Does Residential Real Estate Belong In Your Portfolio?

He is not a full man who does not own a piece of land. —Hebrew Proverb

One of my earliest recollections of a financial lesson happened when I was thirteen or fourteen years old. On a hot summer afternoon, a small group of adults were in the yard discussing the idea of buying a two-family house in the neighborhood and renting it out to earn some extra cash. I was only half listening, but when ‘Mr. G’ (an old-school Italian grandfather whom we all admired) started to speak, even I took note. Mr. G knelt and scooped up a handful of dirt. He gently massaged the dusty soil and let it sift through his fingers. As he was doing this he looked back at the group and quietly declared in broken English, “They no makah no more.”

To this day, it remains one of my favorite lessons—not for the wisdom it imparted—but for the fallacy that is often inferred from this otherwise true statement.

Land is a finite resource. Generally, a commodity with a fixed supply coupled with high demand leads to an increase in price. Land, however, is not priced by the pound, or valued based on the volume of dirt per square foot. It derives its long-term value from its utility such as farmland, pasture, mining, and yes, urban uses including residential housing.

In other words, the value is not in the dirt, but in the productive use of the land. Mr. G was correct when he said they don’t make any more. But I wish he would have added this qualifier…so choose your investment wisely.

The Real Estate Debate

I often find myself in conversations discussing the relative merits of investing in residential real estate versus public stocks. There are proponents on both sides with strong opinions.

I don’t know why, but some people see these two asset classes as almost mutually exclusive—one is better and the other is worse. For me, it’s simply an asset allocation choice and there is nothing inherently wrong with investing in either or both.

What I do find interesting, however, is the apparent disconnect between the ‘wealth-generating’ benefits of each and the level of personal effort required to achieve those benefits. If you buy Apple stock, you are now a fractional owner in a global business. All the day-to-day problems, issues, and challenges that Apple faces are dealt with by CEO Tim Cook and his management team. If their supply chain bottlenecks or the plumbing backs up at their state-of-the-art headquarters in Cupertino, rest assured Tim Cook’s team won’t be reaching out to you to get it fixed. You are a passive owner of Apple.

When you buy the two-family rental property across town, Tim Cook and his team won’t be there to help you with a clogged toilet or a messy tenant. That is your responsibility. In addition to being the owner, you are the active manager of the business.

That is a simple distinction that you need to understand as you make this asset allocation choice. Beyond this threshold difference, what follows are some additional considerations for you as you look to deploy your hard-earned money into these income-producing assets.

Diversification

Diversification is the process of investing in different asset classes so a portfolio is not overly concentrated and reliant on a single source of income or appreciation. The two main elements of diversification: investing across asset classes (cash, bonds, stocks, real estate, commodities, alternative investments, etc.); and adding variety within an asset class.

If a stock investor owns 5 different technology companies, they achieved some level of diversification with the number of investments, but they are still concentrated in one asset class (stocks), and within the asset class, 100% dependent on the technology sector.

Similarly, owning 5 two-family houses in your town spreads some of your risk but you are still 100% dependent on real estate, and limited to one geographical region. Professional money managers may overweight their favorites to capitalize on what (they think) they know, but even they still diversify to protect against what they don’t know. No professional has a portfolio consisting entirely of just their single highest conviction pick!

(For a more in-depth discussion, read Diversification – Don’t Miss Out On Your Only Free Lunch)

Leverage

If you buy a $100,000 asset with $20k cash and $80k debt and the asset value increases by 25% you can sell it for $125k pay off the debt of $80k and are left with $45k, more than double your original cash investment. This is the allure of leverage. If, however, the asset value fell 25% and you sold, you would receive $75k which leaves you with less than nothing. You would need to come up with an additional $5k just to pay off the $80k debt. You lost 125% of your original $20k investment. This is the angst of leverage. With stocks, you can borrow up to 50% of the purchase price but most investors, including Warren Buffett, think that is extremely risky. With residential real estate, investors can and almost always do, borrow 80%+ and believe it’s a shrewd move. Go figure.

Liquidity

Stocks are priced throughout the day and generally offer easy liquidity (i.e., the ability to buy/sell). Continuous pricing can make stock price volatility feel overwhelming.

Houses are priced much less frequently, potentially years between valuations for any particular property. They are significantly less liquid and can take weeks/months to buy or sell. This lack of liquidity and current pricing can lead an investor to conclude that house prices are more stable (by masking short-term volatility). Not seeing price volatility, however, does not mean it’s absent. As long-term investors, we must balance the convenience and liquidity of stocks (which comes with large fluctuations in prices) with the relative ‘stability’ and illiquid nature of real estate (which comes with opaque prices).

Tangible vs Intangible

Stocks are often viewed as intangible with little intrinsic value as opposed to the fractional company ownership that they actually represent.

A house has consistently been a solid asset that you can ‘touch and feel’. When the stock market is sinking and your portfolio is down 40%, a house can still provide a roof over your head (provided the mortgage is being paid!) This can give real estate investors a sense of longevity in a way that ‘intangible’ stocks may not.

Return On Investment

When investors brag about their big investment wins, it’s usually shortened to something like: I bought it for $200,000 and sold it for $350,000. This short-hand profit calculation might be good enough with a stock sale, but for a multi-year real estate property, not likely.

Calculating real estate returns starts with the same basic inputs, original cost, and sale price. From there, however, the calculation gets more complicated with the need to factor in not only rental income but a litany of additional costs such as mortgage costs, depreciation, operating costs (repairs and maintenance), major renovations, insurance, real estate taxes, any management fees, etc. All these costs can be like a slowly dripping faucet—easy to ignore but pile up quickly.

Those abbreviated success stories also don’t usually cover your other landlord responsibilities of arranging mortgage financing, closing costs, finding tenants, dealing with periods of vacancy (i.e., no rent checks), tenant complaints, the occasional tenant phone call that a broken hot water tank flooded the basement; or a clogged toilet is backing up; or here in the Northeast, a frozen water pipe is leaking in the living room ceiling (all scenarios that as a landlord for three decades, I have experienced first-hand).

Let me sum it up this way: As a landlord, in addition to collecting rent and hopefully selling years later for a ‘wonderful’ profit, you need to recognize that throughout the intervening years, you are responsible for dealing with the triple T’s of real estate: Tenants, Toilets, and Trash, and not ignoring their impact on your investment return—and on your psyche.

You Are Free To Choose

I’m not opining on the relative merits of deploying capital into either asset class, but rather on the level of effort and responsibility involved in managing and monitoring each capital outlay.

When you buy stocks, you are a part owner in a business operated by someone else. When you buy individual properties, you are the owner and the operator of that business. You need to understand and appreciate the difference.

Public stocks and residential real estate are just two (of many) asset classes that can help you on your wealth accumulation journey, but neither is effortless, and both carry risks.

If you could only choose between (a) owning stock in any of the world’s companies; or (b) owning houses that the companies’ employees live in, which would you pick? How you answer this question might start to give you some insight into how each asset class fits into your personal portfolio. Your actual choice is not binary, and there is no one-size-fits-all answer. The best asset allocation strategy is the one that works for you.

As always, invest often and wisely. Thank you for reading.

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The content is for informational purposes only. It is not intended to be nor should it be construed as legal, tax, investment, financial, or other advice. It is merely my own random thoughts.