A decade ago, John Paulson, coming off the absolute fortune he had made a few years earlier by shorting subprime mortgages, reportedly told a packed house in New York City to load up on real estate.
“If you don’t own a home buy one,” the hedge-fund legend said at the time. “If you own one home, buy another one, and if you own two homes buy a third and lend your relatives the money to buy a home.”
Fast forward to today, and Wealthfront, a robo-adviser with some $20 billion in assets under management, is offering up a completely different take when it comes to jumping into the real-estate game.
“One of the most common pieces of financial advice our clients hear from their friends and family is to invest their excess cash in rental properties,” Wealthfront co-founder and CEO Andy Rachleff wrote in a blog post. “Unfortunately, this is terrible advice for all but a lucky few.”
Here are four reasons he gave as to why:
1. Income isn’t guaranteed: “Most real estate investments, especially residential properties bought for investment, don’t generate positive cash flow for quite a while. That means you have to fund losses each year.”
2. It’s hard to generate a compelling return: “Generating a compelling return on an investment property requires significant appreciation. That’s because… it’s difficult to charge enough rent to offset the full cost of carrying the property and the real estate broker commission.”
3. Diversification is critical, but more difficult: “The idea of trying to choose the “right” individual property is alluring, especially when you think you can get a good deal or buy it with a lot of leverage. That strategy can work well in an up market. However, 2008 taught all of us about the risks of an undiversified real estate portfolio, and reminded us that leverage can work both ways.”
4. It’s illiquid: “Unlike a real estate index fund, you cannot sell your property whenever you want. It can be hard to predict how long it will take for a residential property to sell. Institutional investors generally believe they should earn an extra 3% to 5% annually on their investment to justify having their money tied up.”
That’s not to say rental properties don’t have their place in a diversified portfolio. Rachleff says it should be treated as “play money” limited to only 10% of your liquid net worth — the rule doesn’t apply to your primary residence.
Of course, there are exceptions to the rule, but, generally speaking, Rachleff, whose got a vested interest in investors putting their money to work in the stock market, says “you’re unlikely to come out ahead” dabbling in rental properties.
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