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Real Estate Investing: The Allure vs. the Reality Thumbnail

Real Estate Investing: The Allure vs. the Reality


Why Everyone Wants Passive Income...But Few Should Pursue It via Rental Properties

I have a dozen calls a week with professionals who reach out to see if we might be a good fit to help them with their planning and investing. On these calls, I get to hear about their financial dreams, their family and financial dynamics, areas where they think they could use some help, and what they’ve been doing thus far, both financially and professionally. I love learning about so many different perspectives and getting to hear so many people’s money stories.

Unfortunately, these calls also give me a glimpse into the way that financial media, TikTok, and Instagram creep into the way that people think about their money. Every so often, I hear prospective clients seeking smart and sophisticated professionals ask about getting involved in rental properties as a way of generating passive income, even though they have absolutely no interest or experience in real estate itself.

Where Is This Coming From?

I hear things like “I want to get into real estate.” “I want to use rental properties to lower my tax bill.” Etc. I can’t help but share that my reaction is akin to when you watch a horror movie and see the monster creep up from behind the main character and you start yelling at the TV in the hopes that they hear you and get out of the way.

My mind defaults to wondering how much they’ve thought through the logistics and details involved in such a venture...or if it just sounds like something they should want. And to be fair, most of the time when I ask a few follow-up questions, it is just that… something they almost felt obligated to ask about, more as a general inquiry rather than something they’re genuinely interested in.

There is a lot of buzz about rental properties and their "benefits" on social media, and I get it. It all seems very appealing.

The Allure of Passive Income

I think one reason young people are drawn to the idea of securing passive income via rental properties is because it’s been presented as this easy, life-hack-type strategy that leads to all the passive income you could ever want so that by 45 you’re able to leave the rat race forever.

You hear the Instagram version of how rental real estate goes and may start to think, “Well, if I could have enough income coming in each month to cover my expenses, such as rent and groceries, then I would be able to stop working. I could live off my rental income and drift off into paradise .…”

Obviously, by my framing, you know that I think this is mostly a dangerous, impractical mirage! And I will explain why. But before I get too comfortable on my soapbox, let me just say what should be obvious:

Yes, it is possible to be profitable in real estate rentals and have this all work out beautifully. Of course. I am not saying it can’t work. I just don’t think it works for MOST people, and I think it carries significantly more risk than upside for almost everyone who mentions it to me.

What Successful Rental Investors Have in Common

My own experience with clients has shown me that people who are successful in the rental real estate game have three things in common:

  1. They treat it as both a business and a job, meaning they dedicate meaningful time to the activity and came into it with applicable skills or knowledge of real estate.
  2. They have a sizable cash and investment net worth (at least $3M+) before they decided to get involved in any capital-intensive real estate projects.
  3. They (or their family) own several properties and have operated them for a long time. This is essentially a combination of #1 and #2 but what we’re really saying here is that they own real estate at scale. They are not trying to generate passive income by owning a single property or two; they are running a business in which their dozen properties are productive for them in the aggregate. It’s a numbers game.

I just genuinely have never seen it work out for the type of family that we most commonly work with: one spouse in big tech, one spouse is a physician (or in finance, or an attorney, etc.), three kids, earning $600k, limited time outside of family/work responsibilities, and then deciding to buy one or two random rental properties for extra income.

Let’s Use an Example to Break This Down

Let’s use an example to highlight what this might look like in practice: You want to buy a $600K property and turn it into an income-generating rental. You decide to put 20% down and finance the remaining $480K. That means we’ll be taking $120K out of your liquid/investable net worth and moving it into a more illiquid/unavailable vehicle. (We’ll come back to this.)

Let’s assume this is your entire upfront cost. (Of course, there will probably be more, closing costs, advertising costs, maintenance and fix-up work costs, furniture refurbishments, and so on before you can rent it out...but let’s keep it simple for the sake of this example.) Now you need to find renters. Let’s say you get lucky again and find renters immediately, so the time of paying the mortgage without receiving rent back is substantially reduced . . . That’s great!

The True Monthly Cost of a Rental Property

A thirty-year $600K mortgage at a 5.5% rate would run you approximately $2,725 per month. You will need to charge more than that to squeeze out that additional cash flow. But wait. You also need to account for property taxes, insurance, factor in future vacancies, and build in enough margin to help fund the maintenance work/costs that will inevitably come up over time.

All of that can, conservatively, mean you need to charge about 30% more than the rent in order to break even and successfully “run” the rental. So now you no longer need to charge $2,725 you need to charge $3,543 before you can start feeling like you truly have “extra” income your family can benefit from. (And remember, that’s just the amount needed to “break even.” We’re not even at positive cash flow yet!)

You’re Still Paying, Just Indirectly

Ok, you might be saying to yourself, maybe it’s not a huge amount of income, but I’m still covering my mortgage which means my renters are effectively paying my mortgage! It’s costing me nothing to build up my home equity!

Here’s the thing though: it’s not costing you nothing! It’s costing you the opportunity cost of not doing something else with that initial $120K down payment and the growth on the $2,725 (plus property taxes, maintenance, money set aside for vacant months, etc.) every single month! What else could that money be doing??

Put even more directly: Is the capital outlay ultimately going to grow at a better rate than if you had invested that same amount elsewhere?

Let’s Talk Numbers

The S&P 500 has averaged a 7% annualized rate of return over the last fifty years. Home prices have risen by only about 4% per year. Assuming these historical rates of return, $100K put into the capital markets will equal about $2.34M in thirty years, whereas that same $100K put into the house on day one will be worth approximately $324K when you’re ready to sell in thirty years.

Feel free to assume the stock market does worse than its historical return and that real estate has done a bit better. It doesn’t change the overall takeaway!

[Is there a chart that could demonstrate the stock market rate of return against the home prices over the same time period to show this argument?]

Appreciation vs. Reality

Don’t get me wrong. You may find a property that generates explosive short-term appreciation, greater than what you can find investing in the stock market, but how likely is that? How much risk are you taking on trying to become the exception to the rule?

And that’s not even considering all the costs along the way. You will have paid property taxes, maintenance fees, housing insurance, liability insurance, normal upkeep costs, home improvements, and more.

All of that will dramatically lower that 4% even further and hasn’t been subtracted from the sale price (though you no longer have that money!).

By “investing” in real estate, you’re giving up some dramatic capital appreciation in the hopes that the positive cash flow you generate in income will make up for the shortfall. (I’m guessing here as, transparently, this is not something I’d ever consider doing personally.)

The Problem With "Passive"

And here’s the rub:

Nothing about it is “passive”! It requires more diligence, know-how, and periodic involvement than can reasonably be considered a “passive” activity. Are you committed to doing all the work yourself? Are you running the property, advertising to find tenants, showing the property, vetting the applicants, responding to maintenance requests, coordinating the repairs, cleaning and staging before each new guest, answering prospective renter emails, collecting and following up on payments, dealing with any legal issues, and so on?

A real estate broker client once told me that when she talks to her clients about buying a potential rental property, she always reminds them that doing so makes them a landlord! Her point: It is a responsibility! If a pipe bursts, there’s a leak, or people move out unexpectedly and you have to scramble to find new renters...or if your renters don’t pay...it’s all on you to deal with it.

Property Management Isn’t Free

Of course, the other option is to do none of this yourself and hire a management company. That helps make sure you don’t have much work to do, but there is a trade-off: a third party is now cutting into your margins. The standard property management fees run 10% of your monthly rent (to say nothing of losing the tax benefits associated with being a real estate professional, which we will dive into in the next section).

After all that, and even assuming EVERYTHING goes right, how much extra “income” are you really generating each month that’s above your costs? $200? $300? $500? We locked up $120K of real capital, which is now unavailable for your family’s other short-term financial goals, and we have to deal with a management company for an extra $500 per month?

For a busy family earning north of $500k per year, I just truly don’t think that juice, when all is considered, is worth the squeeze!

Passive Income... or Replacing a Paycheck?

Now, don’t get me wrong. You can absolutely make money through real estate and property rental. It might make sense for you. But before you get too far down this rabbit hole, it’s worth asking yourself: “Am I drawn to rental properties as a potential profitable, long-term, cash-on-cash investment, or because I’m expecting it to replace my earned income?”

In our experience of working with clients for sixty-plus years, rental income is not a substitute for earned income for truly financially independent clients, and it is absolutely not the primary source of income. Most of the time, it’s supplemental. It’s another investment that provides additional income, allowing them to power save, do more with their lives, and serves as the cherry on top of their retirement sundae.

Why The Quick-Fix Narrative Is Misleading

This whole chapter isn’t meant as a dig at real estate. If anything, it’s more a knock on the idea of passive income as a quick-fix replacement for growing your income, compounding your wealth, and building a legacy.

Case in point: have you read those clickbait articles with the headline, “Thirty-five-year-old Jake has $1.5M and is retired, living off his ‘passive income’”? I find them endlessly amusing. For starters, what sort of life is Jake living to be able to live off that amount of money for the rest of his life? Because $1.5M definitely is not enough money to be retired for 40 years, at least not with any sort of quality of life.

When most people talk about “retirement,” they don’t typically mean the literal fact of not having to work. They mean not being at the mercy of a paycheck AND getting to live the life they imagine. Being retired is the means, not the ends. So, is Jake stretching his $1.5M to last through 50 years of rising costs, living the life he wants? I doubt it.

Of course, those articles are intentionally extreme and outlandish, but they’re popular because they touch on our human impulse to try and short-circuit the time it takes to build meaningful wealth. Suffice it to say, I think those articles are wantonly misleading.

Warren Buffett’s Slow Burn to Wealth

Speaking of legacy-defining wealth, Warren Buffett was once asked why more people didn’t follow his sage advice or financial behaviors. He’s hugely successful and constantly explains what he does publicly...so why not just try to replicate it?

When asked this, he replied, “Oh, that’s easy. No one wants to get rich slowly.” And Warren Buffett knew of what he spoke: 95% of his wealth was attained after he reached age sixty-five... 95%!

I have to be honest. Every time a young person who is just starting out talks to me about rental income, I think about Warren Buffett.

Are You Planning for Income Too Soon?

This gets to a larger issue with the motivations to have passive income (whether it’s through real estate or not): Worrying about income before you’re ready to live off your accumulated assets is like training for a marathon and worrying about how you’re going to run the 26th mile during your first few weeks of running.

Quick tangent: If you’re 43 years old and have an investment portfolio of $2M, all we should be focused on is growing that pot of money to a point where you can ONE DAY generate enough income to live off. Setting up your $2M investment to maximize income TODAY (which always comes at the expense of other goals like growth) might mean generating $80,000 annually (4%). Is that enough to fund your lifestyle indefinitely? I think not.

The Smarter Income Play

If you feel like you NEED to increase your household income now (which may be true), rather than buying a rental property, what if you utilized your skills and knowledge to increase your income earning potential? If neither path is truly “passive,” all else being equal, I’d rather generate additional income through my own skills, while working on my own timeline, with business expenses I can write off, and without being subject to the whims of the housing market or renters.

In fact, I would argue that the most effective way to increase your income is through professional development and acquisition of new skills. This can lead to getting paid more at your job, leveling up to a better role (or a better job), or consulting on the side.

In building out financial plans and looking through decades of cash flows for hundreds of clients, I can genuinely say that continuously and gradually increasing your salary, bonus, and commissions is the most meaningful and easiest way to generate additional income and an enhanced lifestyle for your family. I know this sounds obvious, “Duh, make more money” but I mention it because sometimes we spend so much time and energy trying to find a “second” or “passive” income source when it would be far easier to focus our energies on increasing our primary income!

Discipline Over Distraction

The discipline, optimism, and commitment required to build wealth over time are key to reaching the financial destination we all want. The impetus to buy rental property to generate passive income while you’re still in the accumulation phase (before it might be appropriate, given your cash flow) mostly just seems to me like an attempt to circumvent that process.

And if I can fall back on my most sincerely held financial belief: We all tend to take unnecessary risks to turn a quick profit or generate “passive” income when we don’t have any sort of mechanism (aka financial plan) that tells us how we’re doing. It’s when we’re guessing, stumbling around in the dark of our financial outlook, that we assume the worst and are left feeling like we need a miracle solution.

Most likely, if you’re reading this blog, you aren’t the quick-fix, pie-in-the-sky type. You just need a plan to get you from where you are to where you want to go, and the discipline to stay on that path.

From experience, for most of my clients who bring up real estate investing as something they’d like to “get into,” it’s usually just not feasible or appropriate. (It’s also not necessary... but we’ll save that for the end.)  

Let’s break down why using this real-life example: You want to buy a $500K property to turn it into a rental and generate income. You will put 20% down and finance the remaining $400K. That means we’ll be taking $100K out of your liquid/investable net worth and moving it into a more illiquid/unavailable vehicle. (We’ll come back to this.) Let’s assume this is your entire upfront cost. (Of course, there will probably be more—closing costs, advertising costs, maintenance and fix-up work costs, furniture refurbishments, and so on before you can actually rent it out—but let’s keep it simple for the sake of this example.) Now you need to find renters. Let’s say you get lucky again and find renters immediately, so the time of paying the mortgage without receiving rent back is greatly reduced. That’s great!  

A thirty-year $400K mortgage at a 7% rate would run you approximately $2,660 per month. You will need to charge more than that to squeeze out that additional cash flow. But wait. You also have to account for property taxes, factor in future vacancy rates, and build in enough to help fund the maintenance work/costs that will inevitably come up over time. All of that can, conservatively, mean you need to charge about 30% more than the rent in order to break even and successfully “run” the rental. So now you no longer need to charge $2,660—you actually need to charge $3,458 before you can start feeling like you truly have “extra” income your family can benefit from. (And remember, that’s really just the amount needed to “break even.” You won’t be booking a private jet to the Bahamas any time soon.)  

Now let’s talk about the “passive” part. The number one reason why real estate investing isn’t as great as it seems? Because that “passive” part is pretty non-existent. Be honest. Are you committed to doing all the work yourself? Are you running the property, advertising to find tenants, showing the property, vetting the applicants, responding to maintenance requests, coordinating the repairs, cleaning and staging before each new guest, answering prospective renter emails, collecting and following up on payments, dealing with any legal issues, and so on? If so, when does the “passive” part begin? 

A real estate broker client once told me that when she talks to her clients about buying a potential rental property, she always reminds them that doing so makes them a landlord! Her point: It will feel like a second job. If a pipe bursts, there’s a leak, or people move out unexpectedly and you have to scramble to find new renters, or if your renters don’t pay, it’s all on you to deal with it. Maybe that doesn’t seem too bad to you, but all of that potential work, liability, and responsibility does diminish the whole “passive” appeal of “passive” income. Put another way, “passive” income is a bit of a misnomer—there isn’t really anything passive about you still needing to do all the work and manage the properties. You could do it all . . . but make no mistake, it is no longer “passive.” It is a business (which, as we’ll discuss in the next chapter, is actually how you should be operating rental properties to maximize the tax benefits). You need to ask yourself: Is this what I want to be doing? Is this the best use of my time/energy to maximize my life and my wealth?  

If you want to offload this work instead, then there are even more things to think about. Such as . . . Are you hiring a management company? That helps you achieve a more “passive” state, but there is a trade-off—a third party is now cutting into your margins. The standard property management fees run 10% of your monthly rent (to say nothing of losing the tax benefits associated with being a real estate professional, which we will dive into in the next chapter). After all of that, and even assuming EVERYTHING goes right—how much extra “income” are you really generating each month that’s above your costs? $200? $300? $500? We locked up $100K of real capital, which is now unavailable for your family’s other short-term financial goals. On top of that, you’ve committed your name to a property for maybe $500?!  

Side note: Of course, it is possible to be profitable in real estate rentals and have this all work out beautifully. I am absolutely not saying it can’t work. My own experience with clients has shown me that those people who do have successful real estate rental properties have two things in common: (1) They treat it as both a business and as a job, and (2) they have a sizable cash and investment net worth (at least $1M+) before they look to get involved in any capital-intensive real estate projects.  

You might be thinking,  “Hey! I’m basically building up equity in a home, and I’m not paying anything out of pocket to do so. My renters are doing that for me—that’s a win. I just get to own the house!” This takes us to the second reason passive real estate investing isn’t usually as great as it’s chalked up to be.  

Building up that equity in your house does not cost you nothing. It’s costing you the opportunity cost of not doing something else with that initial $100K down payment and the $2,660 (plus property taxes, maintenance, money set aside for vacant months, etc.) every single month! What else could that money be doing instead of sitting in your new real estate venture? Put even more directly: Is the capital outlay ultimately going to appreciate at a better rate than if you had invested that same amount elsewhere?  

Let’s look into that! The S&P 500, representing the stock market as an asset class, has averaged a 10% annualized rate of return over the last fifty years. Home prices have risen by only about 4% per year over the last century. Meaning that if you bought a home for $300K and sold it for $600K eighteen years later (which might sound good in theory—you made $300K!), you’d actually only have averaged about 3.5% in comparison. At these two historical rates, $100K put into the capital markets will equal about $1.8M in thirty years, whereas that same $100K put into the house on day one will be worth approximately $324K when you’re ready to sell in thirty years. (The difference in rate of return on the full purchase price and its opportunity cost is even more dramatic.) 

Don’t get me wrong. You may find a property that generates explosive short-term appreciation, greater than the 10% you’d find through an S&P 500 index fund, but how likely is that? How much risk are you taking on trying to become the exception to the rule?  

And that’s not even taking into account all the costs along the way. You will have paid property taxes, maintenance fees, housing insurance, liability insurance, normal upkeep costs, home improvements, and more. All of that will dramatically lower that 3.5% even further, but isn’t reflected in the “shiny” price when it comes time to sell ...only by the fact that you no longer have that money! 

By “investing” in real estate, you’re giving up some dramatic capital appreciation in the hopes that the positive cash flow you generate in income will make up for the shortfall. (I’m guessing here as, again, this is not something I plan on ever doing.) There’s a reason we tell clients (regarding their primary home) that their home is not an investment—it’s a place to live!  

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