The Good and the Bad of Real Estate

The Good and the Bad of Real Estate - Transcript

 

Hi, it's Kris Benson, Chief Investment Officer at Reliant Real Estate Management. Thanks for joining us today on the first video of our real estate educational series. Today we're going to talk about the good and the bad of real estate investing. Cue the music. So, I have an iPad down in front of me so I'm going to be doing some of the descriptive writing as we're going through each one of these examples. I think it will be a good visual for you to see so you'll see that pop up on the screen behind me. So let's get started. We're going to take a look first at the good. So, as we had talked about the good things that make up real estate investing.

 

You know, I think the first thing that everybody wants to talk about is the returns. And, we're all taught as young professionals, coming out of school, hook up with a financial planner. Let's put together a diversified portfolio of stocks and bonds, and we're all going to be safe. And I think, for myself at least, I asked the question of, well, are there any other options? And I think you, as an investor, if you're watching this video, you're probably asking a similar option.

 

And I guess the question we all should ask is, is that the best way to accumulate wealth? And so, you know, I spoke to it in my teaser video about this series, that there was a study that was done by a group of researchers from the San Francisco Federal Reserve Bank where they essentially looked at the rate of return of everything. And when I say everything, they looked at real estate, they looked at the stock market, they looked at bonds, T-bills and what they looked at is the real returns. So, taking into account inflation and they looked at it over a period of over 140 years. So, a pretty substantial data set.

 

And so when they looked at the returns, essentially the question was, did they understand which asset class performed the best with the best risk-adjusted returns? And they found an answer to that. The stock market did just over 7% in that same time period. So, stock market were 7% and, let me apologize as you guys see my writing. It's a good thing penmanship has nothing to do with real estate because my penmanship is awful so I apologize for that up front. But that being said, so stocks did 7%, real estate did 8% and then bonds and T-bills; bonds did 4 and then T-bills did just over 2%. So overall, you can see a pretty substantial win from real estate versus some of the other asset classes.

 

But then the next question you may ask is, well Kris, you know, was there a measure of risk there? Because I think for all of us, the risk-adjusted return is a critical component. If you're taking more risk in your portfolio to achieve the return, you know there's some downside there. And so, we'll put the link in the video to the actual study so that you can review the data yourself. But essentially, what the paper found was real estate risk-adjusted returns were better than even the stock market. So essentially, it outperformed the stock market while creating less risk for the investor. And so I guess the question is, hey should we sell our entire 401(k) portfolio and start investing in apartment communities in Atlanta?

 

No, but I think every savvy investor should be looking at real estate as part of their portfolio because it has the best risk-adjusted returns over a significant period of time. So, let's shift gears to another good reason for investing in real estate, and that's using leverage. And so just for those of you don't know what leverage is. Leverage is essentially using other people's money to fund a real estate investment. So it could be using debt, it could be using investor's money.

 

And so I'm just going to draw up a quick example for you that I think will make this pretty clear. So, if I have $1,000 to invest. I can invest that directly and let's say I could buy a house for $1,000. You  probably don't want to buy a house for $1,000. But if I could, there's $1,000 to invest so I can buy one house, for $1,000. Or, I could take that $1,000 and most banks are going to use that as a downpayment and give me another percentage of money in debt or a loan. So, I could take that $1,000 and let's assume that we had a 20% loan-to-value. So, I'm putting down my $1,000 as my 20% down payment and then I can go get a debt for the rest. So, I might have another $5,000 of debt that they allow me to go get.

 

I'm not sure if that math makes sense. We may have to edit that out at the end but, I'll think of that in just a second. So we may have $5,000. So now, I have $6,000 that I can go spend and make a real estate investment with. And let's assume that same thing. We could go buy a house for $1,000. Well now I can buy 6 houses, right? And there's risk to debt, right? No question. As investors, you don't own the actual property. The bank has a lien on it. So, if you're over-aggressive with your debt then the bank can take those properties back. So, as you're evaluating real estate investments, the debt is something you want to look at with a very critical eye to ensure you're not being too aggressive on the debt side of things.

 

Let's go back through the returns real estate - using other people's money or leverage to maximize your investment. Let's shift to the tax advantages. And this is one that I think a lot of our investors are interested in. Most of our investors - all of our investors are "accredited investors", which means, they have either a net worth of over a million dollars, not including your primary residence, or you guys have passed the income test where you've made more than $200,000 a year for the last 2 years in a single income or $300,000 with a joint income for the last 2 years and expect to make that amount of money moving forward.

 

So I think investors in that position typically are looking for some tax advantages and real estate offers that. And there's really 2 things that - 2 areas that it offers that benefit. So one is depreciation. And what depreciation is, is the IRS just allows us to downgrade the value year over year. So, a property takes on wear and tear. The roof is a year older, the plumbing, the electricity, the fixtures, etc. So, the IRS allows us to take that as a write-off - a paper write-off each year and show it as a loss. So, even if a property is producing gains - and let's use an example. So, let's say we made $5,000 and our taxable rate was 20%. So, if we made $5,000 of just ordinary income - I got it in a W-2 from my job, and my tax rate was 20%.

 

Well, I would pay $1,000 in taxes. Depreciation - what that does, let's say we made $5,000 from a real estate asset or a real estate investment and I had $1,000 of depreciation. So the IRS said, hey Kris, your roof is worth less this year, your landscaping, your plumbing, your fixtures, etc. We're going to let you write off $1,000. So now my taxable income is only $4,000 and at that 20% tax rate, now my tax bill is $800. Now, I still made $5,000, but for the purposes of the IRS, I made $4,000 and I only had to pay tax on the $800.

 

Now, there's definitely some benefits to depreciation but keep in mind, the IRS is eventually going to come back and get that money. When you sell your property, you have to pay the taxes on that specific gain and so depreciation will be recaptured in the sale of the property. Now, one other thing with tax advantage of real estate is, the profits in real estate are typically taxed as capital gains and for most of you investors out there, you understand that the capital gains rate at least of 2018, 2019, the taxable rate is somewhere in the neighborhood of 0 - 20% which is typically significantly less than what our ordinary income tax rate is. So, if we can sell these properties at a capital gains rate, then the tax burden of that profit is significantly less than income, than we would have for ordinary income.

 

And I think for all of us, it's not how much money you make, it's how much you bring home. So real estate gives us some really nice tax efficiencies around how we can maximize more of the revenue coming home in our pocket versus being taken in taxes. Alright so what's another benefit of real estate investing? Diversification. And this is something that I think inherently makes sense to most of our investors. We all have a portfolio or most of us have a portfolio of some stocks and playing in the equities market.

 

Most of our investors come to us looking for some sort of non-correlated asset to the market. So what that means is, the market goes up and the market comes down. The value of the real estate investment doesn't follow that. So typically the valuation of a real estate property, at least on the commercial side, is based off of income. So, net operating income. So as net operating income grows, the value of the property goes up if all other things stay constant. So if the stock market goes up and down, that doesn't necessarily affect how much rent I can charge in my apartment or in my storage unit.

 

So, the value of my property may stay consistent even as the stock market fluctuates. And so I think that's something that a lot of our investors are looking for is a non-correlated asset, which just means the market goes up and our properties don't necessarily follow up. But, if the market goes down, our property doesn't necessarily follow the way down. And so it just gives us a little bit more diversification as investors. I think most savvy investors are looking to create that in their portfolios.

 

Alright so the final one on the good side is inflation hedge. And so, for those of you guys who are not familiar with inflation, inflation is essentially the devaluation of our currency. So, as the Fed Reserve Bank prints more money, it's the basic laws of supply and demand. There's more supply so the value of the money goes down. So, if I buy milk today for $1 and inflation happens, it may cost me $4 for that same gallon of milk. And the problem with that is, I may still be making the same amount of money, but the value of my money has gone down. Real estate has proven itself to be one of the great inflationary hedges where typically housing costs and property costs and the rental rates associated with them are going up with inflation. And think about it. It just makes sense, right?

 

If your dollar is worth less, that translates to rents and rents are going to go up. So, property values and the rental rates of properties continue to go up as inflation does. So, as an asset class, it's a really nice way to hedge your portfolio against inflation on the real estate side of things. So, let's transition a little bit. I think we've talked about some of the good things for real estate. Let's take a look at what some of the downsides are. You know, as Poison once said, every rose has its thorn. So, in this case, we're going to go through and outline a few of the thorns. I'll try to have the music cued up on Every Rose has its Thorn to keep you guys honest.

 

So, on the bad side of things, the first thing that I would say is liquidity. Liquidity is a big issue or something you should be thinking about as you look to invest in real estate. So what liquidity means is your ability to translate your investment to cash. And so what I would say is, cash is the ultimate liquidity device. If I have cash, I can essentially do anything with it. A stock - an individual stock that's publicly traded, also a very liquid investment vehicle because today I can go out and buy that stock.

 

If I need the cash back. Tomorrow, I can go back, I can sell it and get that cash. Now, my value may have gone down or up, but I can get it immediately because there's a market for that. In real estate. That's not the case. Typically, you buy a real estate asset or you invest in a syndication or a crowdfunding platform. There's a horizon that you're trusting that the operator or the asset itself, where the time is going to be taken to create value in that property. And so, as an investor, you want to be thoughtful of: is this money that I'm going to need in a year, two years, three years, five years, whatever the investment business plan is.

 

Because if it is, it may not be money you want to invest in real estate. And I can speak to Reliant's specific examples. We tell our investors, somewhere in the neighborhood of a 5 - 7 year hold period. And, what we also say is, but we have the discretion to either sell it sooner or later. Our job is to maximize the value for the investor. And so, the liquidity piece is something you - the money you invest really has to be money that you don't need because you're not - there isn't a market to get it back. And if you buy your own house, it's challenging to sell it and it's expensive to sell it.

 

So, if you need that money in an emergency, you may be out of luck. So, one of the downsides I think you've got to think about as an investor is just the liquidity aspect of real estate. The second thing that I think you should think about is, specifically if you're looking at investing in a syndication or a private placement with a real estate operator, like a Reliant, is complexity. So, for many of our investors, they're not real estate experts. They're trusting us to be the real estate expert and they're doing whatever it is that makes their day-to-day income. And so, I think the complexity aspect of this is a big deal. Just to give you a sense, our private placement memorandum - so the legal document outlining the risks of the real estate investment.

 

Sometimes our PPMs are 60-plus pages of pretty heavy, dense legalese. And so, you want to be thoughtful of that - that you understand the complexities of the real estate that you're getting into or the investment you're getting into because you can make a really expensive mistake. I would highly recommend that you get your attorney to review documents or, if that's your background, you review the contract in detail to make sure there's not anything that doesn't stand out. And, if you are looking at an investment where the operator can't answer their questions about that specific subscription document, which is just essentially the contract between the investor and the operator, I would be careful because typically, those are the rules of engagement between the investor and the operator.

 

So complexity, liquidity - definitely two downsides. You know, I think another one is market risk. So, just like any investment asset class, there are things that can go bad just because of issues in the market that weren't foreseen by you or by us as a real estate operator. It can be larger issues in the community. An employer goes out of business. You buy a property in a community that is anchored by one large employer. Let's say GE has a manufacturing plant and GE decides to pull that manufacturing plant, bring it overseas. Well, that's going to impact a significant number of people in that community and ultimately trickle down into the real estate market. It may be higher occupancy. You know, with storage units, it may not be as many people who are looking to rent storage units.

 

So, there are definitely some macroeconomic things that can happen at a market level that can impact your real estate investment. So, you just want to be thoughtful of it. And, keep in mind, like in our last recession, 2007, 08 and 09. There were markets like Phoenix and Las Vegas where, even if you had a home where you had safe debt on it, the market was flooded with foreclosures. So, all of a sudden, laws of supply and demand, you had all these houses come into the market. So, your home just dropped precipitously in value. Not because of any other reason, except the rest of the market impacted it.

 

So, it's definitely something you want to be thoughtful of. And, I think there's market risks in any investment class you look at. But certainly something you want to understand on the real estate side of things. And then the last one is time. So, time to me is one of those interesting things. It's the only thing we can't create more of. I heard an interview with Warren Buffett, who is one of the richest men in the world, and he said, look, I can buy anything except for time. And so I think you, as a real estate investor, want to understand what your role is in this real estate investing world. Do you want to be a direct investor where you're investing in your own properties and learn how to be an expert? I subscribe to the 10,000-hour rule. So, if you want to be an expert, you've got to spend 10,000 hours on your craft to be that. And so, there are only so many 10,000-hour blocks in our lives. And, you want to make sure that real estate is a passion of yours. That, if you're going to go out and buy your own and be a direct investor, then you're willing to put in the time to become the expert. And, you know, from my perspective, that's the value of what a Reliant does and our investment opportunities do for investors is, you're partnering with someone who is a real estate expert.

 

I mean, we're learning every day. I don't mean to say we know everything. But our team has put in the 10,000 hours and we've spent all day, every day. This is what we live, breathe and eat to ensure that we're trying to maximize value. And so, as a passive investor, which just means you're essentially providing capital for an operator like us. And we'll talk through ways to invest in future videos. But as a passive investor, it allows you to commit your time to what you do every day to make you money and allows us to take your capital and try to go out and maximize it. So, I think time is something that you want to think about and whether you want to be an active investor, which there's certainly a lot of opportunity there, certainly to make more money or a passive investor where you're partnering with a real estate operator like Reliant. So, that's all we have on the "Good and Bad" of real estate investing today. The next video that we're going to put out is going to be around, the different ways to invest as a real estate investor. We're excited for you to join us on that next one. If you have any questions, you can reach out to the email link that we'll have down below and we'll see in the next video.