One of the most common pieces of financial advice our clients hear from their friends and family is to invest their backlog greenbacks in rental backdrop. Unfortunately, this is terrible communication for all but a lucky few. There are four big reasons for this: information technology likely won't generate the income you expect, it's hard to generate a compelling return, a lack of diversification is likely to hurt you in the long run and real estate is illiquid, so you can't necessarily sell it when y'all want.

Before you buy a rental holding every bit an investment, consider the reasons you're unlikely to come out ahead.

Income isn't guaranteed

A popular reason we hear for wanting to invest in real estate is a desire for additional income. Unfortunately most real manor investments, particularly residential properties bought for investment, don't generate positive cash flow for quite a while. That means yous have to fund losses each year. Allow me to illustrate with an instance.

Imagine you bought a house or condo for $500,000 and financed it with a mortgage of $400,000 at a xxx yr fixed rate (with no points) of iii.8%. Your monthly payment would be $1,864. Your monthly existent manor taxes would probably be at least $400. You should also factor in monthly upkeep and insurance, meaning y'all'd demand to accuse a monthly rent of almost $three,000 just to break even. For a condo, yous'd have to add together in homeowner association (HOA) fees. There aren't many $500,000 homes that can command monthly rent of $iii,000 in the areas where our clients alive. Eventually, with almanac rent increases, you could pause fifty-fifty, merely it would be a while before you'd generate the income you originally sought with a real manor purchase. Raising rent tin also exist a challenge in cities similar San Francisco that accept hire control laws and limit your power to enquire your renter to get out if they don't pay their hire on time.

Information technology'south hard to generate a compelling return

Another reason we hear for wanting to ain real estate is it is "understandable" compared to trying to invest in stocks or bonds, which many people believe requires a knowledge of financial markets. People who are unsure of how to offset investing oft perceive investing in stocks or bonds as overly risky and worry they won't be able to time the market correctly. This fear is further stoked by pundits who claim the market is under- or overvalued, despite overwhelming research that marketplace timing is irrelevant to earning a practiced return. Buying a diversified portfolio of low toll index funds requires very lilliputian expertise, peculiarly when managed by an automated advisor like Wealthfront.

In contrast, people recall buying an investment belongings must be like buying a home — something with which most Americans have experience. But buying a home is very unlike than buying a property for an investment return. Not all home values capeesh, and that'southward OK as long as you tin can afford your monthly payment and relish where yous live. But an investment property that doesn't appreciate represents an enormous opportunity cost considering your down payment could have been invested elsewhere.

Generating a compelling return on an investment holding requires pregnant appreciation. That's because every bit we explained above, it's difficult to charge enough rent to starting time the full cost of conveying the property and the real estate broker commission.

Again this is best illustrated with an example. Permit's assume you could charge a rent of $2,000 on the previously described $500,000 property (which is pretty steep relative to the mortgage payment) and increment information technology by 2% per year due to inflation. Let's further presume the property appreciates at three% per twelvemonth (a rate greater than inflation, which is unusual by historical standards), which means it would be worth $580,000 if you sold it after 5 years. Afterwards deducting a 6% real estate commission, the compounded return on your disinterestedness investment would be only 4.i% — and that assumes your rental property was occupied for all five years which is often not the example. The lower the occupancy charge per unit, the lower your return. To brand following the numbers easier, we created a spreadsheet that shows our math.

Just because something is easier to understand doesn't make it better. For comparing, Wealthfront'south average portfolio earned just under viii% net of fees over the by eight years. And the Wealthfront return is far more than tax efficient than the render you lot would receive on real estate due to the way dividends on your Wealthfront portfolio are taxed and our taxation-loss harvesting.

In order to improve upon that four.i% return, you need to have a nose for the neighborhoods that are probable to appreciate most quickly and/or find a terribly mispriced belongings to purchase (into which you tin can invest a small amount of coin and upgrade into something that can control a much higher rent — fifty-fifty better if you can practice the work yourself, but yous need to brand certain you are beingness adequately compensated for that time). The challenge is, despite what y'all may hear or read, a minority of even professional existent estate investors outperform the average return for the existent estate market place over the long term. And we're talking near people who take big staffs to assist them find the ideal property and make improvements.

Information technology'south better to diversify your investments

You should think of investing in an individual holding the same mode yous should call back about an investment in an individual stock: equally a big gamble. Y'all are unlikely to outperform the market unless yous accept an information advantage, which you probably won't have unless you are a real manor professional or are willing to put lots of time and free energy into finding a property.

The idea of trying to choose the "right" individual property is alluring, specially when you think you tin can go a proficient bargain or buy information technology with a lot of leverage. That strategy can work well in an upward market. Notwithstanding, 2008 taught all of us about the risks of an undiversified existent estate portfolio, and reminded us that leverage can piece of work both ways.

Investing in a risky asset form like real estate requires diversification to generate a higher long-term render considering y'all never know when a particular existent estate strategy or type of property will fall out of favor. The benefit of a real estate index fund is information technology's comprised of many Real Estate Investment Trusts (REITs), each of which is diversified amidst many backdrop.

That said, diversifying your real estate portfolio is not enough. You lot as well need to diversify beyond types of investments, or nugget classes, to maximize your long-term, risk-adjusted render. Real estate is a great component to take in a portfolio because it can act as a hedge against inflation (real manor tends to be more correlated to inflation than other asset classes), simply it generally is not very bonny on its own.

Liquidity matters

The last major argument against owning investment properties is liquidity. Unlike a real estate index fund, y'all cannot sell your holding whenever y'all want. It tin can be hard to predict how long information technology will accept for a residential property to sell (and it often feels like the more than eager you are to sell, the longer it takes). Institutional investors generally believe they should earn an extra 3% to v% annually on their investment to justify having their money tied upward. Trying to earn 3% to 5% more y'all would on your index fund is almost impossible except for a handful of real estate private disinterestedness investors who concenter the best and the brightest to do zero but focus on outperforming the market. Exercise you really believe yous can practice information technology when professionals tin't?

Our advice on rental property investing is consistent with what we propose on other non-index investments like stock picking and angel investing: if you're going to do information technology, care for it as your "play money" and limit it to 10% of your liquid net worth (as we explicate in Sizing Up Your Habitation As An Investment, you should not treat your dwelling as an investment, so you don't have to limit your equity in it to 10% of your liquid net worth). If you already own a property that is bringing in more rental income than you're paying in carrying cost in a neighborhood that is appreciating, then congratulations! You probably don't need to bustle and sell. However, if you own a property that rents for less than your carrying price, then I would strongly urge yous to consider selling the property and instead invest in a diversified portfolio of low-price index funds.

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Disclosure

All information provided by Wealthfront's financial planning tool is for illustrative purposes only and you should not rely on such information equally the primary basis of your investment, fiscal, or revenue enhancement planning decisions. Wealthfront relies on information from diverse sources believed to be reliable, including users and third parties, simply cannot guarantee the accurateness and completeness of that information. No representations, warranties or guarantees are made as to the accurateness of any estimates or calculations provided past the financial tool.

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Andy Rachleff is Wealthfront's co-founder and Executive Chairman. He serves as a member of the board of trustees and chairman of the endowment investment committee for Academy of Pennsylvania and equally a member of the kinesthesia at Stanford Graduate School of Business, where he teaches courses on technology entrepreneurship. Prior to Wealthfront, Andy co-founded and was general partner of Benchmark Capital, where he was responsible for investing in a number of successful companies including Equinix, Juniper Networks, and Opsware. He also spent ten years as a general partner with Merrill, Pickard, Anderson & Eyre (MPAE). Andy earned his BS from University of Pennsylvania and his MBA from Stanford Graduate Schoolhouse of Business organization. View all posts by Andy Rachleff