This tale is part of LARRY SWEDROE’s Investor Tales series. Unless otherwise specified, the tales are hypothetical scenarios, designed to educate the reader on investment principles.
Be careful what you ask for. You just might get it.
It was January 2007. For the past several years, Bob had been reading about how hot the national real estate market was. He had also observed that prices of homes and apartment buildings in his home town had been rising rapidly. When Bob learned an apartment building in an attractive part of town had recently come on the market, he decided to speak with his accountant, Paul, about it before taking a serious look at the building as a potential investment.
Bob called Paul and met with him the following day. He began by explaining why he was excited about the opportunity. He asked Paul for his thoughts and advice. Paul began by explaining that one of the issues he was most frequently asked to opine on was related to investing in individual real estate properties. Like Bob, most often the individual was considering the purchase of a local apartment building or single-family home that was for sale, though in some cases he was asked about an office building or a warehouse. However, almost always it was a local property.
Two types of risk
Paul went on to explain there are numerous reasons, all based on the principles of prudent investing, why he didn’t recommend making such investments.
The main reason, he said, is that by purchasing a single property, an investor is taking what economists call “uncompensated” risk. Owning a single investment within an asset class, whether a property or a stock, is considered uncompensated risk because its expected return is the same as that of all investments with similar risk characteristics. By owning just one investment, or a small group of similar investments, you are taking risk that can be diversified away — the market does not reward you with any extra return for taking that risk. Risk that cannot be diversified away, like the risk of owning a broadly diversified portfolio of real estate (or stocks in general), is called “compensated” (or systematic) risk, and the market must reward investors with higher expected returns for accepting the incremental risks.
The bottom line is there are two types of risk: the good kind (compensated) and the bad kind (uncompensated). Effective diversification results in the elimination (or at least reduction) of uncompensated risk.
Diversification by geography and property type
Paul went on to explain that by purchasing a single property, Bob would be undiversified not only by geography but also by property type. Within the asset class of real estate, there are many different types of properties — apartments, warehouses, hotels, offices, and so on.
Paul explained that the most effective way to diversify this type of risk is to own a passively managed real estate fund, with a low expense ratio, that owns all types of properties and is broadly diversified in terms of geography. He told Bob that a good example of such a fund is the Vanguard Real Estate Index Fund Admiral Shares (VGSLX), which has an expense ratio of just 0.12 percent. Other examples of low-cost funds are the Fidelity MSCI Real Estate ETF (FREL) with an expense ratio of just 0.08 percent, and the Schwab US REIT (SCHH) with an even lower expense ratio of just 0.07 percent.
Paul provided several other reasons why he wouldn’t recommend buying an individual building. He pointed out that when you invest in any of the funds like VGSLX, FREL, and SCHH you own a highly liquid security. That is almost certainly not the case, however, when you purchase a single property. At a minimum, there are significant transaction costs that would be incurred upon its sale (such as commissions and legal costs).
In addition, if the market were weak at the time you decided (or needed) to sell the property, there would be a significant risk it might be difficult to do in a timely manner without taking a substantial markdown.
The “cost” of being a landlord
Paul added another consideration. He explained to Bob that when you purchase a property, you become a landlord, with all the attendant headaches of property ownership. This is not a trivial issue. The “cost” of the time you would spend renting out and managing the property should be factored into the net returns expected.
He wanted Bob to be sure he understood that owning rental property means being in business for yourself — and having to deal with deadbeat tenants, plumbing problems on holidays, potential lawsuits and other assorted surprises. For most people, these are not pleasant issues. Paul did point out that Bob could hire a property manager to handle many of them. But he quickly added that doing so would increase costs, thereby reducing returns, and it would not eliminate the headaches, only reduce them.
Familiar doesn’t mean safer
Paul said there is also a factor related to a psychological matter. He again pointed out that most people consider buying a local property. The issue is why that would be the best investment as opposed to properties in other geographic locations. Paul explained there are studies showing it’s a common error for individuals to believe an investment is a safer if they’re familiar with it.
For example, residents of Georgia own a disproportionate share of Coca-Cola (whose headquarters are in Atlanta) despite the fact that Coca-Cola clearly is not any safer an investment for them than it is for residents of any other state. Similarly, residents of Rochester, New York, owned disproportionate shares of Kodak before its bankruptcy.
Is it priced correctly?
Another point that Paul urged Bob to consider is that there is a significant difference between the stock market and the real estate market. The equity market is generally highly efficient and highly liquid. Such markets generally prevent professional investors from exploiting less sophisticated investors because the price quoted is likely the correct price. That isn’t nearly as true in the real estate market.
Paul explained there was yet another factor to consider — a behavioural problem common to investors known as recency bias, the tendency to give too much weight to recent experience while ignoring the lessons of long-term historical evidence. Investors subject to recency bias make the mistake of extrapolating the most recent past into the future — as if it is ordained that the recent trend will continue. And real estate had been a very hot asset class: For the seven years 2000-06, the Dow Jones U.S. Select Real Estate Securities Index returned almost 23 percent per year. These kinds of returns cause investors to think real estate investing is not risky.
Paul pointed out that it was not long ago (in the 1980s) that there were many areas in the U.S. where property values collapsed, and owners mailed in their keys to their mortgage lenders because they had negative equity in their properties. He gave Bob another example of how risky real estate prices can be. After several decades of spectacular returns, in 1990 Japanese real estate prices began a long and steady decline. It was only in 2005 that there were signs they may have finally stopped falling.
A better alternative
Paul concluded by recommending that, since prudent investing is about taking only compensated risk, and the ownership of that single building would be taking uncompensated risk, Bob should not buy the property. However, he added that including an allocation to real estate in Bob’s overall investment plan was a good idea, as real estate is a good diversifier of risk. Paul recommended that Bob consider adjusting his investment policy statement to include an allocation of perhaps five-to-ten percent to real estate. He recommended that Bob look into the Vanguard fund. Paul’s final remarks were that before Bob made any changes to his current plan, he should be sure that including real estate in the portfolio was a good idea and that he was not making the mistake of recency bias.
Bob thanked him for all the good insights and advice, and also for preventing him from making a potentially costly error.
The moral of the tale
Prudent investing is based on the principles of modern portfolio theory and prudent planning — the development of a carefully constructed investment plan. Having a well-developed plan helps prevent investment mistakes. (Investment Mistakes Even Smart People Make and How to Avoid Them describes 77 such mistakes, including recency, speculating on “interesting” investments, and the taking of uncompensated risk.
Important Disclosure: The opinions expressed by featured authors are their own and may not accurately reflect those of the Buckingham Strategic Wealth®. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice. While reasonable care has been taken to ensure that the information contained herein is factually correct, there are no representations or guarantees as its accuracy or completeness. No strategy assures success or protects against loss. The story about Bob and Paul is hypothetical and should not be interpreted as representative of any individuals actual experience.
LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.
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