Should I Invest Directly In Real Estate?

27 July 2013FinanceOpinion

There seems to be a love affair with investing in real estate. Whether it is late-night infomercials, reality TV shows, or discussion among friends at a dinner party, buying a property to flip or rent out often comes up as a lucrative, low-risk investment opportunity. Without getting bogged-down with a lot of numbers, here’s a few reasons why I disagree with this common belief.

I should first point out that I am not against owning a home. Everyone needs a place to live, and buying a primary residence definitely makes sense over renting in many situations. What I argue against is investing in real estate when you don’t ultimately plan to live in the property.

Real Estate is Risky

False Sense of Security
The mechanics of buying a house are straightforward and easy to understand. We frequently see ‘For Sale’ signs in our neighbourhood and we might have already purchased a home in the past. Unlike stocks or bonds, a house is a physical asset that we can see and touch. It makes sense. But just because something is familiar doesn’t mean it is safe or risk-free. House prices can (and do) go down. Like any investment, there are no guarantees.

What makes real estate particularly risky (and therefore inappropriate for most investors) is the amount of leverage involved. If we assume that a house costs $300,000 and we make a down payment of 5% ($15,000), then we have just levered our initial investment 20 times. Leverage magnifies the gain or loss on our initial investment because the entire value of the house we bought rises or falls, not just the $15,000 of our own money that we put in.

As an example, if house prices fall 10%, the value of our house will have declined from $300,000 to $270,000. We just lost $30,000 on our investment of $15,000, a 200% decline! Had we taken our $15,000 down payment and instead invested in a portfolio of stocks with no leverage, a similar 10% loss on the portfolio would generate a loss of $1,500. Comparing the two losses, the $30,000 leveraged loss on the house is 20 times the $1,500 non-leveraged loss on a portfolio of stocks. The smaller your down payment on a property, the higher your leverage, and the more risk you are taking.

Lack of Diversification
We have all heard that it is important to have a well-diversified investment portfolio – the “don’t put all your eggs in one basket” rule. Most investors would agree that this is common sense. But those same investors might also think it makes sense to gain a $300,000 exposure to an income property. Assuming your net worth isn’t yet in the millions of dollars, a $300,000 property will likely make up the overwhelming majority of your portfolio. If you already own a primary residence, you will be concentrating even more of your assets in real estate, and if you buy an income property in the same city as your primary residence, you will be geographically concentrated as well. If your hometown suffers an economic downturn, both your home and your income property will take a hit at the same time.

Each Property is Unique
One of the benefits of capital markets is that they help to standardize financial instruments, making them easier to understand. Rather than having to read over hundreds of pages of documentation before purchasing a company’s stock, we generally know what rights and responsibilities we have as a shareholder. Real estate is very much the opposite, with each property subject to different construction materials, building codes, local Bylaws, home owners’ associations, etc. We all have friends or family members that unknowingly purchased a money pit. If you have spent years of your life becoming an expert in a certain field – perhaps medicine, law, finance, or public policy – what makes you think you can instantly become an expert on real estate? What competitive advantage do you have over other buyers or landlords that will allow you to identify the best property to invest in?

Real Estate is Low Reward

Home Prices Should Follow Inflation
If I am looking to buy a home, I have two options: 1) buy an existing property, or 2) buy land and build new. As such, I believe the long-term return on real estate should approximate the rate of inflation on land, building materials, and construction services. In other words, existing home prices (option 1) should only increase if the cost to buy land and build a new house (option 2) also increases. If you believe that central banks are competent and will keep inflation in check over the medium- to long-term, then there is no reason to believe real estate returns will outpace other assets such as stocks or bonds. The true source of return in real estate is the inherent leverage (as discussed earlier), but this introduces significant additional risk.

Unlike traditional investments, there are additional costs with investing in real estate that should not be overlooked. First, there are the transaction costs associated with buying and selling properties: realtor fees, land transfer taxes, legal fees, and mortgage fees. These can add up to thousands of dollars and can significantly reduce returns. There are then ongoing expenses such as property taxes and utilities that need to be accounted for. There are less tangible costs as well. As there is no centralized market or exchange, real estate is much less liquid than stocks or bonds. It can take months to sell a property, especially in a down market when others may also be rushing to shed their real estate investments.

You should also consider the amount of time that you’ll need to invest in an income property. You’ll need to find tenants, research their credit history, and respond to their various requests over time. If you happen to pick bad tenants, it might require a court order to evict them. Do you really want to spend your evenings and weekends repairing broken appliances or dealing with complaints from neighbours of your income property? Your time is definitely worth something, so add up these intangible costs before jumping into the landlord business.

There Are Better Alternatives

Wouldn’t it be great if you could invest in real estate without having to allocate an overwhelming majority of your portfolio to a single leveraged property, while at the same time getting access to a team of experts that have years of experience buying, managing, and selling properties? Real estate investment trusts (REITs) are a great alternative to investing in real estate directly. You can invest as much or as little as you’d like, they trade on stock exchanges and are generally very liquid, and they provide access to a large pool of properties diversified by geography and industry. While REITs typically borrow money to make acquisitions (meaning they employ leverage), you do not create your own leverage by investing in them like you would when purchasing a house with a mortgage. REITs also allow you to outsource the time and frustration of having to manage tenants. Leave that to the experts.

Leverage Your Existing Portfolio
Another alternative to purchasing an income property is to leverage your existing portfolio. Using our earlier example, if you are happy to take on the exposure of a $300,000 house with a $15,000 down payment, why not instead gain exposure to a larger diversified portfolio of stocks and/or bonds that will most likely achieve a higher return than real estate? Borrow $285,000 from your bank and combine it with your $15,000 to create a $300,000 investment portfolio. Invest this portfolio in index ETFs and magnify your returns over time. In certain jurisdictions, interest on loans used to earn investment income is tax deductible, making this strategy even more compelling.

A lot of people reading this might think it is crazy to borrow $285,000 to gamble on the stock market. They are probably right, and I wouldn’t do that myself. But if forced to choose between investing in a single property using borrowed money or investing in hundreds of well-managed companies across many sectors and geographies, I think the leveraged investment in index ETFs makes much more sense over the long-term.

Opinions expressed are my own and are for information purposes only. Your financial situation is unique and you should always consult with an investment professional before deciding what investments are appropriate for your personal situation.