Friday, November 27, 2020

Real Estate Is Not A Passive Investment

About ten years ago, a friend of mine told me that his wife had just inherited a lot of money and they had decided to invest in real estate.  Their plan was to buy ten or twelve properties and retire.  I told him that I thought that was a great retirement plan, but that it is a job as well.

But then he knowingly assured me that real estate is a passive investment.

He did not speak from experience.  Rather he spoke from what I have found to be common knowledge.  Everyone knows that one sure way to get rich in America is through real estate.  And further, landlords don't really have to do anything except cash the checks.

I think this attitude comes from popular culture and perhaps our experience when we are young rent payers.  Young people pay their rent to the landlord and don't really put all the pieces together.  There is also a class of so-called investment gurus who talk about real estate as a panacea.  Anyway the point is, many people seem to share my friend's beliefs about investing in real estate.

Let's get something out of the way:  What exactly is a passive investment?  Well, if you buy shares in IBM, guess what happens.  They send you four dividend checks a year.  You do nothing except cash them.  That is passive.  Same with bonds.  If you truly believe that real estate is the path to riches AND you want a passive income, I would suggest you have a look at REITs.

Now, perhaps you are wealthy and can afford a large-scale real estate portfolio.  You can hire property managers.  You can purchase multi-tenant properties with triple-net leases.  Your real estate income may come close to passive.  But of course, you have a whole new set of problems.  What's that you say?  Oh, you found out your property manager was taking kickbacks?  Who could have imagined?

Of course, you do not have to be wealthy.  If you own just one rental unit, you can hire a property manager.  For what, eight to ten percent?  Plus the cost of tenant acquisition.  Do the math, there goes your return.  This is why most small investors do not go this route.  Two other points:  One, unless you give the property manager a blank check, you still have to be involved.  And two, do you really think that your property manager won't hire his idiot brother-in-law to service your HVAC system at triple rates?

And to state the obvious:  People who truly believe that real estate is a passive investment are the least likely to hire a property manager.  They don't see the need; so of course, they don't see the value.

So here's how it works for most small investors.  Yes, you are the landlord.  But you are also a service provider.  And yes, you have tenants.  But another word for tenant is customer.  And when your customer calls you at midnight because his heat is not working, it is your job to get it working.  Like any other business, you must serve your customers.

Further, as a small investor, you are probably not buying new, Class A units.  You are buying older, less expensive properties.  Which require more maintenance.  My friend above assured me, that because they were only going to purchase commercial spaces, that midnight calls were not going to be an issue.  But while your CPA tenant may not call you at midnight, that does not mean that there are no maintenance issues.  Anyway they went ahead and purchased ten or so commercial rental units.

Five years later, he shared with me that he gets anxious when his cell phone rings.  Because it is often one of his tenants.  Calling with a problem.  Otherwise, why would a tenant call?

I did not have the heart to tell him:  I told you so.

Finally I should note one other issue that many small investors do not take into account, vacancy.  If you have ten or more units, you can easily plan for and manage vacancy.  If you have a handful of units, or just one or two, the risk of vacancy is high and the expense of vacancy is high.  It is not unmanageable.  But many small investors overlook the issue entirely.