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)

 

 
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  1. Rob commented on Feb 21

    So, in your view, how does a rental property fit into a broader diversified portfolio? How would you measure the contribution of a leveraged and managed asset like this to a broad and diversified (and unlevered) portfolio of stocks and bonds?

    • Ben commented on Feb 21

      That’s a good question. I guess you would account for it just like a stock holding with a yield and include the net value in your asset allocation. But that’s kind of a tough one. I think it takes a certain kind of investor to be able to pull off rental investing. Not saying it can’t be done effectively but it’s not easy, and like you said,it involves leverage which can be dangerous if you don’t know what you’re doing.

      • Rob commented on Feb 21

        I’m curious, how would you look at this from an institutional investor’s point of view? Certainly institutional investors include alternative assets, like income producing real estate, in their portfolios. So, where do alternative assets like real estate, commodities, private equity, venture capital, etc. fit into a portfolio, in addition to stocks and bonds? How do you think about this?

        • Ben commented on Feb 22

          Good point, but you have to remembers that unless they’re making direct investments (only the largest fnds really do this), even insitutional real estate and PE funds are diversified to some extent in a handful of deals. With a rental property that’s a single asset. With a fund structure some of that diversifiable risk is taken care of.