Tuesday, May 13, 2014

Investment Properties, Indexing, and Use Value

Investment Properties, Indexing, and Use Value
Before diving into the post, I need to apologize for not writing more often and for not reading the posts that you all have written. I swore I wouldn't be the type of blogger who would start out posts that way, but here I am. I've been in a funk the past couple months with Mrs. Done by Forty still abroad (off and on since September), and it is finally catching up to me. I'm a bit depressed. It is impacting a lot: work, health, and writing, of course. Trying to just snap myself out of it has proved to not be effective. Despite my best efforts, I have turned into a sad little monkey. Still, I'm trying to find ways to improve my mood, and that will hopefully improve my writing frequency, too. Thanks for your understanding!

Along with an unseasonal amount work, a new project has been keeping me busy lately. The missus and I are in the process of buying our first rental property, the cutest little single family home a couple could ask for. We are working through a turnkey company, which basically finds a potential rental property, renovates it, sells it to an investor (at a profit), finds a tenant, and then acts as the property management company (for a percentage of the rent). We learned about this type of investing from FI Fighter, one of the really good dudes in personal finance blogging, and we're drawn to the light touch approach. Why would a frugal DIYer outsource all of that? The main reason is that Phoenix property values have skyrocketed since 2011, and the numbers look better elsewhere. The rub is that I have no interest in flying out to other parts of the country a half dozen times to find a rental, or in managing a long distance renovation from Arizona. In steps the turnkey company, and we get our one-stop shop.

Still, the process has not been without its snags. I negotiated hard on the first property, getting concessions on price, closing costs, and waiving fees for putting tenants in place. But then there was an issue with the title, and the deal fell through. A new property was suggested, but it only had one bathroom. We were set on a three-and-two, so we went back and forth on how to put in a second bath, and how much of the costs we should bear. After finalizing that, it turns out the taxes were re-assessed, and they doubled, due to it now being an investor owned property. Problems abound, and we haven't even started being landlords yet.

All that said, we're still moving forward with the deal as we think it will still provide good returns. But I was driving home from my mother's this past Sunday, a dull six hour trek from the mountains in California into the desert of Arizona, when I got to thinking. Why is it that I'm so set on owning rental property in the first place? We are basically index investors. We buy index mutual funds because they're diversified, they have low fees, and the strategy is bound to beat active investing over the long haul. We can dollar cost average to avoid trying to time the market. We can rebalance regularly to keep in line with our asset allocation. The strategy of index investing acknowledges that we are not so smart. When it comes to actively picking particular stocks, and when to buy or sell them, I'm subject to a variety of logical fallacies. The way to win at active investing is to not to play in the first place. So why is it that I'm actively investing in real estate?

Buying a piece of property is a bit like buying a single stock. One house is unique from every other, so you try to buy the best value or best performing one. As such, a house or a condo is not diversified: you are not buying the neighborhood or the market at large, but a single asset you're hoping outperforms the other choices available. The process of evaluating a property looks a lot like the fundamental analysis of a company stock: you look at its historic value, the property's costs and predicted revenues, and make predictions about future returns. Worse yet, there might be a little timing of the market involved, too, as we try to buy while the local housing market seems well priced (ignoring the possibility that prices may drop in the near future). We can't dollar cost average since, well, we can't afford to buy a new property every month or two. We can't rebalance, either, since we can't sell off just a piece of the house to bring us back into our desired asset allocation.

Considering all these contrasts with our core investment approach of indexing, I've got to ask why we'd buy rental property at all. Or if we like the idea of real estate being part of our portfolio, ought we just buy a REIT index like VGSLX?

Mrs. Done by Forty points out though that owning property provides some important things that paper investments do not: they give us something tangible. No matter how poorly the property investment turns out to be, we (or someone) can always live in it. In other words, a home has a use value and an exchange value, while paper investments only have the latter. Besides the fact that you can sell it for money, a stock investment doesn't have any real use or value. A home has tremendous use value: it gives shelter from the elements, a place for children to play in the yard, space for a garden, and all the other comforts of home. It's hard to quantify that use value in dollars of course, but we'd do well to remember the benefits of having a roof over our heads. On top of that, there's the fact that we intrinsically want to own property, so we will save at a greater rate to achieve that goal. On the other hand, I have to twist Mrs. Done by Forty's arm to invest in the stock market at all. So there's some unknown (but real) delta between the scenario in which we save because we really want something (a cute house we can rent), and when we save because we know we ought to (investing in index funds for retirement).

As usual, I have a question more than I do a point. What do you readers think? Are we being inconsistent with our investing behavior? Should we just avoid the headaches of owning property, the negotiations and lending hoops and never-ending problems that landlords must deal with, buy a REIT, and be done with it?


*Photo is from krystian_o at Flickr Creative Commons.

52 comments:

  1. I was just wondering about you today! Glad to see you're back, but I hope the funk passes soon. I've been in a bit of a rut myself, but writing and commenting around helps.

    I'm not yet at the investment stage, but I'd like to own rental property someday, too. I've also heard good things about REIT's, but I think if a rental property is what you want to go for, try it! I like the point Mrs. DB40 brought up as well.

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    1. Thanks, EM! The funk, like everything, will pass in time.

      I think the individual properties will be the path we follow, optimal or not.

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  2. Good luck on the rental property. If you want any advice, or run an idea past, let me know. Especially when you get tenants...

    I am getting ready to pick up another unit myself. I should know more in a week or so. It should add another $1500+ per month to my cash flow.

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    1. Sheesh, I need to have a chat with you about buying up north where you are. That's an impressive number!

      I would love to have a chat sometime...will shoot you an email.

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    2. I will look forward to it. I look for a 12% cash on cash return, 8%+ cap rate, and 1.6+ Debt service ration. The latest one will blow those numbers away. As soon as I have it locked up, I will have a post about it. And in a solid area too.

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    3. Very cool. I'll look forward to that post (and just sent you an email via your site.)

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  3. I think a lot of the headache lies in the turnkey premise. Part of the property owning is knowing and having something tangible. With what you're talking about, you own a house in Somewheretownport, USA, but you're never going to go there. You're never going to see more than a few pictures. You're going to give them some money, and, hopefully, they'll provide a steady stream of it back to you. Indefinitely. You want something you can literally touch. A property you can manage and control yourself. Though the numbers might not work out as well as you'd like in Phoenix, might the cost be outweighed by your simple desire to own and manage property? Or, can it wait until you're in a place where the numbers work out? Otherwise, like you said, you can get fairly consistent 7-9% gains with index funds, which is either the same as or marginally/slightly less than rental returns from what I understand. You're a smart guy, Mr. DbF. You'll make it all work. Cheers.

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    1. Maybe. We will surely visit the property some time, and we're buying under the premise that we might move in to the house some day, too. As you know, we're not long for Arizona. We're looking at some other cities with the same idea in mind: one day, either by choice or by circumstance, we might live in the property we purchase. Or not.

      Still, your point about losing at least part of the tangible aspect is a good one. It's certainly good to be able to reach out and touch the bricks.

      As for buying in Phoenix, I doubt that's in the cards. The prices have climbed and the rents haven't plus, and this is the key bit, the missus doesn't like the idea. We already own one property here and she thinks that might be one too many. :)

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  4. I know a lot of people in the FI community are big on real estate because of the cash flow, but to me buying properties and landlording sounds too much like work. It'd be a part time job that I wouldn't enjoy.

    I just threw some money into VNQ and called it a day.

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    1. I think there's a lot of wisdom in what you did, Reepekg. There are many ways to get money...knowing which ones don't fit your approach is half the battle.

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    2. I second Reepekg.

      We've had three rental properties for 7 years now (sold one a few months ago). At this point, I hate nothing more than tenants.

      I also think people skew their supposed real estate returns to solely reflect the set monthly cashflow (rent minus mortgage - lucky if they include insurance or other fixed expenses) or based on the appreciation of the property itself (sale price minus purchase price), but these things don't take into account a lot of different factors. Like the pain of replacing tenants (a gamble every time), the headache of going after late rent and fees, cleaning and showing the property, maintenance expenses (the washer or the fridge always go out when you're headed to your anniversary dinner reservations), and the opportunity cost of having your money literally locked up in a real asset.

      Beyond all that though, I think many of us landlords or would-be landlords underestimate the stress of knowing that at any given moment, a stranger you invited into your life can drastically negatively impact your investment and your peace of mind.

      We are going through our first UGLY eviction and we will sell at all costs as soon as we finally get the scum out of our property. Attorneys, court, police, and locksmiths are really anti-zen. Plus, eviction attorneys are just as scummy as the tenants you're trying to remove.

      Good luck in weighing your options. Everyone is different. I prefer the long-term sense of security in diversified mutual funds.

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    3. That's a helpful perspective, Emily. I very well might be having the same view once we're actually managing a property. We rent out a room now and kind of enjoy it, as we do the easy money, but it's different when we can keep an eye on the tenant all the time.

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  5. So our timing is pretty much in sync. I recently closed on my first turnkey rental property, with the help and advice of FIFighter. The OPPORTUNITY that exists in real estate is much higher - that's why it's worth looking at.

    So I definitely plan on keeping the majority of my investments in index funds for now, but unlike the stock market, you CAN win with real estate and you CAN beat REITs (through cash flow and building equity). If there were a more diversified way to do that, I'd be all over it, but for now turnkey seems like the best option for me.

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    1. Well put, Dave. While it's folly to try to beat a stock index mutual fund (unless you're Warren Buffet, I guess), it doesn't seem nearly as rare to outperform a REIT.

      Just to play devil's advocate though, are those real estate investors who do beat the REIT just lucky, like the active investor who made the right picks out of sheer chance?

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  6. Hugs to you, my friend!!! Rick is a huge fan of owning real estate too, because as Mrs. DB40 pointed out, it's tangible. We will definitely be looking seriously into real estate investing once the debt is gone. After all, everyone needs a place to live.

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    1. Thanks for the hugs, Laurie! I might be overestimating a home's use value, but I think there's something there. I can't put it into the right words though. When the asset you have becomes worth a lot less...there's something incredible about the fact that it's the exact same home, keeps you just as warm, and possibly gets you the same rent. Stocks, bonds, even cash...when their exchange value plummets, there is not a whole lot you can do with them.

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  7. Like you, we are basically index fund investors. I don't like researching individual stocks or all of the ups and downs.

    However, we also own two rental properties. They'll both be paid off in about 12 years (We'll be 46) and at that time we'll have around 2K in additional monthly income. The entire time, the rental income has paid the mortgage and then some. We're only out our time, stress, and initial investment. You really can't beat it.

    Why not do both?

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    1. I'm in a similar situation with the 2 rental properties, any reason you cannot do both?

      I also think the rental vs stocks depends on how much you plan to be reliant on your investment income in FI. I plan to use my rentals as a bulk of our income in retirement and use only a little if any from our stock investments(I'm hoping not to touch and just let them grow).

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    2. Holly: we'll definitely be doing both. My question (and I did a crap job of explaining it) was whether we're better off buying a REIT instead of a single property. That is, since we agree that indexing is the right way to buy stocks, are we being inconsistent when we don't take the same approach with property (i.e. - buying a REIT index to broadly buy the market, instead of one asset)?

      Even Steven: I agree that we should do both. Stocks are a big part of our investment plan, though I'm probably way too heavy in property as it is.

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    3. Hmmm....I don't know. I don't own any REITs to be honest. I prefer buying real estate that I can walk into and see and possibly live in during our retirement. I don't think you could really go wrong either way!

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    4. We like the tangible aspect, too, Holly. I think that's the deal-maker for us.

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  8. I'm sorry you're in a funk DB40 and I hope you can come out of it soon.

    We're torn on this question too. In some respects we can't be bothered with the hassle a rental can bring, but we're also unsure about the stock market. That isn't much help to you is it?! :)

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    1. Thanks for the kind words, Laura. Like they say, this too shall pass.

      We feel the same dilemma in where to put our investment dollars. (First world problems!) Our answer isn't a good one: we just invest in both. ;)

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  9. I've been wondering where you went...hope you get out of your funk! I've been thinking the same thing as you. Why not just buy REITS? But I understand that owning property is much more tangible, but probably comes with more risks. I've thought about buying rental property outside of NYC because it's too expensive here (though some argue that I should buy here cause the prices keep going up). In any case, I think that Mrs. LRC will be happy if we buy a rental property yet continue to rent. So first things first...need to buy a house...I mean co-op.

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    1. Thanks, Andrew! It's good to be missed.

      I've often thought the best approach is to be a renter while having some of your own. You get the advantages of owning property that is an actual investment, while you get the controlled costs and low maintenance approach of being a renter yourself. Throw in a great city like NYC, and what's not to love?

      I'll forever envy that you live where you do. Maybe one day we'll work up the chutzpah to give it a go and move to the Big Apple.

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  10. Sorry to hear you've been sad without the Mrs., Mr. DbF! That's definitely a challenging situation for both of you, but I hope the summer breezes by for you so you can be reunited with her again. I kind of think just because you invest one way, doesn't mean that that's the only way you should invest. You're trying out different things and see what works out - I think those are the best and interesting kinds of experiments!

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    1. Thank you for that comment, Anna! I'll actually get to see her in less than a week! (Don't tell...that's the surprise subject of my next post.)

      We're going to take your good advice and try both, I think. And maybe wait a few months before buying another just to make sure we aren't going down a path we don't like.

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  11. Hi DB40, great to see you pushing through and getting another solid post up!

    I think it really comes back to your own ‘why’. What’s your main goal? If it’s just early retirement, then is adding a rental property the best way to get you there? Will it work for you, based on your own skills, strengths, personality, or are the headaches not going to be worth it for you personally, and your quality of life? Or is your goal to step outside your comfort zone and keep trying and learning new things? Or would you rather put your time and energy towards something else at this point in your life?

    Sorry to respond to your question with a whole bunch of other questions which I’m sure is tremendously helpful, but like most things in life, you’ve got to figure out what’s right for your unique situation. Things that work fantastically for others just might not suit you one way or another. But luckily there’s lots of great wisdom and experience around here from your friends to help you think out loud and test your ideas ;)

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    1. Thanks for the encouragement, Jason. Your email meant a lot to me, and it's sincerely appreciated.

      Like you noted, some answers need to come from within. It's the hard approach, but the right one.

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  12. How did you find the turnkey company? Every site I look at seems so damn scammy offering ridiculous returns...so much so all I can think is why don't they just invest their own money and cut out me! Also, how do you know if they are selling you a good area. For example, the town may be good when you google it but you don't know if 2 blocks over is garbage. How do you overcome that?

    I am going to have to disagree with Mrs DB40 though. Her point makes sense for your main residence, but not an investment property. If the home is 2200 miles away from you what REAL use value does it bring to your family?

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    1. We found the turnkey company through another blogger. As for the neighborhoods, we tried leveraging our network (people who knew the area) and did the best we could. There's certainly a degree of risk involved.

      Re: use value, I see what you're saying, but a property (or any other useful asset or natural resource) still has a use value even if I'm not the one using it at the moment. I think of use value as something that's related to (but is not the same as) an exchange value. That inherent use value is what gives a property the potential to rent, even if the property's exchange value had declined dramatically. Even at 10% of its original purchase price, it still has the same ability to keep your feet warm and your stuff dry. And if circumstances dictate, sure, we could move into the house. It's just one more option we have available.

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  13. Surely the number one reason to invest in property is that you can leverage the deals via a mortgage, thus increasing your cash on cash returns immensely? (I am assuming you aren't just paying for the property outright?)

    I'm fairly certain you can't get a low rate loan to invest in the market, and even if you could you'd be pretty insance to do so (IMO).

    Sad to hear you are feeling down DB40... "chin up son" as we say in the UK!

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    1. Thanks, FIREstarter. Leverage is definitely a key benefit (and risk, of course). I suppose I could take out a home equity line of credit or a cash-out refinance and then put it in the market. Here's a tricky question though: why does that seem more risky (i.e. - taking out a $100k loan to invest in a diversified index fund) than taking out a loan for a single rental property?

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    2. Exactly... I think technically it's probably not.

      I think the main psychological difference is that if everything went totally and utterly tits up, and the stock market crashed to say... I dunno, 20% of what it is now (very unlikely of course), now obviously house prices would crash as well but at least you have some bricks and mortar to sell or rent out still at the end of it. Like I said though it's probably no less risky, as if that would happen you wouldn't be able to pay the mortgage and you would be totally screwed anyway. But then I guess the world at large would have bigger problems for the market to crash that much anyway!

      I think the key point for us in the UK is that the HELOC is very hard to get over here, unless you can prove you are using it for home upgrades, or if you are in the rental property business, then to buy some more properties.

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  14. I have a rental property, not out of wanting to be a landlord, but out of necessity (our place wouldn't sell when we moved). I am in the process of wondering a lot about buying and there have been lots of income properties that piqued my interest. I know I'm just playing right now as I won't realistically buy, but it is tempting. One set of duplexes had rent on one half that covered the mortgage and property taxes. Too bad when I drove by the foundation looked super sketchy.

    Also, I'm in a funk too. And my partner isn't on another continent. I can imagine it gets to you. I hope you feel better soon!

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    1. Thanks, Alicia! I am visiting my wife in a few days, so I'm sure that'll help my mood quite a lot!

      That duplex strategy sounds awesome, if you could find the right neighborhood. We'd love to try that out someday.

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  15. Well, I have no thoughts at all on the rental property, except that having someone else manage the thing sound like the way to go. I've heard enough horror stories about dealing with tenants to scare me out of that gig completely.

    Anyhow, just wanted to say that I'm sorry you're feeling down in the dumps. It must be so hard to be away from Mrs. DBF for such a long time. I always find that exercise helps... well, that and a lot of tequila! Hey, you could always go adopt a kitty or two... there's nothing like a purring cat on your lap to cheer you up! Hope you're feeling better soon.

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    1. Thanks for the nice words, EcoCatLady. I need more exercise, and more booze, too. I think there's an idea for a new sport in there somewhere.

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    2. Margarita relay races, anyone? :-)

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  16. This too shall pass! Sorry you're in a bit of funk. Hopefully, your outlook will improve soon. As for the rental property, think like 700 times before doing it..lol! But then again, you might get lucky and have no headaches . We have had more than our share and have gone from 7 down to 3 rental properties, and hopefully will be unloading 2 very soon. Not for us anymore, with the hassles etc..good luck with your decision. I do know that if you're not hands on, it's not so good. The management companies make the money, they use workers that overcharge etc..etc..most are not there to make you money.

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    1. That's a perspective I hear a lot: that after managing properties for a while, it's not everyone's cup of tea. I suppose we'll find out soon enough!

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  17. First of all, sorry to hear you are in a bit of a funk. That seems to be a common theme going around the PF blogging world lately. I'm not much of an investment expert by any means, but it seems like a good idea to diversify. I hope it all works out great for you!

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    1. Thank you, Tonya! I agree that the funk seems to be going around these days. Maybe it's contagious!

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  18. Investment properties can be paid off by renters, with tax shelters to shield you from the gain. You could conceivably live off rental income and pay no taxes thanks to depreciation.

    No one will give you money every month to index invest. I think I caught your funk.

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    1. Sorry the funk got contagious, Charles. Leverage is definitely one the unique wrinkles in real estate, and the tax shelters are pretty sweet too (though that depreciation does have to be paid back eventually, right?)

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  19. So this is from a real estate virgin, so take it for what it's worth. I'd feel comfortable with doing the rental properties if it were something that I had lived in for a few years and then grown out of. I don't know that I personally would invest in an individual property for the sake of investment. I'd feel more comfortable in an REIT. But that is strictly because of my comfort level. Not because of any real financial reason.

    I hope things start getting better with that funk! It really sucks that she's so far away. It cannot be easy. It will end, though! She'll be back soon!

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    1. Hi Femme Frugality! Mrs. Done by Forty and I are back together now, for a couple weeks, so the funk is definitely gone. :)

      I hear you about the comfort of knowing the property & market for a few years & then converting to a rental. That may end up being the route we go with on our first home.

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  20. I realize I'm late to the party, but here's my two cents.

    First, let me start by saying that I have 0 experience with rental property. That's probably important to take into consideration.

    With that said, there are reasons I've stayed away from it so far. I'm not going to argue that my reasons are right, but here they are.

    First, like you mentioned very clearly, it immediately undiversifies your investments. If you do it well, that can mean huge returns. If you don't, it can mean big losses. Same as picking stocks. Diversification is too valuable for me to give up without some serious confidence.

    As others have mentioned, real estate has the potential to be a huge time commitment. Both on the front end in terms of researching properties (which maybe you've figured out how to bypass for the most part) and on the back end in terms of maintenance. Sure, on the good end of things you'll find good tenants who require little work. But that certainly won't always be the case. I think that time commitment needs to be factored into the return calculation.

    Just like with stock picking, my sense is that there's a strong bias towards only hearing from people who have success with rental properties. That is, how many blogs are continually broadcasting their failures with real estate? Chances are that the people with negative stories by and large aren't sharing them, while the people with positive stories are more than happy to broadcast them to the world and teach everyone how to do it. I would be careful about being seduced by all the positive stories out there before thinking hard about this kind of selection bias.

    I haven't really run any numbers on this, but I feel like the use value you're talking about is overrated. Yes, someone can always use it for shelter, but that doesn't make it a good investment. And you can't use it for shelter unless you decide to sell your other home, which may or may not be a good financial decision. If you're talking about a primary home, then the use value is higher. But for a rental property? I'm not sure.

    Now, obviously rental property can be a good investment if it's done right. Just like picking individual stocks can be. But personally it's not something I would jump into unless I was very, very sure about what I was doing. But I'm also in a different place than you. I have two kids depending on me and I'm not anywhere near as close to financial independence as you are. So you've got a bigger margin for error, and that could certainly be a part of the equation if you want it to be.

    In any case, good luck with the decision! I'll be interested to hear the results either way.

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    1. All good points, Matt, and I won't try to dispute them here. The only one I'd want to clarify is the use value: it might not have a great use value for me in Arizona, but the use value still exists (in this case, for a renter). That is to say, if my stock value goes down 90%, then it really has no value except for its exchange value. If the rental property goes down in value 50%, presumably its rent value might not in any way be correlated to that (and possibly could be unaffected by a drop in price). A long way of saying: it should still have some value to someone to use & rent.

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  21. I think what you are doing is great. I'm trying to do the same thing with my saving (mixing stocks and real estate) and have asked myself the same questions. The opinions I have come up with to support this behavior include:

    1 - The iliquidity involved in buying individual single family homes keeps away most REITs and is really only accessible by direct investing. That means you can only diversify your portfolio in this way if you jump in!

    2 - I think that the iliquidity and the work involved in investing in single family homes means that you can expect slightly higher returns than in the stock market which is soooo much more liquid. With fewer investors competing in the market, due to the extra work, the returns can be higher.

    3 - It is easier to leverage up when you buy a home then with stocks and the rent income helps secure you from default better than dividends do for stocks bought on margin.

    4 - For whatever reason I do not understand REITs still seam to be highly correlated to stock market movement. However, over the past 10 years the rents I've charged have never fluctuated other than slowly creaping up with inflation.

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    1. Thanks so much for that comment, Brett! I have a lot of the same thoughts when it comes to real estate -- I think the good deals have the potential to become great as rents rise and, in the long term, when the mortgages pay off. Shoot me an email sometime at donebyforty@gmail.com if you ever want to chat more about real estate.

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