So you want to invest directly in real estate, and buy a house to rent? Good plan: have the tenant pay off your mortgage, and you end up with a real asset that’s worth quite a lot of money. But what kind of investment is it–in other words, what’s the effective annual rate of return, compared to an index fund, for example? Consider an example: Nice house bought for $150,000. To avoid PMI, you put down 20%* or $30,000, and pay closing costs–this is your initial investment. Your monthly mortgage, plus escrow payment is $1,100 and you rent through a property management company for $1,100 a month. Your actual income per month is lower than $1,100 because you pay a management fee, and there’s some maintenance, and maybe you pay the water bill. You pay tax on the income, but you get a deduction for the mortgage interest paid. You’re out about $200 per month after all this.
Over a 15 year period, the house might be empty a few months which increases your costs, and lowers your income, property taxes rise over time, as do fees, but hopefully maintenance remains about the same. Let’s say it ends up costing you about $40,000 net over the 15 years. (Remember you have to rent for quite a bit more than your monthly payments to avoid any of this loss.) After 15 years you’ve “invested” $70,000 in the house. If housing values rise by 3% per year (note this is about the rate of inflation, so the real value of the house stays constant) then your house is worth about $235,000. The gain is $165,000 which represents about 8.4% return per year. This is quite comparable to the long run annualized rate of return of the S&P500 Index at around 9%.
Investing in this house is about as good as investing in the stock market. But there are a lot of variables, including the initial equity, rental rates, maintenance costs, vacancy rate, the housing market in the future, when you want to sell the house, and of course, what the stock market is doing at that time. Many people have made money investing in real estate, but many have also done poorly, and could have done better by investing in the stock market.
* If you put less down on deposit–to leverage your investment more–you end up paying PMI, and borrow more, so your monthly payment is larger. Your monthly loss will be higher, so your total cost over 15 years might not be so much less than in the example above. It’s not obvious that less initial equity leads to a higher return on investment.