percent of your after-tax income in index funds. Is that going to be reduced if you acquire a rental unit? Because that would be bad. On the other hand, if you can continue to save that much and pay the mortgage on a condo costing $60-80,000, why not save or invest more than you now do instead of becoming a landlord?
I agree with some of the comments about just investing wisely in mutual funds and for the long-term, being a better bet at building wealth compared to small-time real estate. Anecdotally, I know several people who have rental residential properties and all are either constantly in the red or barely breaking even over time, not even considering other hassles demanding their time, and surprise expenses. I also know a few people who have been thru a divorce recently and it devastated them financially (initially).
Take your own advice and live below your means, but remember to enjoy life. Having a child can be difficult, financially, but that does not prevent people from having a family.
Not every investment generates cash flow. Does Apple stock generate dividends? I don’t think they did for a long time but it was still a good investment.
And owning your primary residence may not throw off cash flow, but it does build equity, which certainly adds to your net worth.
It generates effective cash flow in the rent you don’t have to pay to live there.
If the OP is like most 30-somethings living in an expensive urban area who owns a house, that house already constitutes the majority of his net worth. More exposure to real estate is the opposite of “diversification”.
He already has 15% of his income going to mutual funds. More exposure to the stock market is also the opposite of diversification. Like I said, I’m in the “put more into funds” camp, but simply owning a house shouldn’t disqualify additional investment in real estate. Ultimately it’s up to the OP to decide what to do.
I would also suspect that the adage “your house is your biggest asset” isn’t true for people who actually succeed at building wealth. It might be in your thirties, but probably not later.
I own a four-unit apartment building, live in one and rent out the other three. At the moment we don’t technically cashflow, but our monthly housing expense is a small fraction of what rent or a single-family mortgage would be. If we were to rent all four it would be a positive income. That’s not counting equity or higher future rent amounts.
It’s like a second job, though, and you can screw yourself if you don’t know why you’re doing. We already had property management experience, I’m a decent handyman, and my wife is a bookkeeper who keeps the accounting ship shape.
“Asset” in the sense that that’s where most of your net worth is tied up, but not in any kind of income generating potential.
Per the advice about kids and divorce – we’ve been together almost 10 years and I’m quite confident (as much as one can possibly be, I think) that we’re both in it for the long haul. We understand kids will cost money, and we think we have enough of a buffer to handle these extra expenses even with this sort of small real estate investment.
We’re expecting additional income in the form of pay increases in the next few months that would mean we wouldn’t have to reduce our investments at all to afford this. We don’t plan to pull the trigger on any such real estate investment until these pay increases actually occur.
We’re going to take our time with this and won’t jump in. I appreciate all the advice and recommendations!
Are there any worthwhile alternatives to real estate and mutual funds?
From some preliminary Zillow-ing, there are a few areas with such properties (around Richmond, for example). But we haven’t seen any of them yet, and there could be something wrong with either the properties or our search.
This. Do the math, with brutally honest estimates of purchase price, expected selling price (after RE agent commission!), ongoing costs (property taxes, repairs, more repairs, roof replacement, rental agents fees, mortgage interest), and ongoing income (rents, minus the expected vacant periods, minus the rents you’ll end up never collecting from that one bad tenant, etc.). With the wonder of Excel, you can try a whole range of scenarios. I think you might find that in the end everything is dominated by the selling price (rents are just a way to cover the mortgage interest), which means you’re not really buying an income, but betting on housing prices.
Which is certainly one possible way to build wealth, but not the least risky way.
And,
So you’re already exposed to that risk.
IMHO, unless there’s some reason you’ll be much better than average at being a landlord (you’re already a residential contractor, so you can do repairs yourself at low cost, etc.), you’d be much better off sticking with low-cost index funds. It’s fine to pick a couple different ones; maybe a US-centered one, and a developing countries one, or something.
When the value of your index funds reaches the value of your house, then you can think about diversifying some more.
You left out amortization of principal. Even if you break even on a cash flow basis and the house never increases in value, you will be paying off the mortgage and building equity.
There are 3 components of profit (or loss) with real estate. One is cash flow, the second is build-up of equity, the third is increases in property value. (The first and third can be negative.)
The thing about cash flow is that if you have a fixed rate mortgage, it can increase dramatically over time, since it’s leveraged against a fixed payment. So if your payment is $1,000 a month and your taxes/insurance/repairs are $500 a month, and you can get rent of about $1,500 a month, then you’re in a break-even position cash flow wise (leaving aside vacancies). But if rent and taxes/insurance/repairs all increase by 10% over few years due to inflation, then your costs are now $1,550 and your rent $1,650 and you’re ahead of the game.
The same also applies to property values. Essentially it’s a very leveraged investment in a market that tend to increase over the long term. So if you put up $100K on a property that costs $400K and finance the rest, then again if the property values increase by 10% over a few years, then you’ve made a 40% return on your $100K investment, leaving aside any principal that you’ve amortized and cash flow. Of course, if values decrease - which happens - then it works in the exact opposite direction.
That said, RE is not at all a liquid investment, and there are also considerable expenses involved in both buying and selling RE.
From my understanding, the absolute worst case scenario (assuming we have insurance to protect from any natural disasters) for our preliminary plan to buy and rent out a ~$75K property is that the area turns out to be a crappy one for renters (if the nearby factory goes under, for example) and we can’t find renters, the value goes down, and we end up selling the property for a loss after a few years of trying and failing to rent it out.
Am I correct about this? If this is the worst case scenario, it’s something that our finances can handle.