Tuesday, March 6, 2018

Individual Real Estate Investment


I find myself confused at the temptation people have to try buying real estate as an investment. Typically, their plan is to do a bit of research into “hot” areas or engage with a property manager in order to select a property that they imagine has some special potential for either appreciating in value or generating large rents. Then they plan to buy the property, hold and maintain it for some time while collecting rent, and finally sell it for some total gain they expect to be better than if they had invested their money elsewhere. I don’t understand the attraction. And I’m confident the expected returns are poor relative to other investments. I see buying individual investment properties as analogous to buying individual equities on the stock market.

It is uncontroversial that stock picking is for suckers. Putting bets on what will win is fun and exciting, as I am told gambling is. It indulges the human brain’s overconfident capability for predicting the world. But it doesn’t pay off. The vast majority of actively managed funds are outperformed by broad market indices [1]. That is, an investment in a total stock market index fund almost always generates greater returns than careful picks by the investment industry’s top experts. An amateur trying to pick individual winners based on what she read in a few smart sounding articles cannot expect to perform better.

From an expected value perspective, an individual picking a particular real estate property is just as misguided as an individual picking a particular stock in order to “beat the market”.

An index fund provides an inexpensive, diversified investment option. It is designed to eliminate the high risk of picking individual stocks while still capturing the returns from the growth of a market as a whole. The real estate market has investment products designed for the same purpose - real estate investment trust (REIT) indices. A total market REIT index captures the returns from the growth of the real estate market as a whole. It is designed to eliminate the high risk of investing in individual properties.

If index funds are shown to be the best long-term holding of stocks, then a total market REIT is the best long-term holding of real estate. The only reason someone would gamble on individual properties is because they mistakenly expect to beat the total market index.

I spent some time trying to find a study on the real estate market similar to the report above on the stock market. A study that investigates whether or not the vast majority of real estate portfolios containing individual properties are outperformed by a total market REIT index. But either it hasn’t been investigated or I couldn’t find it. So we will have to settle for the argument from structural similarity.

A total stock market index fund returns the average performance of all the companies in the market, weighted by market capitalization. It follows that, over some period, there is a 50% probability that a random selection of stocks will outperform the index fund, and a 50% probability that a random selection will underperform. Despite this prior probability, greater than 90% of managed funds (selections of stocks chosen not randomly, but by intelligence) underperform the index fund. This is due to adjustments to the portfolios that hurt the fund (i.e. picking a promising replacement stock that then drops in value) as well as fees and transaction costs.

A total market REIT index returns the weighted average performance of all the real estate investment companies in the market. Just as in the previous case, a random selection of real estate properties has at best a 50% probability of outperforming the total market index. Equivalently, a real estate investor starts with a 50-50 chance of underperforming an index. Combined with the lesson from the stock market, where the attempt to try to land on the outperforming side of that 50-50 ends up doing the opposite, it appears that investing in individual real estate properties is unwise, as the investor can choose to take the guaranteed average through a REIT and walk away.

As an aside, I was curious to look at historical data. This paper [2] finds that global long-term (1870-2015) mean returns from real estate (including both capital gains and rents) are similar to returns from equities (stocks). The paper also breaks down the results by nation and “medium-term” - for the USA over the last 70 and 40 years, total market returns to stocks have been a couple percentage points higher than those to real estate. But this is only tangentially relevant here.

An objection might be raised that because a total market REIT invests only in real estate investment companies on the public market, it does not capture returns on the housing market as a whole. While this is true, the returns on a total market residential REIT should be comparable to returns on housing [2].

The most common objection to this argument for placing individual stocks and properties in the same risk/reward class is that the motivated investor can discover some type of special information about a property (ostensibly because it is a tangible thing that can be plainly inspected and evaluated) that is much more difficult or disguised in the case of a stock. Perhaps they have noticed a trend in housing prices in the area, or an office park is about to be constructed nearby, or they heard there may be a treasure chest buried in the yard.

The implicit assumption is that the situation is comprehensible. That the investor has a sufficiently accurate model of the adjacent world - of all the major factors that might significantly affect the value of the property - that she can invest with some confidence. But this is classic overconfidence effect in action - an underestimation of the complexity, the randomness, the noise in the world. Maybe that upwards trend was actually an overvalued bubble, or maybe the increased traffic around the office park makes the neighborhood less desirable for families. The same cognitive biases that cause stock pickers to fail apply to real estate investors.

Full time fund managers have access to as much, if not more, publicly available information about the companies they evaluate as a real estate investor has about economic and social forces that govern housing values. There is no such thing as a simplified market playground or some kind of home court local advantage.

Even in areas with booming markets, there is still large local variability. Say an area happens to experience growth rate that exceeds the market average by 2% (something that roughly represents what the SF Bay Area has achieved over the last 25 years). With a relatively large standard deviation in annual property value changes of 9% (typical for the area) [3], only about 58% of properties beat the market average and 42% underperform, assuming a gaussian distribution in values. This same standard deviation means a 16% chance of underperforming the market by greater than 7%. Underperforming the market index doesn’t necessarily mean that the property is losing value, just that an investor could be seeing greater returns if she had taken the easier path of investing in a total market REIT index.

What about the advantages of leverage that are easily accessible in real estate through a mortgage? The potential returns on a leveraged investment are indeed higher, but the potential losses are equally large. Leverage merely magnifies the position - both risk and reward. It doesn’t affect the conclusions above. And besides, the companies held by a REIT hold plenty of leveraged positions on their books already, so there is nothing special about being able to hold an individual leveraged position.

I’ve been assuming the goal of an investment is to maximize returns. The other reason that someone might choose to gamble on individual properties or stocks is because it is fun. Index funds are boring. Some people enjoy the effort of research and the thrill of a bet. But it should be clear that they are spending money for that enjoyment. Just like I spend lots of money on my paragliding hobby.




[1] S&P Global. SPIVA® U.S. Scorecard. 2017.

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