Direct real estate investing

Here are my thoughts and observations on investing in directly held real estate (predominantly residential rental properties but the same principles apply to directly held commercial properties, vacation homes, and even primary residences).

The bar is very high.

First, what is the best alternative that represents a similar risk and return proposition?  In this case, listed publically traded REITs are the proxy. Public REITs have a historical annual return of close to 13% (higher than almost any other broadly-diversified, liquid asset class). Risk and return always go together and REITs are no exception: they lost 67% in the 2008-2009 market meltdown (compared to a 51% loss on the S&P 500).  Directly held real estate has more risk than REITs (not less) due to illiquidity, less geographic diversification, and no economies of scale.  So, you must be prepared to bear a huge amount of risk and you must generate a very high return to compensate you for that risk.

In aggregate, owning and renting are an economic push.

It's a myth that owning is economically better than renting. Economic forces will push rent amounts up or down until the balance regains equilibrium. Think of the many large companies that choose to rent their office properties rather than own them. These companies aren't stupid, they just don't want to be in the real estate business (because their own business is hard enough). The point is, don't own property because you think you must. It is perfectly valid to be a renter (or to not be a landlord).

Real estate doesn't appreciate as much as you think it does.

Residential real estate has an annual appreciation rate of approx 1.5% according to economist Robert Schiller (who has conducted very thorough research on the subject). That's approximately one-half the historical rate of inflation. "If I just break-even along the way, I'll make it up on the back-end" doesn't work (unless you are lucky).

Real estate is a business, not a "write the check" investment.

Traditional financial investments such as stocks, bonds, and REITs within mutual funds or ETFs are essentially "write the check" investments. As long as you have a reasonable knowledge and understanding of market history, you can successfully "write the check" and that's the extent to which your participation is required.  Direct real estate investing is more akin to starting a business: do you have the capital? are you going to borrow money? is property A better than property B? when should you sell? what does the local real estate climate look like? How do you find a good tenant? how much rent should you charge? how much cash must you set aside for vacancies? how do you protect yourself from liability? what if your tenant doesn't pay the rent? can you make repairs yourself or should you hire a property manager?

Your life will become complicated.

If you don't have an attorney, you'll need one. Ditto a tax professional who is very well-versed in real estate. You will need a legal entity to protect yourself which may necessitate one or more tax returns (and your personal return will also become more complex). Get ready for tenant complaints (usually in the middle of the night) and unforeseen expenses. You must keep detailed records. Lots of money will be changing hands, all of which must be accounted for. Some people's personalities are well-suited for this but if you are a minimalist or if you prefer to keep things simple, this is not the road for you.