“Take calculated risks. That is quite different from being rash.” – George S. Patton
First, I like the tangibility of real estate. When you have $50,000 invested in a group of stocks, you have, at best, a piece of paper to prove it and the reputation of some financial institution you know very little about to back it up. With real estate, you have an actual physical property with a deed that has been validated and recorded by the government.
Second, I like the simplicity of it. I’ve been a publisher of investment newsletters for more than 20 years, and I still have trouble understanding options, straddles, and covered calls. Real estate is pretty basic: The only things you have to deal with are the price of the property, the cost of money, simple appreciation, and market value.
Third, because of the mortgaging ordinarily used to buy real estate, the appreciation you get on a property’s value is leveraged. Let’s say, for example, you buy a $100,000 apartment building with a $20,000 (20%) down payment and it appreciates at the rate of 5% per year (which is the typical inflation in real property values). After one year, you’re up $5,000, or 25%, on your initial investment (not counting costs or any amortization or rental gains). However, after the property has compounded at 5% for 10 years, it is worth about $162,000, or 62.9% more than it was worth when you bought it. So, your original $20,000 is now worth $82,000 (again, excluding amortization and other goodies) — making your average ROI (return on investment) in 20 years not 5% per year but 15.3%.
Leverage is usually a net-sum game in investing. You can get more return on your investment by taking more risk, but over the long run — at least in my experience — the riskier investments don’t do much better than the conservative ones.
A market historian would tell you differently — that you’d do better with small-cap stocks than with large-cap stocks and better with large-cap stocks than with bonds. And that may be true on the average — when you include insiders, brokerage houses, and full-time professional investors into the mix. But for the average guy, it’s tough to get higher rates of returns by investing in riskier financial instruments — he just doesn’t know enough to be able to separate the winners from the losers. (The high-tech/Internet collapse has helped many investors understand this. Thus the flight to bonds and real estate.)
What is great about real estate is that the risk you take can be significantly reduced — in practical terms — by real estate’s other virtues: its tangibility and its simplicity.
If you buy local property, you are investing in something about which you already know a great deal. You know the good and bad neighborhoods. You know which are coming up and which are disintegrating. You have a sense of how local business is doing. And you know — or can find out –what other real-estate investors are doing in town.
When you buy a stock, you can’t possibly know more than a tiny bit about the company (unless you buy stock in the company you work for). When you buy a house or office building, you can — with relative ease — find out just about everything you need to know. You can hire someone to do a complete inspection of the structure. You can look up the square footage and compare it, in terms of dollars per square foot, to comparable buildings in the area. You can estimate with a good deal of accuracy how much it would cost to repair or improve any part of the property.
In short, an amateur real-estate investor can get to know a local piece of property much better than an amateur stock investor can get to know a public company. This extra knowledge really mitigates the risk. And that makes the leveraging a much less risky proposition.
PP and I bought a triplex — 2,700 square feet — for $250,000. The current rental income is $29,000, and the current expenses, including the mortgage, come to $25,000. That’s an 8% return on our $50,000 investment, not counting appreciation.
We are improving it at a cost of $20,000 and will be able to increase the rent to $35,000. (It’s in a marginal neighborhood that is quickly improving.) When that process is completed (in three to six months), our investment will be up to $70,000 but our yield will be $10,000 — bringing the return on our investment to about 13%.
Assuming the property will appreciate 5% a year — and knowing the area as we do, we feel very confident in these numbers — our $10,000 rental yield will be supplemented by another $12,500 return in property appreciation. That’s $22,500 a year on a $70,000 investment — about 30%.
A 30% ROI doubles the investment every 2-1/2 years. That means that in 10 years, our $70,000 will turn into $560,000. Where in the financial markets can I make that kind of money without being extremely lucky?
This, by the way, isn’t just theory. I’ve been seeing these kinds of returns on many of the real-estate investments I’ve made in my hometown. In Baltimore, where property has not appreciated as well, I’m still getting ROIs in excess of $15%. Every $1,000 I invested there when I started — in 1993 — has grown to $4,000 today. Not too shabby, considering what I got from the stock market during the same period.
Are you investing in real estate? If not, why not?[Ed. Note. Mark Morgan Ford was the creator of Early To Rise. In 2011, Mark retired from ETR and now writes the Palm Beach Letter. His advice, in our opinion, continues to get better and better with every essay, particularly in the controversial ones we have shared today. We encourage you to read everything you can that has been written by Mark.]