You want to become more independent of your paid job. Excellent! How does that work? You spend less than you earn and invest the difference in building ‘passive’ income streams. In other words, part of your income you don’t put into consumption or keep in cash, but use it to acquire assets, i.e. financial assets. These should increase in value over the long term and / or continuously spit off income.
There are more and less active ways in which you can create wealth and income streams. If you’re considering starting a business – a very active path – you might want to read this post. If you want to build up income streams by investing in stocks or real estate, there are more active and less active options within each asset class as well.
I’ve put together some basic infos for you regarding investing in stocks here.
In this post I’ll be tackling the second big asset category that can produce job-independent income: real estate.
As always, a disclaimer upfront: I’m not a financial advisor and I don’t give individual investment advice. On this blog, I only share my own knowledge, my experiences and my understanding of economic links. Before you make an investment decision, you should inform yourself broadly and make up your own mind.
Real estate as an investment
Very important: when I talk about real estate as an asset I’m not referring to buying a house or an apartment to live in, but to real estate that is rented to others. Owning your home might be part of financial independence that makes sense in your particular circumstances. That’s about savings, not about investing, though.
And owning versus renting doesn’t necessarily have to be what makes most sense from an economic perspective. Very often the opposite is true. Maybe I’ll write a separate post on this one day.
Rental income and rise in value
So how does real estate produce an income stream? Very obviously by the monthly rental income. You buy a house or an apartment for the amount of x, and your tenants will pay you a monthly amount of y for using your property.
When you compare this with stocks, rent works similarly to dividends as an income stream. And just as shares, real estate can rise and fall in value. If the value has risen, you can realize a profit when selling your property, just like when you are selling shares.
But although this looks similar at first glance, there are quite significant differences between investing in real estate and investing in stocks. One big factor is liquidity. Stocks can very easily be exchanged into cash via the stock market. If you’re using an online broker this can in fact be done at one click.
Selling (and buying) physical real estate involves a longer process. But there are ways to combine investing in real estate with the liquidity advantages of the stock market. More on that later.
Another big difference between investing in stocks and investing in real estate are transaction costs. When you buy individual stocks or shares in ETFs via an online broker you’re probably paying less than 1% in commission. There are brokers that are still cheaper than this. If you buy loaded funds that’s different, obviously – but then I’m not a fan of those anyway.
In Germany you have to pay real estate purchase tax. It’s a federal tax that varies between the Bundesländer and costs between 3.5 and 6.5% of the purchase price at the moment. The administration discovered this tax as a very nice source of income and percentages have risen in a lot of the Länder during the last years. On top of that you have to pay a notary for documenting the purchase, and there are fees for registering you as the new owner in the Grundbuch (real estate property register), together around 1.5%.
Depending on whether you’ve found the property via a real estate agent (there is no compulsory use of an agent in Germany) there will be agent’s fees on top. These fees are a federal matter as well and currently vary between 3.57 and 7.14%. When we bought our first apartment in 1997 the rule of thumb was to calculate with purchase costs of approximately 10%. Today it’s more like 12%.
Recurring costs and personal involvement
But here’s the most significant difference between both asset classes in my opinion: If you invest directly in physical real estate, you’ll be responsible for ‘running’ the property yourself. This will not only involve a certain amount of time, but also a certain amount of recurring costs. Companies that you invest in via the stock market will have recurring costs for administration, marketing, personal etc. as well, of course. But you as a shareholder will not be directly involved.
On the other hand your influence on the profit and value of a company you hold stocks in is very limited not to say non-existent. You’re not in absolute control when you own rental real estate either. But you are in charge of important factors such as selection of tenants, regular adjustments of rent, or any investments to boost the value of your property. You can delegate some of this, but the more influence you want or have to exert, the more active your real estate investment gets.
My own learning from than more than 20 years of experience with real estate is that you have to treat rental real estate just like a small enterprise. You have to take care of your clients (your tenants), you have to stay on top of your costs and build up buffers, and you have to grow your revenues. If that’s activities you enjoy, cool! In that case investing directly in physical real estate can be just the right thing for you. And you can benefit from two things where direct real estate investing differs from investing in stocks.
Usually real estate investors don’t pay cash but finance a real estate purchase at least partly with borrowed money. So, if you want to buy a property you will probably take out a mortgage with a bank. That’s a whole topic in itself, so worth a separate post. At this point it’s only important to understand that you can raise the return of your own investment this way. That’s what’s often referred to ‘leverage’ in real estate investing (another parallel to a ‘real’ enterprise’, companies often work with borrowed capital as well).
In theory, you can buy stocks with borrowed capital as well, with a chance of boosting your return on investment. But that’s extremely risks – I know people who did this during the dot-com-bubble at the beginning of the century and lost A LOT of money – and hopefully no bank would give a beginner this kind of credit anymore these days.
The second interesting topic are taxes. Just like a company, you’ll calculate the taxable profit from your real-estate cash-flow by deducting your costs from your revenues. But you cannot only deduct your ‘real’ running costs like mortgage interest, but also a yearly percentage for ‘depreciation’ of your property. This way, you don’t pay taxes on what’s effectively in your account at the end of the year, but on a smaller amount. Often you will end up with a tax loss during the first years which offsets some of your income from salaried work. In that case you’ll get a tax return.
Companies you hold shares from can claim depreciation for tax purposes as well, of course But again, you’re not involved in this directly. And when your shares pay dividends for example, you cannot offset them with the transaction costs for originally buying those shares.
In Germany, proceeds from sales are treated differently as well: When you sell rental properties after a ‘speculation period’ of ten years any gains are tax-free. Profits from the sale of stocks used to be tax-free after a ‘speculation period’ of two years as well. But unfortunately this has changed. Nowadays you have to pay 25% tax plus ‘Solidaritätszuschlag’ (not going into any detail here) for any gains/dividends above a personal tax-free allowance of 801 Euro per year.
Other ways to invest in real estate
And if physical real estate feels too active an investment to you but you still want to diversify into real estate assets? Good news: there are more ways than one.
Typical German real estate investment vehicles are ‚open‘ and ‚closed‘ real estate funds. These are funds that invest into a real-estate portfolio. The former should tradeable on a daily basis. But some of these funds have run into liquidity problems when share-holders wanted to give-back their shares following the down-turn of 2008/9. So these fund were technically closed to transactions and investors were not able to withdraw their capital.
‘Closed’ funds were often constructed as tax-saving vehicles and run for a pre-determined number of years where investors will not be able to withdraw their principal. There have been some problems with this type of fund as well, upto the extent of management embezzling clients investments. Just google if you’re interested in this topic. Personally, I would not invest in either vehicle.
Real Estate Crowd Investing/Funding
There’s a relatively new kid on the block which works similar to ‚closed‘ real estate funds at first glance: Real Estate Crowd Investing. It’s quite a Hype at the moment. In Germany you can invest in a range of fix-term projects on platforms like Exporo, Zinsland or Bergfürst. And different from the traditional funds investment amounts start fairly low. Currently interest payments are between 5 and 7% p.a. – depending on the predicted credit worthiness of the project/ project sponsor.
It’s important to know – and I don’t necessarily get the impression that this is actively communicated – that you don’t invest in the property itself but in the financing of the property project via these platforms in most cases. Which effectively means you’re giving a loan to a property developer. And your loan is only subordinated, and not secured by a lien to the property. Subordinated means that investors will only get their money (back) when senior obligations – commonly a bank loan – have been fulfilled. That’s fine as long as everything goes according to plan.
But if revenues for the sale of a new development don’t match predictions for example or the project sponsor runs into some other kind of problems part of or your total investment might be lost. As far as I know there have not been many defaults yet. I would partially attribute this to the limited number of projects that have been completed so far, though. In the long-term I would calculate with a higher default rate if I wanted to invest via real estate crowd funding.
Always be aware of the risk
There are disclaimers regarding default and loss of investment risk on the real crowd investing platforms I’ve looked at. But my impression is, that a lot of private investors either underestimate the risks or maybe have not done their research as diligently as necessary. In Germany it’s technically very easy to register and invest straight away on these platforms. Maybe interesting to know in this context: One of the most successful real estate crowd investing platforms in the US, Realty Shares, has just shut down their business. This seems to have come as quite an unpleasant surprise even for bloggers who massively promoted this platform before.
My personal view is that interest rates on German platforms are too low, given the risk of subordinate loans. With 5% interest rate, in theory one of twenty projects can default before you lose money if you spread your investment evenly. Your interest from the other nineteen projects will off-set the default in this case, leaving you with no money lost.
Different from ‚closed‘ real estate funds that are legally classified as ‘entrepreneurial’ share holdings you will not be able to benefit directly from depreciation. On the other hand there can be no call for additional cover. Worst case you’d only lose your investment.
All in all an interesting new sector which I’ll keep monitoring myself, too. It is possible to invest fairly limited amounts of money in financing real estate projects. But if you consider investing please don’t let yourself be swept away by the hype. Make it a point with any investment to always diligently weigh opportunities and risks.
Publicly listed real estate firms and REITs
And now fort he last category of real estate investments that I want to introduce you to in this post. You can invest in real estate firms that are publicly listed. In Germany this would be Vonovia for example, or Deutsche Wohnen. A special form of real estate firms originating from the US are REITs (Real Estate Investment Trusts). They have to comply to very specific legal regulations. There are European REITs as well, but I’m not familiar with their legal requirements.
Just like other shares, you can buy US REITs via online banks/brokers. Just like with buying individual stocks, you should research the specific company in detail before you buy. And just like with ‘regular’ stocks, there is the alternative to buy globally diversified ETFs, that will hold a mix of real estate companies and REITs.
Right, this is it for an introduction. Since real estate is the asset class I have the most experience with, I’ll obviously share my learnings and insights with you on this blog. So expect lots of future in-depth posts on this topic…
Financial Independence Rocks!