By | January 3, 2019

Summary

Seeking Alpha is a stock market site, but a large proportion of readers also invest in physical real estate.

Whether to invest in stocks, REITs, or real estate is one of the biggest ongoing debates in personal finance.

Rental real estate, REITs and stocks all have advantages for investors with different circumstances.

Rental real estate may be under-appreciated for its investment potential when the Fed cuts rates. The key to success is the ability to acquire attractive assets and borrow cheaply.

Life is full of debates.

Is Brady the best QB of all time? Probably.

Can you use your e-cigarette in the airplane lavatory? No.

But should you invest in stocks or real estate?

It depends.

Real estate is starting to enter a down cycle in many markets, and I’ve been bearish on homebuilder stocks over the last year. But, with long-term interest rates falling again, the real estate market is starting to get more attractive. When the Fed inevitably cuts rates, real estate will again be a strong buy.

Who Real Estate Works Best For

Real estate works beautifully for two groups of people. The first group is six-figure earners with few assets who are able to borrow heavily and build wealth via home equity.

The second group is the $500,000 to 10 million net worth crowd who can benefit the most from government subsidized mortgages and use real estate to create permanent financial independence. More on this later.

To confirm my hunches, I dug up a fascinating study on asset holdings by social class. The study was done on Swedish households, but I find the results surprisingly accurate when thinking about the U.S.

The share of residential real estate is hump-shaped in net worth. Residential real estate is rarely owned in bottom brackets but is the dominant form of investment for households in the 40th to 95th percentiles, accounting for as much as 64% of gross wealth in the 70th to 80th percentiles. In top brackets, the share of residential real estate declines rapidly and is as low as 2.5% for households in the top 0.01%.

The study goes on to note that there are distinct differences in holdings between social classes.

The poor (as defined by the bottom 40 percent of households) tend to have few assets besides the value of cars and personal items. When they do have financial assets, they tend to be held in cash.

The middle class (as defined by the 40th to 95th percentile in net worth) tends to have nearly all their money either in home equity or tax-deferred accounts such as 401k accounts or 529 accounts. Their largest assets are their homes, and their greatest liabilities are their mortgages.

The upper class (95th percentile and above) tends to have far greater holdings in equities, commercial real estate, and private equity, all of which are nearly nonexistent for the middle and lower classes. By the time you get to the top 0.01 percent, these three categories of holdings represent over 90 percent of total assets held.

Who real estate doesn’t work for

If you live in the five boroughs of New York City, San Francisco or West LA, the average home price is going to be out of reach for many six-figure earners. Cap rates are low and laws heavily favor tenants over landlords, so there isn’t a favorable setup for you to invest in real estate.

If you live in the Sunbelt, this isn’t your problem, and in Texas, Florida, Tennesse, and Nevada, state income taxes aren’t a thing either, giving you more flexibility to invest your bonus/commission income. The result is that it’s a lot easier to get ahead in the Sunbelt states than in wealthier, higher tax states.

I’ll let you guess where the demographic migration trends are going, and where you’re better off investing.

It’s not the rich who are leaving high-tax and high-income states for the most part. Millions of middle-class people are leaving California and New York.

Also if you’re considering investing in real estate, you need to figure out your ROI and compare it to what REITs are getting. You need a spreadsheet.

A theme I hear over and over again on REIT conference calls is how they acquire property from small investors who can’t compete with REITs ability to borrow cheaply.

REITs are typically going to have the advantage over direct investment in asset classes like industrial, retail and office space, as well as niche spaces like self-storage, data centers, and cell towers. Small investors typically have the advantage (courtesy of government subsidies) in single-family and multifamily.

Net lease properties are in the middle. I know a broker who has been crushing it buying and selling net lease properties. I also know that realty income, for example, has economies of scale that beat 90 percent of net lease investors returns by virtue of its ability to borrow cheaply.

What I would avoid doing is buying into fintech syndications. One fintech firm, who shall remain nameless, was selling shares in houses in a well-known crime hotspot near where I grew up. This is an extremely dangerous neighborhood and their appreciation assumptions were laughable. The idea that techies in San Francisco were buying properties in the most dangerous neighborhood in Kansas City gave me pause, as did their smooth pro forma graph of expected appreciation as if the property had appreciated over time, when in fact property values had been falling for decades.

The banks aren’t going to protect you from buying in war zones, lest they be accused of redlining. But make no mistake, high cap rates in dangerous neighborhoods are world class traps for unwary investors.

A few good long-term markets are Dallas-Fort Worth (but give 12 months for migration trends to absorb supply), Austin, San Antonio, Denver, Florida (outside of flood-prone areas), Atlanta, Nashville, and Northern Virginia.

A few bad long-term markets are Ohio (poor economic fundamentals), Illinois (same), Pennsylvania (same), the rest of the rust belt, Las Vegas (consistent oversupply and boom/bust economy), Houston (poor economic fundamentals), New Orleans (economy/geography) and Connecticut (high property taxes and weak demographics).

Also, most non-vacation areas outside of commuting distance of metropolitan areas are bad markets.

Tier 1 markets like NYC and San Francisco aren’t terrible investments per se but aren’t the best places to invest on a cap rate basis and due to difficulty stemming from regulations/ taxes.

There’s a healthy debate on Seeking Alpha. Contributor Jussi Askola has pointed out that many investors are better off investing in REITs than rentals. He also has a paid REIT newsletter that helps investors pick REITs. I have a slightly different perspective on real estate than he does, but I feel that REIT newsletters are among the best values out there.

REITs are not at all homogenous as a sector and really do reward good stock pickers, second only to the fashion/retail/restaurant sector.

Common sense is required to be successful in real estate

I would note that you need to be investing locally to do well in residential real estate, in my opinion.

If you move out, fine, but if you never fully understood the market to begin with, then you have a problem. I’ll also note that the time to buy is when the Fed is cutting rates because you’ll be able to soak up assets with the liquidity you have when many other players in the economy are struggling to deleverage.

I got my first exposure to both stocks and real estate in 2008 at the age of 13. I started trading stocks in 2008 and started working for my mom in real estate, helping fix up foreclosed houses that we bought as investments.

Real estate isn’t easy, but it isn’t hard either. I can tell you with 100 percent experience and certainty that the average person can make more money investing in real estate than stocks, but that real estate is going to punish stupidity and laziness far quicker.

My parents started their real estate business with a home equity line of credit in 2008. The business focused on buying bank REO and auction properties under market value, fixing them up, and selling them anywhere from 4 months to a little over 12 months later. We didn’t hold onto properties because we didn’t believe strongly in the Missouri housing market but considering that the business was started with a home equity line of credit, a business credit card for repairs, and sweat equity, the return was nearly infinite compared to the money put in.

We knew other investors who made far, far more money than we did, some of who now own hundreds of single-family homes. I get the common lines that people repeat about tenants and toilets and the like, but I think most issues with real estate investing boil down to a lack of common sense.

There are some investing guidelines that people just seem to ignore. Here’s a non-exhaustive list.

1. Medical students make great tenants, frats don’t.

2. Middle and upper-middle class tenants are a lot less of a headache than section 8 tenants.

3. 100-year floodplains flood all the time due to urbanization changing the geology of cities. Avoid them!

4. Get the roof (and everything else) inspected if you’re gonna buy a house.

5. Beware of buying into a hot trend without doing the math behind the fundamentals. For example, the real estate investors around TCU seem to have forgotten to count how many students actually attend the school vs. the housing stock around campus. You see "for rent" signs everywhere, year round. Not good!

6. If you cultivate your tenant base from the beginning of your business and do business with upstanding people, you’re not going to have the same kind of issues. If you know how to look, it’s obvious to see who’s doing great in real estate and business, and who is doing terrible.

Landlording is great for people with $500,000 to 10 million in net worth

I mentioned that real estate works wonderfully for the $500,000 to 10 million crowd, so I’ll explain a little more here. Fannie Mae and Freddie Mac allow you to have a maximum of 10 mortgages, but after that, you have to get more expensive financing or move up to commercial properties.

I think this makes a ton of sense because despite what some hedge funds think, there aren’t economies of scale in owning residential real estate. However, Dallas-Fort Worth (DFW) has suburb after suburb with six-figure average incomes. The suburbs of Southlake, Westlake, Colleyville, Keller, and Trophy Club form a giant block of six-figure median incomes, so $300,000 to $500,000 houses are easily rentable. This wouldn’t work in the county where I grew up in Missouri, by the way, where most of the housing stock is well below $200,000 in value.

If you can get 10 mortgages, this means you can have about 4-5 million in assets working in Tarrant and Denton county single-family real estate with government-backed financing. This is pretty easy to acquire over a 3-4 year period for someone earning six figures combined with their spouse because you can use rental income and appreciation to qualify for more loans. If you don’t have that kind of money yet, you can use FHA loans for 3.5 percent down and then move out after a year and move a tenant in. This is called "house hacking" and is a great way to acquire assets.

On the other hand, if you have over 10 million dollars in net worth, acquiring 10 houses to make $300,000 to $400,000 per year in income may not be worth the trouble. The problem with residential real estate is that it doesn’t scale. It would be insane for someone with 40-50 million dollars in the bank to start trying to flip houses or invest in single-family rentals because it simply wouldn’t move the needle.

Your options once you move past the 10 mortgage threshold are either to go up into multifamily, where you have more government-backed loans, start doing development or get into commercial real estate. Multifamily is a natural step for people who really enjoy the residential aspect of real estate. Development is a great way to make money, but requires guts and skill, as you’re often going to be buying a piece of land and quarterbacking the project into a strip mall or subdivision.

Lots of would-be landlords have delusions of grandeur about making money by renting to economically disadvantaged people. They see the higher cap rates and think they can be tough and won’t lose. I think this is a silly risk to take, and the smarter risk to take always is to use leverage on high-quality assets over concentration in low-quality assets.

Some real estate books like to boast that you should try to get a few hundred bucks in positive cash flow for rentals.

Experienced real estate investors were routinely getting $1,000 to $2,000 per month in cash flow per house in DFW when the interest rate environment was conducive. It isn’t now, but it will be again the next time the Fed cuts rates.

Control your interest expense

The biggest trick to make money in real estate is to borrow more like a REIT. Interest rate risk is a lot better risk than renting to low-income borrowers and is more predictable too. If you have stock and bond assets also, you are partially immune to the risk of rising interest rates, because your assets will yield more also to offset your liabilities.

Central bankers have known for a long time that consumers would be better off with adjustable rate mortgages tied to the LIBOR rather than fixed-rate mortgages, assuming they can take some interest rate risk. Investors overpay for certainty. This won’t work right now because interest rates have risen, but 5/1 ARMs let you lock in the interest rate for 5 years, then float against the LIBOR later.

5/1 ARM rates

As you can see, 5/1 ARM rates were below 3 percent for almost all of the last 8 years. Some highly creditworthy borrowers were getting close 2.5 percent in DFW on these, which is insane. Take a cap rate of 8 percent minus a 2.5 percent financing cost, and you’re pocketing about $22,000 per house, per year in mortgage paydown and cash flow. Naturally, when this happens, speculators drive the price through the roof. Long story short, you triple your money in a few years. You’ll still do fine but you won’t cash flow as well on average with a 30 year fixed rate mortgage.

30-year mortgage rates

You can see that 30-year mortgage rates are almost always higher than the ARM rates over time. If you can afford to take some interest rate risk, you’re looking at significantly better cash flow throughout the life of the property. Plus, you’re locked in for 5 years. If interest rates are low, it’s natural for property prices to rise. Note that 5/1 conventional ARMs are not the same loans as the adjustable rate time bomb loans that were heavily marketed to subprime borrowers in the 2000s. This is a Fannie Mae product, not a subprime, no-doc loan with a dangerous balloon payment.

Use transaction costs to your benefit

Transaction costs are another potential drag and benefit of investing in real estate. Novice real estate investors pay huge transaction costs which kill their returns. But by getting a real estate license or partnering with someone who has one, you can earn the spread rather than pay it. My mom got a real estate license to compliment her business, and we were able to earn hundreds of thousands of dollars in transaction cost in the course of doing business, rather than pay it. It makes a huge difference.

Use seasonality to your advantage

Additionally, there is a big difference in the prices that you can get if you buy in winter and sell in summer, as much as a 10 percent swing in some places. Negotiation is another key to making money in real estate, and it is something that not many people are good at. You should be getting rejected 3-5 times for every accepted offer you make, at a minimum. Don’t get emotional.

For example, look at the average days on market for Dallas-Fort Worth. Every year, the best time to buy is in the winter, and the best time to sell is in the summer. Trade against this, and you make money. Affluent families are your competition for buying homes, and they don’t move their kids in the middle of the school year. Their constraints create an opportunity for you. You’re then able to buy when no one else is and sell when supply is lowest. It’s entirely predictable and entirely bankable.

Cha-ching!

Average days on market, Dallas-Fort Worth

Source: Zillow

What kind of return on investment can you get in real estate?

You can get a far higher return than you might think by investing in property. For example, if you had bought a $350,000 house in 2016 a little under market value in northeast Tarrant County with a 2.6 percent interest rate mortgage and 25 percent down, then made some improvements so your tenants could be really happy with where they’re living, you could be getting an 8-9 cap with an interest cost of 2.7 percent, and be getting close to 2k per month (tax-free due to depreciation) between principal paydown and cash flow.

3 years later, due to the rock-bottom interest rates, the house is worth 15-20 percent more, and you’ve tripled your investment on an IRR basis. It isn’t uncommon for savvy real estate investors to use leverage and get 30-40 percent annual returns when they’re scaling up.

Multiply this by ten, and you’re raking it in. Maybe you’re not comfortable with a ton of interest rate risk so your first 2-3 properties are fixed rate, but you’re still crushing the competition who favors buying risky property over buying and leveraging safe property.

It’s not supposed to be this easy, but interest rates aren’t supposed to be near zero, either. That’s the key to making money in real estate. Borrowing at rock-bottom rates and having a great product that attracts great tenants is so much easier than dealing with low rent tenants.

Stocks and real estate can work together

Let’s say you’re a typical executive in Tarrant County.

You make $300,000 per year, have $1,000,000 in your retirement accounts, a $1,000,000 home with a $500,000 mortgage outstanding, and $500,000 in your taxable investment accounts. Your net worth is about 2 million dollars. Both of these are about average for Seeking Alpha readers, according to our media kit.

If the interest rate environment is conducive, as it was from 2011-2017, you could cash in stock market gains to pay for down payments on rentals. For example, the stock market went up 30+ percent in 2013. You could have cashed in stocks for down payments on the property, then cashed in again for another property when the market rallied another 12 percent the next year.

Assuming you get a nice annual bonus the next year, you’re already making enough money from the property to cover a lot of your living expenses, allowing you to invest the bonus in yet another property. Then, after a couple years of sharp appreciation, you might cash out your least favorite property for 2 down payments on better properties.

3-4 years later, you have 10 properties worth about 4 million dollars without about 25-30 percent equity, $500,000 in your taxable brokerage accounts, about 1.5 million in the 401k, and your home mortgage has amortized also. This whole virtuous cycle works because you can fix your borrowing cost at roughly the rate of inflation for 5-7 years, then sit on the properties and sell into the inevitable appreciation that occurs when interest rates are unnaturally low.

The idea is that you can make about a doctor or lawyer’s salary from your real estate investments and live off that while plowing excess liquidity into stocks once you hit the 10 property max. If interest rates are conducive in the future, you could even pull equity out of properties to pay off other properties in full, or to invest in stocks.

REITs also are an interesting idea to play certain asset classes. You might be able to successfully develop pieces of land and invest in single-family real estate, but you are going to struggle to compete in asset classes like self-storage or office space. For these asset classes, REITs provide cheap exposure and allow you to focus on what you’re good at.

When stocks are best:

Investors with under $100,000 in assets looking to grow their wealth, seniors without help, investors in unfavorable markets, and investors with over 10 million in liquid assets.

When real estate is best:

Six-figure earners looking to build seven figure wealth, investors with $500,000 to 10 million in net worth (for at least a portion of portfolio). Additionally, there are opportunities to develop land and invest in commercial real estate too once you move above the roughly 5 million dollar ceiling in what you can acquire with government subsidies.

When REITs are best:

Accessing asset classes that are difficult to compete in or inaccessible locally (for example, if you live in NYC multifamily is inaccessible unless you’ve got a lot of money to play with). Strong management teams are key. Despite what many people seem to say, the tax benefits (typically depreciation) of owning real estate pass through on your 1099 when you own REITs, so REITs tend to be equal, tax-wise to owning real estate.

Risks

Real estate and REITs share a lot of the same risks. The main risk is that you spend and borrow money up front expecting that the underlying economic activity will support your real estate, and it doesn’t happen. This is a big risk in markets with weak economies.

When enough people are overly optimistic and collectively borrow money to build things that the world doesn’t need, it causes debt crises, like the U.S. subprime meltdown from 2007-2009. Whether through a REIT or through private investments, you don’t want to be caught borrowing money to build something that isn’t needed or wanted economically.

The main difference between REITs and private real estate investment is that you’re on the hook if you borrow money to build or buy a bad piece of real estate. Whether the banks have recourse against your other assets depends on state law. Texas (especially Texas) and Florida, for example, are known for debtor-friendly state laws. In California, mortgages are nonrecourse, which strongly protects debtors. New Jersey, on the other hand, gives creditors extremely wide flexibility to go after debtor assets.

You should be aware of the underlying economic/demographic trends and be able to quantify and manage your downside if you’re thinking about getting involved in real estate.

We were also able to use LLCs to manage some of the liability and tax issues of ownership.

If you do so, the upside tends to take care of itself as debt service gets easier over time due to inflation and rents and property values rise.

Conclusion

You should ideally be invested in both stocks and real estate, using them in concert to build wealth and financial independence. Residential real estate has a carrying capacity of roughly 5 million dollars for effective investment in my market, but you can step up to commercial real estate and/or development at that point. Individual REITs are worth a look unless you can beat the ROI on your own. Stocks and bonds are great when invested intelligently in ETF portfolios. If you can pick great stocks, even better.

Good luck to all!

-Logan C. Kane

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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