When I tell people about my passion for real estate as an asset class they often ask why. And I think their doubts are well justified given the recent crisis we have faced and still facing.

In this post I’m going to tell you why I’m passionate about real estate and why you should not invest in real estate.

Real Estate Investment

Why I’m passionate about real estate?

Return: In most of the markets real estate investments perform better than equities and other asset classes. In emerging markets probably you have to go for development projects, as rental yield is not very attractive. In most of the developed markets real estate has performed better than stock market over time. And by leveraging your investment you can increase your return on equity many folds. In the table below I have compiled the return of real estate viz-a-viz S&P 500.

Year REITs RE Index S&P500 CPI
1979 14.30% 21.50% 2.30% 11.20%
1980 58.10% 53.70% 17.10% 13.60%
1981 7.20% 6.80% 1.90% 10.40%
1982 29.70% 23.30% 11.80% 6.20%
1983 69.20% 66.30% 43.50% 3.20%
1984 1.80% 3.90% 4.30% 4.30%
1985 23.90% 31.10% 16.00% 3.50%
1986 46.20% 52.00% 31.20% 1.90%
1987 30.00% 29.60% 42.90% 3.70%
1988 -15.60% -16.30% -14.80% 4.10%
1989 27.30% 34.30% 33.50% 4.80%
1990 -37.80% -39.30% -2.00% 5.40%
1991 25.20% 15.10% 31.50% 4.30%
1992 25.70% 13.00% 14.80% 3.00%
1993 40.70% 49.70% 12.90% 3.00%
1994 15.20% 9.30% 4.00% 2.60%
1995 13.00% 16.80% 30.50% 2.80%
1996 16.00% 17.30% 21.30% 2.90%
1997 39.30% 52.70% 43.50% 2.30%
1998 -18.20% -22.80% 12.00% 1.60%
1999 11.00% 9.60% 40.80% 2.20%
2000 18.90% 20.00% 15.50% 3.40%
2001 15.10% 7.80% -24.00% 2.80%
2002 9.80% 7.00% -16.30% 1.60%
2003 20.50% 19.90% 17.00% 2.30%
2004 28.20% 28.00% 12.20% 2.70%
2005 30.30% 28.70% 12.10% 3.40%
2006 24.40% 23.30% 7.30% 3.20%
2007 -1.60% -0.40% 13.40% 2.90%
$1 Invested in 1979 would have grown to:
$106.43 $94.72 $41.38 $3.43
Sourse: Datastream
Notes: U.S. REITs, Real Estate Index and S&P500 total returns CPI is the year-over-year change in the U.S. Consumer Price Index 

Cash flow component in return: This one of the best thing about real estate investments – it behaves like a fixed income security, and with better yield. Rental income makes real estate more attractive even during tough time and many investors love to focus on the cash flow. 

Depreciation: You can’t depreciate your stocks, bonds and mutual funds. Depreciation is a gift from the government for real estate investors.

Dampening of volatility in the portfolio: Real estate prices don’t fluctuate on daily basis. Fully optimized portfolios with real estate component in it have much lower volatility.

Inflation hedge: If you analyze the above table, you will realize that real estate investments provide a good hedge against inflation. Rents usually increase with inflation, while mortgage payments on the property remain stable. This increases cash flow component.

Why should you not invest in real estate?

Illiquid: Many a times real estate investments behave like illiquid assets. Generally it takes time to execute an actual exit, and liquidity can completely disappear from the market in tough times.

Management intensive: Yes, it takes time and skill. You need to be able to find a host of reliable professionals to perform tasks that you are not able to do yourself.  You need to be able to coordinate activities between various contractors and tenants often times when you are not going to be there. Hiring a professional property management company can reduce some of your headaches.

High transaction cost: Real estate transactions, like other financial transactions, cause transaction costs. These fees include the agent's commission and closing costs such as title search fees, appraisal fees and government fees. 

Transaction costs reduce returns, and over time, high transaction costs can mean thousands of lost dollars. Your goal should be to identify and possibly reduce these transaction costs.

Non-standard pricing: I often wonder if real estate valuation is an art or a science. Is fair market price for real estate a myth?

The truth is that the real estate market is less efficient and less transparent compared to equity market. Non-standard pricing and low transparency can become a real issue in the emerging markets. However, in developed markets like US, reliable data is publically available. Probably you should check NCREIF Property Index and Property Index Values & Returns from REIT.com to see the kind of data available free of cost.

Hope you enjoyed this post about real estate investment. What do you think, use the comment section below.

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