My Advice For Young Real Estate Buyers

“What we learn from history is that we don’t learn from history.” – Benjamin Disraeli

The Wall Street Journal ran an article last week chronicling the stories of young buyers who are stepping up their investments in real estate by, “skipping the starter home and betting heavily on high-end real estate.”

We’ve seen this movie before and it doesn’t end well.

Here’s a story about a young man who’s only 26 years old, owns a $1 million home in LA, and has recently purchased a second home for $1.7 million:

“I have always felt that having your money in property is the safest and best thing to do if you want to grow your personal wealth,” says Mr. Winter, who founded his design company at 23. None of Mr. Winter’s assets are in the stock market—he says the market “spooks him” and that he prefers to invest in real estate.

Mr. Winter is part of a growing group of wealthy young buyers who are making inroads in the world of high-end real estate, acquiring properties at prices, and at a pace, that brokers say they have never seen before. Real-estate agents say that young people are buying more expensive homes than previously. They are also more likely to buy several properties, and use one as an investment. Buying real estate has grown more attractive, these young buyers say, compared with the stock market, which appears riskier to a generation that entered the workforce during a market correction.

Here’s another young buyer:

Mr. Rankin helped broker a deal for Grant Allen, a 34-year-old who works in venture capital and paid $1.1 million for a 2,400-square-foot three-bedroom row house in D.C.’s Logan Circle neighborhood. His 28-year-old fiancée also owns a condo in the city, but in part because of Mr. Rankin’s advice the couple decided to keep it as an investment and now rent it out for $3,250 a month. “The stock market has popped lately, but I view it generally with a lot of skepticism,” says Mr. Allen, who adds that he has recently reduced his exposure to public equities to about two-thirds of his assets from three-quarters. “These days, I feel like you need to put your money in something that’s more of a sure thing.”

Coming off the heels of one of the largest real estate crashes ever, I can’t believe how similar this article sounds to some of the behavior from the last cycle.

That doesn’t mean we’re in another housing bubble, but the lack of risk control or understanding in this article is unbelievable.

Let’s review what you get from investments made in real estate:

• Historical investment performance that barley keeps up with inflation
• A leveraged investment in the form of a mortgage
• Rental income
• Property management duties
• A depreciating asset (the house goes down in value because it requires constant upkeep while the land is what really appreciates)
• Recurring costs
• Property tax payments
• Exposure to a single, local economic market
• Complexity
• An illiquid investment
• Unknown valuation until you want to sell

Now, what you get from a diversified investment portfolio:

• Historical investment performance that outpaces inflation
• Compound interest on your savings
• Tax reduction through tax deferred accounts or index funds and ETFs
• Exposure to a wide range of markets, economies and companies
• Low costs
• Simplicity
• Liquid investments
• Daily pricing and valuation

I’m not saying you shouldn’t buy a home. I just have never looked at my house as an investment. For me it’s simply a choice that I have made over renting. It does allow me to build equity, but there are substantial costs involved as well.

Buying multiple homes for investment purposes can be a dangerous game. There are people who can do this and make money. They are called professionals. We saw in the housing bust a few years ago that amateurs shouldn’t play this game unless they really know what they are doing.

Even then it still probably doesn’t make sense when you weigh the pros and cons. You can build wealth in real estate, but the probabilities are against you.

Ignoring the financial markets to invest in a handful of real estate properties also exposes you to the risk of putting all of your eggs in one basket. Diversification over the long haul is one of the few free lunches in the world of finance.

If investors are going to invest in real estate, they should at the very least consider investing in other financial markets to spread their risks. This will help cushion the blow if they make a bad purchase and get stuck with an underperforming property.

It’s too easy to lose money when substantial amounts of leverage are involved, especially in illiquid markets. James Montier from GMO sums up leverage perfectly:

“Leverage is a dangerous beast. It can’t ever turn a bad investment good, but it can turn a good investment bad.”

Hopefully these young buyers don’t find out the hard way. Unfortunately, I think that eventually they will.

Source:
The Rise of the Young Buyer (WSJ)

Further Reading:
Investing in Real Estate (Can I Retire Yet?)
It’s Not Everyone’s Time to Buy  a Home (NY Times)