The U.S. was very lucky that Hurricane Dorian didn’t do the same kind of damage that it did to the Bahamas, where the loss of life and property has been horrific. As summer gives way to fall, it’s a useful warning to those dreaming of buying that condo at their favorite beach. Often the reasoning is that since it’s a great place to vacation, it’ll also be a good place to invest. Those positive feelings from a great family vacation can blind us from the cold hard truths of real estate investing. Here are 10 reasons why, for most people, a beach condo should be regarded as a recreational asset rather than a serious investment. Then at least you’ll have a more balanced view of the vacation condo “investment” idea before you go that route.
- Planning. To rent that ideal condo at a beach community you really like usually requires booking long in advance of when you actually want to visit. Some vacationers even book next year’s visit as soon as they get back from this year’s vacation. If you own a condo as an investment you’ll want vacationers to be booking it well in advance too, which obviously means you will have to plan your visits well ahead. Just like you would if you were renting someone else’s condo! So an investment condo might not provide those spontaneous visits to the beach after all.
- Guilt. Avoid tying yourself down to one beach community if you like going to new destinations. Some property management companies have multiple communities that you can visit, but so can VRBO.com and other vacation rental web sites. You don’t need to own to enjoy. If you’re not using your condo much, nor making money on it, you may start feeling guilty about owning it.
- Interest rates. Interest rates have fallen relentlessly since inflation peaked at just under 15% in 1980, which has increased asset values, making real estate look like a no-lose proposition. We don’t know whether interest rates will stay low for the long-term, or move higher in response to easing trade tensions or some other economic factors. If interest rates do rise, capital gains will be much tougher to achieve than they were with falling interest rates. The other source of potential gain from real estate—cash flow—would also be crimped by rising borrowing costs.
- Climate change. Perhaps this should be been number 1 on my list? Rising global temperatures are making tropical storms more frequent and more severe. That will increase the cost of maintenance and repairs to structures in coastal areas, as well as insurance, over the long-term. Some coastal areas may become uninsurable. Already the Federal government is funding buyouts of vulnerable coastal homes in what’s been dubbed a “managed retreat”.
- Management fees. Paying property managers can take somewhere in the neighborhood of a fifth of your revenue, which for many condos, may be the bulk of any cash flow remaining after expenses and mortgage payments. In general, real estate investors do best when they manage assets themselves and have an edge in figuring out which opportunities will do better than others. For example, locals with insight into potential zoning changes can acquire and develop more cheaply than investors without that insight. Making money in real estate is like any other competitive endeavor: it requires skill, time, and fortitude.
- Special assessments. These can be big ticket items that hit condo owners with little or no warning. Individual condo owners typically have no control over management of their building but remain liable for their share of major building repairs and upgrades. Also, as a building ages its major repair and replacement needs tend to increase, particularly to remain competitive against newer condo developments. Special assessments are a serious risk that you should factor into your investment considerations.
- Leverage risk. If you’ve taken out a mortgage to purchase the condo and increase your after-tax returns you need to understand how your finances will hold up in a severe recession. Expensive beach vacations are one of the first luxuries eliminated from a family’s budget in tough times. Condo vacancies can skyrocket and rent revenues can plummet, but the monthly loan payments remain. If you lose your job and have few other financial resources to tap, you could be in trouble.
- Illiquidity. Unlike the contents of a brokerage account, a condo can’t be tapped cheaply and quickly for cash. To do that you’ll have to find a buyer and probably pay that 6% broker fee. Surveys by the National Association of Realtors have shown that vacation home investors intend to own their properties for anywhere from 5 years (2015) to 9 years (2017)—let’s call it eight years for our calculations here. That 6% broker’s fee represents 0.75% of the value of the condo each year assuming an eight-year ownership period. On a $400,000 condo, that’s about $3,000 each year that you should factor into your investment return estimate.
- REITs. Most investors would achieve better returns from real estate by investing in professionally managed real estate investment trusts (REITs), without assuming all the risks I’ve listed above. For example, Equity Residential (EQR), a middling performer in the apartment REIT sector, generated a roughly 13.7% pre-tax annual return, on average, over the last decade. Over that same period, the Bureau of Labor reports that US housing appreciated in value by 2.0% annually, or about 1.4% after a 6% broker’s fee is factored in. The 12.3% annual difference between these two returns (13.7% less 1.4%) is roughly the cash flow return on investment you would have needed to achieve to earn what Equity Residential did—no easy task! Now I realize that the BLS 1.4% housing appreciation statistic is an average that may not apply to particular pockets of the country. But it’s a useful starting point for figuring out how much cash flow return on investment you’d have to generate from your condo to earn what you could have from a REIT, with zero effort.
- Concentration risk. If you’re of moderately affluent means, buying an investment property on top of owning a primary residence represents a large portion of your net worth invested in a very narrow segment of the overall real estate asset category. That in turn is a tiny part of the global investment opportunity set available to you. It’s also one of the worst asset categories you can invest in. For example, a globally diversified all equity strategy from Dimensional Fund Advisors would have generated 10% annually over the last 10 years, while the S&P Global REIT index would have returned 10.1%. You might be thinking that’s all well and good, but over the long-term residential real estate has done better. Well, looking all the way back to 1967, when the Bureau of Labor’s housing data began, residential real estate inflation has averaged about 4.2% annually. That compares with general inflation of 4.0%. What this means is residential real estate has merely maintained purchasing power versus other things you may want to buy. Over the same time span the S&P 500 returned 10.3% annually, on average, of which two thirds was due to price appreciation—the rest is the effect of dividend reinvestment—roughly in-line with inflation. At 10.4% annually, a lump sum investment in the S&P 500 in 1967 would have compounded to a value 20 times that of the typical residential real estate asset, excluding the effect of taxation!
If you want to buy a vacation condo be cognizant that it’s highly likely to be a risky, low return, illiquid asset in which you have little control and no investment edge. Think of it as a recreational asset, not an investment. If you want a genuine investment that builds long-term wealth, consider a globally diversified portfolio of equity investments in companies with talented management teams. That is where most wealth is really created. You’ll get more beach time that way.