“Their investments are going to bankrupt them.”
Mario and I usually grab a beer and talk shop when I’m in Lima. Like me, Mario married a Peruvian woman and thus finds himself spending a lot of time in Peru. And like me, he finds some of the investment decisions made by his Peruvian friends to be a little less than mathematically sound.
“He has his primary apartment in Lima – it wasn’t cheap,” Mario started. “His mortgage has to be at least $4,000 per month. But you have to live somewhere. I get that.”
“It’s the rest I don’t understand,” he went on. “He has a beach house that his parents left him. But he only uses it two months out of the year, and the maintenance and cleaning is at least $1,000 per month.”
I nodded and took a sip. I’d seen it plenty of times before with some of my wife’s friends.
“And then there is the country house in the mountains. I’ve been there. It’s lovely. But does it really make sense to have a third house that you only use on the weekends? His running costs are at least a couple thousand dollars per month, and that doesn’t include the mortgage.”
If Mario’s friend were a multimillionaire, none of this would really matter. If that’s what he wanted to spend his disposable income on, who are we to criticize? Alas, he’s not. He’s just a regular guy with a decent paycheck that inherited a couple houses from his parents. And rather than sell the properties and use the proceeds to put together a proper nest egg, the poor dumb bastard was hell bent on holding on to them in the belief that they were “investments.”
The Curse of Costly “Investments”
Now, I’m never going to fault anyone for seeking their fortunes outside of the stock market. My shtick in Peak Income is specifically looking for opportunities that are a little outside of the mainstream. But a proper investment needs to put money in your pocket rather than sucking it out.
With a piece of real estate, that means that the income generated needs to be enough to carry your costs with a little left over as profit. If the property rises in value over time, that’s great too. But it’s not a necessary requirement for investment success.
Returning to Lima, it’s virtually impossible to earn a positive return on a financed property, at least at the higher end of the market. The rent payment is generally 20% cheaper than a mortgage payment would be, and that’s before maintenance expenses, which tend to be substantial. That means there are a lot of property “investors” losing their shirts these days. And the economics of beach and country houses are even worse.
Not to pick on poor Lima. I’ve seen similar numbers in plenty of American cities as well.
Again, I’m not telling you to swear off of real estate investing. Plenty of fortunes have been made in real estate, and plenty more will be made in the future. But if you are thinking about buying a property, let’s go over a couple rules.
Most of the return from real estate comes from leverage. If you’re borrowing 80% or more of the value of the property, even small price improvements can translate to small gains. Let’s say you put $20,000 down on a $100,000 property and that property rises in value by 5%, or $5,000 after a year. That $5,000 represents a 20% return on your original $20,000 investment. Not too shabby!
The problem is that debts have to be financed. You have to make payments on the money you borrowed. So if you’re not generating any current income on it, the money comes out of your pocket. You might still be making capital gains on paper, but you can bleed yourself dry in the process.
Look for Sticky Revenues
Buying a beach house might be the dumbest thing you can ever do with your money. It’s only usable (or rentable) for a couple months out of the year, and it’s going to sit unused the rest of the year.
Compare that with, say, a self-storage facility. Once renters move their junk into a storage unit, they’re not likely to go anywhere. They’ll continue paying the rent for months or years. Assuming you paid a reasonable price and your rents cover your mortgage and operating costs, that investment will put cash in your pocket every month until the end of time.
Gritty is Usually Better
This might seem counter intuitive, but gritty properties often make the best investments. Warehouses, storage units or even low-end apartments require very little in the way of maintenance, and no one is going to complain about a few dents and dings. In contrast, higher-end apartments, offices or retail properties often require a ton of regular maintenance to keep the tenants happy. It’s generally a better business to be a slum lord.
Of course, real estate isn’t for everyone. If you like the idea of regular income but want the convenience of generating it from a brokerage account, take a look at my Peak Income newsletter.