Why Real Estate?
Why Real Estate?
I think there is a battle deeply ingrained in the financial independence community. The battle has been waged since the earliest beginnings, and has become a part of the otherwise tranquil landscape. We barely realize that it is even there. It is a well argued disagreement that leaves both sides shaking their head. I’m talking, of course, about real estate. Peruse a few blogs and you will see that it has both supporters and detractors. But beneath all this respectful debate are a series of questions that we as a community have yet to find a satisfactory answer. Why real estate? And can a true financial plan be successful without its fair share of this asset allocation?
The answer varies depending on who you talk to. I am going to discuss the place of this important asset class on today’s post and follow up with some of the negatives tomorrow.
It is notable that most of my discussion centers on buy and hold real estate or even flipping. I will not be discussing REITs, crowdfunding, syndication, or the other various vehicles available.
Diversification
As I have said before, great financial plans have at least four legs. The reasons are simple. You don’t want to put all your eggs in one basket. The financial independence community is very comfortable in promoting broad-based index fund investing. Within the stock market, this is the best way to diversify. The market, however, as a whole can take a plunge. Yes, even index funds can tank. Thus, it makes sense to diversify outside of the stock asset class. For this reason, many have some portion of their investments as bonds. The next step further is to move out of paper assets completely.
Why real estate?
Because real estate adds to diversification immensely. When talking about assets, we often look at how closely they correlate.
According to Investopedia:
Correlation, in the finance and investment industries, is a statistic that measures the degree to which two securities move in relation to each other. Correlations are used in advanced portfolio management, computed as the correlation coefficient, which has a value that must fall between -1 and 1.
A portfolio of investments in which the correlation coefficient is 1 is not diversified. Imagine holding half your money in a total market index and the other half in a S&P 500 index. These holdings will do very poorly when the market goes down because they are so similar. A portfolio with investments with a correlation coefficient of -1 means that the investments are the polar opposite. For instance an underlying stock and its put option tend to run in equally opposite directions.
Real estate and the stock market tend to be much less correlated. I have seen coefficients anywhere from -0.2-0.2 depending on the year and whether you are looking at residential or commercial real estate.
The point is that they are not correlated at all.
Efficiency
The wondrous thing about real estate, if you are going to be a landlord, is that the property can provide both investment and speculation. The investment comes from creating cash flow through rent collection. The speculation comes into play when considering property appreciation.
Why real estate? Because if you buy low and sell high you can make a fortune.
But I thought we were against speculation?
While it is true that stock market and collectibles speculation is risky, real estate speculation is a little bit less so. To understand the reason, you need to think about efficiency.
The stock market is truly efficient. There are so many smart people buying and selling that on any given day the stock price tends to be very close to the value. The moment the novice investor like you or I recognize an inefficiency (a disconnect between price and value), thousands of other investors have jumped to attention and swayed the price back in line before we have had time to act.
Real estate, however, can be incredibly inefficient. Sellers are often under duress to sell for a multitude of reasons. Seasonal variation affects price. Offers can be made before a property is listed and therefore never exposed to market conditions.
It is a speculators paradise.
Tax Efficiency
While it is far above the purview of this blog to get into the specifics of our tax code, buying and renting real estate provides a number of tax benefits. Most of these center on the idea of depreciation. Although we hope our property will appreciate, you are allowed by our tax code to depreciate a property over a set number of years and use these “losses” to offset income. You therefore are able to defer paying until the property is sold.
Furthermore, if the property is sold and certain criteria are met, the taxes can be further deferred if another investment property is bought. This is called a 1031 exchange and will not be covered here.
The point is that if you are asking why real estate, tax benefits is a very reasonable answer.
Final thoughts
While real estate is not for everybody, there are many reasons why it rounds out a financial plan nicely. It helps diversify the modern portfolio. It adds a less risky form of speculation because it is such an inefficient market. And finally, it provides tax benefits that may last for years.
The better question is why not real estate?
We will cover that tomorrow.
Good points! Personally, I don’t think it should be an either or proposition. It’s about having options. And I agree, you shouldn’t have your eggs all in one basket. It’s wise to do both if you can. Real estate can be challenging for many due to the management aspect. It is like running a business versus paper assets (such as stocks) where there is less involved. When managed properly, real estate can be very rewarding and does give you more control. But if mismanaged, it can be a nightmare. It’s definitely not for everyone.
Your definitely right about how you manage. Luck doesn’t hurt either.
Long ago I realized the power of real estate (I have a radiology colleague who has built a mini-empire of single family homes and has great monthly cash flow). My issue is that I am not made out of the active management style required to be successful in managing that many SFH (his wife helps him out which is a tremendous benefit, but even if I had a partner to help I don’t feel I would enjoy it).
So I decided that I am okay with not getting as high a return and let someone else manage the property and found a great compromise in crowdfunding and private syndication. The tax benefits are great and often in the beginning even if you are getting great cash flow it doesn’t raise your tax burden at all because of the depreciation you mention. And the 1031 exchange can basically make you defer taxes to the point where if you die, no taxes will be required at all due to step up basis.
There is definitely nothing wrong with using a manager.
We have 2 paid-for rentals and at the time of retirement 8 years ago, the typical 25X stock portfolio, which is up a lot due to the hot market. The fact is, real estate cash flow is really sustaining a lot of our annual spending and we have barely touched the nest egg. You can’t get that kind of cash flow from dividend income.
I’ll save my “but” for tomorrow 🙂
I think this is a very diversified way to approach retirement.
“Real estate, however, can be incredibly inefficient. Sellers are often under duress to sell for a multitude of reasons. Seasonal variation affects price. Offers can be made before a property is listed and therefore never exposed to market conditions.”
Great news if you’re a buyer! What if you’re a seller? What about when you’re the seller in distress? There is an inherent unadvertised risk specific to real estate specifically because it’s not an efficient vehicle. Otherwise it’s the same as any property. Stocks are property, houses are property. Stocks pay a dividend, houses pay rent. Buy low sell high rules the day for either “property”. The tax advantage is a good deal but you can gain tax advantage in stocks by proper tax loss harvesting. I haven’t paid capital gains in decades. BRK.B has a 0.3 correlation to VTI. About 10% of my dough is in BRK.B for this reason, and the fact they pay no dividends (so I pay no taxes) and they can use the insurance float to self fund loans dirt cheap so my money at some level is also providing leverage (slight but real effect and part of the diversity). If you venture outside of the bogglehead silo of “buy cheap index funds bla bla bla” There are a lot of things you can do. Real estate is a good choice but you have to love the hassle and adequately fund the investment or it will eat you alive. It is not part of the bogelhead silo which is why you get heated argument from the purists, but as a non-silo investment there are other alternatives. I do think non-silo investments like real estate are important.
I think non-silo investments are important. Real estate fulfills that role for me. Balances the bogle head stuff.
There are supporters, detractors, and a third group that you didn’t mention that’s probably the largest (which I’m in) which is people who realize it’s awesome but who just didn’t want to do it. Probably because I was too busy working at my W2 to take the time. I may in the future though!
It seems like that third group is a big portion of the population.
I am coming around to real estate as a good investment. Just trying to find a way it fits with how I want to invest in it.
In almost every market, there is someone making money on real estate.