As mentioned in some of my previous articles, I started investing in real estate almost 20 years ago but until recently most of my investments were in stocks, bonds and Gold. However, I recently realized, after reading few books and attending a couple of seminars, that Real Estates have great advantages and must have bigger part in my investment portfolio. I would like to summarize these advantages in the next few points:
Power of leverage:
If you have $100k, you can buy exactly $100k worth of stocks. I know some of you would say that you can buy stocks on margin but brokers don’t allow that except for very limited numbers of stocks and for only 30% of the stock’s value. Also, if the stocks bought in margin went down, the broker will ask you to pay portion of the plummeted value. However, if you have $100k, you can invest in a property worth $400k with an 80% LTV (loan To Value) mortgage. There are many banks competing to offer you this loan with competitive interest rate. Now, assume your investment in both stocks and properties increased by 10%. Your stocks value will be $110k (i.e. $10K profit or 10% of the invested money) while the property value will be $440k (i.e. $40k profit or 40% of the invested money).
Power of improvements:
Once you buy the $100k worth of stocks, you can’t personally do anything to improve the its value. However, when you buy a property, there are endless number of ways to significantly increase its value; Painting, erecting a fence, changing the front door, modernizing the bathrooms, adding an extra room, adding a swimming pool, prettier garden, etc.
Power of refinance:
Assume your initial $100k stocks investment doubled in value. What must you do to use some of the increased value in another investment? The simple answer is “sell” some of the stocks hence not only paying capital gain tax but also reducing the amount that is left that can earn further profits for you. However, if your $400k property doubled in value, you can get a new appraisal and go back to your bank asking for a new mortgage (i.e. refinance). At 80%LTV for the now $800k property, the bank will lend you $640k which not only pay the old $300k mortgage but also provide you with additional $340k for more investments. Also, you will not pay any capital gain tax.
Power of diversification:
There are lots of sound reasons for including property as a diversification element in your portfolio. Here’s a roundup of the main ones. Firstly, it’s one of the few truly effective diversifiers left. Diversification is an easy concept to understand, but it can actually be pretty hard to put into practice – and evidence suggests that it’s getting harder. A portfolio is diverse if it contains a proportion of assets that are weakly correlated with the rest; in other words, the prices of those assets move separately from the remainder of the portfolio. To take equities as an example, a couple of decades ago an investor with a large stake in the S&P 500 might have looked to another major stock market such as the FTSE 100 or DAX for diversifying assets. Likely, such an investor would have been able to identify suitable candidates.
But as just one example, you only have to look at how tightly correlated the US and UK equity markets have become since 2000 to realize just how interconnected the world’s markets are now. Globalized markets and instant trading are driving this interconnectivity. You’ll find, for instance, that no longer is it the case that commodities move completely independently of equities. What’s more, as Blackrock pointed out in its 2017 outlook, we’ve even seen the direct negative relationship between stocks and bonds get weaker over the last few years – making it harder to go down the traditional route of using bonds to buffer equity market swings. It means that so many markets are a direct proxy for the same ‘events’ – making it harder to pinpoint investments that are driven by distinct factors and which move in ways independent of the rest of your portfolio. Property is one of the few asset classes that still fits the bill as a diversifier. Property still has a low correlation to stocks, bonds and commodities. Yes, it’s affected by the wider economy, but it’s a lagging indicator, i.e. the effects of ‘events’ tend to take longer to feed through to real estate compared to most other markets. It moves in a different way to other asset classes.
Its fundamentals – which often include population growth and an inelastic supply side that fails to keep up with demand – are unique to this particular market. It’s one of the reasons why residential property tends to trump commercial real estate as a diversifier. While shocks affecting the wider economy can often be felt in areas such as demand for office space, those reverberations tend to be much weaker in the housing market. It’s also the case that each particular residential property market has its own characteristics. What’s true of Berlin might not apply to Frankfurt; the factors driving growth in booming areas of South London might apply differently in other parts of that city – and certainly, the UK. No two real estate markets are the same – and it’s these distinct value drivers that enable property to bring a welcome risk-reduction element to your portfolio. Property – and, more specifically, distinct property markets have a ‘rulebook’ all of their own.