Investing in Real Estate

 

Buying a main residence may be the single best decision someone can make for their financial future. However, when you get into second homes, holiday houses, rental properties, commercial buildings, and raw land held for potential appreciation, you’re playing a whole new ball game. That is because, over long intervals, the real returns (net of inflation) provided by common stocks has crushed those available by real estate ownership.

Yep. Americans have become so enthralled with possession of real estate that they often don’t recognize a property increasing in value from $500,000 to $580,000 within five decades, after backing out the after-tax interest expense on the mortgage, additional insurance, title costs, etc., doesn’t even keep pace with inflation! That $80,000 gain isn’t going to buy you some more goods and services; the same quantity of hamburgers, swimming pools, furniture sets, grand pianos, cars, fountain pens, cashmere sweaters, or anything else it is that you may want to acquire. Assuming a complete mortgage at 6.25%, during those five years, you would have paid $151,401 in gross interest, or roughly $93,870 following the suitable tax deductions (and that assumes you are in the top brackets, the most positive case.) During that time, you’d have shelled out $184,715 in payments.

Factoring in property care, insurance, and other costs, your gross out-of-pocket expenses could have been at least $200,000.

This should illustrate a fundamental principle all investors must remember: Property is often a means to keep the money you would have otherwise paid in rent expense, but it isn’t going to probably generate high enough rates of return to chemical your wealth substantially.

There are, of course, special operations which can and do generate high returns on a leveraged basis such as builders with a very low cost basis buying, rehabbing, and selling houses, hotel designers creating an exciting destination in a popular part of town (it has to be pointed out that in this case, the wealth creation is coming not from the real estate, but from the company — or common stock — which is created through resort operations), or storage units in a town with no other comparable properties (although, again, the true wealth comes not from the real estate but from the business that is created!)

What caused this great real estate myth to develop? Keep on reading for insights, answers, and practical information you may be able to use.
1.

The ordinary investor probably doesn’t look at her or his stock as a fraction of a real, bona fide business that has facilities, workers, and, one hopes, profits. Instead, they view it as a sheet of paper that wiggles around on a graph. With no idea of the inherent owner earnings and the earnings yield, it’s clear why they may panic when stocks of Home Depot or Wal-Mart drops from $70 to $33.

Blissfully unaware that price is paramount — that is, what you pay is the best determinant of your return on investment — they think of stocks as more of a lottery ticket than ownership, opening The Wall Street Journal and expecting to see some upward movement.

You may walk into a rental property; run your hands along the walls, then turn on and off the lights, mow the lawn, and greet your new tenants. With stocks of Bed, Bath, and Beyond sitting in your brokerage account, it may not appear as real. The dividend checks that would ordinarily be mailed to your home, company, or lender, are usually now electronically deposited to your account or automatically reinvested. Although statistically over the long term you’re more inclined to build your net worth through this type of ownership, it doesn’t feel as real as property.
2. Real Estate Does Not Have a Daily Quoted Market Value

Real estate, on the other hand, may offer far lower after-tax, after-inflation yields, but it disturbs those who haven’t a clue what they’re doing from seeing a quoted market value daily. They could go on, holding their property and collecting rental income, completely ignorant to the fact that each and every time interest rates move, the inherent value of the holdings is affected, just like stocks and bonds. This error was addressed when Benjamin Graham taught investors that the market is there to serve them, not instruct them. He said that getting emotional about movements in price was tantamount to allowing yourself mental and emotional anguish over other people’s mistakes in judgment. Coca-Cola may be trading at $50 a share but that does not mean that cost is reasonable or reasonable, nor does it mean if you paid $60 and have a paper loss of $10 per share that you made a poor investment. Instead, the investor should compare the earnings yield, the expected growth rate, and current tax law, to all of the other opportunities available to them, allocating their resources to the one that offers the best, risk-adjusted returns. Price is what you pay; value is what you get.
3. Confusing What Is Near with That Which Is Valuable

Psychologists have long told us that we overestimate the importance of what is near and readily available as compared to what is far away. That may, in part, explain why so many people apparently cheat on their partner, embezzle from a corporate conglomerate, or, as one business leader illustrated, a rich man with $100 million in their own investment accounts might feel bitterly angry about losing $250 because he left the cash on the nightstand in a hotel.

This principle may explain why some folks feel richer by having $100 of rental income which shows up in their mailbox every day versus $250 of “look-through” earnings generated by their own common stocks. It may also explain why many investors prefer cash dividends to share repurchases, even though the latter are more tax efficient and, all else being equal, result in more wealth created on their behalf.

This is often augmented by the very human need for management. Unlike Worldcom or Enron, an accounting fraud by people whom you’ve never met can’t make the commercial construction you rent to tenants disappear overnight. Besides a fire or other natural catastrophe, which is often covered by insurance, you aren’t going to suddenly wake up and find that your property holdings have disappeared or that they are being closed down because they ticked off the Securities and Exchange Commission. For many, this provides a level of emotional comfort.

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