Letter 4: Real Estate Vs. Equities
For most investors, this is a key question to think about
This is the fourth in the series of emails on Investing in Real Estate by Roshan D’Silva, founder of Tripvillas - one of the world’s largest holiday property management companies - written exclusively for subscribers of Holiday Home Times. Previous letters can be found on the main HHT Website.
I am often asked about Real Estate in the context of other investments - mainly equities and the stock market. Firstly, please take my note below in the context of my overall opinion - which is that you must have a diversified portfolio of investments - which encompasses real estate, debt securities, and equities. I find it foolish that so-called investment advisors tell their clients that they should never own anything other than their primary home or any flavor of this unidimensional investing advice - If you are getting such advice, it’s smart to assume moral/ intellectual bankruptcy from the advisor and dump them and move on to someone more balanced.
Now coming to a balanced view on real estate Vs. equities and why they should both have a place in your portfolio:-
Real Estate has theoretically a finite minimum - usually, real estate can not fall below replacement value - which is the cost to buy land and construct a similar home / commercial building and so if you have bought at a discount to replacement value - let’s say 0.9X then your 10% gains are protected. If you have bought at 1.2X of replacement value, you can expect that you can at max lose 20% of your capital. Equities on the other hand can go below zero - so the value of a stock can be negative and you could theoretically go to zero where the company goes bankrupt and then fresh equity comes in wiping out past shareholders. However, equity also has theoretically no upper bound as companies in a large, scalable business or accumulating users or data rapidly can then monetize that data or userbase in ways limited only by their creativity - (think google) - and hence equities offer unlimited upside if you bet on the right management team.
Real Estate provides significant leverage - this is one of the key ways in which real estate differs from equities. While most stock brokers also provide leverage against securities in your account, the risk is high due to volatility and usually, leverage would be 50%. In real estate, both seller financing - i.e. where you pay as per a negotiated payment plan as well as bank financing - where you take on debt based on the assessed value of the property - sometimes as high as 90% of the value of the property - is possible and common. Income-producing real estate provides significant safety and rentals usually escalate at a pre-negotiated rate with significant inconvenience - financial and mental to the tenant to move and so it’s normal to assume that effort spent in finding the right tenant would follow the thesis for 4-5 years at the minimum. Generally, the financing institution would also not be able to revalue the property in the short term and change the terms of the arrangement thus reducing any sudden shocks as compared to the leverage around equities.
Real Estate and Equities both counterbalance your debt investments:- It is important to keep in mind that an overall portfolio should have real estate, equities, and debt. Given the nature of the beast, most people would end up with significant allocations to debt and real estate with a smaller amount to equities unless they really enjoy stock picking and are very good at it. However, debt investments while being most time-efficient are also very rarely in your control - so the only way to balance exposure to debt investments is to have exposure to other asset classes that are positively impacted when debt rates go low reducing the income from those investments. These tend to be companies that have debt and so when interest rates are high, their profits tend to be lower due to having to pay for debt but whose profits get a boost when debt rates go lower. Similarly, real estate income gets a boost when debt rates fall as the amount of interest you have to pay will come down thus eating away less of your income and improving what you can take home.
Time efficiency and compounding:- Equities have to be managed more actively as companies are dynamic - a great franchise like Microsoft coming off a great leader like Bill Gates can significantly underperform under Steve Ballmer and then again start performing under Sundar Pichai. Most investors would also have a primary source of income - salary, a business, etc. which also requires significant time and dedication to continue to produce cash at supernormal levels. Usually, with these sources, the early years of your career are most crucial and require total dedication and so getting into equities very early tends to be counterproductive in my opinion. I find it much better to dedicate the first 20 years of your career to your profession and develop deep and significant expertise there - If you do this, you will generate significant capital and this will need to be invested in a reasonably low touch investment - I recommend real estate for this and buying young and stretching. If you dedicate yourself to your career for the first 20 years, you can expect significant remuneration there which will pay off most of these properties and generate significant growth in capital value and income as they are paid off over a 10-15 year horizon. By then, usually, you would be generating significant cash both from your profession and passive income to then start looking at building an equities portfolio that you can monitor and manage over the next 10-15 years. Real estate also due to the transactional costs involved, tends to be held for longer periods which allows compounding to work in your favor. As such, I recommend it for those in the early part of their careers and who want a fire and forget option that will allow them to focus on building their primary source of income for the first half of their life.
Please send me your emails or comments. I’m happy to hear alternate points of view and broaden my own learnings.