Many clients we work with have large windfalls of cash from their stock options. Either right after an IPO, a merger / acquisition, or some other event. Some choose to invest their proceeds into the stock market, while others want to own something for long term cash flow. We often hear the question, “should I invest in real estate?” or “What do you think about buying a rental property?” or “should I use my stock compensation to invest in the stock market or in real estate?”
Let’s be clear, using stock compensation to invest in the stock market or in real estate is a great start to building investments and supporting your future life 🙂
This blog really aims to discuss the question, “Should you buy a rental property with your stock compensation proceeds?”
Now, keep in mind this is a loaded question! There are so many variables at play. So, for the simplicity of this blog, we are assuming the investment strategy of buy & hold residential properties (single-family homes, duplex, triplex). We broke down the primary pros & cons of real estate investing to help you wrap your mind around this type of investment strategy.
This is for educational purposes and does not take into account your personal financial situation.
As always, if you have any questions around real estate or stock, reach out and schedule a time with us!
Pros of rental real estate investments
Leverage: Being able to use leverage (i.e. a mortgage) to stretch your investment dollars is one of the primary advantages of real estate investing.
- For example: Let’s say you have $100,000 in cash sitting on the sidelines, and you want to invest. You can:
- Either invest that $100,000 in the stock market (or fully buy one $100,000 home) or
- Invest a percentage as a down payment on a property and invest the rest of the money elsewhere
- If you placed only 25% down on the property, you would have the $75,000 left to invest in improvements, another property, or to invest in the stock market.
- Let’s use the 1% & 2% rule. This rule states that you should buy a property that will have a gross monthly income of 1% or 2% of the property value. For example, if you buy a $100,000 home, that property should bring in a monthly cash flow of $1,000 or $2,000. Now, keep in mind this is a big rule of thumb. There are other variables at play (like HOA expenses and other upkeep requirements); but, using this rule of thumb is a good starting point.
The reason this is a big deal is that if you invest in the stock market, only $100,000 of your money is working for you. With real estate, you can leverage these funds with a mortgage, so you can buy multiple homes and increase your cash flow fast.
For example, you can buy five $100,000 homes by placing 20% down on each one. This will make your total investment value of $500,000. Then let’s assume the homes you bought are profitable and meet the 1% to 2% rule, so they cash flow $1,000 to $2,000 each month per property. That will be a total of $5,000 to $10,000 per month of gross cash flow! Now, of course, some expenses, the mortgage, and taxes must be taken into account; That will be for another blog post 🙂
Leverage is a double-edged sword. On the one hand, it enables you to increase the return of your initial investment by using the bank to generate leverage. On the other hand, there is a lot of risk if you cannot make the property profitable or have large unforeseen expenses pop up.
The best way to approach leverage in real estate is by being mindful of the risk you are willing to take. Understand what the ‘worst-case situation’ may be and how much work you want to put into real estate to ensure you do not end up ‘underwater.’
The conversation of ‘worst-case situation’ is even more apparent now that we’ve seen what can happen in a pandemic. Be honest about the downside.
Cash flow: In general (not always), good investments in real estate tend to have higher passive income cash flows than dividend stocks or REITs. While the property may appreciate slower than stock, the cash flow could be stronger than dividends from stocks. This is especially true once the mortgage has been paid off.
One of our favorite metrics is the ‘cash on cash return’ when looking at possible real estate properties to invest in. To summarize, it is a percentage of the amount of net cash flow (before taxes) / total cash invested.
For example, if you buy a $100,000 with a 20% down payment, your cash invested is $20,000. Then, if the property has an annual net operating income before taxes of $2,250 per year, your equation would be $2,250 / $20,000 = 11.25% cash on cash return.
In general, we suggest that clients obtain properties with at least a 10% cash on cash return or greater for true investment potential. Now, keep in mind that this is a ‘rule of thumb’. So for some properties, it would make sense to invest in even if the cash on cash return is lower than 10%.
Note: net operating income before taxes still includes expenses. i.e. maintenance, management fees, mortgage payments, and so on.
Taxation: This blog does not dive into the tax advantages of real estate investing (that will be another blog post soon!). There are some large tax advantages of this type of investment. This includes:
- Depreciation
- 1031 exchanges
- Ability to ‘write off’ expenses
Control: Control is also a double-edged sword. If you are willing to put in the sweat equity (hard work and time), real estate can enable higher returns. For example, if you put in new floors & cabinets to increase perceived value. This allows you to charge higher rent.
However, the downside of control can create:
- Paralysis from analysis
- When things go wrong, it is on your shoulders to fix
- Having control will eat up your time. You will need to make executive decisions often in the beginning, and throughout the journey of being a landlord.
Cons of rental real estate investments
A lot of time & work: Real estate takes A LOT of work, especially in the beginning. Even though real estate is considered a more passive investment, in reality, it takes time. Analyzing deals, finding the right deal, applying for financing, inspecting the property, fixing up the property, and so on. Even after you own the property and get a renter in there, you will have to manage the property & make sure things go smoothly. Even after you own the property and get a renter in there, you will have to manage the property & make sure things go smoothly. Even if you hire a management company, you will still have to be the manager of the manager.
Economic Challenges & difficult to diversify: As with all investments, there are risks. You may encounter vacancy problems depending on the area you invest in for a slew of reasons. Since you only buy one property at a time, it can be difficult to diversify. For example:
- If you invested in Detroit during the manufacturing boom, then the plants shut down.
- If you invested in Pittsburgh during the steel boom, then the plants shut down
- If you invested in Orlando before COVID-19, then Disneyworld shut down.
- If you invested in 2007 before the crash of 2008, many properties went ‘under-water’ with their mortgages
- If you invested in New Orleans before Hurricane Katrina.
Less than ideal tenants: Many landlords encounter some irresponsible or harmful tenants. Between destructive behavior to your property, lack of payment, and additional headaches, it is wise to highly screen tenants before renting to them. This requires you to develop a screening process.
Hiring a property manager will eat up cash flow but may also allow you more freedom by not needing to deal with “people” issues regularly. Keep in mind that you will have to ‘manage’ the manager.
Lack of liquidity: Real estate is naturally an illiquid investment. This means that for you to obtain the value from your property, you will need to sell it. This could require you to hire a real estate agent. There are very high transaction costs associated with selling properties, and it can take weeks to several months to sell.
To summarize whether to use stock compensation to invest in the stock market or in real estate:
- Real estate enables the use of ‘sweat equity’ to increase the investment value, which in turn, could yield higher cash flows.
- If you are busy & do not have time to dedicate to the real estate market, we do not recommend you jump into real estate investing at this time.
- Know your metrics! You cannot analyze real estate unless you know the mechanics of metrics. Here is a good article that summarizes the six most common metrics used.
- Real estate is an investment – if you can’t get the returns you are looking for on a property after 6 months to a year, was it worth not investing in the stock market and sitting on that money?
by Jim Garvin, CFP®. Lead Planner at SeedSafe Financial LLC
At SeedSafe Financial, we review the best ways to use stock compensation to invest in future self – in the stock market or in real estate. We review current real estate investments and provide perspective on future real estate projects that come up. If you’d like to work with an advisor who can help you think about stock market investments and real estate investments, book a time to chat with us now.
Not ready to book a time? Find out more: How do we work with clients?
Did you enjoy this post? Sign Up for our newsletter so you won’t miss another article.
The above discussion is for informational purposes only. Recommendations are of a general nature, not based on knowledge of any individual’s specific needs or circumstances, and there is no intent to provide individual investment advisory, supervisory or management services.
