Financial gurus and Twitter money bros constantly bombard the financial independence space with the same advice: real estate investing is the key to wealth.
The stories all have a similar ring to them. “How I achieved financial independence with real estate investing” and “How I make $200K per year investing in real estate”.
While I’m sure these stories are mostly true, they don’t tell the whole story. Investing in real estate isn’t a magic button to wealth building.
Here’s the absolute truth about real estate investing: know what you’re getting into!
14 Harsh Truths About Real Estate Investing
I tried investing in real estate, with both a primary residence and as a landlord. My experience doesn’t always match the outcomes we are bombarded with on Twitter.
Here are some of the harsh truths I learned while trying to build wealth through real estate.
1. Buying a House is Impossible if You’re Poor
The most significant limitation with real estate investing is the lie that anyone can do it. Homeownership is out of reach for millions of Americans. The barriers to entry are too high for many people to overcome.
To even consider buying your first home, you need a decent credit score and a hefty down payment. You must also show a steady income and have enough cash to pay closing costs. And don’t forget all the extras that come with a mortgage payment: interest, taxes, PMI (primary mortgage insurance), and homeowners’ insurance.
The best option is a conventional loan because you won’t have the additional burden of PMI payments. However, you need a 20% down payment to access a conventional loan. With the average home price in the US reaching nearly $350,000, you’d need $70,000 in cash to obtain a conventional loan – and that’s before considering closing costs!
Even Programs that “Help” are Expensive
Programs are available to help more people get into houses. FHA (Federal Housing Authority) loans allow borrowers to take out mortgages with only 2.5% down. That same $350,000 home would only require a down payment of $8750 with an FHA loan.
However, FHA loans come with additional costs. Borrowers will have to pay an extra 1.75% at closing for the upfront costs of PMI and then pay an additional fee every month of approximately .85% until the loan is at least 20% paid off. These payments can add thousands of dollars to the cost of a home over the years, sometimes putting the mortgage payment out of reach.
How I Bought a House
I could only afford a home because I had access to a Veterans Administration Loan (VA Loan). VA Loans are offered to service members as a benefit for joining the military, so they aren’t an option for most Americans.
The VA loan allowed me to purchase a home in Southern California with no money down and didn’t require a PMI. Without these two benefits, I would not have been able to buy when I did.
2. Secret Safety Nets Help More Than You Know
I’m sure you’re wondering, “if buying a house is expensive, how do people afford it? How do they afford to buy more than one?”
I suspect the truth can be found in the media. You’ve seen the stories. “How this millennial used real estate to retire at 30!” and “How I saved 75% of my paycheck, and if I did it, anyone can!”
You know these articles. And you also know what you will find when you read them.
Many of the people extolling the virtues of real estate investing have help. Their parents or grandparents gifted them money for a down payment, got them a high-paying job, or even bought them a whole house. While I don’t blame them for taking advantage of the available resources, I think it’s disingenuous to assume everyone has the same kind of support.
While you can still find people who have done it independently, those stories seem scarcer by the day. Generational wealth is a massive component of successful real estate investing. Those with access to it have an enormous head start.
3. Real Estate Investing is Difficult if You Don’t Have Capital
We talked about how hard it is to buy a first home, and that doesn’t begin to scratch the surface of how crucial access to capital is if you want to make good money investing in real estate.
And by capital, I mean cold hard cash.
The old adage it takes money to make money is true. Access to cash for 20% down payments is just the beginning. You will also need cash at closing and funds available to pay for any necessary repairs while you own the property.
Repairs are difficult to estimate. You never know when an air conditioning will go out, a roof will leak, or an appliance will bug out. My house in Savannah had constant problems with the HVAC. It required repair after repair, costing me upwards of ten thousand dollars.
Unfortunately, I didn’t have the money in my bank account to cover these repairs, so I had to rely on credit. The end result was a lower credit score and increased debt load until I sold the house.
4. It’s Actually Not Passive
Financial advisor Nathan Mueller, owner of Blackbird Financial Planning, often sees clients interested in real estate investing who believe it’s a passive way to build wealth.
Although Mueller acknowledges that a property manager can make things easier, he often has to advise clients that it still isn’t passive.
Property managers can’t make decisions on repairs or evictions. The property owner must make every decision regarding the property. Once a property owner has made the decision, the property manager can facilitate the actions if desired.
Without a property manager, you have to do everything yourself, from finding tenants, collecting rent, coordinating repairs, and, if needed, working through the eviction process.
5. There’s so Much Stress
The need for capital and responsibility for all decisions intensifies the stress of real estate investing. I was more stressed out as a landlord than at any other time in my life, including my tour in Iraq.
When you don’t have an emergency fund capable of covering any housing repair, you begin to dread the phone calls. All you can think is, “What’s wrong now” and “What needs repairs next.”
Your entire existence is spent waiting for the other shoe to drop, waiting for the property manager to call you and tell you about the next extensive repair.
Selling my rental property was the most significant stress reliever of my life, followed closely by selling the fixer-upper nightmare I used as a personal residence for three years.
6. DIY is Harder than it Appears
Speaking of the fixer-upper, flipping houses is often hailed as an easy way to make money with real estate.
Buy a home in dire need of repair, fix it up, and sell it for a considerable profit.
Home improvement shows make it look easy, but it can become a massive and costly headache if you don’t know what you’re doing.
My home in Pennsylvania was a fixer-upper, and I quickly learned I’m not good at DIY. I didn’t have the skills to put in a new floor on my own or to demolish and rebuild a bathroom completely. Installing even a new toilet is beyond my capabilities!
I ended up paying contractors over $20,000 to fix all the problems with the house and couldn’t recoup these losses when I sold.
Though buying a fixer-upper may be an excellent option for those with construction skills, it’s not good for everybody, and don’t let home improvement shows sucker you into thinking it’s easy.
7. Surprise Damage Can be Costly
Although I knew the home I purchased was a fixer-upper, I wasn’t prepared for the scale of the project. I knew that a bathroom was leaking, the kitchen was dated, the carpet needed replacing, and the roof was old.
Unfortunately, I didn’t know that all three bathrooms had plumbing issues, the sewer was backed up, and the kitchen floors were uneven.
Even real estate professionals find nasty surprises while trying to flip houses. Brian Davis, the owner of Spark Rental, bought a seemingly perfect property to flip. He did his due diligence, getting inspections and quotes from contractors before buying.
The deal closed, and the contractors got to work. Upon tearing down the walls, the contractors discovered the entire frame was rotted and needed to be replaced. The repairs cost Davis thousands of dollars more than he had bargained for, so much more that he could no longer sell for a profit.
Davis decided to keep this property as a rental, but he put so much into the renovation that he lost money on it every year.
8. Bills Don’t Stop Coming
No property has a 100% tenancy rate, meaning you will have months without renters if you’re a landlord. The bills don’t stop coming when you don’t have a tenant to help you pay them.
Adam Kol of the Couples Financial Coach Podcast reminds listeners that real estate investing often requires borrowing a large sum of money. Borrowing to invest is called leverage, and it can be a powerful wealth-building tool.
However, Kol advises caution. You will still owe your payments if you can’t find a renter. Although you can decrease your risk by making larger down payments and having a bigger cash cushion, those options can also lower your overall return on investment.
The possibility of overleverage is even more dire in a lousy economy. Just as you still owe on a vacant property, you still owe in a bad economy. If you’ve taken on a lot of debt to acquire properties, you may find that you owe far more than the properties are worth. A decline in real estate values could lead to a financial avalanche that’s difficult to dig out of.
9. Returns Aren’t Always High
If you’re looking to invest in real estate due to the massive returns of the last few years – look again. Current returns are far from ordinary.
Mueller helps his clients make good decisions on real estate investing by looking at the complete data. He found that, on average, real estate tends to provide a 3.5% rate of return. In addition, many people don’t even consider their costs when calculating their returns. Interest payments, inflation, closing costs, and other things can eat into the income.
Of course, the average tracks the entire US, and some areas may have vastly different outcomes. But it’s essential to look at the whole picture before investing and remember that real estate has long been considered a conservative investment vehicle.
10. The Housing Market Doesn’t Always Go Up
Speaking of low returns, you also need to consider that the market doesn’t always go up. Sometimes it goes down slightly, and sometimes, like in 2008, it crashes and burns.
Investing in real estate, like any other investment, comes with risk. Unfortunately, unlike stocks, it can turn into a risk that keeps on risking.
Let’s say you have $20,000 to invest. You can either purchase stocks or real estate. If you buy stocks, you invest the $20,000, and that’s it. You may lose it all, or you may win big, but unless you are making risky put buys (which is, in my opinion, like gambling on stocks and not a good investment move), you are only exposing your initial investment of $20,000.
Real estate is different. If you’re investing $20,000, you’re likely using that for a down payment and closing costs. You will have to add money to your investment each month to pay the mortgage, taxes, insurance, and other maintenance fees. The thought is you are paying down the mortgage, which is good, and you will recoup those costs when you sell.
Real Estate Carries Additional Risk
However, real estate doesn’t always go up, either. Suppose you bought a $150,000 property with your $20,000 initial investment. The market crashed, and you need to sell, but it’s only worth $100,000. You’ve lost $30,000 more than you did in the stock example.
Obviously, this is a stark oversimplification and far more goes into real estate investing. Most people in the second situation would opt for a short sale or bankruptcy rather than lose the additional $30,000.
However, the point remains that you could lose far more than you bargained for with real estate if the economy takes a hit. In the 2008 collapse, Americans lost over 3 trillion dollars in home equity. It would be unwise to assume a housing crash could never happen again.
11. Tenants Destroy Things
Another harsh truth about real estate investing is that you must rely on the integrity of others. While most people are good and don’t want to destroy the place they live in, there is no guarantee that you will find great tenants. Even the best credit checks and referrals can’t catch everything, leaving you stuck with a less-than-stellar tenant.
Tenants can trash a property. Some refuse to clean, leaving the landlord a mess when they move out. Others steal anything not bolted to the ground. Others have out-of-control animals or children who destroy walls and carpets.
A True Story of Terrible Tenants
Tomas Satas, the founder of Windy City Homebuyer, has first-hand experience with nightmare tenants. Satas conducted a credit check and employment verification, which the young couple passed with flying colors. They seemed perfect on paper: A young professional couple who always paid the rent on time.
Satas thought everything was great until they moved out.
That’s when he uncovered the horrifying truth. His property was a disaster. The seemingly perfect couple trashed the place, leaving cigarette burns in the carpets, holes in the walls, and trash everywhere. After further research, Satas learned the couple constantly fought, and the cops came by at least once a month.
Satas learned a valuable lesson from this experience: Always conduct a background check. He created his own rigorous screening process after this horrific experience to avoid similar situations.
12. Taxes are Complicated
Don’t get me wrong, the tax benefits of a real estate investment can be fantastic. Many of the expenses we discussed previously (maintenance, insurance, property taxes, etc.) can be written off as business expenses, resulting in a much lower tax burden.
However, the rules regarding what’s deductible and what’s not can get confusing, especially regarding depreciation. Real estate investors should talk with an accountant to ensure they correctly complete their taxes each year.
The more confusing and sometimes shocking tax burden comes when you sell. Unless you have lived in the house for three of the past five years, you need to pay capital gains tax on the sale of your home. If you rented the property and claimed depreciation over the years, you will also need to pay the depreciation recapture tax.
Depreciation recapture is calculated based on the years you owned the property and the depreciation you claimed each year on your taxes. Although it’s capped at 25%, it may be a nasty shock for small-time landlords unaware of it.
13. Cashflow is More Complex than it Seems
Kevin Lao, a financial planner at Imagine Financial Security, finds that investors often make mistakes when calculating cash flow. Lao advises that it’s not as simple as taking the mortgage and subtracting the rent.
There are many other costs to consider before measuring cash flow, such as taxes, insurance, maintenance, management fees, and possible vacancies. These costs can potentially eat into monthly earnings, depending on the rental value of your property.
When I rented my house in savannah, I barely made enough money from rental income to cover the mortgage and property manager fees. I struggled to afford maintenance costs and often relied on credit to fix more significant problems.
My cash flow didn’t cover my expenses.
Although Lao cautions potential investors to understand everything that goes into cash flow, he also reminds us that cash flow isn’t the only way to make money with real estate.
Investors make money with tax breaks, real estate appreciation, and by paying off mortgages. However, these alternative methods of earning money through real estate take more time and are less liquid. If you don’t have enough cash on hand to cover a maintenance issue when it arises, it doesn’t matter that the property is worth 3% more.
14. Illiquid Capital
That brings us to our final harsh truth about real estate investing. Even if the property appreciates, you may be unable to pay your bills. The only way to access money made via real estate appreciation is to sell, and real estate sales take time.
In the hot 2021/2022 market, it took approximately 21 days for a home to sell, on average. However, the time to sell doesn’t tell the entire story. Usually, after an offer is accepted, it takes 25-35 more days to close on a property.
Another thing to remember is that the 2021/2022 market isn’t typical. In 2010, it took an average of 140 days to sell a home, from arrival to the market to closing. Different cities and neighborhoods will have varying rates of sale as well.
The harsh truth is that there is no market where you can put your house up for sale today and have cash tomorrow. Real estate doesn’t work that way.
Loans for Capital
Of course, experts will tell you there are loans available. Rather than selling, you can take out a home equity loan to gain access to the appreciation immediately.
I’m not a fan of home equity loans. While I understand that you sometimes need the money, I don’t think getting into even more debt will help in the long term. There’s also no guarantee that prices won’t fall again, and a home equity loan may leave you underwater when you decide to sell.
Investing in Real Estate Can Help You Build Wealth
Another harsh truth is that financial advisors are right: investing in real estate CAN be a great path to building wealth. Thousands of people have made fortunes with real estate.
I’m one of them.
Okay, so I haven’t made a fortune. But, buying a home in Southern California near a market bottom and selling it in a rising market is the number one reason I’m in the financial position I’m in. I’ll be able to quit my full-time job in a year or two, primarily thanks to the sweet payout I received when I sold.
My other real estate deals weren’t awful, either. Although renting out my Savannah house was a massive headache and stressor, I came out positive in the deal, banking nearly $40,000.
I lost money overall on my third house, but living mortgage free for three years helped me fully fund my emergency accounts.
Overall, investing in real estate was a win for me. And it can be for you too.
How to Win at Real Estate Investing: 7 Tips
Despite the pitfalls, there are many great reasons to invest in real estate. Property ownership is still one of the best paths to building wealth, so here are some tips to help you avoid the pitfalls of real estate investing.
Of course, any investment carries risk, and even the most cautious investor can lose in an economic downturn.
1. Indirect Real Estate Investing
The simplest way to invest in real estate without much capital is via a Real Estate Investment Trust (REIT). REITs are basically like index funds for real estate. They invest in apartment complexes, office spaces, business complexes, and even real estate centers across the nation and pay investors a portion of the rent profit via dividends.
Investing in real estate via REIT minimizes your risk and is a passive real estate investing method. The drawback is that you don’t have a full ownership stake in any of the properties and likely won’t see many gains when the market has wild appreciations, as we’ve seen in the past few years.
Real Estate Crowdfunding
Brian Davis of Spark Rental recommends real estate crowdfunding as an alternative to REITs. Although commonly referred to as “crowdfunded REITs” or “private REITs,” they don’t follow the same SEC (Securities and Exchange Commission) rules as publically traded REITs.
Real Estate Crowdfunding platforms allow you to invest with as little as $10, making it one of the most accessible forms of real estate investing. The downside is the time requirement. Most funds require you to stay invested for 3-5 years or face a steep penalty, matching the illiquid nature of traditional real estate investing.
2. Start Small
If your heart is set on investing in physical real estate, my best advice is to start small. Become a homeowner first, so you understand the total costs of owning a property.
Many people stop at one. Owning one home, the one you live in, can be enough to build generational wealth. Every mortgage payment will help you build equity, and if you keep the home for over 30 years, you can be mortgage free at the end of your life. You can also pass the house on to any offspring or dependents to give them a leg up in life.
Alternatively, you can sell your home when it appreciates. A lot of people purchase a starter home to start building equity and cash out at opportune times to invest in their dream homes.
One great thing about starting with a small home you plan to live in for a while is that you don’t have to worry much about market crashes and being over-leveraged. It doesn’t matter if your home is underwater for a few years if you can afford the payments and have no intention of selling.
Eventually, the market will recover, and over the course of 30 years, it’s likely (though not guaranteed!) that your home will increase in value. Even if it doesn’t, you will have a ton of equity in the house which can be used for whatever you need if you choose to sell.
3. Don’t Over-Extend Yourself
After you’ve experienced the joys and pitfalls of property ownership with personal property, you may want to consider expanding your portfolio and becoming a small landlord.
Looking at affordability if you decide to go this route is essential.
When I rented my home in Savannah, I made sure I could make my mortgage payments regardless of whether I had a tenant. Although the vacant months would be a struggle, they were doable. In this way, I protected myself from the dangers of overleverage.
It may not be feasible to be able to pay every bill for both a rental property and your personal residence with your paycheck. In fact, the ultimate goal for many landlords is to quit their job and use rental income to pay for living expenses!
While that’s a great goal, it’s best to be conservative when first starting. If you can’t afford to pay the mortgage with your paycheck, ensure you have extra cash in an emergency fund to cover a few months of mortgage payments.
4. The Duplex Route
One more accessible way of entering the real estate investing market is via a duplex or small apartment complex. Many investors start with a duplex, renting one side while living in the other.
Davis recommends this method for those wanting to dip their feet into real estate investing. Davis advises that you can use a conventional loan to buy a multi-family property with up to four units. You can even use the rent to qualify for the loan.
Ideally, the rent from the additional units will cover the mortgage, interest, taxes, and most routine expenses, allowing the landlord to live “rent-free.”
5. Have a Massive Emergency Fund
Extra months of mortgage payments aren’t the only reason you may need cash on hand. Things break. Appliances need replacement, sinks get backed up, paint gets chipped, and the carpet gets worn.
When you’re a landlord, you never know when the tenant will call with a costly repair request. You also never know when a tenant will decide to move out, forcing you to pay for cleaning and possible repainting.
If you can’t cover these expenses with cash on hand, you will have to rely on credit. Not only will this cause additional stress, but it can lead to a lower credit score, reduced credit availability for personal needs, and risk overleverage.
To be on the safe side, your rental property emergency fund should have enough money in it to cover three months of mortgage payments, the deductible on your insurance policy, and at least $5000 extra to cover the cost of a broken appliance, a paint job, or other maintenance costs not covered by your insurance policy.
Even that may not be enough.
6. Invest in Home Warranties
To avoid the high costs of repairs, invest in a home warranty. The home warranty I had on my Savannah house was my saving grace. I wouldn’t have been able to afford all the repairs without it.
My home warranty cost about $800 per year and covered nearly everything that might go wrong with the house. All I had to pay was a $100 service fee for each issue – far less than the cost of most repairs.
While I lived in the house, the home warranty paid for itself. I replaced an AC drip pan, fixed a broken toilet, and repaired a massive plumbing issue outside using the warranty.
However, keep in mind that a warranty has limitations. It got immensely harder to use the warranty when I became a landlord.
Home Warranties as a Landlord
Using my home warranty was straightforward with my first tenant. She was a friend, so we didn’t use a property manager. I added her as an authorized user to my home warranty, so if a problem arose, she called them, they billed me, and then they coordinated with her to fix it.
It was a simple, straightforward process, and she only had to use them a handful of times.
When she moved out, I was already living in Pennsylvania, so I opted to have a property management company handle tenants. Unfortunately, this made using the home warranty harder. I couldn’t add my tenants to the home warranty because they needed to call the property manager if there was a problem.
The property manager was flakey about being an authorized user, and for some reason, I could never get them to call the home warranty company. They continued to call me whenever there was a problem. I then needed to reach the home warranty company, which needed to work with their vendors.
It became a convoluted trail of coordinating with six different entities to get a simple job done. In the meantime, my tenants would complain that it took too long to solve problems in the house.
In hindsight, I realize the property manager should have taken a more prominent role in working with the home warranty. Be sure to discuss your home warranty with your property manager before hiring them to ensure they will be the middle man between the tenant and the home warranty.
7. Do Your Research
The final tip to help you successfully invest in real estate is to do your homework. Although not all-inclusive, here’s a short list of items you need to research before making your first investment.
Research the Area
Research the area you will be investing in. How have property values moved over the past 10-20 years? Will people move to or from the region in the next 10-20 years?
You may also want to consider the job market when considering the area. Are industries moving in or out? What types of jobs are available to people who live in the region?
I made the mistake of buying real estate in a dying coal town. People and jobs are moving out of the town, not in. The depressed area is unlikely to get better in the foreseeable future.
To become a landlord, you also need to research potential market rents. How much money can you reasonably expect to charge for rent? Will that cover your expenses? Is it ethical?
Research the Laws
Some areas have laws that strictly protect tenants, while others favor landlords. Before investing in a given area, be sure you fully understand the laws regarding tenants’ rights.
As a landlord, you need to know exactly what your obligations to your tenants are, when you can start an eviction process if a tenant doesn’t pay, and how to notify tenants of any changes to their contracts or maintenance issues.
Although a property manager can help you navigate any issue you may come across, it’s best to have a baseline understanding of the laws before making your final decision on where to buy.
Research Your Investment Property
After you’ve decided on an area, it’s time to make your purchase. Don’t skip the research phase on this step!
Be sure to conduct a thorough home inspection to ensure you know everything that could be wrong with the house. Negotiate with the seller to fix any immediate problems before close, and work with a contractor to estimate the potential costs of anything you want to update.
You may also want to note the age of all the appliances and structures, considering when they might need to be replaced. For example, if a roof is 20 years old, you will probably want to replace it within the next 2-5 years. Be sure to consider all of these possibilities before purchasing the home.
Don’t just focus on the physical condition of the home. Get a title inspection to ensure you’re truly getting the deed, free and clear. If there are current tenants, understand all applicable laws of transferring ownership with tenants in place, and check to ensure all interested parties receive proper notifications.
Research Property Managers
As we saw in the home warranty example, you also need to research potential property managers. Will you do it yourself, or is there a company in the area that can manage it for you? What will they and won’t they handle?
You may be surprised when you work with a property manager to find they will only collect rent but won’t deal with angry tenants. Before signing a contract with them, ensure you fully understand what your property manager will and won’t do for you.
Research Potential Tenants
If you opt to use a property management company, they should do this work for you. However, if you opt to manage the property on your own, be sure to research your potential tenants. Many landlords do simple background checks and credit checks to ensure tenants are safe and likely to pay rent on time.
While researching tenants, be sure to follow any applicable laws. The Fair Housing Act bans discrimination on the federal level, and local/state laws regarding what you can/can’t ask may vary.
Real Estate Investing Isn’t for the Faint of Heart
Investing in real estate isn’t the easy path to building wealth that many people say it is. It is a fantastic way to build wealth but it isn’t easy.
Taking off the rose-colored glasses and getting the real down-low and gritty truth about the stress, risks, and potential downfalls of real estate investing is essential.
Use this information to make an informed decision about real estate so you can go forth and build wealth!