From The Mail Buoy: Hawaii Investment Rental Properties

A reader writes:

Hello Doug. I really enjoyed your interviews and what you have to say about how you got to where you are now. I am looking into financial independence as well. I had a late start, so I feel it’s going to take a while for me to get there, and it may not even be early retirement by then.

The reason I am contacting you is because I heard your interviews both on the Millionaires Unveiled and the Bigger Pockets Money podcast and I have a few questions and I would love to hear your answers to them.

In the Millionaires Unveiled podcast interview you stated that it’s not a good idea to buy investment real state in Hawaii. I would like to hear from you on why is that? Is there any circumstance where buying real state to rent would actually work here?

I am pretty convinced that buying and renting or flipping real estate would be the fastest way for me to get to financial independence. It does not necessarily have to be in Hawaii, although there’s a few properties for sale right now near me that are very tempting. I am not even close to being financially independent as I stated, but with the options that we have right now, and the economy being hit with COVID-19, I feel like this is the time to act on certain opportunities that we may not see in a while, and I want to make sure I don’t miss out this time. Thank you!

My response:

Thanks for listening to those podcasts! Mindy and Scott do great interviews and I’ve enjoyed the other Millionaires Unveiled episodes.

Let me take you through Hawaii real-estate investing logic and its conclusions.

“Why not invest in Hawaii real estate?”

Image of an investment rental real estate single-family home on Oahu. | The-Military-Guide.com — It looks pretty good now!

Investment real estate offers an entrepreneurial career without the stock market’s volatility. You have more control over your real-estate investments, although it’s more work to analyze and buy the properties than to buy a stock index fund. Some people invest only in real estate and others stay with the stock market, or you could diversify with a combination of the strengths of each.

Over many decades, the stock market’s long-term return (after inflation & taxes) has been about 7% per year. (Although it’s very volatile from one year to the next, that’s the compounded annual average.) Those returns can come from a passively-managed total stock market index fund with very low expense ratios. (The popular examples are the Thrift Savings Plan, Vanguard’s mutual fund VTSAX, or the exchange-traded fund version VTI.) The funds offer about 99.97% of the market’s return for almost no personal effort at analysis or management.

Once you’ve started the process, you can use your numbers to calculate roughly how long it’ll take you to reach financial independence. All you have to do is save and invest as much as you can, and you’ll even automate that process. When you’re doing it consistently in autopilot, it’s actually pretty boring.

Image of dirt and debris under refrigerator from tenant not cleaning under it. | The-Military-Guide.com — “Uh, sure, we cleaned under the fridge…”

If you’re investing in real estate for a lower return, then you’re working way too hard for less money. You might have more control over the real estate, but it’s more work than the stock market– and real estate work can happen at inconvenient times. I’m not referring to the mythical 2 AM phone calls about plugged toilets but rather broken appliances or storm damage or tenants who simply move out at the end of their lease and leave some messes.

When you search for investment properties with the BiggerPockets thumbrules of 1% and 50%, it implies that you’re earning 12%/year in gross rents and spending half of it on operating costs. Just investing with those two thumbrules results in an after-inflation after-tax long-term capitalization rate (your rate of return) of about 6%/year. Yes, there’s appreciation too, but the long-term average appreciation of real estate is only about the rate of inflation.

Rental cash flow (net rental income) and the stock market are the only assets which routinely (over the long term) grow faster than inflation.

You very rarely see a Hawaii property with monthly rents of 1% of the property value. You almost never see it on Oahu, although it’s possible to bottom-fish through the foreclosures and abused/neglected properties. When you make an offer on those properties, you’re competing with professional real estate investors who’ve spent years building up their teams and networks to search for them and negotiate a good price for them.

When you receive a military housing allowance, there’s even more temptation to invest in real estate. You’re earning tax-free money to buy a home instead of renting or living on base, so why not leverage it with a 0% down VA loan that even includes the closing costs? Psychologically you’d hesitate to use excessive leverage with the savings from your own paycheck, but for most military families the housing allowance is the biggest income stream they’ve ever experienced. A housing allowance doesn’t seem as hard-earned as real pay, and you could invest it instead of collecting rent receipts! Taken to extremes, you could buy a home at every duty station around the country— and when you left the service you’d have a very diversified portfolio of investment rental properties!!

That starts the urban legends of real estate profits: leveraging your equity with a mortgage and hoping that nothing bad happens while the property appreciates at least as fast than inflation. Over the very long term (30 years) that probably happens. Over the shorter term (10 years) it’s affected by local conditions. Over the very short term (a military tour of 2-3 years) it’s gambling.

Very few bargains on Oahu

My spouse and I have lived on Oahu for over 30 years. There may be coronavirus real-estate bargains here if a landlord or homeowner loses their income and can’t pay their mortgage. The island’s collapse of the visitor industry has created double-digit unemployment, and people are struggling even more to pay their rent. However those bargains can be found all over America, and there will be better deals on the Mainland.

There might not be any appreciation in Oahu real estate for the next five years because of new construction.

During the Great Recession, the number of Oahu’s real estate sales dropped by 25%. However single-family homes & condos only lost about 10% of their value and quickly recovered. Since then, the construction industry has been very slow to rebuild, and our current values have been forced over the last decade up by a lack of new homes. That’s starting to change with Ho’opili, Koa Ridge, and the light rail’s Kakaako corridor– which should add at least another 5000 homes to the Oahu market in the next few years. In addition, COVID-19 self-isolation is accelerating the growth of remote work and could reduce rush-hour traffic. That could even reduce property values.

From 1990-2000, Oahu real estate lost 30% of its value. Japan’s 1980s real estate bubble drove real estate to ridiculously high starting values just before the 1990 Gulf War. The decade-long drop was exacerbated by the U.S. military’s drawdown (and base closures) of 1993-2000. Coronavirus will not change Hawaii real estate value that much for that long.

You might occasionally win with appreciation, perhaps by owning a cheap property that suddenly turns out to be a block away from the new light rail station. However you’re competing on those unicorns with full-time professionals who have better research tools, better networks, and more access to loans than us.

Better places to buy

Investing in real estate is best done with a team, or else it’s simply a second job where your time & efforts do not scale. (Especially if you already have a different full-time career.) You’d want to form your team of a property manager, a realtor, a contractor, and eventually a lawyer & accountant. The Pro memberships on BiggerPockets are an example of people networking across the nation. When you can form a good team then you can work with them anywhere. It doesn’t matter whether they’re in Honolulu, in Hilo, or… in Houston. You have the entire Internet to research America’s best investment real estate by ZIP codes, and you can build a team of professionals to help you manage those properties even when you’re thousands of miles away.

It’s a lot easier to find Mainland properties that return a capitalization rate of at least 6%/year. (It’s possible to find them returning >10%.) If you have an experienced team of real estate professionals then you might even outperform the stock market.

Two conclusions.

The first conclusion is that it’s better (in the long term) to form a real estate team. It seems hard to form that team (let alone at a distance), which is why people try to invest by themselves in their own neighborhoods. Once you find the team, though, you’re well on your way to finding good properties across a much bigger area. It’s also easier to grow that business.

The second conclusion is that your team will find better investment real estate on the Mainland. Land and construction are cheaper than Hawaii, and if the rents are a little higher in a popular area then the math quickly jumps up into bigger returns.

What works for investing in Oahu real estate

There are professionals making good money from Oahu real estate. I’ve met some of them and talked with a few of them. They tend to do the following:

Commercial real estate, which is a specialized career built through experience.
Foreclosures, which have significant individual risks and take a lot of patience over months of effort.
Kitchen rehab after 39 years.
“Gut and rebuild” rehabs, frequently on neglected or toxic properties. You’ll need contractor skills in this area, along with nerves of steel to efficiently borrow money and execute quickly.
Neglected multifamily. This is a specialized area where you buy from a landlord who’s mismanaging the property, or you fix a backlog of repairs/maintenance, or you squeeze out new efficiencies by billing separately for utilities. Again it takes time & experience.

If you decide to pursue any of these areas then I can put you in touch with local military families to learn more. If they don’t invest in that niche then they’ll know who does. They’ve also attended a lot of real estate investor meetups and can help you find the right gatherings.

There are a couple options you can do on your own in Hawaii… but again they’re specialized skills and might not work for military families.

Image of Scott Trench's "Set For Life" book from BiggerPockets | The-Military-Guide.com — Click the image for more info.

– Live-in flips. You buy a crappy place and live in it while you do a gigantic rehab. Mindy & Carl Jensen accelerated their FI this way in Colorado. It can be a stressful lifestyle if you’re in the middle of a huge plumbing or electrical overhaul. (On the other hand, your whole family could learn to lay flooring along with other valuable contractor skills.) You’d want to live in the property for at least two years (to defer the capital-gains taxes on the sale), and then you end up moving every 3-4 years when you search for the next property.
– Multifamily as your primary residence. You buy a duplex (or bigger), live in one of the units, and have the tenants pay your mortgage. For higher returns you can move into each of your units for a few months (as tenants move out) and rehab them to eventually upgrade the entire property (and charge higher rent). There are also standard ways to bill each tenant for their individual utilities, even if there’s only one set of meters for the entire property.
– House hacking. (See Scott Trench’s “Set For Life” book.) You buy a single-family home (perhaps with an accessory dwelling unit on the property) and rent out bedrooms (and the ADU) to multiple tenants. It’s shared living, and there may be more drama. This can be problematic if you have kids/pets.

Personally, I prefer stock index funds. (We also do live-in home improvement.) Our biggest driver of our financial independence has been a high savings rate with an aggressive stock-market asset allocation. It’s very volatile, and I don’t have as much control over the stock market as I might have with a rental property. However it’s a lot less effort and I can absolutely reach financial independence with a combination of a high savings rate and regular investments in passively-managed stock indexes with cheap expense ratios.