By Mark Ward, CFP®, ChFC® Vice President & Chairman, Investment Policy Committee
Over the course of the last several months my fellow advisors and I have had a remarkable number of comments and questions from clients, friends, and acquaintances regarding the possibilities of investing in real estate. We get comments like, “I know Austin Real Estate very well, because I have lived here all my life,” or “Real Estate investing is a lot less risky than investing in stocks, and at least as profitable.”
The assumption on the first quote is that knowledge of the local market will give one some kind of advantage over other investors; and the second quote is just plain wrong.
My personal experience as a financial advisor has taught me that for every 20 people who tell me they want to be a landlord, maybe (and I do mean maybe!) one or two of them actually have the time, patience, financial wherewithal, and fortitude to be successful at it. Let me be clear that I am not against investing in real estate. In fact, those of you who are familiar with our LSG Model Portfolios know that many of them currently have meaningful allocations to that sector of the investment markets; and I myself own a few single home residences around town that I rent out with a business partner. It is just that I firmly believe that most people can be much more financially successful when they spend the majority of their time focusing on their true strengths.
The reality is that the potential risk in all “ownership” investing is the same. The difference is one of perception. Many people have a tendency to perceive that they have made better returns on their personal residences during their lives versus those in their stock and bond market investments, when the reality may be dramatically different. I can say this with some confidence because I know how terrible most people are at comparing returns between the two. For example, for those of you who have investment accounts you know that all of your rates of return are tracked for you by your custodian. They keep track of every dollar in, every dollar out, and your internal rate of return. The only thing they do not track for you is your after tax return when you make withdrawals. Conversely, I have yet to meet the person who has owned a home who kept track of every maintenance dollar that went into the residence while they lived there, the interest paid, the closing cost at purchase and refinancing, and the taxes paid during the ownership period. This means they have no accurate way at all to track their actual return on investment. Therefore, people tend to just remember what they bought a house for and what they sold it for, and use that as rough means of (completely incorrectly) figuring out how much money they made.
The other false perception around real estate is that homes are not as volatile in price as stocks. The difference is that stocks, by rule, have to be valued and posted every single business day; so it is easy to observe their inherent up and down movement. The value of a home, on the other hand, is only known at lengthy intervals such as when the annual market valuations are sent out by the county, or when it is bought and sold. Therefore it is impossible to see the daily fluctuation in the market price of a home, and this allows people to avoid the feeling of anxiety that naturally comes when they see price volatility over short periods of time.
Other items of note when it comes to being a landlord are the time and monetary commitments involved. In a hot real estate market like Austin is currently experiencing you may have to look at dozens and dozens of homes before you even find one that is suitable for your purposes. Then you must make multiple offers, and participate in bidding wars with other investors before you even get your first property. For those who do not have enough money to pay cash for the home, you will have to spend a great deal of time getting your financing set up ahead of time. Then you will have to pay to get the property up to code before you rent it, market the rental, insure the property, and to maintain the home while you have active renters in the unit. There is no homestead exemption on rental property in Texas so your taxes can go up every year with no restriction and this number needs to be calculated into your cash flow projections. Then there is the personal interaction side of it. Renters are human beings, and inevitably there will be time consuming disagreements and late rental payments that will have to be dealt with.
Finally I would like to point out some issues of timing and performance using my personal real estate business as an example.
On timing: When I purchased my rental homes in 2010 when Austin real estate was a great deal less expensive than it is now, most people I talked to thought I was crazy. Since then we have had four years of enviable price increases in the Austin real estate market. I find it remarkable how many people now think it is a good idea to become a landlord after it has become a much more expensive proposition to do so.
On performance: Just as a comparison point, let’s take a snapshot of the Austin real estate market over the last 5 years from June 30th, 2009 through June 30th, 2014 and compare the percentage increase in the median home price* to a real estate sector mutual fund over the exact same time period (I will use the AMG Manager’s Real Estate Fund as we currently use them in our Growth Model Portfolio) During that specific time period the average median sales price in Austin increased 6.32%* annualized versus the AMG fund at 23.98%# annualized. Granted that this is not an apples-to-apples comparison for two reasons: One, the return on price increase does not include any of the cash flow items of a rental house that could increase the return rate assuming you could get a property that could rent for more than the monthly cost of the house; and two, getting the return on the rental property can be very work intensive (like the time an uninsured driver drove into one of our houses) while the returns in an open market mutual fund come with very little effort beyond that of our normal research process. Additionally, should one ever need to get to the cash in my open market mutual funds one could in most circumstances get to it within a week if not sooner versus the months it could take to market and close on the sale of a home. In other words, even though the Austin real estate market has experienced superior returns over the last five years; it would have made a lot more sense in terms of free time, liquidity, and returns if one would have left it to the professionals.
To bring this article to a close I want to point out that my purpose is not to dissuade those of you who really want to personally invest in real estate, but to have you go into it with open eyes and at least a partial understanding of the commitments involved. I can say with some authority that it is definitely not for everyone, and I caution all of you to think on it long and hard before you jump. As well, please remember that all of the advisors here at Lucien, Stirling & Gray can be excellent sounding boards in a discussion regarding the above, and we always stand ready to help you hire excellent professional fund managers (In the context of an otherwise highly diversified portfolio, of courseJ) should you want to take a less demanding approach.
To receive our monthly Enewsletters in your inbox, clickhere