If you have your eyes open, one of the first curious things you notice about the “FIRE” community (Financial Independence, Retire Early) is their fixation on real estate. For example, Mr. Money Moustache “retired” from his job as an engineer in order to become a residential property manager, writing that “many of us consider property ownership to be a key part of our early retirement strategy.” One of the very first real life conversations I had with a FIRE enthusiast very quickly turned to his plans to buy up residential real estate in Memphis. And of course the Saverocity Forum has extensive threads on the promise and peril of real estate management.
Residential real estate is a fairly curious asset class. It’s a depreciating asset (the structure) resting on top of a commodity (the land). Meanwhile, converting the asset into a revenue stream requires active management. It doesn’t have to be actively managed by the owner, of course: there are residential real estate management firms that will handle tenant screening, maintenance, and so on for a fee. But whether it’s managed by an amateur or a professional, the size and steadiness of the revenue stream ultimately depends on the competence of the management in addition to the quality of the structure and desirability of the land.
Based on everything I’ve seen and heard, here are four things that I think make residential real estate appealing as an investment to people in the finance hacking and FIRE community.
Ease of leverage
If you simply want to invest in real estate as an asset class, Vanguard offers mutual funds that give you exposure to domestic (VGSLX) and ex-US (VGRLX) real estate investment trusts. The Admiral shares have expense ratios of 0.12% and 0.15% and have non-SEC yields of 3.92% and 4.73%, respectively (I had to manually calculate the yield on the ex-US fund so it’s as non-SEC as it gets).
I recently listened to a podcast episode with someone who decided to coin the term “house hacking” to describe buying multi-unit properties, living in one unit and renting out the rest of the units to cover his mortgage payments. One of his key concepts is “the 1% rule,” whereby you should aim to buy properties where the monthly rent is 1% of the property’s purchase price. If you bought a property outright according to this rule, you’d earn 12% annually, minus taxes, maintenance and vacancies.
But if you buy the property with a 20% down payment, your return on equity is suddenly five times that (minus the interest on the 80% of the purchase price you borrow).
The key advantage of doing so is not the leverage itself: you can buy stocks and bonds on margin if you’re so inclined. The key advantage is that the underlying asset is never marked to market! Even if you found a broker willing to let you buy VNQ or VNQI (the ETF equivalents of the mutual funds mentioned above) with 20% equity, even a modest decline in real estate prices or change in interest rates would wipe out your equity and trigger a margin call. In the residential real estate market, you can take advantage of rising real estate prices through cash-out refinancing, but even if housing prices decline you’ll never lose your shirt as long as you keep making your mortgage payments (which are currently being offered on very generous terms).
Value of specialized knowledge
The stock market is a brutal place to try to apply specialized knowledge. You can know everything there is to know about solar panels, electric storage technology, and self-driving cars, and it still shouldn’t give you the slightest hope of guessing whether Tesla’s stock will go up or go down, or whether it will do so tomorrow, next month, or in a decade.
The residential real estate market, on the other hand, is the kind of place where a person feels they should be able to fairly easily apply their knowledge, experience, and intuition. Everyone knows the neighborhoods in town which are becoming more popular and those which are becoming less popular. Everyone knows where students and young families like to live, and where drug dealers and vagrants gather. You can flip open the local newspaper and see where hip new bakeries are opening and where storied local institutions are closing because of lack of foot traffic.
All this means that a person feels like they should be able to pick the “right” properties to invest in even if they’re fully aware they’re incapable of picking the “right” stocks to invest in and sensibly choose a low-cost indexed portfolio instead.
No matter how pure your intentions, nobody stays a residential real estate investor for long before they also become an amateur CPA. If you’ll allow me to quote at length from the Saverocity Forum:
“Now seeing that we have a positive cash flow on the year most people might think that we’re due to owe uncle same based on this cash flow. What most people don’t realize is that when you own rental real estate, you are required to depreciate the cost of the property and apply that towards your income/expenses on your Schedule E(real estate profit/loss tax form). Without getting too complicated this means that a portion of the property value(not including the land it sits on) gets to count as an expense over the next 27.5 years of your ownership. So while you get the benefit of claiming an additional expense(albeit an invisible one) on your profit/loss sheet, this does effect the basis value of the property for when its time to sell. For now, based on the property value I get to claim $3000 of depreciation for the year. If I count this against the 1080/year in cash flow, I have a $1920 tax loss on the year. The nice thing about losses from your Schedule E is that they can be counted against your primary income(as long as your income is below 150K, between 100K-150K the amount of losses you can claim against income is phased out and above 150K you can only carryover those losses to use against future capital gains from sale of property). In this case, assuming I am able to claim the loss against my income, that $1920 loss could equate to about a $500 in tax savings(assuming a 25-30%ish tax bracket)”
Obviously I don’t have anything against CPA’s, amateur or professional, but it’s hard to argue that becoming an amateur CPA looks anything like “retirement.” To me, it looks like spending a lot of time poring over the tax code making sure all your T’s are dotted and all your I’s are crossed.
Nonetheless, being able to deduct depreciation against earned income gives middle- and upper-class taxpayers a big incentive to actively invest in real estate, essentially supplementing their rental income with subsidies in the tax code.
The triumph of the material?
Together, I think the three features above explain 85% of the appeal of investing in residential real estate for finance hackers and FIRE enthusiasts, and if you asked 85% of them they would say that those features explain 100% of the appeal.
But I think it’s worth mentioning, at least, that there’s something potentially uncomfortable about “just” owning a slice of the S&P 500, or the total US stock market, or the total world stock market. In fact, it might not feel like you own anything at all when the only thing you can see are digits bouncing up and down on your quarterly brokerage statements.
Owning real estate isn’t like that. If you manage your own properties, you can drive by and see them every day. You have deeds that are recorded in government offices that meticulously spell out the boundaries of your property. You can mow the lawn, lay down new pavement, replace the appliances. The properties, in other words, exist in your own material world, and I think some people find comfort in that above and beyond their tax-advantaged, highly-leveraged, compounding-revenue-stream-generating residential real estate business model.