Real Estate Should be Cornerstone of Your Investment Portfolio

Different NFL teams have different identifies. One team might be known to be offensive minded with a middling defense. Another team might be more defensive minded with a serviceable offense. One team might favor a ground and pound approach on offensive, another team might like to air it out. The Seattle Seahawks relied heavily on their defense and the “Legion of Boom” to triumph over the Denver Broncos in Super Bowl 48.   Super Bowl 51 saw the New England Patriots defeat the Atlanta Falcons. The Patriots ended their regular season that year as a top 3 team in both points scored by the offense and points allowed by the defense. It was also the “Revenge Tour” year when Tom Brady, the quarterback for New England, was suspended for the first 4 games of the regular season for his involvement in Deflate Gate. The Atlanta Falcons carried their vaulted league leading offense into the Super Bowl.

There is not only one definitive way to build an NFL team and not one way to build a Super Bowl winning team. This can be applied to building out your investment portfolio as well. There are a lot of different investment choices and asset classes you can invest in: listed equity, fixed income, real estate and alternatives. You can invest in listed equities through mutual funds, UITs, CEF, indices or by holding individual names. There are a number of sectors you can focus on such as healthcare, technology, retail, manufacturing, etc. Fixed income runs the gamut from triple A rated securities to stressed/distressed and workouts. There are also choices for treasuries, munis, corporates, ABS, etc. Real estate can be holding direct title to a property, investing in real estate funds such as REITs. In the alternatives category, you can choose between hedge funds, private equity funds, investment in timber, aircrafts, royalty streams etc. There isn’t just one definitive way of building out a winning portfolio.

I have investments in a number of assets: stocks through mutual funds, individual names, private equity investments, muni ETF, a fixed income CEF, CDs, money market and real estate. Out of all those investments, real estate is the cornerstone of my investment portfolio. I really like real estate as an asset class a lot because it provides me with a number of benefits. Just as there are a number of different ways to build a Super Bowl winning team, a tried and true way is to focus on building a league leading defense. There’s a reason why “defense wins championship” is a mantra spewed by pundits in football. I view real estate in the same light as football pundits view a great defense. I own 5 investment properties directly as opposed to investing in REITs and crowd sourced funding. There are two main reasons for my preference of directly owning real estate. One of the reasons is that I have total control over the investment property. The second reason is that it is easier to perform due diligence over a single property and I can fully see, feel and understand what I am buying.

There are also numerous benefits for owning real estate I really like. Some of the benefits are listed below:

Appreciation 

Real estate has traditionally appreciated at the rate of inflation.  While this will not set the world on fire, at the very less, real estate should at least protect the real purchasing power of your capital.  Over time, inflation will eat away at what you can purchase with a dollar and real estate will help guard against this. Appreciation can be significantly greater than inflation if you invest in an up and coming area and then drastic gentrification happens. Take 125 Maple Street in Brooklyn New York for instance. The property sold in December 2010 for $729,750. It is currently on the market now asking $3.5 million. The townhouse is located in Prospect-Lefferts Gardens. Prospect-Lefferts Gardens has seen a tremendous amount of gentrification and real estate prices have gone up accordingly. It is close to Prospect Park which provides another benefit. Even if the property sells for a $500,000 discount, the property has appreciated over 3 times in value over an 8 year span.

125 Maple Street Listing Floor Plan

Cash Flow 

Rental properties produce cash flow. The ability to generate a cash flow stream from outside of a corporate job is the key to one day, hopefully in the near future, of saying adios to mega corporate and hello to having time and location flexibility. I am a big fan of residential real estate. Automation, machine learning, artificial intelligence and other technological enhancements can cause disruption in a lot of industries. Disruptions lead to uncertainty around job security and opportunities.  I can’t see how technology will impact the need for a home and residential space for people to live. The world’s population has doubled in the past 40 years (3 billion plus people) and is projected to increase by 50% over the next 40 years (3 billion plus people). The US population has grown by 45% over the past 40 years (100 million people) and is projected to continue to increase 18% over the next 30 years (60 million people). Everyone needs a place to call home.

Leverage

The ability to be able to borrow is another positive for real estate. Banks and portfolio lenders provide financing for the purchase of a property. The goal here is to obtain a property which can yield a higher return (capitalization rate) than the interest charged by the lender. Buying the property with a mortgage or a loan can produce a greater return on your investment. See below for an example of the impact to return with 25% down versus 50% down when applied to the return profile of one of my properties:

25 vs 50 percent down return comparison

Pay-off of Mortgage Principal

The other benefit of real estate is that if the property is purchased with a traditional mortgage (fixed rate mortgage or adjustable rate mortgage), each mortgage payment includes a portion which is applied to the principal balance. I view this akin to a forced savings. The amount owed on the mortgage decreases with each payment. It might not seem to be a big amount at first, but over years, the principal balance could come down significantly.

Ability to Add Value

For people who want to put in the way, real estate allows you the opportunity to add value. Renovation is one way to add value to the property above the cost outlay on the renovation. Converting a two bedroom apartment with an oversized living room to a three bedroom apartment with a regular size living area is one of increasing value. There are numerous other ways as well to renovate and add value to the property including but not limited to: adding a second bathroom to a three bedroom unit; finishing the unfinished basement; putting a skylight to let in more lit; duplexing the basement with the first floor; and putting in stainless steel appliances.

Ability to Buy under Market Price

There isn’t an open exchange to buy real estate unlike publicly traded stocks. There is a seller asking for a price. The asking price might be low relative to a comparable property. At times, the listing agent isn’t very good at marketing the property. There can be times when the property doesn’t show well because the people living at the property are very messy. There can be a variety of reasons a real estate property can sell for less than market price. On the flip side, as a buyer, this provides a tremendous opportunity for you to pick up the property at a below market price. I plan to publish a future blog post regarding certain instances I’ve seen a property sell for below market price.

Tax Advantages

There are a number of tax advantages to owning real estate.  But the one that really makes rental properties very attractive to me is the ability to take depreciation on the building.  Depreciation is a non-cash expense deduction that can be taken against the rental income of the property.  The reason for depreciation for tax purposes is that the IRS is assigning a useful life to the property (27.5 years for a residential property) and each year you own the property, you are allowed to take a 1/27.5 of the value of the building into expense.  This is very powerful because it allows for you to collect cash in the amount of the depreciation without having to pay taxes today on it. For example, I purchase a property for $1.2 million dollars and I allocate the cost between the land and building.  The cost of the land is at $200,000 and the cost of the building is at $1 million.  The depreciation each year I can take is $36,363. That means I can still pocket $36,363 in cash without having to pay any taxes for the year. You can have cash income without paying taxes on it. There are a few more tax advantages: long term capital gain treatment if you sell the property after holding it for longer than a year, the ability to do a tax free 1031 exchange by selling your existing property and buying a new property, by having the ability to monetize your appreciation on the property without triggering a tax bill by obtaining a cash out (re)financing.

Illiquidity

There are definitely downsides to the fact the illiquid nature of real estate.  Unlike owning shares of Apple in which I can sell thousands of shares with a click of a button and at a visible market price, I do not have the same benefit for real estate.  However, illiquidity can also provide a couple of benefits.  The first one is that there isn’t an exchange that is constantly providing prices on real estate, unlike stocks.  Therefore, I won’t run into any psychological traps of seeing huge decreases flash across my computer screen.  In the event of a downward trending market, real estate will at least not produce the same level of concern as a listed stock which has lost 30% of its value over the past month.  Additionally, given there is an exchange with a listed price for real estate, there can be mispriced real estate listings you can acquire.

It isn’t all sunny in owning real estate. There are also some downsides to owning real estate directly as well:

Wear and Tear 

Renting to tenants can produce wear and tear on the property. What was once a newly renovated property might look very worn and lived in after a couple of years of usage. Appliances might need to be repaired or replaced. I’ve had a sewer main line separate while owning a property which caused sewer to flow into my basement. It was quite an ordeal to first fix the sewer line and then to detox the basement.

Dealing with Tenant Issues 

Owning an investment property is very similar to running your own business. You have to deal with tenants whom you can view as your customers. They might come to you for a blown light bulb, for a toilet clog, for leaks, to have the dishwasher fixed, and a whole host of problems. There were times when I felt like a psychiatrist, having to listen to a tenant complain about life, how hard it is to find work, and why it is a struggle to make the rent payments. There were other times when I felt like an arbiter having to settle disputes between tenants. Also, tenant issues can pop up anytime and, seemingly, always do whenever I am on vacation.

Late Rent 

You might have to deal with late rent. This results in a lot of administrative work to follow up. I have tenants whom I have to remind every month or a few times a month before rent is paid. Also, with late rent, I would have to front the money to satisfy my mortgage bills, utility bills or payments to contractors.

Paying Bills 

The more properties you own, the more time is spent dealing with bill payments. There might be numerous accounts with the electricity providers, water providers, gas companies, real estate tax payments, mortgage payments, insurance, and contractors.

Dealing with City/State Jurisdiction 

Your state or local jurisdictions might have strict rules and regulations. You might have requirements to pass periodic inspections, to obtain approval for renovations and to deal with changing regulations such as rent control. I once was about to make a purchase on a three family house in Union City NJ thinking the 3 units are all free market rent. I had an accepted offer and was going through contract review. Fortunately, my agent informed me before getting into contract that Union City recently changed its rent control regulation to now scope in 3 family properties as well. I decided the restrictions placed on a rent control property weren’t worth the headache of the potential return on the property.

Dealing with Service Providers

You have to deal with a number of service providers ranging from managing agents to banks to insurance companies to utility companies. You might have to allocate time to deal with those providers. I’ve had to set aside time to deal with the water company replacing the water meter, for the gas company to come in and install new meters, to clearing comments from insurance companies in order to continue with coverage and a number of other meetings.

But all in all, I believe the benefits to real estate ownership far outweigh the negatives. Those benefits are the reasons why I own 5 rental properties totaling to 15 residential and commercial units and am currently in contract to purchase the 6^th rental property.

To the audience: Do you own any real estate? Do you believe real estate should be the cornerstone of your portfolio? What other asset classes do you prefer to like better and why? 

SoM @ SportofMoney.com

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