If only we had a dollar for every time we heard some version of this question: “Should we buy an investment property?”
As financial advisors, we love to see our wealth management clients feel motivated to explore opportunities to accelerate their progress toward their financial goals. Getting proactive and seeking out paths to grow wealth is a great thing!
But, most people come to this particular question with a lot of (false) assumptions and little knowledge or experience.
After we talk, most clients realize that getting into an investment property would be at total odds with their other goals and priorities. Some others realize they truly have a real passion for the idea, and can then work with us to develop action items to support exploring this opportunity.
How can you tell which camp you fall into?
Here are 3 questions to consider if you’re wondering whether or not you should buy an investment property as part of your overall financial plan.
1. Does the Tactic to Buy an Investment Property Align with My Overall Financial Strategy?
The first point we want to get clear on is to define the potential purchase of real estate for investment purposes as a tactic you could implement as part of your bigger-picture financial planning.
Once you understand that this is one of many financial tools you can consider deploying, you can move forward with a better mental framework for the question at hand.
And that should be, “does this particular tactic — to buy an investment property — have a place within my overall financial planning and management strategy?”
Your strategy is the big picture. It’s the overarching system you’re working within to reach your goals. Your tactics are the specific methods you could apply to execute your strategy.
And not all tactics are created equal, nor are they all appropriate for your specific strategy.
When we ask our clients why they want to explore real estate investing as a means to grow wealth, it’s a huge red flag when the asnwer is, “because I want passive income.”
Investment properties can produce income, and they can provide returns. But virtually no real estate investment is truly passive.
Real estate typically requires a lot of work as well as considerable upfront capital. You may or may not have cash available to deploy to execute this tactic properly, especially if you’re buying and managing the project as an individual (versus an entity like a developer, whose entire business is real estate).
Even if you do have the money available to put into a property, you have to consider (a) the source and (b) the opportunity cost.
Where you’ll get the necessary capital matters. Thinking you can just pull money from your taxable investment account to serve as a down payment on your investment property is almost always ill-advised.
Doing so will very likely set you backward on where you should be in terms of capital accumulation (in other words, what will fund your life in the future if making work optional is important to you).
You will also likely realize capital gains and pay taxes if you sell out of your investment portfolio to free up cash for a real estate purchase, making this an expensive source of funding.
Then there’s the opportunity cost to consider. What else could you have done with that money that you will now have to say no to, if you use it to buy what you hope is a profit-generating property?
There are other effective tactics — namely, investing in a diversified portfolio in the financial markets — that are likely to produce better results with less risk (and work!) than investment properties. Don’t be fooled into thinking real estate is somehow a golden ticket or a sure bet; it’s anything but either of these things.
Proper long-term investing is boring, but it’s also more reliable and effective for most people if the goal is increasing your net worth to afford the life you want to live.
2. What Are the Tradeoffs I’m Making If I Buy an Investment Property, and Are They Acceptable?
Perhaps your interest to buy an investment property comes from a desire to start a real estate business. Or maybe you like the idea of buying a multifamily home so you can live in one unit while renting the others to help subsidize a mortgage cost.
When the motivation is more than just “someone said this was a quick and easy way to make more money,” — which isn’t true in the first place! — then you can dig further into the financial planning considerations around investing in real estate as one of your goals.
That means looking at the upsides as well as the tradeoffs to ensure pursuing this goal does not interfere with any other stated priorities.
Because you need a large cash outlay to purchase a property, trying to buy real estate might mean delaying or even abandoning other financial goals and options.
Are you willing to incur that opportunity cost? Can you afford to incur that cost?
You might need to cut back on your normal annual spending so you have available cash flow to direct toward management and repairs on your property, for example.
Or you might have to adjust your target retirement date if you redirect some of your assets to this project (thereby taking them away from the portfolio that’s supposed to fund your lifestyle after you stop working).
Because of this, it’s a good idea to ask questions like:
- Do you want to bear the responsibility of owning and maintaining a rental? Even if you use a property management company, to buy an investment property is not a set-it-and-forget-it undertaking. It requires ongoing costs of both capital and time as well as energy.
- How much do you know about owning a rental property to earn income? Are you willing to spend considerable time/money to learn and gain experience in this area?
- Do you have a way to evaluate rent potential before you try to buy an investment property? This is critical, especially given the huge expense of buying a home between high interest rates and limited inventory. There are simply not a lot of good opportunities for investors in this market due to the inflated costs required to buy. Even the experts are shying away from deals now.
- How does your desire to buy an investment property impact your other stated goals and priorities? Will it take away from something that is more important for you to accomplish, or does it align with your values and what you want to do with your resources of time, money, and energy?
- Are you familiar with the logistics, maintenance, upkeep, and management required on the type of property you want to buy?
There’s no objective right or wrong answer when it comes to making tradeoffs. What’s important is in acknowledging the future impact and potential consequences of your decisions today — whatever they may be.
3. Have I Considered All Possible Options for Achieving What I Want?
When it comes to making financial decisions, most clients want to know what the “right” choice is. It’s reasonable to focus on that, but what might be even more important is to know the wrong decisions you can easily avoid.
The worst mistakes to make are those that come from unforced errors: decisions you didn’t have to make, or situations you didn’t have to get yourself into.
One great way to avoid backing yourself into a corner, especially when you find yourself very excited about an idea or convinced that there’s only one solution to your problem, is to force yourself to do a little thought experiment.
Sit down with your goal, whatever it is you want to achieve at the end of the day — and brainstorm at least 3 ways you could accomplish it. Some great practices for any decision-making process include:
- Coming up with a variety of alternatives (because there’s almost always another way, even if it’s not the first thing you thought of)
- Reframing choices or situations from “either/or” to “both/and” — how can you expand the possibilities so you’re not looking at a narrow range of binary options?
- Use caution if you find you plan only works if A then B then C all line up exactly as you assumed they would; there’s no buffer room for what happens if things don’t break your way
- Get a second set of eyes or an outside opinion on the situation to check your blind spots or point out potential errors
Investing in Real Estate Is One of Many Tactics You Could Use to Grow Wealth. Choose Your Path Wisely!
This is the point in the process in which the majority of our clients realize that while investing in real estate sounds wonderful in theory, there are a lot of practical considerations that make the endeavor much less appealing.
The good news is that you do not have to buy an investment property to grow wealth or get rich. Most people will find that investing wisely in a low-cost, globally-diversified portfolio of mutual funds and ETFs is not only an easier way to accumulate more assets, but a less risky and more reliable strategy as well.
Investing in real estate through the purchase of a rental property can be a reasonable goal to work toward if:
- Buying an investment property actually makes financial sense for you and your situation.
- Owning an investment property fits with what you want to do with your time and your money — because owning rental property is a huge commitment of both.
If you’ve made it this far and you’re feeling fired up about the goal to buy an investment property, great! It’s time to look at next steps to make that happen.
Here’s what we’d suggest as immediate next steps to consider:
- Set the purchase as a specific mid-term goal within your overall financial plan. Identify how much you need to save up for your down payment, and then work toward that over the next 1 to 5 years (the exact timeline depends on the specifics of your situation).
- Use the time in between now and when you hope to accomplish this mid-term goal to furiously study and devote yourself to everything you can learn and experience about being a landlord, how to to identify an income-producing rental property, and how to manage property in a way that results in a profit.
A truly great financial advisor is not just someone who can orchestrate a financial plan and show you the right strategy to use — but is also someone who should take it as their responsibility to remove any rose-colored glasses and point out the potential pitfalls that are easy to gloss over when you’re only focused on the upside.
We take that part of our work seriously. It’s never to say the opportunity isn’t real. It is, and we have clients who successfully own and manage real estate as part of their overall portfolio.
But you have to evaluate potential opportunities with a critical eye, and remember that any chance of reward comes hand-in-hand with the possibility of realizing downside risk.
When considering this tactic or any other in your wealth-building journey, acknowledginng the impact of potentially realizing those risks is part of the broader decision-making process.