The Real Estate Investor’s Mindset: Live The Way You Believe

Santorini Property Overlook CraterThe real estate market is picking up steam. In some places such as San Francisco and New York City, the recovery has turned into a frenzy where rents are surging and multi-bidding situations are now the norm. As a prodigious wealth builder, it’s important to assess your local real estate environment.

I’m down in the Sunday open house trenches to get a first hand view of what’s going on. I talk to Realtors about their property listing durations, understand why the sellers are selling, and get opinions on the market. You can never fully trust a Realtor because to them, it’s “always a good time to buy or sell property.” By going to open houses yourself, you can at least observe the amount of foot traffic and listen to the enthusiasm or lack thereof.

It should be obvious I’m an advocate of homeownership by now for the following reasons:

1) You have to live somewhere.

2) The homeownership stock is better quality than the rental stock to live.

3) Most people can’t save for poop, so paying down principle is better than poop.

4) Tax shield on income, which is especially helpful for those in higher brackets.

5) The long term trend is always up so long as there is limited land and population growth.

6) You can potentially make a lot of money over time.

7) More control over your lifestyle e.g. never have to move, remodel as you will.

8) Build real assets that can be passed along to your children.

9) Inflation hedge as your mortgage becomes cheaper in real dollars.

10) Inflation play as your asset inflates.

11) The first $250,000 in profits is tax free for singles, $500,000 for couples.

There’s nothing wrong with renting if you don’t have the money, don’t know what to do with your life, have a lot of debt, or are not sure whether you want to live in one place for more than five years. The mobility of being a renter is wonderful, so is the lack of responsibility for property taxes and maintenance. Just know the return on rent is always -100% every month. At least with homeownership, you have a chance of making some money.

This post isn’t about the merits of homeownership. This post discusses how to think about your current living situation and whether it gels with your investment outlook. Remember, the name of the game is passive income, increasing assets, and creating financial freedom.

A RENTER IS NEGATIVE REAL ESTATE

A renter benefits when home prices and rents go down, which is why I say renters are “short” real estate. If rents and home prices go up, renters get “short squeezed” as they have to pay more of their disposable income on rent, a downpayment, and a mortgage. The concept is the same with the stock market. If you short Apple stock at $520, it means you believe you can buy back the stock at a lower price and pocket the different. If Apple rebounds to $600, you may have to buy back the stock at $600 and lose $80 a share.

With inflation, population growth, QE3, QE4, QE Infinity, and limited land, the natural trajectory is “up and to the right” for rent and housing prices. Housing costs are a key component of inflation and something we must all pay in some way or another. A renter is a price taker, just like a car driver is a price taker of gasoline. As a renter, you may actually not want rents to drop because that signifies a weakening economy.

If you are still renting 40 years from now, you won’t have a place to live rent-free in retirement, nor will you have an accumulated asset you can pass down or draw from. Like gasoline and tuition, the rent you pay now will undoubtedly be much higher when you become a senor citizen. Don’t believe me? Just ask your parents or grandparents what they were paying in rent during their working days.

A ONE PROPERTY HOMEOWNER IS NEUTRAL REAL ESTATE

When it comes to investing, everything is relative. Given you have to live somewhere, if you live in your home, you are neutral on real estate. If the market goes up, your house value goes up, but it doesn’t matter because you aren’t selling. You can take out a home equity line of credit to buy a Porsche 911 Turbo instead of a Honda Accord, but that’s not very wise.

Let’s say your $500,000 home appreciates by 20% to $600,000 over 10 years. You put 20% down ($100,000) and now your equity is worth $200,000 for a 100% increase. Awesome! But the house you want to upgrade to now costs $1 million from $800,000, because it too has gone up! The only thing that allows you to purchase more house is not your own home equity, but your savings and investments.

On the other hand, if you want to downsize from a $1 million dollar house to a $600,000 house, you have benefitted more financially if you are OK with the downgrade. You made $200,000 ($800,000 to $1 million) and only have to put $120,000 down on a $600,000 house. You therefore bank the $80,000 and pay a smaller $480,000 mortgage if you are fine with simpler living. As a homeowner, you are in a neutral positive situation.

On the flip side, if your $500,000 home loses 20% of its value to $400,000, you’re not really affected either because you aren’t moving anywhere unless you can’t afford the payments. Interestingly, that $1 million dollar house you’ve been eyeing may have also lost 20% of its value down to $800,000. You no longer have to put $200,000 down and take out a $800,000 if you want to move up. You can now put $160,000 down and assume a $640,000 mortgage instead! In a declining market, those who have the financial means to “upgrade” are the ones who benefit.

As a one property homeowner, you’re like a small boat who happily floats along the rolling waves. Unless you are easily susceptible to sea sickness, the movements don’t really matter.

A MULTI-PROPERTY OWNER IS BULLISH ON REAL ESTATE

The only way to really benefit from a real estate recovery is to buy more than one property. When the markets are hot, you can raise the rent or sell the property to realize a gain. If you only own one property that you live in, you can’t do much at all except for downsize.

Why do you think there are countless examples of real estate magnets like Li Ka Shing, Sam Zell, and Donald Trump? They made their money (and lost some as well) through buying multiple properties on debt. Many have also gone bust buying at the wrong time, being over levered, and not holding on long enough. Over the long run, property has proven to be a consistent wealth builder for so many.

To recap, the point of this post is to get you thinking about how your outlook on housing and the economy fits with your current living situation. If you are very negative on housing, then owning multiple properties doesn’t make sense. If you believe there will be a multi-year housing market recovery like I do, renting doesn’t make sense because you’ll get squeezed. Rental yields are much higher than mortgage rates, which makes for an instant positive carry while you wait for capital appreciation.

Make sure your living situation is congruent with your real estate investor beliefs. Live the way you believe and everything will fall into place over time.

Recommendations For Property Owners Or Potential Owners:

* Check Your Credit Score: Take a moment to check your free TransUnion credit score through GoFreeCredit.com, a company I trust. 30% of credit reports have errors, which could put a serious hamper on your refinancing or new loan borrowing abilities. I had a $8 late payment I didn’t even know I owed crush my score by 100 points come up during my last refinance! The average credit score for rejected mortgage borrowers has risen to 722 due to more stringent lending requirements. Do you know what your score is? If you don’t want the credit monitoring service, simply cancel before the grace period is up.

* Get the best home insurance possible. In order for your property to grow in value you must protect your property from damage. Fires, floods, leaks, theft, and other accidents happen all the time. If you have cut-rate insurance, you could very well pay way more than you should. I highly recommend checking with USInsurance.com online to find the best home insurance rates. They have a huge network of providers that will compete against each other to provide the most tailored home insurance coverage possible that is affordable. Mobile home insurance, renters insurance, condo insurance, and homeowners insurance are just a few of the options based on the type of home in which you reside. Leverage the internet to save money and protect your largest asset.

Photo: Santorini Property Overlooking The Crater, Sam D, 2011.

Regards,

Sam

Sam started Financial Samurai in 2009 during the depths of the financial crisis as a way to make sense of chaos. After 13 years working on Wall Street, Sam decided to retire in 2012 to utilize everything he learned in business school to focus on online entrepreneurship.

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Comments

  1. says

    We are definitely bullish on RE in our local market. About 10,000 baby boomers will hit 65 years old every day for the next 10-15 years, and for many of them, the retirement dream is to move where we live, and spend their money and their days puttering around in the sunshine and the beaches. I don’t think RE is going to go completely insane the way that it did from 2003-2006, but there’s only so much beach, only so much open water access lots (we own 1!), so we think supply and demand are going to be on our side.

  2. says

    I’m very bullish on real estate, but I don’t want to over leverage either. We have 4 properties in the US and I think that’s plenty. My mom told me my cousin just sold some acreage in Thailand and made over $500,000/acre. His grandparent got it for very cheap many years ago.
    The condo market is Portland is really heating up too. Quality units are getting hard to find and price should go up soon. Now I’m thinking I should have picked up that 1 bedroom condo I saw for $100,000 two years ago (foreclosure?). They are going for $160,000 now.

  3. nbsdmp says

    Hard assests are definitely the spot to be…I’m probably a little RE heavy from an overall net worth standpoint between residential and commercial property, but I’m very happy about my position right now. I “doubled down” at the end of 2010 on a nice newer home in foreclosure that cost $4M to build on the water for $1M. The lot sold for more in 1992 than what I paid for my house, since I’m love where I’m at and going to live there for 20+ years I can’t imagine it not being worth substantially more in the future. It was hard to write the check when you don’t know was going to be, but if can afford it & get the enjoyment of living in it…go for it. I’d much rather have hard assests these days than cash!

      • nbsdmp says

        That’s the best part…I was in a position to snap up a property like this because I had all of that stuff in place beforehand and was patient. When you know what you are looking at and understand the market, being in a cash position to close a deal with no contingencies and close in 7 days, there are amazing deals to be had! Key is to be debt free…its shocking how much cheaper stuff gets!

  4. Michael says

    I agree with your assessment about the neutrality of real estate with one caveat. It’s important to buy your first property in a declining/declined market.

  5. Marcel says

    What do y’all think is a good percentage allocation of real estate as a percent of your networth? I’m at about 40% real estate and sometimes I wonder if that’s too high. Part of it is that I own a condo in San Francisco and it’s gone up quite a bit this past year. I’ve been renting it out for a while now and rent prices keep going up. How long will that last? I also just picked up a condo in Punta Cana to live there for a while and possibly rent out or sell in the future.

    • says

      Depends on the cycle, income power, and ability to earn more money and whether you have an X Factor.

      The median homeowner has something like 90% of their net worth in property. I wouldn’t go beyond 40% for any single asset for sure.

      • Marcel says

        Thanks Sam, I agree that more than 40% in real estate would be too high. My income power has gone down a lot since I got out of the tech PR business and started teaching tennis and doing occasional music gigs. Fortunately I moved out of SF a few years ago, started renting out my apartment and living in much less expensive areas. Right not I’m in Montreal with my girlfriend splitting a $700 rent. . imagine that. Regarding the X Factor, I’m trying to figure out a way to make some serious income out of tennis realizing it may be a tennis school. Perhaps in Punta Cana. . anyone interested in investing!?

  6. says

    I’m very bullish on real estate over the next few years. Especially in my area where RE prices are low and there is finally some positive economic momentum building. My only hope is that I’ll be able to come up with another down payment or two before prices rebound too much!

  7. says

    I am heavily bullish on real estate, mostly because I like tangible assets and if the stock market crashes I still have a roof over my head and other places to rent. I started looking into land and own some in 5 countries, I believe there is only so much space on Earth and people have to live somewhere!

  8. says

    Thanks for the great analysis of the state of the real estate market. How do you feel about REIT funds? I rent my primary residence because I’m thinking of moving across the country within the next few years. Do you think REIT funds are a good compromise to be exposed to the housing market, even if I’m still renting?

    • says

      Good question, and yes, REIT funds are a good compromise, but there are tons of REIT funds, so you’ve got to do your research. Would love to hear more about the economics behind renting out your own house and renting yourself.

  9. says

    I think you should always have some real estate. Owning a home is a given, but any other investment can be in a variety of forms. You can own a second home, condo, apartment building, commercial property or a REIT. It should be part of any investment portfolio. The only caveat is, as the housing bubble showed, you should be careful. In other words, the prices have to make sense!

  10. says

    Sam, I would like to buy a 2 family property soon, but given the interest rates being so low and in my situation I still have student loans would it make sense to jump in and buy something in a year to take advantage of interest rates or wait to pay off the loans? I think by the time I pay off loans, rates will be going up.

    • Jonathan says

      I would ignore your student loans. Take advantage of RE NOW with the rare convergence of low prices and low rates. Plus, the student loan debt isn’t frowned upon when you’re applying for a mortgage (assuming you don’t have any cash flow problems or debt-income ratio problems as a result of it).

      • says

        I agree with Johnathan. I bought my first house a year out of college. I got rented the second bedroom which helped me pay the mortgage. After a few years of getting my income up through raises or what not I was able to pay off the student loans while still having a mortgage. That would have been three years I would have lost of paying down my mortgage over a student loan.

        Again there are many opinion on this topic but I would say go ahead and get into the market. I would just caution you to not rush into it and look for a great deal. This same property got hit pretty hard in the “bubble” but at the end of the day I will own a property which I can continue to rent and earn additional income. So I am still happy I got into the market.

    • says

      If after doing the math and believing in the security of your job, I would gravitate towards property ownership if you have the money.

      I bought my first place 10 years ago while I still had student loans. Just really do the math and make sure you plan to own for at least 5 years.

  11. says

    There is one thing that you didn’t really address, which is an issue that I’m mulling at the moment.

    I rent a nice one bedroom apartment for basically half of what it would cost to buy a mediocre starter home. In exchange, that money is invested. Given that I’m shooting to achieve financial independence as soon as possible, it seems to make more sense to build income streams then to become a homeowner. Homes here are obscenely expensive for what you get and I’m not sure about heavily deferring investing for the 3-4 years just to save a down payment.

    There’s plenty of other issues that I need to address regarding home ownership too, but I’ll leave those for another time.

    • says

      If you can build income streams that can eventually cover your rent, then go for it. It depends on your age as well. If you’re over 60, it might be better to just rent.

      Also consider the speed of rising rents/inflation vs your income stream creation growth.

  12. says

    We are definitely bullish when it comes to real estate. However, I like to invest in things that I understand and am comfortable with. We own two rental properties at the moment with plans to add more in the future. I wish now was a better time for us to buy additional rentals since things aren’t really moving in my area and interest rates are still so crazy low!

  13. Mitch says

    I really like the Ten Reasons you listed for home ownership. Be it land or a second home, over the long term they have always been a reliable asset in ones portfolio.

  14. John says

    Based on your QE infity comments and the fact that rents would increase; do you still favor an ARM over a fixed mortgage?

    • says

      QE shifts the money supply curve to the right, leading to a decline in interest rates. The output gap is sufficiently wide so I don’t believe there will be beyond normal 2-3% inflation for a while.

      Yes, I still believe one will save money over the life of their homeownership with a 5/1 arm. Median homeownership duration is only 6-7 years too. If that is the case, then one will most certainly save.

  15. says

    Sam, I firmly believe in real estate. There is a money in real estate properties either short term or long term. Yes, I am bullish with this kind of investment that is why last year I bought condo property and lot property.

  16. Andrew @ Listen Money Matters says

    So I’m just about to close on my first place after being against realestate to the core for sometime. I’m buying into about half of what I can actually afford with the thought that I’ll get a second mortgage down the road on a new place and rent this one out. Am I crazy for not just taking all the free money that I can (nothing interest rate) and getting a second place now to immediately rent?

      • says

        Isn’t your return on investment higher if you mortgage it?

        Let me give you my case:
        Price: $321k
        Down payment: 20% ($64,200)
        Mortgage: $256.8k
        Interest rate: 3.375%

        The place is kinda dumpy (in NYC area) but rented previously for $1,900 a month. I think with roughly $15,000 worth of improvements I can rent it out for $2,500 (it’s a 2 bedroom).

        Based on my mortgage rate, down payment, taxes (very low surprisingly) and condo fees my monthly payment is a hairs breath above $1,500. That gives me a rough profit of $12,000 a year on a layout of $79,200. A return on investment of roughly 15%.

        If I were to pay the entire thing (with no mortgage) I would have a base spend of 321k and a yearly profit of $30k. That would put my return on investment at roughly 9%.

        Am I missing something? It seems to me that the low rates make it extremely attractive for those of us who have a solid income to leverage up to generate more income.

  17. says

    I love real estate. Undoubtedly, it is the easiest way to riches. I have a friend who buys fixer upper and lives there for few years to avoid capital gain. He is single, and works from home. So, he can move anywhere in the country. The fellow now lives in a million dollar home after selling 4 different houses in last 10 years — way to go!!

  18. says

    Real Estate is a big part of our plan for financial independence. I’m not sure that we will replace our current incomes solely with rental income, but it will be a pretty good percentage of our passive income for when we give up the day jobs.

  19. JayCeezy says

    Lots of bullish sentiment for real estate on this thread. There is very good reason for it, in SF and NY. My guess is not too many FS readers from Detroit, those impacted by Hurricane Sandy, or San Bernardino County.

      • JayCeezy says

        Sam, you are not missing anything, and I don’t think you miss anything, either. Both NY and SF have limited land, are great places to live, visit and be, and most importantly have an abundance of highly-compensated jobs. (Not too many $250,000/yr jobs in S. Dakota)

        Places like Detroit (where jobs have been outsourced, offshored, relocated, and dislocated for decades) have homes that have been abandoned for back property taxes, and are available for $1. San Bernardino County has practically unlimited land, and a drive along the 210 past Riverside towards Palm Springs is an illustration of what easy money to builders, govt. incentives, and subprime lending produces…tens of thousands of abandoned home sites. Nobody paying taxes on any of it. Municipalities obligated to provide services that aren’t paid for. Underwater mortgage holders walking away. Personal, corporate, and finally county and city bankruptcies. Disaster areas (Arrowhead after a forest fire, Sandy, Galveston, New Orleans, Avila Beach after Chevron oil remediation) may be built up nicer than they were, but the insurance rarely covers the actual cost, let alone the PITA factors. Renters walk away.

        The nice thing about being an ‘investor’ who is retired, such as yourself, is that you have flexibility on what, when, and where you buy. Things happen in life (job loss, divorce, etc.) and Real Estate is great when times are good, there is money in the bank, and a surplus of qualified buyers (i.e. NY and SF). I have seen a flip side to the market (15 years of decline in the Los Angeles South Bay, after the aerospace bust and the fall of the USSR). It is ugly and costly, and leverage works both ways. Getting in is easy (often when sentiment is bullish), but getting out is hard (even more painful/costly when it is forced by circumstances).

        Personally, I have both made and lost money in RE, and am ‘neutral’. A paid-off home is the equivalent of a risk-free return on whatever the mortgage rate would have been, frees up cashflow, and pays a psychic return. Myself and family members have sold homes in the past few years, always disappointed with the selling price. The sentiment on this board seems to be from entry-level people on the buying side. For those who would like a concrete illustration, pick a property on Zillow, and go to the graph showing ‘home value’ over time; you will see price changes in both directions that are shocking.

        All your reasons listed are very good ones for building equity over time. Life is long, and it would be nice to have something to show for it after a period of time.

        Just curious, what reasons are you finding for people selling in the Bay area?

        • says

          Thanks for your insights JC! One of the biggest thing that annoys the hell out of me is the monopoly pricing on real estate commissions. 5-6% is outrageous, especially for higher price locations such as SF and NYC. I am for a flat rate, or scaling flat rate, and that’s it. Why does it cost $50,000 to sell a $1 million condo in SF? It shouldn’t.

          The reasons I hear from people selling in the Bay Area are:

          * Divorce
          * Trading up to a bigger house
          * Empty nesters
          * Sick of being a landlord

          Of course there are probably those in dire straits, but those stories are not told to prospective buyers for obvious reasons. I would not be selling now. Life is short, but if you have enough life, than sellers will kick themselves in the head 10 years from now. BTW, if you would ever like to share your financial advice or story on FS, please feel free to let me know. I always enjoy your insights and I think others would too.

  20. says

    I am a home owner and my home is and will continue to be the largest part of my retirement plan. I plan to sell it and live on the proceeds for about ten years. I do not know exactly ten years I will need the money for but it will be the time when I can no longer live alone or when I need special care.

    Being bullish on real estate is not for me because I am not handy and if anyone ever called me in the middle of the night and told me their toilet wasn’t working I would give them directions to the nearest 24 hour gas station.

  21. says

    I like your point of reference to the stock market with these real estate examples. It definitely made it easier for me to understand and I agree. With low interest rates and all of this QE I agree that it is inevitable we see a huge bull market in real estate. My only concern is that when inflation starts to get out of control the federal reserve with raise rates which in turn SHOULD lower home prices since buyers are predominantly concerned with the monthly mortgage and not the price of the home.

    • says

      The Fed and other Central Banks have made publicly stated they won’t be raising rates until 2014 or before unemployment goes below 6.5%, and we should believe them.

      With 7.7% unemployment, there is too much slack in the system to see inflationary pressure imo.

  22. Rowhoss says

    I am in the negative real estate category! I am active duty military, so I have moved around a bit and never been a homeowner. I have a fresh opportunity where I am moving to Hawaii for at least 4 years. I may have a chance to do a consecutive tour there adding my total time there to 8 years but its not guaranteed.

    What is a man to do? I don’t want to be in the negative category no more. Should I grab a nice SFH or condo? It is just me and my wife. I can use my VA loan which requires zero down. I am afraid of taking a loss when I leave. I could try to rent it out since most military members do not buy. I think renting it out to peers would be fairly easy.

    I am a noob to your blog but it is on point! Look forward to more reads.

  23. says

    I’m very bullish on RE. The first 6 properties we bought were rental properties and we have finally bought our long term house. I love RE because it is easily leveraged and risks can be mitigated.
    The risk taker in me wants to continue buying highly leveraged properties but instead my conservative side is forcing me to diversify in entrepreneurship.

  24. Jason says

    do you have any views of what will happen to real estate prices if interest rates increase in the coming years? i’ve noticed a big theme of your posts revolve around refinancing to lower rates, but surely rates can go up as well if the economy continues to recover.

    thank you,

    jason

    • says

      Rates have been coming down for 30+ years in a row. They could rise, but I don’t think by more than 2% over the next 5-10 years on all mortgage durations.

      Rising rates means stronger economy, higher inflation, higher real estate prices. I’ll take it. In real estate, you are hedged both ways if you hold on long enough. Compare to renting over 30 years. You’re only losing with higher rents/inflation.

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