The hot real estate market in Boulder and Denver has generated a lot of interest from investors who wonder whether they should get in on the real estate action instead of investing in the stock market. I don’t blame people for wondering. Through both the popular press and word of mouth, success stories abound, suggesting that an investment in real estate may offer a more reliable ride to easy street.
Is the hearsay worth heeding? I’ll explain more in a moment, but here’s the bottom line: There is solid academic evidence suggesting that the real estate market often marches out of step with stock and bond markets, and that it has its own risk/return story to tell. That means that a sensible (typically, small) allocation to real estate may make sense within a well-crafted, globally diversified portfolio.
But, as with any investment, there are rational and speculative ways to go about incorporating real estate into your portfolio. Let’s look at the differences.
A tale of risks and expected returns
First, let’s debunk that myth that real estate is less risky than the stock market. Whether you’re investing in real estate, stocks or bonds, remember this No. 1 rule of investing: Risk and expected return are almost always related. There are rarely, if ever, dependable opportunities to earn greater rewards without accepting greater risks.
Some of the risks to be aware of in real estate investing include volatility, concentration and leveraging.
If you’re invested in a piece of property or similar venture, it may feel less risky than the stock market because you won’t see its value continuously fluctuating the way you do with a stock or stock fund. That’s your investment’s volatility, or how much and how often its value moves up, down.
You can Google “Apple” and watch the share value fluctuating right in front of you. You can’t do anything like that with a piece of property, so it may feel as if you’re on more solid ground. In reality, the value is still frequently fluctuating with every new bit of news, and chances are, it’s fluctuating more wildly than if you had invested the same chunk of change in a 50/50 portfolio of structured stock and bond funds.
When we help clients invest in real estate, we want to help them maximize available returns from that market while minimizing the risks involved.
One of the biggest risks to eliminate is the risk of owning too few properties. Individual properties can be mismanaged or burn to the ground. Renters can default. Neighborhoods decline. Local governments claim eminent domain … there’s almost no end to the misfortunes that can wipe out the worth of concentrated property investments.
Fortunately, this form of risk is also one of the easiest to eliminate with a simple and obvious solution: Instead of trying to get lucky on a concentrated real-estate bet, invest in well-structured Real Estate Investment Trust (REIT) funds that capture entire domestic or global real estate markets.
Historically, long-term real estate returns have been good (although highly volatile from one year to the next). One big reason for this is leverage. If you put 25 percent down, you’ve got renters covering your mortgage and your expenses are modest, it all looks pretty good. Your 25 percent down controls 100 percent of the value of the property. If the property appreciates at 3 percent per year and you’re breaking even on cash flow, your annual return is 12 percent.
What could go wrong? Unfortunately, leveraging works both ways. Say, for example, the property goes down by 2 percent a year for four years and then you need to sell it. Typical transactions costs are 6 percent for selling. Therefore, you are down 14 percent on the full value of the property. You have lost more than half of your investment (down payment). This is a real risk.
In short, if you’ve underestimated your maintenance costs, Boulder Creek floods the first floor, oil-dependent Denver goes into recession, or your adjustable rate mortgage skyrockets (I’ve seen all of these things happen), your leveraged risk exacerbates the risk of being overly concentrated and creates a perfect storm that can wipe out your retirement income faster than you can say “Go, Broncos.”
By the way, all of this is before we even talk about the time and energy required to properly manage the taxes involved in direct real estate investing. Suffice it to say, you’ll want to have a good accountant to assist you on that.
Investing on Easy Street
If you would like to speculate in local real estate — i.e., if you have money with which you can afford to win big or lose entirely — I wish you well, but this post is probably not for you. If you would like to invest in the real estate market, seeking to efficiently capture its expected returns while managing the very real risks involved, consider a modest allocation to a well-diversified, thoughtfully structured REIT fund or funds covering U.S. and/or global real estate markets. Look for funds that are relatively low cost and widely diversified across types of holdings as well as geographic locations.
Robert J. Pyle is president of Diversified Asset Management, Inc. This column reflects the writer’s views, is not a recommendation to buy or sell any investment and does not constitute investment or tax advice. Reach him at 303-440-2906 or firstname.lastname@example.org.