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Real Estate Investment
Ruminations on Real Estate
By David Hultstrom
President, Financial Architects, LLC
Lately it seems many people have asked us for our opinion on individually-owned real estate as an investment (as opposed to publicly traded Real Estate Investment Trusts (REITs), or purchasing a home to live in). This in itself may be a sign of a market top, but in any case I thought you might like to see our latest thinking on the subject. There is no right answer for every situation; different people will weigh the factors differently. Here are some items to keep in mind (in no particular order):
People like real estate emotionally; it is tangible and substantive and that gives them comfort. There is danger these emotions will get in the way of an objective decision however.
Returns lately have been very good and it should be noted that behavioral finance research has demonstrated that people tend to overweight recent data. Long-term returns on real estate (longer than the past few decades) have been just above inflation (0.4% according to one study), though this ignores income or expenses of the real estate. Income producing investments can have very high returns (similar to stocks) if unleveraged (no debt) and potentially even higher if levered (debt financed). Thus, flipping is probably not a successful long-term strategy.
Real estate is a good inflation hedge, particularly when financed with a long-term, fixed-rate mortgage. Thus it can be a risk-reducing part of a prudent financial plan, though it is difficult to get proper diversification due to limited personal resources except for the very wealthy. Also, people typically don’t diversify because of comfort with “known” types of real estate and the local area (e.g. they tend to buy single family residential rentals in their area rather than warehouses in another part of the country)
High leverage (debt) frequently used exacerbates cash flow issues if properties are vacant temporarily (this is ameliorated of course by not using leverage).
There are some tax advantages to real estate as an investment.
It can be more work than people realize (and they rarely factor the value of their time into their basis when computing their returns) and it is generally illiquid and transaction costs are generally high. Because of these factors, publicly traded REITs may be a more appropriate alternative.
It is a relatively inefficient market (i.e. mispricings can happen and can be large) so there is opportunity to outperform based on skill. Even assuming skill exists however, it is difficult to have the requisite number of transactions for it to evidence itself. See the detailed explanation of this below.
The riskiness of real estate is frequently not recognized – there is artificial smoothing of prices which reduces the standard deviation of the data. See the detailed explanation of this effect below also.
I would like to dilate further on the last two points because they are important in areas other than real estate as well.
It is not enough to have skill; there must be adequate opportunities to evidence that skill. This is one of the primary problems with attempting market timing with traditional investments – even assuming some people have skill, they don’t get to exercise it often enough. To illustrate, suppose I have a coin that has a 60% chance of coming up heads and a 40% chance of coming up tails. Would you bet $1,000,000 on one coin flip that it would be heads? You pay $1,000,000 to plan and if you win you get $2,000,000; if you lose you get nothing. The expected return is $2,000,000 x 0.6 + $0 x 0.4 = $1,200,000. I assume the answer would be no, even though on AVERAGE you would win $200,000. However, you would almost certainly be willing to bet $1 on that coin flip and do so 1,000,000 times, even though the expected return is the same. The difference is the outcome becomes practically guaranteed because of the volume of wagers. You will almost certainly have a profit of close to $200,000 at the end. In real estate, even presupposing superior skill, many transactions are necessary to eliminate bad luck and evidence that skill with high certainty.
Real estate may look less volatile than it actually is for two reasons: First, properties don’t trade every day so prices between trades are estimated. These estimates tend to be based on the last transaction and/or the last estimate, which tends to smooth the volatility (hedge funds with illiquid holdings have this same artificial reduction of volatility). Second, when prices “decline” many people, exhibiting typical loss aversion, don’t sell but rather pull the property from he market until it recovers. Thus while the true price is a loss, it doesn’t show up in the data, rather volumes simply slow dramatically.
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