Thinking of investing in real estate? Don’t do it

Lack of financial literacy can lead people to consider investing in direct real estate. A provocative statement to say the least, so let me explain.

There are three dimensions when considering your finances: how much you earn and the stability of those income streams, your spending and how to keep it check, and what steps you are taking to plan for future expenses including your pension. The younger you are the more you should be investing in you, i.e. education, training, networking, etc. As you grow older, you should start saving for your pension and major expenses, e.g. buying a car, a home, etc. When you approach retirement, it’s all about being able to access your investments to sustain your lifestyle and mitigating future losses as you have less time to recover.

Where does investing in direct real estate come into consideration? Real estate is illiquid, has high management and running costs, and, if you are going to use a loan to finance its purchase, carries with it the risk of turbulence in credit markets, i.e. fluctuations in interest rates. Thus, its not suitable for older individuals approaching their pension age or for those at the start of their careers who need to be channelling their money, time, and focus on learning and networking (which also means remaining flexible as to where they live).

Those in the age bracket of 35-45 (or even 30-55) could be looking at investing in real estate, only if they have maxed-out the tax incentives granted by government to save for their pensions (this is essentially free money), have significant savings in international shares and bonds, and have a “rainy day” fund which equates to 6-12 months’ expenses. With the above in place, they can consider real estate as an investment option provided that that investment isn’t more than 10-15% of value of their overall portfolio (this ratio is the one used by pension funds, provident funds, etc).

But what type of real estate? Not a one- or two-bedroom apartment! No. No. No. Investing in real estate through an Exchange Traded Fund (ETF) provides the owner with liquidity, diversification, and less time needed to manage their investments. An ETF is a type of investment fund that is traded on stock exchanges like individual stocks. It holds a number of real estate, such residential, offices, shopping malls, etc which are professionally managed, and can be bought or sold through a brokerage account.

Let’s investigate further “liquidity” and “being able to pick a winner”.

At what point does a problem of liquidity become a problem of solvency? A problem of liquidity in real estate investing refers to the difficulty in converting assets into cash quickly and without a significant discount. For example, if an investor needs to sell a property quickly but the real estate market is slow, they may have to sell at a lower price than they expected. This lack of liquid assets can make it difficult for the investor to meet their short-term financial obligations, such as paying bills or making loan payments.

On the other hand, a problem of solvency refers to the inability of an investor to meet their long-term financial obligations, such as paying off debt or funding their retirement. For example, if an investor has taken out a mortgage to purchase a property and the property's value decreases significantly, the investor may owe more on the mortgage than the property is worth. In this case, the investor may have difficulty selling the property and paying off the mortgage, and they may eventually face the risk of default or foreclosure.

Does this remind anyone of what we have been experiencing since 2008 across South Eastern Europe? Most people approaching “real estate investment age”, i.e. 30-35 years old, don’t have such memories because they were in high school or university when the Great Financial Crisis (GFC) was happening. Current examples include the blocking of withdrawals from some of the biggest real estate funds, such as Blackstone’s BREIT (a $69 billion vehicle), and the (hilarious) reference in Norway’s sovereign fund’s presentation of 2022 performance where it stated that real estate values of listed vehicles (i.e. those traded in the stock market) were down 31% whilst those of unlisted real estate (i.e. for which their pricing is based on valuers’ opinions) remained stable/ the same.

And what about your ability to pick “a winner” because of your connections and deep insights.  In 2008, Warren Buffett placed a $1 million bet with the top hedge fund investors on Wall St. He bet that over 10 years, a simple index tracker fund would outperform the best hedge funds. The results were surprising as Buffett's plain-vanilla stock fund averaged 7.1% while the hedge fund portfolio produced only 2.2% after fees. Buffett won the bet and donated the winnings to a non-profit organization. He advised both large and small investors to stick with low-cost index funds, stating that when trillions of dollars are managed by Wall St. charging high fees, it will usually be the managers who reap the profits. Standard & Poor's has been tracking the record of active managers and found that 84% underperform after 5 years and 90% after 10 years. The performance was "worse than would be expected from luck." Large fees are still deducted despite the poor results.

Direct real estate investing is great! You get to see and touch your investment, get a loan to finance it, receive rental income, and then sell it when prices are high. At the same time, it limits your flexibility, its costly to manage, its highly taxed, and you are unlikely to be able to outperform simpler and more liquid options out there.

Nobody listens to this advice.

It hasn’t stopped me from giving it.