So you've decided to invest in real estate!

Become a Patron!

Last week over at Travel is Free Drew wrote a very thoughtful post about his experience taking out long-term residential leases and then subletting them for short-term stays through a variety of platforms. The post has a lot of details on the various expenses and complications he encountered and is worth a close read if you’re considering doing the same.

He concludes that while this temporal arbitrage is a potentially profitable business, he wouldn’t rent to arbitrage again, in the future planning to buy properties for short-term rentals instead. This ultimately led to a long, branching, fruitless Twitter argument about what kinds of risks this kind of strategy entails. At the instigation of reader calwatch, I’ll make a few general observations about residential real estate in general and short-term rentals in particular.

Cash flow, basis, and return

One of the most dramatic claims Drew made on Twitter was that “the actual cash on cash return is near infinite.” As ludicrous as it sounds, this is actually a fairly common claim made by real estate investors, which Drew spelled out more explicitly a few tweets later, when he said “if you buy at 80% value and refinance, then your $0 in. So all cash at that point is profit.”

The mechanics of what Drew is talking about here are simple enough to describe in a few words: if you buy a piece of residential real estate with a 20% down payment and an 80% mortgage, then you have 20% equity in your home. If you can then take out another loan (or refinance the existing loan) against your equity stake in the property, and you’ll end up having purchased the property entirely with borrowed money.

At that point you have a simple calculation: does the property produce more money than it costs, on an appropriate time scale, for example quarterly or annually? Many people make a big deal out of one real estate expense or another, but that’s totally unnecessary for this calculation. Just add up all your costs: your mortgage payments, utilities, insurance, maintenance and repairs, lawyer fees, furniture, linen, dishes, housekeeping, landscaping, and everything else you can think of. Even add an additional safety buffer if you like. Then add up all the revenue the property produces. If your income is higher than your costs, you arrive at Drew’s “near infinite” cash on cash return: you didn’t put any of your own money into buying the property, so your return is on a basis of $0 (until your mortgage payments begin to rebuild your equity).

Of course, eagle-eyed readers will have noticed the necessary corollary: if your revenue is less than your costs, then your rate of return is near-infinitely negative. You’re pouring money into a hole without receiving anything of value in return, especially since traditional mortgages apply payments overwhelmingly to the loan’s interest, rather than principal, for much of the loan’s term.

The rest of this post is not about disproving or challenging anything above, since everything above is true: if you are able to secure the necessary loans, you can achieve near-infinite positive or negative returns by purchasing real estate entirely with other people’s money. Rather, I want to explain why nothing about this is “risk-free.”

There’s nothing special about real estate

One of the most common claims by real estate enthusiasts is that real estate is “different.” Drew made this precise argument when he tweeted, “Real estate is the only investment I know of where you can benefit from appreciation (while claiming depreciation on taxes) without putting your own cash.“

But this is false. I’ve never added it up, but I probably have around $200,000 in unsecured credit available to me on my credit cards, and many of those lenders mail me checks every few weeks I can use to buy anything I want. It’s true the interest rates are high, but they’re not in the stratospheric, payday-loan territory. Instead, they typically top out around 30-35%. My guess is it would take me about 5 days to deposit that $200,000 into my checking account, transfer it to my Vanguard account, and then buy any mutual fund or ETF I pleased with it.

And this would put me in precisely the same position as Drew’s real estate investor:

Exactly like the real estate investor, I would be making my purchase entirely with other people’s money.
Exactly like the real estate investor, I would have a near-infinite rate of return if the dividends and appreciation of my investments exceeded my cost of financing.
Exactly like the real estate investor, if I had to sell investments to meet those financing expenses I would be able to deduct those losses against my ordinary income (the equivalent of Drew’s “depreciation”).

Now, you might rightly point out the difference is that my financing expenses are 30% and Drew’s are 5%. That’s all well and good, but as Churchill apocryphally told the society Lady, now we’re just negotiating over the price. If you have an investment idea that you believe will generate more revenue than your cost of finance, you should consider pursuing it.

Of course it’s true real estate has some special treatment in the tax code. I’ve written about it before. But so does horse-breeding! The principle is the same in both cases: as long as you are calculating your total cash flow properly, i.e. including any tax benefits and penalties, then all you have to do is compare it to your equity to derive your return, whether it’s on real estate, stocks, bonds, or horses.

With that out of the way, let’s turn to some idiosyncratic risks of investing in real estate, in particular for short-term rentals.

Regulatory risk

Regulatory risk is what I call changes in government regulations and the effect they have on your cash flow.

This can happen when a community bans short-term rentals, passes new regulations, or begins enforcing its existing regulations. Importantly, this can easily affect your expenses, your revenue, the value of your property, or all three.

If a community bans short-term rentals, you may still be able to rent out your property to long-term tenants, but at a lower rate. Keeping monthly expenses fixed at $1,000, moving from $6,000 in income to $800 in income is the difference between earning near-infinite profit and incurring near-infinite losses on your near-$0 equity.

On the flip side, if a community passes new regulations or begins enforcing existing regulations, for example by forcing landlords to acquire hospitality licenses, pay for annual inspections, and pay hospitality taxes, then your expenses may overcome your revenue even if your revenue remains unchanged.

And finally, in a real estate market where prices are driven by demand for short-term rentals, either of those changes can affect the value of your property, meaning your expenses can rise, your revenue can fall, and you can end up with a property worth less than you owe on it.

Regional risk

More than any other kind of investment, real estate is tied to the land, which creates regional risk: Drew’s most profitable months were during Austin’s South by Southwest festival, when demand for hotel rooms swamps the city’s capacity and many people turn to expensive short-term rentals. Those profits can make up for less-profitable or even unprofitable months — as long as South by Southwest continues to drive visitors to Austin. But tastes change, fads come and go, and who knows if South by Southwest will still be a phenomenon in 5, 10, or 15 years? Relying on a few profitable months really means relying on things staying more or less the same — things you have no control over.

Secular risk

In the aftermath of the global financial crisis, Larry Summers re-popularized the idea of “secular stagnation,” one version of which says that the stubborn slowness of the economic recovery was the result of long-term, economy-wide forces, not just bad short-term public policy. In other words, the best that the government could do was manage stagnation and decline, not spur accelerated catch-up growth. Larry Summers was wrong about that, but it’s a useful framework to think about long-term, economy-wide changes.

If Americans overall travel less, if more business is done through long-distance conference calls or virtual reality, if new technology makes it fast and cheap to build new structures, then the overall rental real estate landscape might be completely changed. Your revenue might dry up and your land and structure might become near-worthless, not because of anything you did or didn’t do, but because of changes in the overall economy.

Platform risk

One fascinating element of Drew’s post was the sheer number of different services he mentioned as part of his short-term rental empire: AirBnB, Homeaway, PayPal, Venmo, InstaCart, Favor, Walmart Delivery, Craigslist, TurnoverBnB, Your Porter, BeyondPricing, PriceLabs, plus a few I’m certain I missed.

That’s not to say he uses all these services: some of them were mentioned specifically because he tried and didn’t like them. The point, rather, is that a big part of the short-term rental economy is powered by these third-party services, and the more dependent you become on them, the more vulnerable you are to platform risk: losing access to a service, either because you’re (rightly or wrongly) accused of a violation, or because the service itself goes out of business.

Since my expectation is that in the next downturn all the unprofitable service business platforms will go out of business, this exposes you to a kind of compound risk: just when occupancy rates are falling, you’ll also lose access to your main booking channel.

I’m particularly sensitive to platform risk because of my own personal experience with it, when the business PayPal account I used to collect monthly reader subscriptions was closed and I had to beg readers to create new subscriptions on my new subscription platform. Most of them migrated over, much to my surprise and pleasure, but it was still a harrowing couple months.

Platform risk can be mitigated, of course: you can build your own booking channels, diversify into as many booking channels as possible, maintain multiple backup accounts, etc. But mitigating platform risk creates its own costs, and its own drag on your total cash flow.

Volatility risk

The risk that real estate investors least understand is price volatility, and no wonder: stock investors can see the price of their assets fluctuate second-by-second, which may even lead them to believe stocks are more volatile than they actually are (if you don’t believe me, just turn on CNBC after the S&P 500 drops 0.5%). Meanwhile, real estate investors tend to anchor the value of their property on what they paid for it, and can only guess within broad ranges what it’s worth on any given day.

The other risks I mentioned revolve around factors that might permanently reduce your income, raise your costs, or lower the value of your property. Volatility risk is different: it’s the risk that your property will be worth less, or worthless, at the moment when you happen to need the money.

This is true whether or not you believe, as Drew does, that real estate “consistently goes up.” Many people describe real estate as a kind of savings vehicle: you borrow money, and the payments on that loan slowly build up equity, which you then own and can “withdraw” through a sale or refinance. But while it may be a savings vehicle, real estate is not a savings account. A savings account has a known, federally-insured value. But even if you are certain the value of your real estate will increase over 5-year, 10-year, and 20-year time horizons, that tells you nothing about its value over any of the intermediate periods!

Conclusion

None of this is intended in any way to discourage people from investing in real estate. To me, it sound like a phenomenal amount of work, but as I always say, if you do what you love you’ll never work a day in your life. I like writing, Drew likes buying and managing rental properties, it takes all kinds to make the world go ’round.

But this post is intended to make it emphatically, entirely, and conclusively clear that real estate is not special, it is not risk-free and it is not even particularly low-risk, although many of the risks are unusually well-hidden. Like all investing, it can be done with your own money and it can be done with other people’s money. It can be done well and it can be done poorly. It can be profitable and it can be loss-making.

So if you do decide to invest in real estate, do yourself a favor and do it with both eyes wide open.