Many Americans believe that real estate can do no wrong as an asset class upon which they can build wealth. I disagree. Building wealth through real estate depends on your ability to distinguish among the three types of real estate ownership – investment, speculative, and personal. If you don’t know the differences, you may soon discover that you don’t own real estate, real estate owns you.
Investment Real Estate Puts More Cash in Your Pocket Than It Takes Out
Investment real estate refers to the ownership and operation of income-producing real estate whereby the income generated by the property – usually, rent payments from tenants – more than covers all the costs of owning and operating the property. If the income is high enough to cover all the costs of ownership and operation plus leave cash left over for the property owner, the property is said to be cash flow positive. If the income fails to cover all the costs of ownership and operation, the property is said to be cash flow negative, whereby the property owner must dig into his or her pockets to come up with the cash to pay for the remaining, uncovered costs.
A bona fide real estate investment puts more cash in your pocket than it takes out, on a repeatable, consistent basis. As such, a cash flow negative investment property is really not much of an investment at all. If you continue to hold on to a cash flow negative investment property out of pride or any other emotional attachment to the property, you are not maintaining an investment; you are maintaining a hobby. A rational real estate investor would put a stop to the repeated, consistent cash drain ASAP. In many cases, it is simply best to swallow your pride and sell a cash flow negative investment property. That way, you can let a new owner cope with the income shortfall each month while you put your sale proceeds to work in a cash flow positive investment property you can find elsewhere.
Speculative Real Estate is a Bet Against the Odds
When buying real estate at or near the prevailing market price, many people firmly believe they will make a profit upon the future sale of their real estate. Unfortunately, there is wishful thinking and there is reality. Wishful thinking plays a prominent, defining role in speculative real estate. A new property owner may hope to sell his property at a higher market price in the future, but in reality, he has no idea what the future market price will be. Nobody does – all future market prices are unknown to everyone. That is, until the future arrives.
In the face of such uncertainty at the time of purchase, all the new property owner can know is that there are three outcomes for a future market price: significantly lower than, similar to, or significantly higher than the current market price. In other words, unable to know at the time of purchase what future market prices will be, the new property owner has only 1 in 3 outcomes where he can sell his property at a future market price significantly higher than the current market price. If each outcome is equally likely, the new property owner's odds of selling his property at a highly inflated market price are low.
Unfortunately, the odds of making a profit on a property purchased at the prevailing market price are made even worse by the high transaction costs of buying and selling real estate. Even if a new owner sells his property at the similar future market price, he still loses money thanks to brokers’ commissions, legal fees, and other closing costs incurred to sell the property. He also loses money selling the property at a significantly higher future market price if that future market price is not quite high enough to cover the high transaction costs. Clearly, the odds of making a profit are against those who buy real estate at the prevailing market price and hope to sell later at a higher market price. Such is the nature of speculation and the wishful thinking that leads to it.
Personal Real Estate is Simply a Purchase, Not an Investment
Personal real estate is real estate you buy primarily because you believe you and your family will enjoy living there. Making money, if at all possible, is secondary. In fact, it is hard to make money with personal real estate. To make it your home, you must take cash out of your pocket each month to finance it, insure it, maintain it, fix it, furnish it, and pay property taxes on it. Unlike investment real estate, your home generates no income to offset these out-of-pocket expenses. So, while you likely derive much pleasure from owning your home, you lose money on it every month. Don’t fool yourself – your home is not an investment. It is simply a purchase.
Nevertheless, despite draining you of cash every month, owning personal real estate generally beats renting a house, condo, or apartment for an extended period of time. Owning personal real estate gives you at least two options that renting does not. These options provide you with real value.
First, unlike renting, ownership of personal real estate gives you the option to keep more of your income out of the hands of career federal politicians in Washington, D.C. Current U.S. federal tax laws allow you the opportunity to deduct mortgage interest and local property taxes from your taxable income. This helps reduce your U.S. federal income taxes. So, when you own personal real estate, more of your outgoing cash ends up helping your surrounding community, its schools, and its hospitals instead of largely going to waste in Washington, D.C. This is especially true if the investors in your mortgage are also local and in your community; such investors are more likely to reinvest your interest payments locally as well.
Second, if you ever have to move due to a job change or relocation, personal real estate ownership gives you the option to hold on to your personal real estate and rent it to tenants after you move out. Exercising this option gives you the opportunity to turn your personal real estate into investment real estate. Of course, exercising this option might not make sense given your personal interests or financial situation at the time of your move, but it is an option you would not have had if you were simply renting the roof over your head. When moving out of a rental unit, despite all the monthly payments you made to your landlord, you walk away with no ownership in any real estate asset whatsoever. The advantage goes to personal real estate ownership.
You Don't Really Own Real Estate If It Can Be Taken Away From You
The differences among investment, speculative, and personal real estate ownership are clear. However, you don’t really own real estate. You only think you own it. Even if you have paid off your mortgage in full, a county, city, or local public school district can still take your property away from you. Just stop paying the tax bills these governments send you each year and you will quickly discover who really owns your real estate.
Paying property taxes is all you need to do to keep your real estate out of government hands, right? Sorry, but no. You could pay property tax bills in full year in, year out for decades and still lose your property to eminent domain, whereby a government expropriates your real estate to use it for what it claims to be society’s “greater good” – your personal property rights be damned.
Clearly, while many Americans believe that real estate can do no wrong as a way to build wealth, it sure is hard to build wealth with real estate when, in so many different ways, you don’t own real estate, real estate owns you.