Real estate the new Bitcoin – I don’t seriously think that, right?
No, that’s obviously exaggerated and the comparison generally falls short in some respects. But there is a current development around real estate investment in Germany that bothers me. I assume you read on this blog since you’re looking for ways to optimize your personal finances and to build salary-independent income streams. That’s why I want to share my impressions here – you can then go ahead and judge for yourself.
Generally real estate is an interesting option to build (additional) income. For starters, I’ve put together the basics in this post. Rents are a significant part of our ‘passive’ income as well. We’ve more or less stumbled into this kind of investment by coincidence when the 1.5 bedroom apartment we originally bought grew too small for a family including a child and an au-pair.
So we rented the apartment out. Both my husband and I have an interest in architecture and interior design and my husband used to ‘stalk’ construction workers as a kid which left, leaving him with great practical skills. We’ve continued to scan properties during the following years and now rent out four apartments in different locations and with different concepts. I’ll go into more detail about this in another post.
Become a real estate millionaire via Youtube
So where’s the problem? In the past one or two years quite a hype has grown in the German-speaking internet around real estate as an investment. I particularly notice that on Youtube. Today you’ll find a vast number of videos promoting becoming financially free with real estate.
There are the typical books like ‚How I became a real-estate-multi-millionaire in three years without putting down any of my own money’. And the successful (?) real estate investors will interview each other on their respective channels or bring on other Youtube-gurus like sales or motivational coaches whose products get linked in the show notes as well.
Despite that obvious sales and network marketing angle, you can, of course, extract useful information from the content if you want to dig deeper into real estate as an investment vehicle. And I assume that among the Youtubers there will be some who have actually succeeded in building a relevant networth or significant cash-flow from real estate. But what bothers me is that blogs, videos and comments will often indiscriminately promote and multiply strategies ‘for everyone’ that I think are quite risky.
Is 100%+-financing really always great?
Let’s take financing as an example: there’s quite some shoulder-clapping and high-fiving around doing your real estate ‘deals’ based on 100% financing, or even financing the transaction costs on top of this. The majority of the viewers and readers will most probably not even get this kind of financing any more, since banking rules have become more strict lately (link in German). I can confirm this from my own experience: Both we and friends of ours noticed last year that, even with very good credit ratings, documentation you have to provide for financing has become much more extensive than what we were used to. But completely independent of this, your financing has to match your strategy. And just as with stocks, you have to distinguish between speculation and investment.
As a private real estate speculator, your strategy could be to buy a multi-unit property with as little of your own money as possible with the intention to sell it again after 10 years with a substantial, tax-free profit (after pay-back of outstanding loan) when the ‘Spekulationsfrist’ has ended. To make this work rents should cover all costs, otherwise you will have to top up with your own money while holding. And the value of the property needs to go up during those 10 years in line with the risk you’ve taken up with the 100- to 110% financing. That kind of deal is very hard to find in the current market climate in Germany. Plus you’re not generating income streams substituting your income this way either.
Investing for cash-flow
That’s a different kind of strategy: the property you financed, e.g. an apartment, has to produce a positive monthly cash-flow, i.e. the rent has to cover interest and principal payment plus all other costs the apartment occurs, optimally leaving a surplus. This way, your renter will pay off the property for you over time. But with a typical 2% principal-pay-off we’re talking 30 years plus here.
Given current interest rates, there’s a rough guideline of 2% interest, 2% principal, and 2% for other costs (mandatory payments for the common parts of the building, your own reserves for necessary repairs, safety reserve for loss of rent, etc.). In this case a rental return of 6% will only cover your costs and you really need a property with a higher rate of return if you want to be cash-flow positive.
And that’s where you’re back to the problem of the current real estate market in Germany (which generally works differently from other countries, and does not deliver returns in residential real estate that are anywhere near the figures you’ll see in the US, for example): In top cities and locations where you can be quite sure to be able to rent the apartment continuously and adjust rents to inflation, returns of 6% plus are currently unrealistic. You’ll typically find those types of property in areas with structural problems or with a problematic clientele of renters. Which goes with the associated risks. That’s not at all to say, that money can’t be made in these types of area. But when you’re just starting out in real estate investing you shouldn’t pile too high a financing risk on top of this in my opinion.
And that’s where we’re back at how much capital to invest. The less of your own money you invest when buying a property, the higher the return on the capital invested, that’s simple math. This effect is what’s being hyped in the community as well. What nobody seems to talk about though is that technically your yield on capital goes down as soon as you’ve made your first payment on principal since your capital in the property rises month by month with each principal payment until you own the property outright. Then your share of capital in the property is 100% and the yield only equals the rent’s rate of return after costs. (Yes, I know, there are models where you only pay interest on the loan, but let’s keep it simple at this point).
It’s only at this point in time that you will be able to realize the full income stream from your investment as well. Based on the financing outlined above after more than 30 years, that is. During that period you can encounter the situation that you will already incur a book profit that you have to pay taxes on based on your personal marginal rate of tax although you’re still making your monthly credit payment. This might result in turning a positive cash-flow before taxes into a negative cash-flow after taxes.
Investing little of your own capital is not good or bad per se, but I’m getting the impression that – again – speculative and investment strategies are mixed indiscriminately. You can benefit most from the leverage effect associated with real estate when you use it in speculation. Or when you’re actually building up a real estate company which will be run separately from your private investments in legal and tax terms.
Cash-flow versus capital versus loan
But if you want to build an income stream from rents to cover your living expenses in say 15 to 20 years, you will have to invest enough capital to have the loans paid off by that time. Or your property portfolio has to be so big that you realize enough cash-flow to cover expenses plus loan payments. This video (in German, no affiliate link) illustrates this (but careful there’s another thought-trap: the ‘income’ adjusted for inflation still only has today’s purchasing power since your living expenses will rise with inflation as well). And there remains the question how many properties a bank will finance for a ‘newbie’ investor.
A portfolio up to a million Euros should be possible with a high income from a secure job and a good credit rating. That’s probably not enough cash-flow to become financially free if you still have to service the loans. On top of this you might run into problems in this constellation if you’ve already given up your salaried position when you need to refinance. Either way, the higher the loans, the higher the risk since you have to be able to make your payments long-term.
Learn first, scale-up later – not the other way round
That’s why I think it’s quite irresponsible on the one hand, and quite naïve on the other when aggressive growth strategies are multiplied or taken at face value as a simple path to financial freedom. And I’m not sure whether some of the Youtubers and bloggers don’t underestimate their personal risk themselves.
When someone buys an apartment in a rural area in eastern Germany for example, without even looking at the property only based on the current rental yield, I find that quite negligent. And honest but still astonishing that subsequent problems seem to surprise. My take-away would be to rather start small than maximize risk as a new part-time real estate investor. Make your own mistakes like everybody does and only scale up when you’ve got some experience. Probably doesn’t sound as sexy.
So, back to the beginning of this Post – we’ve not reached a Bitcoin-like hype with real estate, but we might already be in what’s called a ‘Dienstmädchen-Hausse’(‘maid’s hausse’, though that normally refers to the stock market). That shouldn’t keep you at all from checking out whether real estate might be an interesting source of income for yourself – but keep your common sense switched on J.
Financial Independence Rocks!