Investing in Rental Properties: A Sure thing

It’s heartening to be able to talk about investing and money out in the real world. At least I got to talk shop with some old friends at a recent social gathering. Anecdotally, I think that the number of money conversations I’ve been having in the real world has increased over the years- Have we a society become more comfortable talking about money?

Maybe. But, it could also be me subconsciously steering the conversation towards money and investing because I enjoy hearing other peoples experiences. Or, maybe it’s that my friend group is getting further into their careers, and money isn’t as scarce anymore. Whatever it is- I’m enjoying having “money and investing” conversations face to face.

The one thing that still irks me when I’m having these conversations is the stigma about the share market. There are often comments about how risky investing in shares is- “You could wake up one morning and all your money could be gone- look what happened in 1987”.

And at the same time investing in real estate being hailed as the best bet to get ahead financially. ” You investing in something physical, the land can never just disappear like shares”

Real Estate Investing Talk

One particular conversation that is fresh in my mind is one I had with an old friend who I grew up with. We caught up over a few brews, discussed how life was going, what we’ve been up to. And then we got talking about money and investing.

He’d started using a particular method of investing in real estate that is supposably a winner, every time. Now it should be said that I’m not trying to call my friend out on this, I personally just don’t agree with the confidence that he had in his investing method, especially in real estate.

We went on to talk about the multiple rental properties that he had invested in, and the method that he uses to acquire more. He urged me to get into it too, so as not to lose out on the gains to be had.

The Winning Method with Rental Properties

The method he was using sounds good on paper. The idea is that you find a house and land package in a newly developed suburb. You can secure these packages with a deposit, sometimes as little as 5% deposit of the fixed build price, and settle the rest when the house is finished.

And, he told me, the genius to this method is that once the house is completed and you settle the remainder of your pre-agreed purchase price, the value of the house has already increased- since the market has been ticking along for 12 to 14 months. Instant Equity Gain!

He then expects the value of the property to increase further over time as the suburb matures and becomes more desirable once all the other builders leave and the greenery starts to grow. And, he told me, there’s no need to worry about maintenance either- it comes with a 10-year builders guarantee- And being a new house, you can secure better tenants. Win-win.

A summary of his method is shown below. The idea is to rinse and repeat. He’s currently onto his 4th house and aiming for a 5th this year.

The confidence he had in his method made me a bit sceptical. You should always be a bit sceptical when someone is trying to sell you a “sure thing”. I’m sticking to my index investing for now. I told him that one of the main benefits I see in property investing is leverage- which can work both ways. But there was no buy into that idea.

I mentioned that I was investing in the share market. He had the same visceral reaction that many people have- Why would you invest in the share market. You could wake up tomorrow and it could all be gone. That won’t happen to houses. Houses are solid and on land. You can even drive past to have a look at how it going. You can’t do that with shares.

So, am I silly for not jumping into real estate investing in this way? Or should I just stick with index investing

Examining the Realestate Investing Method

So today, let’s examine this “sure thing” real estate investing strategy. And to get a wider view on it, I’ve asked fellow NZ personal finance bloggers, Kelvin from MoneyKingNZ, Ruth from the Happy Saver, Sonnie from Wealth and Risk, Nick from Your Money BluePrint, and PikiLiving to weigh in on the discussion.

Now, I’m not going to get into the debate about whether investing in houses is moral or not. I’ll let you decide on that. In either case, New Zealand desperately needs more houses to quash the demand, which may hopefully decrease house prices and allow first home buyers to get on the ladder as they say. The problem is that too many people, like my friend, who have a vested interest in keeping house prices high.

We’re just going to discuss the above method of real estate investing and the pros and cons associated with it.

Real Estate Investment Strategy

First up, it’s always nice to talk about your investment strategy with friends and family. And even though I don’t agree with his method, I cherish being able to talk about money and investing so openly.

how lucky are you to have an old friend to chat money with, it’s always good to hear another perspective to check whether you are happy with the path you are on or not.

The Happy Saver

Now to discuss the Strategy. At the end of the discussion, I was nearly sold on his idea. And on paper, the strategy sounds good. Secure a deposit, use the building company’s money for the build, settle up with a low-interest mortgage from the bank, find quality tenants, increase equity, and then rinse and repeat.

I can certainly see the method in what he is doing.  If he can get a bank willing to lend to him, a developer who is able to build to a timeframe and a fixed price then I see how the math can work out.  He will of course be paying to “use” the developers money while the build happens, he will be paying a higher upfront cost because as the build goes along, the builder needs to pay their creditors, chances are they have taken out lending of their own to do this, so they will pass those costs on, with a little bit extra on top.  So he won’t be getting the ‘cash price’ that’s for sure and he would more likely get a better price if he secured his own lending.

The Happy Saver

Securing House and Land Package

Securing the house and land package doesn’t seem to be that difficult either. A quick google search will reveal many building companies offering them. Many with low deposits in the range of 5 to 10%. Some even advertise $0 upfront schemes, which rely on your KiwiSaver withdrawal and government first home grant- obviously- that is for a personal home and not an investment property.

But even with 5% deposit, we are still talking about a significant amount of change- which sets a high bar to enter the real estate investing game.

You need a lot of money to get into real estate investing. Even a 5% deposit on a $500k home is $25k – let’s say $30k required once you factor in the overheads. Multiply that amount if you want your portfolio diversified, and spread across multiple properties

Money King NZ

So you secure your first house and land package. All there is to do now is wait until it’s built. No risk in just waiting right? Your deposit is sitting with the building company securing your property. What can go wrong?

Having worked for a couple of housing companies I have seen it done many times.  If he can just pick a plan, sign off a specification and then leave them alone it works better than a customer constantly changing plans and meddling.  (But) Housing companies go under ALL THE TIME so I wonder what the deal is if that happens?

The Happy Saver

Well, your building company could go bust. In New Zealand, there is a history of big building companies going bust. Just last year, Stanley Ecobuild, Stanley Construction, Tallwood Projects, Todd Kirk Halliday, Welstruct, and Tower Cranes all went into liquidation. And look at the likes of Fletchers, who have been announcing hundreds of millions in losses in 2018.

I believe that fixed-price contracts are to blame. There is so much competition in the market that the fixed prices have to be as sharp as possible to secure customers. But the build will take 12 months or more, and as time goes on, the price building materials and subcontractors increase- eating into the already slim margin to a point were it does not become financially sustainable anymore.

I don’t know exactly where your deposit would go into his situation, but I’m guessing you’re not going to get it back.

Borrowing against Gained Equity

A 5% deposit on a house and land package can be a good way to enter the property market for your personal home. But if you are investing in real estate, where does it end? Do you continue the cycle until you retire? Forever increasing the number of rental properties you own. Securing more and more house and land packages. Finding more and more tenants? When does it stop?

…But why stop at four, while lending is cheap and housing supply is high, what’s he waiting for, if his strategy is as “sure fire” as he is suggesting surely he should x10 this?  I bet his bank won’t lend him anymore right?  He is already probably $2 mill in the hole and the bank does it’s own risk analysis on speculative investors such as your mate

The Happy Saver

Right on the money. At this moment, my friend is waiting for the bank to lend him more money before he kicks off his 5th house and land package. He’s relying on time to go by until he can get a new valuation on his properties, which will hopefully reveal available equity to borrow against.

Downsides to this Real Estate Investing Method

If you are a savvy investor you might be able to make this method work. But this method also has many downsides to it. There is a lot of risks involved with the leverage, the assets you are buying are not very diverse even if you had multiple properties, the investment isn’t very liquid, and it’s an active investment type. And finally, it’s hard to quantify true returns on real estate.

Risk and Leverage involved

Now the first thing that I was concerned about this investing method is that there is a lot of leverage and hence risk involved. Any time you buy an investment using leverage it increases your risk. So why invest with leverage? Well, it can magnify any returns you get because you are using someone else’s money. And with low-interest rates at the moment, this can work out to be a good strategy. But you have to always remember that leverage can also amplify any losses.

Leverage is the key ingredient in a property investor’s tool kit. It can turn an average asset class into an outstanding one. It is much easier to get lending for real estate as opposed to shares and index funds, making it possible to use a bank’s money to magnify your investment returns from property. But it seems like no one talks about the risk – leverage also magnifies investment losses. With an unleveraged investment, the most you can lose (in dollar terms) is the amount of dollars you put in. With leverage, you can lose more than your initial investment. 

Money King NZ

The concerning part of the conversation was that the level of risk was downplayed. What can go wrong with real estate? High immigration, lack of supply. It’s a sure thing that values will continue to increase.

…most people I’ve met who have made – and kept – a lot of money via property are usually the first to acknowledge the risks and that what they do isn’t for everyone. It’s usually a red flag if someone thinks there are little to no risks

Wealth and Risk

Real Estate is an Active Investment

So even If I could be comfortable with the increased risk from leverage, the next thing that concerns me is that real estate is an active investment. And what I mean by active is that with real estate there’s a lot of work involved. You have to perform house inspections, deal with insurances, secure favourable lending with the bank. There is a lot of time involved. You could outsource all this work to a large extent, but that eats into your returns.

While the numbers surrounding real estate investment look great on paper, I think people also understate the effort required. Dealing with lawyers, agents, banks, builders, councils, property managers, accountants, insurance companies, and tenants are all time-consuming overheads people seem to forget about. With index funds, all I need is to sign up with an online investment platform, deposit some money, and make an investment order. It takes 15 minutes at most, and as The Happy Saver says “Not once have those investments phoned me at 10pm and asked me to come and unblock a toilet”

Money King NZ

Real estate does not always have to be active if you are investing in real estate through property funds.

Passive Investment in Real Estate is investing in things like REITs or indirectly investing by buying shares in a property company or property sector fund. Active investment is actually going out there and directly buying, selling, upgrading, and managing properties

Piki Living

Real Estate is not Liquid

The liquidity of an investment is how easy it is to sell it when you need to. Property is not a liquid investment. It takes time to sell it, and there are large fees involved with real estate agents. And you can’t fractionalize it- sell small chunks of the house for some cash- this leads many property investors to be asset rich, but cash poor. The same thing for farmers who spend their entire lives paying off a mortgage so that once they retire they can live off the capital gain.

So, I can see the pro’s but personally I see more con’s.  But that is just me, I have friends who are passionate about housing and they tell me all about it but our conversations are generally cut short because they have to head off to their day job, which they have to keep of course to fund their daily life, because despite having $1,000,000 in rental property, they see $0 of this money because it’s so deeply leveraged.  And will be for the next 30 years.

The Happy Saver

Why not employ a different strategy, say index investing, where if you need to sell some of your investments you can sell only the proportion that you need, in a matter of days.

There’s a Lack of Diversification with Real Estate

We all know that we need diversification when it comes to our investments. It’s hard to get diversification when investing in real estate. My friend has 4 investment properties and his home. All in the upper North Island. All his assets are in property, in roughly the same region. Any downturn in the property market will affect him greatly.

…I’ve come to realise that those who have such a singular strategy can hit the wall hard.  Because they fail to take life into account.  Shit goes wrong, for all of us, at different times in life.  For me it was the CHCH earthquakes, for others it’s a job loss, the death of a spouse or cancer.  And if you have failed to create a diversified life then you can often make a tough situation tougher.  Up in Auckland all it takes is for the price of houses to drop slightly to have many shaking in their boots about being “upside down” on their house – owing more than it’s worth.  Banks are worried about this and lenders should be too.  Throw a job loss into that or the decision of your partner to have a child and stop work, then they have opened up a huge amount of pressure.  And pressure equals risk.

The Happy Saver

Having a leveraged investment portfolio all in the same asset class can really amplify any gains to be had when the market is going strong. And property sounds like an attractive prospect with the current housing market. But it can turn quickly, and you could end up with owing more to the bank than what the property is worth.

True Returns of Property Investing

Real estate investors are happy to talk about the returns they are making. But I’ll take a bet that they are not true returns. There are many things that you need to consider with real estate. There are ongoing costs associated with insurance, rates, house maintenance, lawyers, accountants, and I’m sure there are more. Then there’s the risk of losing cash flow if your tenant decides to leave suddenly.

There are so many things to consider that unless you’ve sat down and worked out the numbers, it’s hard to know if your even making money, or just churning through life to pay a mortgage on your leveraged property portfolio.

As with all of this housing stuff, to me it just fails to take into account risk and living a good life today.  Personally I know a lot of people (Mum and Dad investors) who dabble in housing and I think that if they all sat down and looked at the actual math then they are not doing all that great – particularly with the complexity of owning property.  There are so many balls in the air and levers to pull when owning property that to me it’s just not worth it but we are sold the idea that it’s the only way to get ahead, so that’s why many try.  

The Happy Saver

Ok, you might say, sure you can work out all the costs associated with insurance, rates, banks, lawyers and accountants. And you could factor in any lost rent due to vacancy. But there’s one more thing that you need to factor in to get a true value of return- that is your time. How much time do you spend managing your investment portfolio, and what is your time worth?

if you’ve got the time, energy, passion and desire then go for real estate flipping. you can go for buy and hold strategies and hire people to do everything for you though, but this is likely to eat into your profits.

The problem with the New Zealand housing market is that investors put in money for the appreciation potential, not the actual cashflow. The house prices are too high for you to rent it out and actually make a profit, let alone paying other people to do any legwork for you.

Piki Living

Real Estate or Index Funds

So real estate or index funds? Which should you choose? Should you choose either?

When it comes down to it- it’s not really an either-or situation. You can don’t have to do one in spite of the other, you could do both, or stick to one. You can even invest in property through index funds.

…nothing in investing is an either-or choice. There is nothing wrong with investing in both real estate AND index funds. You can also invest in index funds that contain real estate (e.g. Smartshares NZ Property ETF), although remember these primarily invest in commercial real estate, rather than houses and apartments.

Money King NZ

There are pros and cons on both sides or real estate and index funds.

So it’s impossible to have a blanket statement for investing in shares vs real estate. But if we’re talking about actively flipping real estate vs buying index funds long term here are the pros and cons I can see.

Piki Living (table of pro’s and con’s below)

Index Funds as an alternative to Real Estate Investing?

I’m a big advocate for index investing and I hope my biases towards index funds hasn’t affected this discussion too much, but I suspect it has. Many of the cons of real estate investing, for example; lack of diversification, ease of entry, and liquidity, can easily be overcome by investing in index funds.

With index funds, all you need is $50 to get started in the case of InvestNow. This gets you an investment in a fund potentially diversified across thousands of companies in many different countries.

Index funds are more liquid too – It takes just a couple of business days to sell your investment and get cash out, as opposed to property, which could take months to complete a sale. I think this makes index funds suitable for beginner investors. You can exit any bad investment decisions easily, without suffering major losses in dollar terms, since you can dip your toe in with just some spare change. 

However, I believe the ease of getting in and out can be a con for index funds. It could result in investors not doing enough due diligence before investing, treating the markets like a casino or get rich quick scheme, or panic selling when volatility hits.

Money King NZ

The liquidity of index funds can be a Pro and a Con too. I have personally dabbled in too many index funds without doing true due diligence. That is how I ended up with 11 funds at the end of 2019. It turned out that I had many funds that were overlapping, but I could sell out of these funds with a click of a button.

…I’m an investor in index funds as well and it just sits better with me.  I would rather invest in our economy by supporting the top 50 or the top 10 or 20 companies who are working day in day out to grow their businesses and companies.  These are the real workers in our economy, they are creating something that benefits both themselves and many others.  They provide the jobs to the tenants who occupy your friends houses.  But I also own a house.  So for me, no single strategy is the winner, you need to diversify and have a foot in a few different camps and that is where I think that those who are so passionate about property have it wrong.  The number of them I have met who are not even in KiwiSaver because “it does not make financial sense” is alarming.  They are singularly focussed on housing and that’s a mistake in my humble opinion.

The Happy Saver

So the pro is that making a mistake with index funds won’t usually incur major losses, and the Con is that it’s so easy to buy different funds that it’s easy to chop and change all the time. But overall, index investing is easier.

If you want a simpler solution then go for index funds. It’s dead simple and the main challenge is actually not touching your money.

Piki Living

Tangibility and Leverage of Index Funds compare to Real Estate

There are two aspects of real estate investing that index funds cannot easily replicate. Those are tangibility and leverage.

The tangibility of an investment is how real it feels to you. In other words, can you touch your investment? Is it physical? My friend is right about that one. You can drive past your real estate investment and feel secure in the knowledge that it’s there. It’s not truely the same with index funds, which can sometimes just feel like numbers on a page.

Real estate is tangible. It’s easy to see, feel, and understand the meaning of. It’s something that everyone needs – a place to sleep, eat, and shower. I think with index funds and shares, people often forget what they are. People often treat them as just a ticker symbol on the market, and invest in them based on which one pays the highest dividend, or which one they think will go up in the next 6 months. It can feel like a casino at times. In reality, shares and index funds is investment into a business, or set of businesses, but sadly this fact is hidden by the fact that your ownership of these assets is simply having your name on a registry

Money King NZ

Leverage in index funds can be replicated. You can go to the bank and borrow money to invest in index funds, but it’s not a common thing. I’ve always thought about leveraging to buy index funds but never have the guts to do so.

We are quite debt averse ourselves. In fact some of the reasons were still renting are the high house (and mortgage payment) prices and because we are still building our portfolio. We want to minimise our leverage even on personal matters.

If you still prefer to take a loan for investment, I highly recommend to go for real estate rather than shares. When you take a loan out to acquire real estate you at least get something that has intrinsic worth. The actual house and land is worth something in any market.

If you’re heavily leveraged in a share market and a company tanks, for example, the share prices can drop down to zero. which means all you’re left with is debt, mountains of it.

This is comparing an asset (property) vs a derivative (shares). As Warren Buffet said “Derivatives are financial weapons of mass destruction” Derivatives played a big role in the 2008 GFC.

Piki Living

It seems strange that people are so comfortable taking on large mortgages on a home which is a single asset class but consider investing in the share markets through diverse index funds scary, or is that just me? I guess it’s all about individual risk tolerance.

And to your question on is it a good idea to borrow to invest?  No way, it’s not for me, because it just adds an element of risk that I’m not into.  I know people who have, and given our strong markets, it is working out OK but these also seem to be people who really speculate, they buy and sell and trade and take risks that if you talk to anyone who has written a book on investing, these are things they would tell you you should not do…. Apart from buying a house, I am not a fan of any leverage – all it points to is that I’m probably trying to buy something that I can’t afford.  

The Happy Saver

Real Estate Investing, A Sure Thing

No matter whether you think this is a winning method for real estate investing or not, the one thing to remember is that any time someone mentions and investment strategy that is a “sure thing”, or too good to be true- alarm bells should be ringing

…as soon as people start thinking they are onto a “sure thing”, that is a sure sign of an asset bubble

Your Money Blueprint

The same thing was happening in the asset bubble of 1987.

…I guarantee that someone doing similar will eventually find out the hard way that this isn’t such a “sure fire” investment.

Wealth and Risk

And if it was such a “sure thing”, then why don’t the banks just cut out the middlemen and do it themselves? We all know how banks like to make huge profits.

If housing was so good, why doesn’t the bank just cut out the middle man and buy property?

The Happy Saver

The way in which I see it, the banks are trying to push the risk to the investors, while still profiting on the investments- but that’s just my opinion.

Final Points on Investing

At the end of the day, it’s everyone personal choice. You can invest your money where you like. Just remember to not be blinded about any risks involved, and make your own personal decisions.

I always think everything in investing is completely a personal choice. Always look at the pros and cons of each, and see whether they fit your preferences, personal situation, and investment objectives. And just because your friend, relative, or favourite investment blogger is doing it, doesn’t mean it’s right for you.

Money King NZ

For now, I am not going to be looking into any real estate investment, rather I’m going to simplify my index funds and employ a buy and hold strategy. But I can’t tell you what to invest in, you will have to make that decision.

You will note that I talk more about real estate in this email than investing/anything else, that’s because there is not much to say about index funds.  Buy and hold.  Simple!  

The Happy Saver

Thanks to Ruth from the Happy Saver, Kelvin from MoneyKingNZ, Sonnie from Wealth and Risk, Nick from Your Money BluePrint and PikiLiving for their insight on this property investment strategy. Go check out their websites.