Sunday, February 8, 2009

Sunday Reflection: Real Estate as an Alternative Investment

I've often heard the argument from naive investors (usually ones who have been burned by the market) that purchasing stocks is inherently risky because you are only buying a "piece of paper" (or now adays, even less with electronic brokerages). The argument is that if you buy real estate, you can collect rent to pay against the mortgage and build equity. From a "solutions" perspective, you are essentially providing financing and profiting from your renter. There is also the argument that it will always be worth "something", even if the building burns to the ground you'll still have the land.

Generally speaking, anyone who invests according to cliches had better be prepared for a rough ride. Just like anything which can be bought and sold there is always a timing risk when it comes to investing. A prime example is what is happening in the Calgary housing market (as a result of falling oil prices and companies pulling investment from the area).

I always like returning to numbers to prove a point. Assume you buy a cheap investment property for $150k. Some of the obvious inherent risks are 1. You can't find a renter. 2. The principle value of the property drops below what you payed for it (capital loss). But assume that these aren't the case here. Assume you can rent out the house for $1k a month or $12k a year (net, excluding maintenance, taxes etc). That's an 8% annual return, which seems decent. However, consider too, the following: As an investment vehicle, you have little liquidity (if you sell the house with an agent your fees are approximately 6.5% of the value of the house) and you can't sell "portions" or units of your $150 investment to liquidate portions of equity (without complicated financing agreements which have fairly high price tags).

In this case, what is the difference between buying a house with the intent to rent versus buying $150k worth of preferred shares with a high annual yield?

I have always believed that (as it is with any sales transaction) the buying side is easier to execute than the selling (ceteris paribus regarding market conditions). If you have the financing in place, you can pull the trigger and decide to buy, but you can't pull the trigger to get people to buy from you.

Not that real estate is a bad investment. Suitability is an important factor when choosing investment vehicles. Perhaps buying something you can see and feel makes helps you sleep at night. Or you have long term goals for the property and can weather housing market volatility.

As with any investment, the biggest risk is not throughly understanding what you are buying.

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