When I first started researching real estate investing, I often encountered the refrain about “having someone else pay your mortgage” used to explain one of the best features of investing in rental properties. It is invoked regularly — and often quite enthusiastically — as evidence of the superiority of real estate investing as compared with, say, putting your salary into a 401K.
But how much is having someone else pay your mortgage really worth?
Let’s use a super-simple example, one that conveniently sidesteps tax considerations (I know that tax savings are a big reason people invest in real estate, but the “having someone else pay your mortgage” argument isn’t about taxes, it’s about the quite enticing prospect of having your bills paid for you!)
Imagine you have $20,000 available to invest, and you’re given the following two choices:
- You can put the $20,000 into a Roth 401K, invested in a vanilla mix of stocks and bonds (which of course includes underlying real estate sector exposure). You will receive an average annual return of 8.67% (which is slightly higher than the long-term average since 1900, but quite a bit lower than several of the 30-year periods over the past century). You make no further contributions to that account for 30 years, and then withdraw it tax free.
- A friend calls you up with an unusual proposal: you’ll put in the $20,000 as the down payment on a $100,000 rental property; she’ll keep any cash flow along the way, but you get to keep 100% of the proceeds when you sell the property in 30 years. The home will appreciate an average of 3% each year (in line with historic trends). After 30 years you sell the house, and your friend pays all closing costs and any taxes due on the sale. In the purest possible sense you’ll have bought a house and someone else will pay the mortgage for you during the entirety of the mortgage term.
So what happens in each case after 30 years?
Well, let’s look at the house first. You’ve put down $20,000 on a $100,000 property that has appreciated at an average of 3% a year, so it’s now worth $242,726 and has a mortgage balance of zero. In other words, thanks to the power of leverage (and the fact that someone else was paying those mortgage payments), you’ve been able to earn more than 10X your original investment, turning $20,000 into almost $250,000. Not bad! Certainly a compelling case for having someone else pay your mortgage.
But wait, let’s look at the Roth 401K balance. Remember that we expected an average return of 8.67%? That $20,000 initial balance after 30 years would have grown to … $242,281. In other words, you’ve also been able to earn more than 10X your original investment, turning $20,000 into nearly a quarter million.
Now, I’ll be the first to acknowledge this is a simplistic example, with a lot of assumptions baked in. But it’s also a useful illustration that while the leverage you get from having someone else pay your mortgage is indeed quite powerful, it is not by itself enough to justify choosing real estate over other alternatives.
But what if you buy a house in a really hot area and it appreciates much more than that 3% rate? Well, congratulations! But your improved return was a function of appreciating land value, and had nothing to do with having someone else pay your mortgage.
IOW having someone else pay your mortgage is like getting about 5.5% on your money
Remember that in our fictitious scenario the property appreciated at 3%, which influences the total return. But if we instead assume zero appreciation, we can isolate the return from just having the mortgage payment made by someone else. If our return was a bit more than 8.5% when the annual appreciate was 3%, then our “pure” return on the mortgage leverage is 8.5% – 3% = 5.5%.
Put another way, having someone else pay your mortgage is like earning about 5.5% on your down payment over 30 years. Not too shabby (especially given current interest rates), but again while that’s pretty nice, it’s by itself hardly a slam dunk in favor of putting that money into rental properties.
To be clear, I think real estate can be an outstanding investment, and fortunately there are now more ways that ever to get exposure to real estate in your portfolio. But it’s important as an investor (especially if you’re a newcomer to real estate) not to get caught up in the excitement of what certainly sounds like a free lunch (having someone else pay your mortgage) without making sure you really understand how that lunch is made (and what else is on the menu).Have a question about crowdfunded investing? Want to learn more but aren’t sure where to start? You can explore more than 100 crowdfunding investment platforms in our database and learn more about the nuts and bolts of crowdfunding and alternative investing on our blog. And before investing, we strongly recommend getting a clear picture of your overall finances using a tool like Personal Capital. It's free, it's what we use to track our own finances, and when you sign up using that link you'll be helping to support YieldTalk.