Is real estate passive income? What returns can I expect from buying my practice office?

Here’s my post about how to invest in real estate through direct investments, syndication, and REITs.

As continuation of my other post where I said you don’t have to have any equity to become rich, and that buying your office won’t automatically make you rich, I wanted to research what the typical returns are for family homes, rentals, commercial properties, REITs, and discuss whether they should be part of your portfolio and how much.

To cut to the chase, real estate and REITs have decent returns, although they might slightly trail the stock market, and there’s less diversity (more of a gamble to put a lot on a single asset rather than many assets) and illiquidity.

Let’s talk first about single family homes or multi family units. Ironically what prompted me to write this email was this article from the WSJ.

The article discusses how professional real estate investors use computer programs and algorithms that quickly determine how much to pay for a house and whether it’s a good buy based on cash flow.  The computers even look at the sunlight through the kitchen window, and whether the property is close to a Starbucks, yoga studio, or tattoo parlor (not making this up- read the article). So as an individual investor you’re going up against the computer (although the computer isn’t always right, you better bet they fine tune the algorithms).

For example, you’re going against LLCs like this one who bought 600 houses under $300,000 in Phoenix. The “leftovers” will go to individual investors like me and you.

I agree there might be market inefficiencies where a local investor might be able to pick a up and coming area that some big firm isn’t aware of. But, there’s also a risk that you might pick wrong and underperform the average. Here in Phoenix the areas that crashed the hardest in 2008 were precisely the “up and coming” areas. I personally know individuals, even real estate agents, that barely broke even or lost money on their investments.

So what type of returns should you expect from residential real estate?  According to this article, big investors expect a 5-7% return. But individual investors should shoot for 10%, because they don’t have to pay for overhead/ support staff. Don’t know If this takes into account mortgage closing and real estate transaction fees.

But this brings me to the point I made in the other post- if you’re not paying someone to manage the property, it’s a business, not passive income. You’ll have to spend time on it, or pay someone to do so. And as a physician making about $400,000 a year, your time is more valuable than the Joe Schmoe that earns $80,000 a year.

The SP500 typically returns 10% every year with dividends. This is a higher return than what big investors expect for residential real estate, but about equal to what they say individual investors should shoot for.  There was a study I found that stated returns might be almost as good as the stock market- 9%, but it was not clear to me whether they took real estate transaction fees into account. But the stock market is less work, as long as you can consistently save and not buy a ton when prices go up and sell when values drop, which is human nature and what most people do.

One compounding factor when comparing real estate yields vs stock market yields is taxation. Equities are almost exclusively taxed at capital gains rates, which max out at 23.8%. But real estate income from cash flow is taxed at ordinary rates (property appreciation at capital gains).  If you’re in the highest bracket, even with the pass through deduction you’ll be taxed at 28%, which might cut real estate returns another 0.25%.

If you still want information about how to get started read this article about how to calculate cash flow returns.

I agree that real estate will appreciate. But overall, usually not faster than inflation. Some parts of the country it’s shot up faster- but in other parts it’s underperformed. Putting all of your eggs in one basket (or house) is a lack of diversification risk.

Next let’s turn to real estate syndication (crowdfunding). This is when a group of investors get together to finance a investment (usually that they couldn’t otherwise individually afford). This might be a commercial property or apartment building. This is pretty close to passive investing, because the syndicator (sponsor) is in charge of choosing and buying the property, and managing the tenants and repairs etc.  This article describes it in more detail very nicely.

And according this article, the average return was 8%, usually between 5-10%:

But the devil is in the details, and the returns can be all over the map. If the syndicator buys several properties, this provides for more diversification. If the syndicator charges a lot for their services, it eats into the returns.  And it’s passive once you invest, but you would need to do a lot of due diligence to the syndicator to make sure they’re legit and not the next Bernie Madoff who is gonna take your money and run. These investments aren’t regulated the same way that a mutual fund at a brokerage firm is.

Next, let’s turn to REITs. They are the mutual funds of real estate. A REIT owns real estate and is required to pass 90% of income as dividends to investor. Often REITs are broad based, like the total stock market fund- they invest in residential, medical real estate, shopping malls, office buildings, storage units, hotels, industrial.REITs can be bought or sold just like other funds or stocks.

As I mentioned earlier Vanguard has a REIT. Here’s the link.

Click on “portfolio and management” to look under the hood to see if there what the holdings are.  Click on price and performance- REITs appear to average 8-10%. Note that the SP500 historically returns 10% including dividends, and in the same timeframe it’s returned 10-15%.

Now you need to look at many different time periods to draw a conclusion, not just one three five and ten years back from today, but it does seem that the SP500 or total stock market outperforms real estate- but not as much as I thought.

Some folks think real estate moves independently from the stock market, but I would argue when the economy is doing well business can pay more for rent and folks can pay more for houses, and when the economy crashes credit is tight and businesses don’t want to open new offices, people will rent cheaper places or crash with their friends. While I agree there isn’t as much of a correlation as other stock funds, there still is some relationship.

So this led me to my next question- how much of my portfolio should I put in REITs or real estate vs stocks?  As I mentioned, I own my poor cash flow  consumption rather than investment condo. Most articles I found say about 10-15% of your portfolio could be in REITs, including this one that looked at three experts and studies.

And if you want to own individual real estate, how much of your portfolio should be in it?  I completely agree with this excellent article.

Basically, if your net worth is between one to five million, they advocate 5-15% depending on if your timeline is under 5 years or over 10 years. Why?  Because real estate is illiquid.  But the illiquidity can be a benefit!  Why?  Because most folks sell their stocks when the market tanks. If you own a few buildings, it’s much more difficult to panic sell real estate which takes months when the market hits bottom- but for stocks a few clicks on your iPhone will cause you to sell low.

So for those of you who want to own your building- if you know you’re the type of investor who sells stocks when the market drops, real estate’s illiquidity might be a benefit to you. If you blow all your cash on new cars, fancy dinners, and business class, having a mortgage will force you to save equity rather than spend money.  But if you’re a disciplined investor, and buy when the market tanks, I would argue that stocks have higher returns with more liquidity and less hassle factor- more passive than real estate for income.

Finally, I will say if you want to buy your own building, keep it practical. I would buy something big enough to grow into, but if you overbuild, you’re paying a ton of interest to the bank when you’re in the process of building equity. It’s kind of like buying a 6000 sq ft home instead of a 3000 sq for home- you’d be better off buying the smaller home and investing the rest. Yes you’ll build more equity,  but you’ll also pay a ton more interest and more maintenance and property taxes. Same goes for appearance and upgrades- I’d want my place to look nice but I don’t need the fanciest place if I want to do comprehensive oph on insurance patients (apologies to cash pay oculoplastics and lasik jockeys).

If you really can’t find something in your area to rent that’s suitable for your practice but your dream location and floor plan is for sale I say go for it. But you’ll make your money from having your practice succeed due to the location, not just from the real estate in investment itself. Kind of like investing in a photopter and slit lamp. The office which would get you the best return on investment for real estate may NOT be the best office for your ophthalmology practice due to size or location.

So what I said in my post a few weeks ago is true- you can get really rich with zero real estate equity. Buying real estate in REITs has better returns than I thought but still trails the stock market in my view. And buying a individual property is not a slam dunk sure fire way to get rich; it has risks of underperforming the market as well as illiquidity as well as the hassle factor. While this is for real estate investments let’s not forget that your residential home is not a investment, it’s consumption.

But, buying individual properties might appeal to some people who want to “see” their tangible investment or can’t stomach the market.  To each their own. After writing all this, I do think I’ll slightly increase my allocation in REITs, but I’m not up for buying individual properties.