If you want to invest in real estate because you want passive income, keep this in mind: There is no kind of investing that produces income more passively than a traditional investment portfolio.
When I talk about a “traditional investment portfolio,” I mean owning individual stocks and bonds or, more likely, funds (mutual funds, index funds, ETFs) of stocks and bonds in accounts like a 401(k), IRA, and taxable brokerage account. You know, the Boring Stuff.
If you’re looking for passive income, a traditional investment portfolio can create that easily! You just sell shares of the aforementioned stocks, bonds, or funds with a few clicks of a button and take the cash.
(Okay, yes, investing is more nuanced than that. But apparently it has never occurred to most people that you can generate income from a traditional portfolio just by selling stuff. In fact, that’s probably how most clients of most financial advisors get income when they retire!)
The Potential Benefits of Owning Investment Property
I’m not a “real estate guy.” I know financial planners who are, and who specialize in helping people build wealth through real estate investing, like this planner. If you’re interested in buying real estate, you likely don’t need me to enumerate its virtues, but let me give it a bit of screen space…before I start digging into the potential negatives.
It Scratches that Cultural Itch We Almost All Have.
It’s pretty clear that, in this country, we love owning property we can touch. Also there’s a deep-seated appeal to the idea that “If I buy a property, then not only do I now own an asset that increases in value over time, I also get checks every month. It’s the best of both worlds.”
And that’s okay.
It Might Help You Reduce Taxes Over Your Lifetime.
I’m not an expert on this. TikTok will give you all sorts of wrong and potentially “If the IRS finds out, you’re going to jail” advice on using real estate to reduce or avoid taxes.
In the legitimate world, I know and respect enough tax and financial planning professionals with real estate expertise to know that there are legitimate ways that real estate can help optimize your taxes over your lifetime.
Please keep in mind that, we generally shouldn’t care about optimizing taxes in any one year (which unfortunately is the focus of far too much tax advice). Who cares if you save $5k in taxes this year…if you still have to pay that money plus more in the future? The goal is to minimize taxes across your entire lifetime. And sometimes that means that paying less in taxes this year is the wrong thing to do.
It Can Be Emotionally Easier to be a Successful Long-Term Investor.
Behavior is a huge component of investment success. If you want to be a successful investor in the long term, you want to be a long-term investor (duh). The most reliable way to accomplish this is to buy investments and then just keep holding them.
In this way, owning real estate directly can have an advantage over a traditional investment portfolio.
You can see the value of your stock, bond, or ETF every day. When it goes up, glorious! You’re floating on air! Envisioning those first-class tickets you can now afford. When it goes down, ack! Gloom and doom and everything is horrible.
When you own, say, a single-family rental home, you know what its true value is on the day you buy it (i.e., it’s the price you paid) and the day you sell it (i.e., it’s the price someone else is willing to pay for it). The best you can do on every other day is “comps,” which are just informed guesses, and not a number you’re confronting daily in the headlines.
We financial planners try to train clients to not look at their investment portfolio very often, so as to minimize the self-defeating emotions that looking at the numbers can stir up. You don’t have to worry nearly as much about that if you own a single-family home…because there’s nothing for you to see. It’s therefore easy to ignore the daily, weekly, annual vacillations in the value of a single-family home. That probably makes it easier, emotionally, to own long term.
The Downsides of Owning Real Estate, and How to Avoid Them by Owning a Traditional Investment Portfolio
It’s Often Anything but Passive.
As the saying goes, “Your index fund doesn’t call you at 3 a.m. to complain about a leaky pipe.”
For sure, you can reduce this problem by hiring a property management company. But that is still one more relationship you have to commit time and energy to, and it doesn’t get you out of all decisions and effort associated with the investment property. (Not to mention the cost, of course.)
Even after you buy it, you have to keep spending on it.
You have to pay the pest guy every month to come keep the rats out. Or the landscaper to keep the lawn mowed. Or the property tax. Insurance. Or repairing the roof. Replacing the carpet. Paying a property management company. Etc. If you own your own home, you already are well aware of many of these “hidden” costs of owning real estate.
Yes, obviously the point is for rent to cover these costs. And ideally it will (plus some!). But just keep in mind that these costs are always there…rent may or may not be.
It increases the complexity of your financial life.
It is hard enough keeping track of all your 401(k)s and IRAs and 529s and Robinhood and Coinbase accounts, not to mention your eight different bank accounts.
Now you’re going to add an entirely different kind of asset to the mix, with an entirely different way of tracking and managing it. Not a deal breaker! But it should be a consideration.
Unfortunately, I think our modern financial lives are irreducibly complex. We cannot make them simple. But we can fight to make them simpler. Not only does that make our lives more pleasant, but I firmly believe it indirectly benefits us financially. We’re more likely to understand and stay on top of all the bits and pieces when there are fewer moving parts.
You’ve just complicated your taxes (and have to pay for that complication).
This is a special case of the above mention of complexity. But I think it warrants calling it out by itself, because taxes are such a source of stress and anxiety for most of us.
Somebody has to prepare Schedule E—and possibly a bevy of other schedules and forms, depending on what you’re doing with your real estate—on your tax return. Either you’re taking your time and energy to do it (which I highly recommend against), or you’re now paying your CPA more money to plan more and do more tax paperwork.
Real estate prices don't actually grow all that much over time.
The stock market, historically, has meaningfully outperformed real estate. According to this Investopedia article,
Yes, there are regional variations.
Real estate—much like company stock or a cryptocurrency—tends to produce a lot of stories (from your cousin or your co-worker or the internet). But stories aren’t a good basis for long-term investing. Data is.
You just increased your investment risk.
You’re probably aware of the benefits of “diversification.” Diversification means, simplistically, owning lots of stocks instead of only a handful of stocks. It’s described as “the only free lunch in investing.”
If you looked at someone’s net worth (possibly even your own!), saw that it was $2M and that $1M of it was in their company stock, I bet you’d be all “Whoa….that’s a bit crazy.”
But if you buy real estate as an investment, you’re likely going to be putting a lot of money into that investment and could end up in the very same situation, where $1M of your net worth is in this single investment property.
Concentration risk is concentration risk. That one house gets hit by an earthquake. That one neighborhood becomes unpopular. These things are outside of your control but have a huge effect on that one asset. It’s similar to owning a bunch of a single company’s stock, say, BlueApron, and then riding the stock down from its IPO price of $10 to below $1 less than two years later.
It’s illiquid. Otherwise known as, you can’t buy groceries tomorrow with your property value today.
I’ve written a critique of investing in “fancy” investments. One of those critiques is that many fancy investments are “illiquid,” that is, you can’t easily sell it and turn it into dollars to buy groceries with tomorrow.
The same thing applies to owning real estate. You do have some tools for getting money out of these assets if you need it, like a cash-out refinance. But in general it is way easier, faster, and less expensive to get money out of a traditional investment portfolio. You just sell shares of your stocks and bonds and funds during the next day that the stock market is open. Which it is almost every weekday of the year.
You can’t just buy or sell small bits at a time. It’s all or nothing. That might not match up with your finances.
When you’re buying a property, you likely need a lot of money as a downpayment. (Sure, at times you can secure a mortgage that enables you to make a very small downpayment. I’d argue that just because you can doesn’t mean you should.)
Maybe you only have $100s or a few $1000s at a time to invest. You can either wait, maybe years, to accumulate enough to buy real estate…or you can just start buying stock and bond funds Right Now. You can usually start investing in a traditional portfolio with just a few bucks.
Now let’s say you need some money, say, $50,000 out of your investment portfolio. You can easily sell $50,000 out of your $2M investments…if it’s a traditional investment portfolio. But how do you get $50,000 out of your $2M investment property (or four $500k investment properties)? It’s probably possible, but it sure as heck is also more complicated.
This might be the wrong time, in your financial life, to receive more income.
When you’re retired and living off of your investments, having an investment that generates income every (or most) months could be a great match for your needs.
When you’re still working and earning a paycheck, you might not want additional monthly income from your investments, and it certainly isn’t appealing from a tax perspective. Why pay taxes on income that you don’t need if you could instead delay that income into the future when you do need it?
Either way, you might not have as much control over when you receive—and are taxed on—the income.
By contrast, you have a lot of control over income and taxation timing when you own a traditional investment portfolio. Yes, even the most tax-efficient stock, bond, or fund distributes dividends, interest, and capital gains on occasion, at a time that you have no control over. But you can minimize current income (by quite a lot!) by choosing tax-efficient investments and strategically choosing when you sell the investment.
I know there are a lot of tax maneuvers to reduce your current taxable income from investment real estate. Maybe you can arrange it so that the tax impact of the real estate income is a non-issue. You’d want to work with a tax professional to figure that out before committing.
Most people don’t have the skills and experience to properly evaluate a real estate investment opportunity.
I know I don’t, which is a big reason I don’t invest in real estate or seek to provide much advice to clients.
The wonderful thing about a traditional investment portfolio is that it’s easy to understand and implement the best practices of “own a diversified portfolio of low-cost funds, mostly in stocks when you’re many years away from your investment goal.” I don’t have to know—and I don’t—how to evaluate the investment worthiness of Airbnb or Coca Cola or Exxon to successfully invest in the stock market.
If you’re going to drop $100ks into a single investment property, you’d better know how to evaluate its investment worthiness. If you do, yay! But I reckon that more people think they do than actually do, and it’s too big a risk to take without actually being one of those few.
When Owning Real Estate Could Be a Good Solution for You
You like the game.
You like evaluating properties and bidding on them and managing properties and improving properties and maybe even the interpersonal demands of tenant relationships.
One of the things I love about my traditional investment portfolio is that I basically never have to think about it (even before I hired my own financial planner). I just set it up once, plow money regularly into it from my paychecks, and check in once a year to make sure it’s all copacetic. I really really don’t want to have to think about my investments more frequently.
You have the necessary expertise to evaluate the investment.
You have sufficient expertise or have hired professional expertise so you can properly evaluate investment opportunities.
You have the necessary skills to maintain properties.
You either have the skills to maintain properties or have a network of professionals who are willing to do it for you.
If You Really Want to Own Real Estate
There are smart, successful people out there who grew meaningful wealth through real estate. I’m not one of them, and I don’t know enough about real estate to help anyone else be one of them.
If you want to own real estate but don’t like the idea of everything that comes with tangible property, considering owning real estate through a public REIT (real estate investment trust), which offers the same ease and liquidity of your S&P 500 fund.
And don’t forget that if you own a “total US stock market” fund, you almost certainly are already invested in real estate. Vanguard’s Total US Stock Market ETF (ticker: VTI), for example, currently allocates about 2.5% of its money to real estate.
If you really want to own something you can touch, then alright.
Because of the complexity and cost involved in evaluating, buying, maintaining, and managing property, I recommend you work with a specialized financial planner (not a real estate professional, who would probably have pretty profound conflicts of interests or unhelpful biases). You can start that search in the XY Planning Network’s Find an Advisor tool, filtering by Profession > Real Estate Professionals.
Do you want to build wealth and passive income the easier way?