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Investing in real estate can be a nightmare when things go wrong.
For example, I was about to start looking for my next rental property when I got a call from a tenant. She told me that the door on the mechanical closet was warped to the point that the door was jammed shut. When I got there, I had to saw through the door to the maintenance closet!
It turns out that the owner of the condo a few floors below mine had ignored the maintenance on his water heater. His water heater failed and shot hot steam into my unit, which caused nasty mold and a host of other issues.
This nightmare took a full month to fix, and over 5 months of dealing with insurance to get reimbursed for my expenses.
Because of this disaster, I started having second thoughts about investing in real estate. Is it really worth it? Why would I buy another rental property when I could just park cash in an index fund? Would my real estate investment have a higher return than an index fund? And if it does, would it be a high enough return to justify the headache?
I set out to answer these questions and what I found is that comparing real estate and stocks isn’t easy. For me, the bottom line comparison is net worth. I wanted to be able to compare the impact on my net worth if I buy a rental property vs. the impact on my net worth if I invest in stocks. To do that, I came up with a metric that I call net worth impact. I want to share this metric with you so that you can use it for your own investment decisions.
To compare the net worth impact of real estate vs. stocks, the first thing to do is figure out how much cash you would need to invest in a rental property. In other words, what is your principal? For a rental property investment, your principal will be the sum of:
Rental Principal = Down Payment + Closing Costs + Make-Ready Repairs + Vacancy Expenses
Let me give you an example using an actual property that I am in the process of buying. It’s a 3 bedroom, 3 bathroom townhouse worth about $300,000. It’s a short sale, and my offer of $270,000 has been accepted by the seller. I’m putting 20% down, which is $54,000. Closing costs will be about $7,000, and I plan to put in roughly $8,000 for make-ready repairs. The repairs will take a couple weeks, setting me back about $1,000 for the initial vacancy. This leaves me with a nice round number of $70,000 for my principal.
One quick clarification: When I say stocks, what I really mean is a passive investment portfolio. I invest in a mix of stocks, bonds, and REITs. I want to compare the net worth impact of that mix to the net worth impact of a rental investment.
Calculating the net worth impact for a passive investment portfolio is relatively easy. The hardest part is figuring out what kind of return you’re going to get. I’ll use an example that assumes a 6% return. Jack Bogle and Warren Buffet have estimated roughly a 6% return in the stock market going forward. If you think the number should be different, it’s very easy to calculate using different numbers.
I calculate my net worth impact at the end of 30 years because that’s when the mortgage will be paid off, and I’ll be nearing the retirement age. The calculation for net worth impact (NWI) is:
NWI for Stocks = Principal × [(1 + Return) ^ Years]
Here, $70,000 is our principal, our return is 0.06, and the number of years is 30. So, if I take my $70,000 and invest it in a passive income portfolio instead of a rental property, I can expect a net worth of roughly $402,000 after 30 years.
NWI of $70,000 stock investment at 6% for 30 years = $402,000
That’s pretty good! Can we do better by investing in real estate?
The net worth impact of a rental property investment in a particular year will be the value of the property in that year plus the cash flow accumulated to that point, minus any mortgage debt still owed.
NWI for Real Estate = Property Value + Accumulated Cash Flow – Mortgage Debt
For our example, we’re using 30 years as the time period, which means the mortgage debt will be zero. The calculation for property value is similar to the one for stocks. The difference is that I use a return of 2% because that is in line with historical inflation.
Property Value = Value at Purchase × [(1 + Return) ^ Years]
For the $300,000 property that I’m looking at, the property value will be roughly $543,000. We’re already doing much better than our stock investment, and we haven’t even considered accumulated cash flow yet! This is the power of leverage.
Calculating your accumulated cash flow is a bit trickier – I use a spreadsheet to help figure this out. The first thing to understand is that your annual cash flow will be your rental income minus your expenses. (read more about calculating cash flow)
I use Zillow and Craigslist to estimate what I can charge in monthly rent and multiply by 12 to get the annual rental income. I then multiply that by 95% to account for a 5% vacancy rate in case I’m unable to rent the property for a few weeks during the year. Over the past year, the Zillow rent estimate for the property I am buying ranges from $1,800 to $2,000 per month, so I’ll stay conservative and estimate rent at $1,850. Below is my expected rental income for the first year:
$1,850 × 12 × 0.05 = $21,090
Calculating expenses is a bit more involved, but I’ll break down everything below. The below list includes typical expenses for a rental property and how those expenses can be estimated:
In my case, the numbers are as follows:
Those expenses add up to $20,798 in the first year. So the cash flow for the first year of this property is as follows:
$21,090 income – $20,798 expenses = $292
To calculate the accumulated cash flow over 30 years, we need to know how much our cash flow will increase every year, which we can do by comparing the first year cash flow to the second year cash flow. To calculate the second year cash flow, I assume inflation of 2% on rent and all expenses other than the mortgage payment, which is fixed. So our rental income becomes $21,512 because $21,090 × 1.02 = $21,512. From the table above, the non-mortgage expenses become $7,818 because $7,665 × 1.02 =$ 7,818. So our second year cash flow is:
$21,512 income – $20,951 expenses = $561
The difference between the first year cash flow and our second year cash flow gives us our cash flow increase, which will also increase at a 2% rate every year:
$561 – $292 = $269
Now we have both of the numbers that we need to calculate accumulated cash flow: (1) the first year cash flow, which is $292, and (2) the cash flow increase after the first year, which is $269. Getting from these numbers to accumulated cash flow after 30 years is a bit tricky, so I use a spreadsheet. If there are any math gurus out there that can come up with a simpler calculation, I would love to hear from you! Here is the spreadsheet, which I’ll explain below:
The numbers in green are our inputs, and the yellow number is our accumulated cash flow after 30 years. The base cash flow is our starting point for a year, which is based on the previous year’s annual cash flow. The annual cash flow for a year is the base cash flow for that year plus the cash flow increase for that previous year. In year 1, we use $292 as our base cash flow (calculated above). There is no cash flow increase in the first year, so our annual cash flow for year 1 is $292. We set the base cash flow for year 2 equal to the annual cash flow for year 1 ($292), and add the year 2 cash flow increase of $269 (calculated above) to get an annual cash flow of $561 for year 2. This pattern continues through year 30.
After we know the annual cash flow for each year, it’s easy to calculate the accumulated cash flow for any year. The accumulated cash flow is simply a sum of all of the annual cash flows up to and including the year in question. As you can see, the accumulated cash flow for year 30 of the property I am buying is about $151,000.
As a reminder, we can calculate our net worth impact for real estate as follows:
Property Value + Accumulated Cash Flow – Mortgage Debt
We calculated our property value after 30 years as $543,000, and our accumulated cash flow as $151,000. And since the mortgage will be paid off in 30 years, the mortgage debt is zero. So, for the property that I am buying, the net worth impact is:
NWI (no reinvestment) = $543,000 + $151,000 = $694,000
This is $292,000 more than the $402,000 NWI that we calculated for stocks! This is assuming that you do nothing with the accumulated cash flow. The last column of the table above shows what happens if you reinvest your cash flow at the 6% rate that we used for stocks. In this case, your accumulated cash flow grows to $271,000, giving real estate a $412,000 edge over stocks!
NWI (reinvesting cash flow) = $543,000 + $271,000 = $814,000
Assumptions and Considerations
Here are a few additional considerations:
The two biggest assumptions here are a 6% return on a stock portfolio and a 2% inflation rate. Those numbers are reasonable because they have historical backing. However, you can easily adjust the above calculations to test various returns and inflation rates. By changing these values, you can see the net worth impact for your particular portfolio and your assumptions about the future.
Given that I will be moving my portfolio from riskier investments like stocks to safer investments like bonds as I near retirement, the 6% return may be a bit aggressive. My portfolio returns will decrease (down to maybe 4%) as I near retirement. This makes real estate even more attractive.
Another assumption is that I will have a 5% vacancy rate. Given that I have rented my condo continuously for 2 years without vacancy, the 5% vacancy rate is a conservative estimate. A 2% vacancy rate (1 week per year) adds an additional $25,000 to the net worth impact of my rental property investment.
Finally, you have to figure out if the additional net worth from rental property is worth your time. Investing in a passive income portfolio is as passive of an investment as there is, whereas managing a rental property is passive most of the time, with occasional bursts of active management. One way to figure out if rental property is worth your time is to take the difference in net worth impact and divide it by 30 years. This gives you the average impact to your net worth per year. In my case, that would be:
$412,000 / 30 years = ~$13,750 per year
Divide that value by the number of hours you expect to spend managing the property per year. In a good year, I spend 10-20 hours managing a property. In a bad year (like this one, which is pretty rare), I spend 40-80 hours. If I spend roughly 30 hours per year managing this property, I will be making $460 per hour. Nice!
$13,750 / 30 hours = $410 per hour
This analysis also doesn’t take intangible benefits into account. For example, I love crunching the numbers and analyzing different investment properties, and buying a property is exciting! Also, I plan to use rental properties to teach my kids about running a business. I plan to have at least one rental property per child, so that each of them can learn about managing people, managing a business, and have a nice recurring revenue stream when I’m gone.
Overall, a balanced approach to real estate and stocks is best because it diversifies your risk. But if there are any readers on the fence about whether to invest in rental properties, hopefully, this article shows you the real boost to your net worth that you can gain from investing in rental properties. If you take the time to analyze potential rental investments using net worth impact, you can increase the odds of making a wise investment.
Readers: What do you see as the pros and cons of investing in real estate vs. stocks? For those thinking about investing in real estate, what is holding you back? For those who have invested in real estate and stocks, have you analyzed your returns? Which is a better investment?
My name is Neil Kardos, and I am a patent attorney who invests in real estate to supplement the income from my day job. I'm a big believer in earning more than you spend and investing the difference in income-generating assets. My goal is to earn enough passive income from real estate to cover my expenses so that I can be financially free!
I started out as a full-time student, over $60,000 in debt, and didn't even have a full-time job (two part-time jobs).
Learn the system I used to create a 6-figure passive income.
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