Real estate investing can be pretty lucrative, generating high returns but make sure you understand the risks.
Before I began investing in stocks, I enjoyed the romantic aspects of real estate. My parents would pick me up to watch the construction workers through the tiny holes, mesmerized by their activities when I was a little girl. On a once-empty lot, here was the construction of a tall building or skyscraper that would house people in their offices and homes. I would observe the structural development take shape brick-by-brick.
One of my favorite books was The Fountainhead by Ayn Rand. The story took place in New York City, against a backdrop of Manhattan’s skyline filled with skyscrapers and an architect’s battle against conformity. This book stimulated my interest in real estate and possibly a career as an architect.
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Why Are We Attracted To Real Estate?
“Ninety percent of all millionaires become so through owning real estate. More money has been made in real estate than in all industrial investments combined. The wise young man or wage earner of today invests his money in real estate.”
Wealth from homeownership remains the single most significant contributor to the increase in net worth across all income levels in 2019. Housing wealth represented, on average, nearly 75% of the total assets of the lowest-income households. As you move to higher income levels, the percentage drops to between 50%-65% for middle-income homes, while only 34% for the wealthiest.
Owning real estate, whether it is your home or for investment purposes, can be a great path to wealth. Depending on the property, it can generate predictable cash flow, appreciate value, build equity, be improvable, and provide tax deductions.
Many people are attracted to owning their home as their primary means of real estate investing of a tangible asset. Homeownership provides a sense of stability and belonging, and pride. Our family is currently renting a house, so I am not opposed to the trade-off between owning or renting your home.
Real Estate Investing Has High Risks And High Returns
I found several ways to invest in real estate beyond owning our home, but my experience was lumpy.
Real estate investing is challenging with high risks that can be financially destructive. I have invested in different types of real estate, each having its unique issues. Some were economically rewarding, but one was disastrous, and it is the one that made me want to quit real estate investing.
When investing in real estate, it is essential to understand the whole picture. Real estate investors, especially novices, tend to understate the challenges and overestimate the opportunities. Investors do not control many of the critical factors that can make real estate deals onerous.
There Are No Quick Paths To Riches
Real estate investing is far from a get-rich-quick scheme. The longer timeframes require patience, especially when delays are out of your control. It is a capital-intensive business, and leveraging through increased borrowing is dangerous if you aren’t generating positive cash flow for a while. Should a severe recession occur, your challenges only get more significant.
Every real estate market has its respective social politics, but the more significant the market, the more challenging the rules to comply. Places like San Francisco or New York City are very hard to get projects completed. There may be liquidity issues when investing in the stock market, but nothing like the real estate market.
Location matters for real estate, but be aware of price fluctuations in the future and the present as rezoning can change values. Stigmas can sometimes overhang areas undergoing gentrification far longer than you may want.
Like investing in stocks, avoid being greedy when investing in real estate. We have passed on higher offers on land we owned because we were stuck on what we paid for the property.
What Went Wrong With My Real Estate Investing?
We have invested in homes where we lived. When the land adjacent to our house became available, we rushed to buy the acreage (over 50 acres) but had trouble selling it when the market turned negative. The land was no longer in demand in our area, so we sold it at a slight profit. We had a few other small properties, including timeshares. However, only one property gave me a teachable moment I would like to share with others. The magnitude of this real estate investment exceeds all the others.
My Experience Taught Me A Lesson
I want to share my experiences that provided early successes initially, with profits. I invested money with a private real estate investment group in several urban properties more than ten years ago. The real estate investment group varied by the property, fluctuating between six to ten people, including the builders who owned the majority control and several investors with diverse backgrounds. Eventually, I almost lost it all as the size of investments grew larger.
All of the properties were multiyear projects, ranging with fixed annual payouts of 20%-35% that would accrue in an escrow account until tenants occupied the buildings after the sale. Minimum investments ranged from $100,000 to over $1 million. Typically, the existing property would be gut renovated. Gut renovation means that the construction crew would take the original building down to its skeleton structure. The building’s renovation transformed it into mixed-use luxury condominium projects, typically spacious high-ceiling apartments, mainly in Manhattan.
My initial investment was about $100,000 on a small property. The construction workers tore down this property that housed a factory to convert it into a mixed-use commercial storefront, offices, and residential apartments. I more than doubled my money over compounded earnings on the high-interest payouts and invested in the following property, which happened to be more significant.
Feeling more confident, I invested a higher amount at the higher 35% interest rate once again ringing the cash register in this multi-year project. One or two more similar successful projects came next, and I participated in them, receiving attractive payouts after three years.
I made these investments in the early 2000s. The investment group, particularly the builders, were feeling no pain and sounding a bit giddy. I recall sharing our successes one evening when we all went to a “topping off” ceremony. A”topping off” ceremony is a tradition of construction workers to commemorate the completion of a building’s structure.
Biting More Than We Can Chew
We learned the next project would be very ambitious for our real estate investment group, requiring more significant investments of at least $1 million. The project would transform a seedy part of the Times Square area. This involved tearing down porn stores to make room for a modern high-rise apartment building or hotel.
By this time, I had left my lucrative job as an equity analyst on Wall Street to attend law school. I spent more time analyzing this deal. However, no amount of time studying the prospectus could assure the risks we would encounter. I made my most significant investment in what would be the most challenging project.
Facing Significant Challenges
The real culprits were the original real estate owners who wanted to participate in the real estate deal. We needed their cooperation to move tenants and business owners out of the small buildings sitting on several lots to make room for our high-rise building. It was a very time and capital-intensive effort, but we were eventually successful.
The original plan was to construct an apartment building selling luxury condos. However, you need legal permission to do so through the respective housing authority and community board. I attended countless meetings, which required many architectural changes to the project. Newly constructed or renovated apartments need to be set aside for affordable housing. Previous smaller projects did not receive the scrutiny that accompanied this project.
All of this caused enormous delays in the project just as the Great Recession began. We needed more capital and sought a more prominent partner. However, everyone was having the same trouble in the real estate market in New York and elsewhere.
Greed Destroyed Value
You can probably guess what happened, but not so fast. There seemed to be some hope as some generous offers to buy the property initially came our way. The builders, who had majority control, passed on each of them one-by-one as liquidity quickly dried up. They were greedy, believing that this was their penultimate deal and would not give any capital away.
Instead of the typical three-year timeframe for the smaller projects, this project dragged on for more than seven years with a financially devastating result. Eventually, the bank bailed us out at about twenty cents on the dollar instead of the more eighty cents on the initial offers. I lost more than I ever thought I would have in my life. Losing nearly a million dollars on one real estate deal is not an experience I want to revisit.
For me, it was a lesson in humility and how fast the ground can move while investing in real estate. We faced many challenges in this deal that real estate investors should know:
- Intense capital needs requiring more loans.
- We didn’t factor in the substantially higher payments to buy out the relevant parties.
- The group underestimated the longer timeframe than we budgeted with substantial delays.
- The severe Great Recession in 2008-2009 caused liquidity to vanish.
- Social politics comes with more significant responsibilities for more major real estate deals. (Ask Donald Trump!)
- Greediness eliminates reasoned decision-making.
After my experience, I quit the real estate investment group, no longer wanting to invest in property requiring significant renovations or tearing down existing buildings. Although I faced a massive loss from the last project, I ended up slightly ahead due to the tax loss benefits. I learned priceless lessons about real estate investing, along with the tremendous headache.
I prefer investing in stocks, bonds, and passive real estate investing with more liquidity and fewer capital requirements at this juncture of my life. Our two teens are soon to be college-bound. I still believe in real estate investing as a desirable avenue for young investors so long as they are not using money to pay their bills and have an emergency fund.
At the time, I was overexposed to real estate deals where I could not liquidate independently. This deal accounted for a significant portion of my net worth. I felt guilty and irresponsible to my family, including two young kids. As a minority investor, my voice did not matter when it came time to sell the property to a more experienced real estate developer. The investor with the majority control did not want to accept defeat.
Your investment portfolio should always reflect asset diversification in stocks, bonds, and real estate, periodically reallocating the holdings. It should represent your risk tolerance based on your age and lifestyle. As you move closer to retirement, consider the Dividend Aristocrats as a nice addition for reliable income and growth.
I still own real estate, but I am no longer in the market for big deals. My preference is to make passive investments in real estate through ownership of REITs, Fundrise, or Groundfloor with less capital and diversification.
This article is not to say that “real estate is bad” or that this asset should be avoided. Not at all. It is a cautionary tale to understanding that when you are committing money to investments, to be mindful of your risks. As a professor of business and finance with both a law degree and an MBA, I consider myself knowledgeable in these areas. Yet, this experience gave me wisdom obtained in the school of hard knocks that I wanted to share.
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This article first appeared on the Physician On Fire.
With a passion for investing and personal finance, I began The Cents of Money to help and teach others. My experience as an equity analyst, professor, and mom provide me with unique insights about money and wealth creation and a desire to share with you.