Real estate is a hot topic on Seeking Alpha, and I'd like to offer my perspective, as I grew up working for my parents' real estate investment company and have traded stocks for over a decade. Today, I like to use data-driven research to identify opportunities. This is part 2 of my real estate series. The first article covers my strategy for investing in REITs.
I'm no longer bearish on the national real estate market due to the fall in interest rates. However, if your local market can't meet a reasonable return hurdle, the global REIT market is likely to be a better home for your money.
Does investing in rental property work?
Investing in residential real estate is a popular strategy for retail investors. To test out whether investors are getting solid returns, I found some excellent data on investing in residential real estate from Rutgers Business School. I like using data from New Jersey because it's long been an affluent place but hasn't seen a huge real estate boom like coastal areas of California, for example. New Jersey's data is likely to be representative of more markets than not.
They found that lower-priced homes had better yields than higher priced homes (note that returns are adjusted for inflation). Additionally, they found that rents track interest rates and have fallen over time.
Source: Rutgers Business School
This is unsurprising, as most new supply built is of higher priced ($300,000+) homes, but most demand is for lower-priced homes. It turns out you can make roughly double the return on your money by buying middle-class rental houses than by investing in more expensive homes.
Additionally, the greater return comes almost all from rental yield, which is easier to predict than future capital gains. Most homes appreciate at about the rate of inflation over time.
Source: Rutgers Business School
Additionally, they showed Sharpe ratios that are significantly higher than the stock market's average Sharpe ratio of 0.5, implying that real estate investing is both less risky and potentially more profitable than stocks.
Source: Rutgers Business School
However, research shows that Sharpe ratios for real estate may understate the true risks of investing and as such are not apples-to-apples comparisons. This is due to something called serial correlation, which mathematically can make investments look less risky than they actually are. Additionally, while the fundamental conclusion of modern portfolio theory is to use cheap leverage on diversified assets to get the highest possible return, investing in real estate fails both of these conditions. Mortgage leverage is more expensive than sophisticated investors can get on stocks. This gives you about a 250 basis point disadvantage for real estate on average against the risk-adjusted returns of leveraged portfolios of other assets. Also, real estate investments tend to concentrate rather than diversify risk in an economic downturn. If you leverage up to buy property and it works out, you make millions. If you fail, the debt service will overwhelm your income and you'll have to let your investments go and ruin your credit.
How much you have to make from rentals to justify investing in them over REITs
If you want to be successful at investing in real estate, you have to make sure that you can do two things. The first is that you beat the returns of a global REIT portfolio, which will currently pay you 4.75 percent per year in income. The second is that you need to be able to justify the time and effort involved with the addition of the illiquidity premium. I'll assume that the property values will increase at the same rate for REITs and private real estate but model a 250 basis point liquidity premium for REITs.
Using this, I'd put your minimum hurdle at a 7.5 percent EBITDA yield (earnings before interest, income taxes, and depreciation) on your real estate investments. In other words, this is how much you need to be able to make from rental properties to beat REITs on a risk-adjusted basis.
Otherwise, rentals aren't worth the time and energy. Feel free to adjust the illiquidity discount to suit your own preferences. 7.5 percent likely means you need to collect 1 percent of the property value per month to get a 7.5 percent yield after expenses, such as repairs and property taxes, however. As you can see from the graphs above, this requires you to buy inexpensive and in-demand properties, which require far more work than REITs, or even more than if you bought more expensive properties. These yield targets also make it extremely difficult to invest in markets like New York City and coastal California based on valuations. The REIT market is global but real estate markets are local, so you should aim to get the highest return and not simply rely on your local market to give you the best deals.
You're kind of stuck investing based on where you live because stress and problems tend to multiply when you can't drive by your properties and check-in. If your local market doesn't suit your needs, REITs tend to offer competitive yields.
The US government will let you have 10 mortgages before loans start to get really expensive, so buying 10 profitable middle-class homes at 25 percent down will let you get at most about $750,000 in initial equity working ($2-3 million in home value). This is great for a middle-class investor with a friendly mortgage broker but won't move the needle for the work you have to do if you have $5-10 million in net worth. Real estate is a much better deal for middle-class investors. You can also use your job income to get leverage quite effectively, for example, if you had a $100,000+ per year job but not a big nest egg yet, you could accumulate middle-class rental homes fairly quickly once the banks start letting you count rental income to qualify for more loans. To get above-market returns, you have to do more work.
As interest rates have fallen through the floor in the last 6 months, areas of the country (and world) are starting to become good values again. How you play the trend depends on your circumstances.
Many successful real estate investors approach their business like a private equity investor would, buying distressed homes and fixing them up to increase the rent that they can receive or by developing assets like raw land into brand-new properties. Also, not all market participants have the same cost structure. For example, my mom had her real estate license as part of our real estate investment business, which cut our transaction cost from 6 percent to 0 (by earning 3 percent on the buy and only paying 3 on the sale).
This would help your returns by about $5,000 to $10,000 per transaction. If you don't have a structural advantage or the ability to work your tail off, you're better off in REITs. You can also get consistently better deals by buying in the winter when the real estate market is consistently the weakest due to the microeconomic structure of the market (people won't move their kids during the winter and houses are uglier).
Rental real estate is a nice way for middle-class investors to become upper-class investors via leverage and cash flow. However, you need to be able to beat the returns on a global portfolio of REITs to justify the time and effort involved. With my new discoveries of compelling value in international REITs, I'm no longer recommending investing in physical real estate for high-net-worth investors unless there is a highly specific angle to improve profitability enough to be worth your time. Whether you invest in REITs, rentals or none of the above is ultimately a personal preference, and my hope is that having good data and knowing all the options can help you succeed.
For middle-class investors, there are opportunities to make money in residential real estate if you know how to play the game. If you're young and childless with a good credit score, you don't have a lot to lose by accumulating some rentals. You're taking a lot of risk but taking risks that have been historically rewarded. Your tenants will pay your mortgage if you set it up right, and it's an easier path to become a millionaire through 5x leveraged real estate than 1-2x leveraged equities, assuming your local market is valued fairly.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.