A lack of financial literacy can lead people to consider investing in direct real estate. This a provocative statement, to say the least, so let me explain.
There are three dimensions when considering your finances: how much you earn and the stability of those income streams, your spending and how to keep it checked, and what steps you are taking to plan for future expenses, including your pension.
The younger you are, the more you should invest in yourself, i.e., education, training, and networking.
As you age, you should start saving for your pension and major expenses, e.g., buying a car or a home.
When you approach retirement, it’s all about accessing your investments to sustain your lifestyle and mitigate future losses as you have less time to recover.
Where does investing in direct real estate come into consideration?
Real estate is illiquid, has high management and running costs, and, if you are going to use a loan to finance its purchase, carries the risk of turbulence in credit markets, i.e., fluctuations in interest rates.
Thus, it’s unsuitable for older individuals approaching their pension age or those at the start of their careers who need to be channelling their money, time and focus on learning and networking (which also means remaining flexible about where they live).
Those in the age bracket of 35-45 (or even 30-55) could be looking at investing in real estate only if they have maxed out the tax incentives granted by the government to save for their pensions (this is essentially free money), have significant savings in international shares and bonds, and have a “rainy day” fund which equates to 6-12 months expenses.
With the above in place, they can consider real estate as an investment option provided that that investment isn’t more than 10-15% of the value of their overall portfolio (pension funds, provident funds, use this ratio).
But what type of real estate?
Not a one-or-two-bedroom apartment! No. No. No.
Investing in real estate through an Exchange Traded Fund (ETF) provides the owner with liquidity, diversification, and less time needed to manage their investments.
An ETF is a type of investment fund traded on stock exchanges like individual stocks.
It holds real estate, such as residential, offices, shopping malls, etc., which are professionally managed and can be bought or sold through a brokerage account.
Let us investigate further “liquidity” and “being able to pick a winner”.
At what point does a problem of liquidity become a problem of solvency?
A problem of liquidity in real estate investing refers to the difficulty in converting assets into cash quickly and without a significant discount.
For example, if an investor needs to sell a property quickly, but the real estate market is slow, they may have to sell at a lower price than expected.
This lack of liquid assets can make it difficult for the investor to meet short-term financial obligations, such as paying bills or making loan payments.
On the other hand, a problem of solvency refers to the inability of an investor to meet their long-term financial obligations, such as paying off debt or funding their retirement.
Suppose an investor has taken out a mortgage to purchase a property, and the property’s value decreases significantly.
In that case, the investor may owe more on the mortgage than the property is worth.
In this case, the investor may have difficulty selling the property and paying off the mortgage and may eventually face the risk of default or foreclosure.
Does this remind anyone of what we have been experiencing since 2008 across Southeastern Europe?
Most people approaching the “real estate investment age”, i.e. 30-35 years old, don’t have such memories because they were in high school or university when the Great Financial Crisis (GFC) happened.
Current examples include the blocking of withdrawals from some of the biggest real estate funds, such as Blackstone’s BREIT (a $69 bln vehicle), and the (hilarious) reference in Norway’s sovereign fund’s presentation of 2022 performance where it stated that real estate values of listed vehicles (i.e. those traded in the stock market) were down 31% whilst those of unlisted real estate (i.e. for which their pricing is based on valuers’ opinions) remained stable/ the same.
And what about your ability to pick “a winner” because of your connections and deep insights?
In 2008, Warren Buffett placed a $1 mln bet with the top hedge fund investors on Wall St. He bet that over 10 years, a simple index tracker fund would outperform the best hedge funds.
The results were surprising as Buffett’s plain-vanilla stock fund averaged 7.1% while the hedge fund portfolio produced only 2.2% after fees.
Buffett won the bet and donated the winnings to a non-profit organisation.
He advised both large and small investors to stick with low-cost index funds, stating that when trillions of dollars are managed by Wall St. charging high fees, it will usually be the managers who reap the profits.
Standard & Poor’s has been tracking the record of active managers and found that 84% underperform after five years and 90% after 10 years.
The performance was “worse than would be expected from luck.”
Large fees are still deducted despite the poor results.
Direct real estate investing is great!
You get to see and touch your investment, get a loan to finance it, receive rental income, and then sell it when prices are high.
At the same time, it limits your flexibility, is costly to manage, is highly taxed, and you are unlikely to be able to outperform simpler and more liquid options out there.
Nobody listens to this advice.
It has not stopped me from giving it.
By Pavlos Loizou, CEO, Ask WiRE