Real Estate Investing
Southern California has been a “hot” real estate market for such a long time that investing in it has become sort of a family business for many people, even continuing into the second and third generations. These folks are often putting every last dollar they make into the next property. But is this the most efficient use of their financial resources?
Why Real Estate?
In my experience, there are three primary reasons why people love investing in real estate.
First, it’s a tangible asset class. You can touch the soil and the structure and even alter or improve the look and feel of the property if you so desire. There is a certain romantic physicality and emotional salience to it, unlike the balance in your brokerage account.
Second, it’s what you know. You’ve purchased your own home. Maybe your parents owned some rental properties, it’s something that people in your social circles seem to do, or you just picked the idea up from the many real estate and home-remodeling-focused TV shows. In any case, the business models (renting or flipping) are relatively easy to understand.
Lastly, leverage is a powerful tool. Taking out loans on one property to buy the next can provide a multiplier on the returns you can generate.
What The Data Says
As with any traditional investment, total returns include income and capital appreciation. With that in mind, let’s look at the data:
Per Zillow, the average home value in Orange County (one of the hottest real estate markets in the country) in 2011 was $477k, whereas today, the average home value is $897k. That represents a 6.5% average annual return based on capital appreciation only.
Meanwhile, the average “cap rate” in Orange County is around 4.3%. The cap rate is how much a property produces in annual rent as a percentage of its value. Cap rates are the income return for real estate. Of course, there are many expenses like property taxes, insurance, maintenance, etc., which all eat into the income produced by the property. Ignoring all of that for the sake of the point: the total average return on these homes (including capital appreciation) is around 10.8%.
Now, let’s compare that to a broad stock index like the S&P 500, which over the past 10 years has averaged annual capital appreciation of 13.9% (excluding dividends to keep the comparisons apples to apples) and has had an average dividend yield (i.e., the income return of stocks) of 1.9%, for a total annual return of 15.8%, or a full 500 basis points higher than these hot real estate investments over the same time period.
The last 12 months have been one of the best periods for real estate in the past 50 years: Orange County real estate appreciated by an outstanding 17.4% vs. an amazing 33.15% for the S&P 500.
And with flipping, generally speaking, any money you put into the property only increases the home value proportionately. In other words, you should expect to break even on any renovations (unless you are doing it at a large scale and therefore saving on remodeling costs). Most of the potential profit in flipping actually comes just from the underlying appreciation during your holding period.
Finally, while it’s true that leverage will enhance returns (or your losses — it works in both directions), the same is true of investing in stocks on margin, which is borrowing capital to invest in your brokerage account. But one of those feels “safer” to some folks, even though they present very similar upsides and downsides — both real estate investing and investing in the stock market on margin have higher risk/reward ratios than normal stock market investing does.
The above comparisons are a simplification, but the simplifications are in real estate’s favor (no expenses are being factored against income, nor transaction fees from buying or selling real estate). Still, I think the conclusion is pretty straightforward. In terms of broad asset classes, capitalism works, and stocks will outperform real estate over the long term (and that’s not even considering the preferential tax treatment that our government gives to stock market dividends over rents).
If you are investing in just a vanilla S&P 500 index fund, you are investing in oil companies, paper companies, and railroad companies; even as you are investing in solar power companies, electric vehicle companies, and technology companies. Good investment managers can be selective about your exposure to maximize long-term growth and avoid investing in slower performing parts of our economy that are being replaced by the current green Revolution in energy, as one example.
And comparing returns doesn’t even begin to touch on the headache (or the liability!) of having tenants.
It’s not all or nothing. If you are comfortable with real estate as an investment, by all means, continue with it. What I’m merely suggesting is smart diversification, and well-balanced portfolios tilted toward growth, like we specialize in at GK.
As always, I am happy to do a deeper dive into your specific situation if you are investing in real estate. Let me know if you’d like to explore this topic more with me.
Thomas Donnelly is a Financial Advisor of Santa Monica, Calif-based Gerber Kawasaki Inc., an SEC-registered investment firm with approximately $2 billion in assets under management as of 06/29/21. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which course of action may be appropriate for you, consult your financial advisor. No strategy assures success or protects against loss. Readers shouldn't buy any investment without doing their research to determine if the investments are suitable for their situation. “All investments involve risk and one should consult a financial advisor before making any investments. Past performance is not indicative of future results."