What’s so bad about the Stock Market?

What’s so bad about the Stock Market?  That’s a fair question.  After all, there are those who would point out that the long-term average return of the stock market exceeds that of real estate; and as surprising as it may seem, I’d be willing to agree.  However, I also claim that’s a largely deceptive statement that is commonly, if not deliberately, misconstrued by supporters of paper assets.  Let me explain.

Let’s start with risk.  All investments carry some risk and it is reasonable for an investor to be paid for taking that risk.  In fact, the greater the risk, the more an investor should expect to be paid.  Clearly, this is the reason that credit card interest rates exceed those of class A home loans.  Therefore, if it can be shown that investments in the stock market have an inherently higher risk than real estate investments, then we should expect a higher return on stock investments.

Volatility → Uncertainty → Risk

Investment volatility is the rate at which an investment changes value, which is measured by monitoring changes in the market price.  The more volatility that exists in a market, the more uncertainty there is.  It’s not rocket science; uncertainty IS risk.  You don’t need to be stock broker to know that the market prices of stocks change every single day the market is open; in fact they change many times per day.  You probably see where I’m going with this; and I can already hear the din of paper investors calling out, “Over the long-term, stock prices are much less volatile!”  So let’s just put that argument to rest straight away.

It turns out that research has shown the opposite is true.  Lubos Pastor, a Professor of Finance at the University of Chicago – Booth School of Business (also associated with the Center for Economic Policy Research, CEPR, and the National Bureau of Economic Research, NBER) and Robert F. Stambaugh of the University of Pennsylvania – the Wharton School (also associated with the National Bureau of Economic Research, NBER) conducted a study and have concluded that, “Conventional wisdom views stocks as less volatile over long horizons than over short horizons due to mean reversion induced by return predictability. In contrast, we find stocks are substantially more volatile over long horizons from an investor’s perspective.”  In addition, Mark Hulbert of the New York Times and Editor of the Hulbert Financial Digest, having reviewed the research of Pastor and Stambaugh has written, “New research, using different statistical techniques aimed at capturing the uncertainty of future returns, suggests that the [stock] market may be much riskier than many investors have understood (emphasis added).”

If a picture is worth a thousand words, perhaps I can save my finger tips some effort tapping away at the keyboard.  The following graph (excluding the text bubble overlay) by G. William Schwert, a Professor of Finance and Statistics at the University of Rochester’s William E. Simon Graduate School of Business Administration, clearly shows the degree of volatility in the Dow Jones Industrial Average, a leading and comparatively stable stock market indicator, has increased dramatically in recent years.

Stock Market Chart

And as I stated previously, with your agreement to be sure, the greater the risk, the more an investor should expect to be paid.  With that, we should expect to see a similar increase in the returns generated by the stock market as indicated by the Dow Jones Industrial Average.  However, the following graph (again excluding the text bubble overlay), also by Dr. Schwert shows no such increase.

Stock Market Returns

This leads us to the potentially distressing conclusion that stock market investors of late are accepting greater risk with little, if any, additional reward.  Is this a reasonable course of investment action?  Perhaps it would be, if we had no other options.

What Makes Real Estate So Good?

What makes real estate so good?  Well, for starters, just as surely as volatility represents risk, stability assuages it.  And real estate is the antithesis of the stock market in terms of volatility, i.e. market values are comparatively quite stable.  Real estate changes value very slowly compared to the stock market.  Even in the “bursting of the real estate bubble” that occurred in 2007-08, there were indicators months in advance to alert investors of the coming adjustment; ample time to refinance or liquidate existing investment holdings.  This is probably a characteristic of the real estate market you’ve noticed before, but perhaps you’ve never put your finger on any particular reason.  So let’s examine some of them as compared to the stock market.

Stability → Certainty → Risk Reduction

In the real estate market, there’s something know as “comps,” which is short for “comparables” or “comparable sales.”  Comps are a review of the recent sale prices of similar properties in a given area.  This gives you a pretty good idea what the general value of a particular property is, which, in turn, means that one seller’s price on a property is somewhat tied to that of other sellers of similar properties in the area.  Why is this?  Quite simply because, if one seller tried to sell at a substantially greater price, potential buyers of that property would be inclined to purchase from one of the other similar sellers.  What this means is that in order for the market to shift, there has to be a certain degree of agreement (or at least acceptance) of that shift among most of the sellers of the comparable properties.  And as you can well imagine, this doesn’t happen overnight.

Interestingly, comparable stocks are not linked in this manner, giving them much greater flexibility in setting the market price.  In fact, one noteworthy investor could conceivably begin buying shares of a particular company and drive that stock price higher in a single afternoon.  In this example, notice that it would only happen by having the investor purchase many shares of that stock in very short time.  So you could make the argument that this could happen in real estate too, but how many investors go around purchasing many properties of the same type in the same area in such a limited time frame?  We can probably agree, not many.

Another reason for difference in volatility between the stock market and the real estate market is that stocks are more liquid than real estate.  That simply means that stocks can be converted stocks to cash more quickly and easily than real estate.  Selling a stock is practically as simple as logging onto your Internet brokerage account and hitting the “Sell” button.  Whew!  That took all of five minutes.  I’m beat.  But selling real estate is a more complicated matter.  Brokers help sellers set the price; they advertise; they show the property; they find buyers; they write up contracts; buyers arrange financing; a title search has to be completed; the settlement is scheduled; and hopefully none of the pieces fall apart in the process.  What this means is the people in the real estate market (buyers and sellers) are accustomed to the idea that it takes a while to consummate a real estate transaction.  And the slower the process, the slower the realization of market adjustments.

Bottom line:  The real estate market has built in inhibitors to volatility, whereas the stock market seems to encourage it.

A Safety Net for the Falling Dollar

Liquid assets lose value in an inflationary environment.  Simple and sensible; inflation, the rising of the costs of goods and services, reduces the buying power of each dollar you have, i.e. you have to spend more dollars to get the same results.  But tangible assets (like real estate) hold value in the face of a falling dollar, because the costs of those assets are subject to the same inflation, which drives up the price.  And this doesn’t even take the real rate of return (in both cash flow and equity) into account, which further enhances the value.

The point is that real estate is an outstanding hedge against inflation.  David Lereah, chief economist at the National Association of Realtors states, “In the past, investors bought gold as a hedge against inflation… now they buy real estate”. It is achieves high returns with reasonable risk, as The Appraisal Institute states: “Real properties…pay relatively high dividends, compared to other asset forms… The result has been a reduction in the risk premium.”

The Power of Leverage

CNNMoney.com reported a study by Jack Clark Francis, Professor of Economics and Finance at Bernard Baruch College, and Roger G. Ibbotson, Professor of Finance at Yale School of Management, that “compared the annual returns of real estate from 1978 to 2004 compared with those of 15 different ‘paper’ investments, including stocks, bonds, commodities futures, mortgage securities and real estate investment trusts (REITs).”  They reported the following results.  “Housing delivered a solid but unimpressive annualized return of 8.6%. Commercial property did better at 9.5%. The S&P, however, delivered a crushing 13.4%.”  On the surface, this would tend to steer investors away from real estate and toward paper assets.  But the CNNMoney report goes on to note that “these academic studies leave out [real estate’s] strongest advantage: leverage, or the use of a mortgage to amplify the return on your cash.”

A quick example will illustrate this concept.  Assuming we disregard brokerage fees and the like, how much money do you have to spend in order to buy $100,000 worth of stock?  It may seem like a trick question, but it’s actually straight forward.  You would have to spend $100,000, unless you’re willing to accept the added risk of buying on margin and you’re buying marginable stocks (as determined by the Federal Reserve Board).  But interest will accrue and stocks rarely produce enough dividends to pay it.  Further, the margin costs reduce your return on investment.  Therefore, most investors don’t buy on margin and those that do typically do so only for short-term investments.  As such, it’s reasonable to expect the average investor to spend $100,000 in this example.  Now what if you wanted to buy $100,000 worth of real estate instead?  Not many people put up all of the money; they go to banks and acquire financing.  In fact, it’s not unusual for buyers of real estate only to put up 20% – 25% of the purchase price, depending on the type of real estate.  That’s right; it’s reasonable to expect the average investor to finance a real estate acquisition.  This means that in order to buy $100,000 worth of real estate, you wouldn’t need to spend more than $25,000.  Let’s keep it simple at first and say that the value of each investment (stocks and real estate) went up by 10%.  That means the value of each investment is now $110,000 (a gain of $10,000).

Let me just take a moment to note that return on investment (ROI) is defined as the ratio of the change in value of your investment (∆I) and the amount of money invested ($), which can be written like this:

Therefore, your return on the stock investment is:     10,000 / 100,000 = 10%

But your return on the real estate investment is:       10,000 / 25,000 = 40%

Now let’s use the power of leverage to examine the returns reported by Francis and Ibbotson.  Even if we use what was reported as an “unimpressive” return by housing of only 8.6%, if you only have to put up 25% of the purchase price for the housing, the numbers fall out as follows.

S&P:                                    13.4%

Housing:          8.6 / 25% = 34.4%

In this example, leverage translates a 4.8% lower return into 20% higher return.

Leveraged vs. Unleveraged returns

However, there is an important caveat to leverage.  Just as quickly as it amplifies an increase in value, so too it amplifies a decrease in value.  Needless to say, that makes it very import to buy real estate wisely.  Fortunately, it is not difficult to calculate real estate values and separate the good deals from the bad, but that’s a topic for another article.

Opportunity is Knocking Your Door Down!

So you’ve heard of that real estate bubble burst (you may have even been stung a bit).  Then who in his/her right mind would recommend buying real estate when it’s just lost so much of its value?  Well, I would, for one.  Think of it as part of that whole “buy low; sell high” philosophy.  When a market loses value, is it high or low?  This is where you would placate me with a guarded, if not tenuous, “Low.”  And do we buy or sell when it’s low?  I believe I’ve made my point.

And I’m not alone.  Marian Snow, of Success Magazine, got right down to brass tacks when she wrote, “Real estate is the best long-term way to build wealth, ever.  Hands down.  No argument.  Case closed.  It’s millionaire math—really.”  She went on to provide her “Right-Now Reasons to Invest,” which include the following.

  1. We need homes; a roof is a must. Its value isn’t affected by corporate theft or takeovers. Keep it insured and it’s not going anywhere.
  2. Current Crisis Creates Opportunity. The drop in values was sad for those who purchased at the top of the market, but what a fantastic “gift horse” if you’ve got some cash to invest.
  3. Wealth creation through strategic acquisition held for long-term income is the smartest plan. I know it’s not as exciting as the quick turnaround of a dirt-cheap property, but much more secure.
  4. Multiple tenants… lower your vacancy risk and here’s why. When one renter moves you’ll only miss a fraction of your rental income until you lease the unit again.
  5. Reduce Risk with Diversification.  Real estate frees you from dependence on the flaky returns of the stock market.

We’ve even got Fidelity Investments jumping on the proverbial band wagon.  Fidelity?  Don’t they sell stocks?  Yep!  And yet they published a SmartMoney article on Fidelity.com entitled “It’s time to invest in real estate,” by James B. Stewart, Bloomberg Professor of Business Journalism, in which he writes, “the data suggest that real-estate prices hit a bottom some time during the second quarter [2009], and have now begun to rise…That means if you’ve been sitting on the fence, it’s time to act.”  He goes on to say, “with real estate prices nationally now down about 30% from their 2006 peak, and showing signs of turning up, the prices aren’t likely to go much lower.”  Dr. Stewart concludes, “Overall, though, I can’t imagine a better time to buy than right now.”

The current real estate market is in a once-in-a-lifetime position.  How many times have you said to yourself, “If only I had known that investment was such a good deal…”  Well now you know, but it’s your call.  Don’t miss out.

Multifamily Real Estate – The Best of the Best

As I’m sure that by now I have you convinced that real estate should be a part of your investment portfolio, let me tell you why multifamily real estate is the best direction for your real estate investments.  First of all, as noted above, Marian Snow succinctly described how multifamily real estate lowers your risk.  And although Dr. Stewart recommended buying now in his SmartMoney article, he also mentioned his concerns about the “demands (and headaches) of being a landlord.”  But with the economies of scale generated by multifamily real estate, hiring qualified property management is SOP (standard operating procedure).  Okay, so you might be thinking, “why not a nice office building or a strip mall?”  And here’s your answer.  Lots of prospective tenants in multifamily; and they all want pretty much the same thing, e.g. a living room, a kitchen, a bathroom, one or more bedrooms.  Commercial-use properties tend to be more functionally specialized, which often means it takes substantially longer to get vacant space rented.  The turnaround time with multifamily properties tends to be relatively short.  It’s a simple formula; get it rented as soon as possible so it can generate more income.

Not sure yet?  Then let’s take a look at the recently released Price Waterhouse Coopers (PWC) 2009 Emerging Trends in Real Estate report.  PWC describes “Emerging Trends” (now in its 30th year) as “the oldest, most highly regarded annual industry outlook for the real estate and land use industry and includes interviews and survey responses from more than 600 leading real estate experts, including investors, developers, property company representatives, lenders, brokers and consultants.”

The report was so encouraging that Susan Smith, director in the real estate business advisory services group at PWC commented, “Even though there is a lot of doom and gloom in terms of the fundamentals, interviewees really believe that 2009 is a great time to buy.   The No.1 buy is apartments.  One of the main reasons why is interviewees see a very diverse economic and demographic demand for apartments.”

The PWC “Emerging Trends” report cited the following.

Buy or Hold Multifamily

Apartment investments get a boost from a host of significant trends: increasing numbers of young adults who leave their parents’ homes, more aging baby boomers looking to downsize from suburban lifestyles, and stiffer mortgage costs/ requirements that make homeownership too expensive for some prospective buyers. Increasing renter demand helps blunt ongoing recessionary impacts and ensures solid cash flow increases when the economy improves.

Property Types in Perspective

In 2009, apartments reclaim the number-one position [among real estate sectors]. Demographics (more young adults) and the housing market collapse boost the number of renters, keeping apartment occupancies high and firming up rates.

Apartments Strengths

Over time, apartments solidify their position as the best risk-adjusted core real estate investments. Demand from the burgeoning Generation Y/young adult population kicks into gear just as housing woes push defaulting homeowners into rentals and tougher mortgage underwriting prevents some renters from buying homes. “Owning doesn’t look like a reasonable option for many people.” As folks marry later in life, they stay in apartments longer, too.  More empty nesters and retirees, meanwhile, give up suburban homes for easier upkeep and the convenience of apartment living in infill areas. “Apartments are a bright spot.” No wonder institutional investors never tire of buying these properties—“you almost always have an exit strategy.”

Best Bets [in Apartments]

Everybody likes value-add plays, rehabbing older product into workforce housing where demand is strong.  Possible government subsidies can provide a bonus. “You put $5,000 to $10,000 into each unit and can convert B-/C+ product into B/B+ and sell to core investors at a premium.”  Owners need to focus on hiring the “right” managers who can enhance leasing activity and retain tenants.

Conclusion

It’s clear, particularly in today’s economic environment, that investing is necessary in order to maintain, much less accumulate, wealth.  But it’s not always clear where to invest.  The primary investment vehicle for most people has been stock-market-based, i.e. not necessarily individual stocks themselves, but also paper assets like mutual funds used to purchase stocks.  Many people never come to the realization that there are other options that may be better suited to their investment objectives.  But it was not the intent of this article to persuade investors that real estate is always the best choice.  It was, however, part of the intent to convince investors that real estate has many advantages and the current buyers market makes this an unusually good time to consider adding it to one’s investment portfolio.  In addition, I hope I was able to shed some light on a particularly advantageous sector of real estate investing:  multifamily.  With risk mitigation characteristics, passive income, value-adds, equity build-up, and much more, it’s no wonder so many prudent investors are taking notice.  It’s worth a look!