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How Risky Is Real Estate Investing?

“Knowledge is power.” – Francis Bacon (Meditationes Sacrae, 1597)

When it comes to earning a second income, I believe in real estate. No other investment I know of has its beneficial balance of capital appreciation, income, and risk management.

I explained my ideas last year in a series of messages (#394-#400) that elicited a good number of questions, positive comments, and a few criticisms.One criticism came from PS, a friend and an expert in investing — someone whose opinions on the subject I take very seriously. PS said that my preference for real estate over stocks exists because (1) I don’t buy stocks and (2) housing prices are much, much less volatile  than stock prices.

Because stocks appreciate slowly — about 4% a year according to most long-term studies — PS argued that “to make money quickly,  you have to use extremely large amounts of leverage (debt).”

An investment I had talked about at the time was “the perfect example” of the danger of leverage, PS said. In order to make a 50%-per-year return, he pointed out, you’d have to put $10,000 down on a $100,000 property and sell it 12 months later for about $111,000 (taking into consideration the $5,000 profit plus $6,000 in commissions and closing costs).

That’s an appreciation of 11% — almost three times the long-term average. “And what happens if the market slumps? You’re not on the hook for $10,000, you’re on the hook for $100,000.”

PS said, “The proper way to account for investment returns is to measure the amount you’re risking vs. the amount you’re making. And by this formula, if you make $5,000 on $100,000 risked, you’ve made 5.5%” — hardly an impressive number.”

I don’t see it that way. When I invest in local real estate — and that’s the only kind I recommend — I do not have at risk the entire value of the property I’m buying. What’s at risk — at most — is 20% of that number. And that only if the market collapses.

I’ve been investing in real estate for 20 years. It started out very badly (see Message #395), but it quickly got better and has continued to improve with almost every deal. My most recent deal — the purchase of a cluster of little buildings that house businesses of mine — is providing me with a direct cash return of 16% a year, not counting tax savings and depreciation.

This is also without counting last month’s conversion of the garage into a one-bedroom studio. It cost $12,000 to complete and is earning $8,000 a year in rentals.

Over the years, my real-estate investments have appreciated about three times the historic rate. I’ve been able to do that by following some simple rules:

1. Buy only good properties.

2. Buy only at a good price.

3. Buy properties that can be improved without spending a lot of money.

But the No. 1 reason I’ve been successful — I think — is that I’ve stuck to my local area. That means I’ve been investing in things I pretty well understand.

Let’s face it, you don’t have to be a genius to understand real estate. It’s not like biotech stocks or nuclear energy. And you don’t have to be able to understand complicated annual reports, balance sheets, and other nebulous documents prepared by dubious accounting firms.

You need only some time and common sense. Time to look for the good deals. And sense enough to walk away from the bad ones.

To be good at stock investing, you need to be pretty smart. And disciplined. And you need to spend time learning. I don’t have the time or talent for that. But I do invest in stocks. I believe in stocks and consider them a very important part of my portfolio.

My strategy with stocks is simple and chicken-hearted. I spread my investments to reduce risk and follow the investment advice of someone trustworthy. That includes people like Steve Sjuggerud, who wrote our guest editorial last Friday.

I’ll tell you more about the stock-investing strategy I follow in another message. For now, I’d like you to consider real estate — how it could work into your financial plans and future.

[Ed. Note.  Mark Morgan Ford was the creator of Early To Rise. In 2011, Mark retired from ETR and now writes the Palm Beach Letter. His advice, in our opinion, continues to get better and better with every essay, particularly in the controversial ones we have shared today. We encourage you to read everything you can that has been written by Mark.]