Investing in real estate can be both profitable and enjoyable. Whether you are hand-picking your primary residence or investing in a speculative or rental property, a lot of money can be made by astute investors. However, as with any investment, there are plenty of risks involved in buying real estate.
As of mid-March 2021, there are many macro- and microeconomic factors in play that could make buying real estate a risky endeavor. Beyond these near-term question marks, there are some long-term, inherent risks to buying real estate that may give some investors pause. Before you take the plunge into the real estate game, consider whether these 10 factors outweigh the potential upside you may see in your purchase.
Supply Is Limited
The available supply of houses dropped by more than 48% over the past year, according to Realtor.com. Not only does this drive prices higher, perhaps even more importantly, it means that what you want may not even be available. So, that leaves you in the position of either buying something you don’t really like – and paying a premium price for it — or waiting for a better opportunity to get what you want. It’s never a good idea to feel rushed into an investment, so don’t be afraid to step back and think twice before you invest in this real estate market.
Prices Are Skyrocketing
In the first three to six months of 2020, home prices cratered as the coronavirus pandemic drove the economy into a tailspin. In retrospect, that might have been a good time to step into the market. However, since then, housing prices have exploded. Although real estate is generally regional in nature, prices went ballistic nearly across the board, in some cases making double-digit percentage moves in a matter of months. Overall, median list prices in February 2021 were up 13.7% over the prior year.
If you’re a believer that prices generally regress to the mean, it might be a good time to wait out this price explosion, which some observers are referring to as a bubble.
Inflation May Be Coming
In response to the coronavirus epidemic, both the Trump and Biden administrations injected massive stimulus money into the economy. The most recent legislation, a $1.9 trillion stimulus package, is the largest government spending bill in history. Many economists feel that all of this excess capital flowing into the economy will trigger inflation. Coupled with a likely pickup in consumer spending as the pandemic recedes, some feel that inflation could move up sharply.
While a slowly rising inflation rate can often be a tailwind for housing prices, when inflation spikes, it generally hurts all capital markets, including housing.
Real Estate Is Not Liquid
Although real estate can provide solid long-term returns, it is one of the least liquid investment markets there is. While you can liquidate a stock in a nanosecond just by entering a trade with an online broker, real estate typically takes weeks or months to sell. If you have an urgent need to pull out the money you’ve invested in real estate, you may have to lower your price to fire-sale levels to move things along more rapidly. In most cases, this makes real estate an inappropriate investment for short-term investors.
Real Estate Carries Extra Costs
Buying real estate isn’t as simple as agreeing on a price and handing over the money. There are numerous additional costs involved in real estate transactions that make it hard to profit over the short term.
For example, in addition to the purchase price of a home, you’ll have to pay a host of additional fees, from title insurance and home inspection fees to property taxes and lender costs. All told, the final cost of your transaction may be 5% or more than the sale price — and that’s before you invest any additional money to change, upgrade or repair the property. If you plan to sell the property in the future, your closing costs will likely be even more, as they average about 8% to 10% of the value of the transaction.
You May Not Get a Deduction
One of the often-touted benefits of buying a primary residence is that you can deduct your mortgage interest on your taxes. However, this only applies to taxpayers who itemize their tax deductions. With the near-doubling of the standard deduction in 2018, the standard deduction became quite generous, to the point that in tax year 2018, only about 10% of taxpayers itemized their deductions. For tax year 2020, the standard deduction for joint filers is a whopping $24,800. What that means is nowadays you’ll need a pretty substantial mortgage if you plan on deducting your mortgage interest.
Returns Can Be Market-Specific
Although to some degree the rising tide lifted all boats in 2020, in most cases, real estate returns are very market-specific. Remember the old adage that the three most important things in real estate are “location, location, location”? If you’re an investor, this is a pretty accurate statement. This means that you can’t simply buy random real estate thinking that “real estate always pays off.” Just as if you’re buying a stock, you’ll have to analyze the property you’re considering buying to determine if it has a chance to outperform.
Everything from state politics to weather patterns, demography, school districts and crime statistics go into determining what makes a good real estate investment, and it can take a professional’s eye to factor in all of the relevant elements.
Your Purchase Is Highly Leveraged
Most people think of housing investments as safe, consistent and reliable, but in reality, buying a house is a highly leveraged purchase. The traditional, “conservative” recommendation to put down 20% when you buy a home means that you’re borrowing 80% of the value of your house. If your home price drops by 20%, it doesn’t mean that you’ve lost 20% of your investment, it means you’ve lost 100%!
Think of it this way — if you buy a $100,000 house and put down $20,000, you owe the remaining $80,000. If that house drops in value by 20% to $80,000, you could sell it and pay off your mortgage but you’ve lost all of your initial $20,000 investment.
Some loans are even more lenient in terms of a down payment. FNMA offers a 3% down mortgage option, and the VA offers a 0% down home mortgage. In these cases, you’re even more leveraged. True, leverage works both ways, and you stand to gain a similar amount if your home appreciates. However, many people don’t understand how putting down a small amount of money magnifies their leverage.
Pricing Is a ‘Best Guess’
Unlike the stock market, where buyers and sellers actively provide real-time market prices, real estate pricing is opaque. Although you can use the sales transactions of similar properties in your neighborhood, known as “comps,” to estimate the value of your home, the real value is what a buyer will pay for it. This can be a complete unknown until you actually put your home on the market. Online real estate services provider Zillow is often used as a reference for home prices, but actual sales can be far above or below the “current market pricing” offered by Zillow and other providers. This adds another layer of complexity and difficulty to real estate investments.
Investment Properties Require a Lot of Work
If you’re intending to invest in real estate for the rental income, you should know going in that it’s not as easy as it may sound. Yes, if you can consistently rent your property you can earn more than your mortgage payment, but the entire process is much more involved.
For starters, you’ve got to find a tenant who’s willing to pay the rent you require. Once your tenant is in, you’re on the hook for maintenance, repairs and any complaints your renter may have — which often seem to come in the middle of the night. If you’ve got an unruly tenant or one who consistently pays the rent late, you may find that it’s more difficult than you imagine to get them out. Investment properties for rental income can be lucrative, but all the work involved means they are not a good fit for everyone.
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