The pros and cons of investing in real estate

This time of year, you’ll often hear discussions about the proper “asset allocation”, or the mix of stocks, bonds and cash that you should hold in your portfolio at various stages of life. A Successful Investor Wealth Management client once asked a related question that rarely gets the attention it deserves. He asked where investing in real estate fits in your asset allocation.

Investing in real estate: More like running a business than owning stocks

In reality, owning investment real estate doesn’t quite fit within any of asset allocation’s pigeonholes. It’s more of a small business than a passive investment like stocks and bonds. (I call them “passive” because you don’t need and aren’t expected to help manage the companies you are investing in. Of course, you do have to manage your investment portfolio, or hire somebody to do it for you.)

Real estate investors have to make periodic business decisions, such as whether to replace or repair faulty furnaces, leaky roofs and so on. They need to advertise for tenants, winnow out bad prospects from good ones, negotiate rents, keep the plumbing in good repair, decide when to paint and what colours, and so on.

Many real-estate investors have had good results in the past few decades. Growing population and rising affluence deserve a lot of the credit for these gains, because they’ve helped push up virtually all real-estate prices. However, investors with capital gains from investing in real estate also owe some of their success to two additional factors:

1. The unpaid and often uncounted hours of labour (sometimes referred to as “sweat equity”) they devoted to their properties, and
2. The fact that they employed leverage — borrowed money — to invest. Leverage magnifies the ultimate return, but at a cost of magnifying your risk.

If we have to force real estate investments into one of our five main economic sectors, Manufacturing & Industry would be the best choice. A strip mall or five-plex may not superficially seem to have much in common with IBM or Ford Motor Company, but there are similarities.

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Like manufacturing, real estate requires a high level of capital investment. It is also subject to cyclical shifts in demand, though it may not seem that way during the lengthy rising phases that real estate markets go through. It can suffer due to changes in government regulation, taxes and other outside influences that can raise costs, cut your income, push property prices down or prevent them from rising for years if not decades.

Meanwhile, regardless of rents and vacancies, you have to keep paying the mortgage, taxes, maintenance and other costs.

Whether they make or lose money, many real estate investors fail to take note of the risk. That’s partly because the real estate market has no daily price quotes, unlike the stock market. For that matter, when real estate demand weakens, sales may simply dry up because many owners refuse to sell at a loss.

When you sell real estate in a depressed, illiquid market, it’s likely to take longer and bring a lower price than you expected.

Knowledge and a long time horizon are the keys to successful real estate investing

If you do invest in real estate beyond owning your own home, it’s crucial to learn as much as you can, about property management, taxes and other legal issues, and the local market. Make sure you are prepared to hold for years if not decades, and to invest additional funds if necessary.

Keep in mind too that Canadian real estate prices have risen sharply in the past decade or so, helped along by falling interest rates. Now, however, the outlook is for higher interest rates. So a lull, if not a downturn, in real-estate prices is a possibility over the next few years.

Real estate investment has provided a foundation for many fortunes. But you rarely hear about the investors who bought and/or sold at the wrong time, and have a loss or meagre profit to show for their efforts.

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