Why Real Estate?

I think there is a battle deeply ingrained in the financial independence community. The battle has been waged since the earliest beginnings, and has become a part of the otherwise tranquil landscape. We barely realize that it is even there. It is a well argued disagreement that leaves both sides shaking their head. I’m talking, of course, about real estate. Peruse a few blogs and you will see that it has both supporters and detractors. But beneath all this respectful debate are a series of questions that we as a community have yet to find a satisfactory answer. Why real estate? And can a true financial plan be successful without its fair share of this asset allocation?

The answer varies depending on who you talk to. I am going to discuss the place of this important asset class on today’s post and follow up with some of the negatives tomorrow.

It is notable that most of my discussion centers on buy and hold real estate or even flipping. I will not be discussing REITs, crowdfunding, syndication, or the other various vehicles available.

Diversification

As I have said before, great financial plans have at least four legs. The reasons are simple. You don’t want to put all your eggs in one basket. The financial independence community is very comfortable in promoting broad-based index fund investing. Within the stock market, this is the best way to diversify. The market, however, as a whole can take a plunge. Yes, even index funds can tank. Thus, it makes sense to diversify outside of the stock asset class. For this reason, many have some portion of their investments as bonds. The next step further is to move out of paper assets completely.

Why real estate?

Because real estate adds to diversification immensely. When talking about assets, we often look at how closely they correlate.

According to Investopedia:

Correlation, in the finance and investment industries, is a statistic that measures the degree to which two securities move in relation to each other. Correlations are used in advanced portfolio management, computed as the correlation coefficient, which has a value that must fall between -1 and 1.

A portfolio of investments in which the correlation coefficient is 1 is not diversified. Imagine holding half your money in a total market index and the other half in a S&P 500 index. These holdings will do very poorly when the market goes down because they are so similar. A portfolio with investments with a correlation coefficient of -1 means that the investments are the polar opposite. For instance an underlying stock and its put option tend to run in equally opposite directions.

Real estate and the stock market tend to be much less correlated. I have seen coefficients anywhere from -0.2-0.2 depending on the year and whether you are looking at residential or commercial real estate.

The point is that they are not correlated at all.

Efficiency

The wondrous thing about real estate, if you are going to be a landlord, is that the property can provide both investment and speculation. The investment comes from creating cash flow through rent collection. The speculation comes into play when considering property appreciation.

Why real estate? Because if you buy low and sell high you can make a fortune.

But I thought we were against speculation?

While it is true that stock market and collectibles speculation is risky, real estate speculation is a little bit less so. To understand the reason, you need to think about efficiency.

The stock market is truly efficient. There are so many smart people buying and selling that on any given day the stock price tends to be very close to the value. The moment the novice investor like you or I recognize an inefficiency (a disconnect between price and value), thousands of other investors have jumped to attention and swayed the price back in line before we have had time to act.

Real estate, however, can be incredibly inefficient. Sellers are often under duress to sell for a multitude of reasons. Seasonal variation affects price. Offers can be made before a property is listed and therefore never exposed to market conditions.

It is a speculators paradise.

Tax Efficiency

While it is far above the purview of this blog to get into the specifics of our tax code, buying and renting real estate provides a number of tax benefits. Most of these center on the idea of depreciation. Although we hope our property will appreciate, you are allowed by our tax code to depreciate a property over a set number of years and use these “losses” to offset income. You therefore are able to defer paying until the property is sold.

Furthermore, if the property is sold and certain criteria are met, the taxes can be further deferred if another investment property is bought. This is called a 1031 exchange and will not be covered here.

The point is that if you are asking why real estate, tax benefits is a very reasonable answer.

Final thoughts

While real estate is not for everybody, there are many reasons why it rounds out a financial plan nicely. It helps diversify the modern portfolio. It adds a less risky form of speculation because it is such an inefficient market. And finally, it provides tax benefits that may last for years.

The better question is why not real estate?

We will cover that tomorrow.