When it comes to finances, 2019 was an eventful year for the Banker On Fire family.
Early in the year, I had a pretty significant setback at work which caught me totally off-guard. It was totally out of my control and yet had a meaningful impact on my trajectory within the firm.
Landing on the wrong side of a third-party political argument is never good.
It took about half a year, a ton of remedial action and some deft footwork, but I managed to get things sorted out. Looking back at things now, I’ve ended up in a far better place (professionally and financially) because of what happened.
In a way, I’m almost grateful for having gone through the experience. So if things ever go off the rails for you, remember – whenever one door closes, another one opens.
You don’t always control what happens to you, but you sure control the way you react.
While I was busy sorting out my situation at work, the stock market kept going on a tear. As a result, our family’s portfolio grew at a very healthy clip.
I haven’t run the precise numbers as we have ongoing contributions across multiple accounts and currencies. However, given our portfolio is concentrated in US equities, I’d estimate our return to be in line with the ~30% gain by the S&P 500.
However, the story is rather mixed when it comes to the other pillar of our investment portfolio – real estate.
Our Real Estate Journey
As I’ve written before, our rental property is the best investment we have ever made.
It generated an 18% annualized return over a decade. Last year alone, it contributed another $68k to our net worth in a span of just ten months.
In the first couple of years after moving to London, we were focused on paying down my student loan and loading up our pensions and Lifetime ISAs. It’s hard to say no to free money!
Can’t beat an opportunity to triple your money on the spot!
But as our stock market portfolio grew in value and started to account for an ever-increasing percentage of our net worth, we started thinking about real estate again.
Given all the uncertainty around Brexit, we decided to buy in the same area as our existing property. Therefore, all the numbers below are in dollars – but the lessons we learned apply pretty much everywhere.
Towards the end of 2018, I refinanced the mortgage on our rental unit, releasing about $200k of equity. The idea was to combine this money with some of the cash we saved up and add another property to our portfolio.
This time around, we were looking at commercial or mixed-use (i.e. commercial and residential) properties.
The yields on such properties tend to be higher than on pure residential, which means its easier to find something that will cash flow with a reasonable LTV. In addition, it’s helpful to diversify your real estate portfolio beyond a single end market.
However, as we have quickly discovered, there are challenges with commercial real estate investing that you rarely anticipate until you get in the game.
Don’t get me wrong – I still believe that real estate is one of the best ways to build sustainable wealth. At the same time, it just isn’t as straightforward or easy as some people make it out to be.
Sourcing Good Deals Takes A Lot Of Effort
As anyone who has ever done it will attest, buying a flat or a house can be very time-consuming. But when it comes to commercial real estate, the amount of time and effort required goes up exponentially.
By definition, there are fewer opportunities in the commercial market. As a result, you need to look at a broader geographical area and different types of properties (multi-family, pure commercial plazas, warehouses, etc.)
Then there’s the deal evaluation. Understanding the local economic, demographic and macro prospects. Evaluating the viability of the commercial tenant and its resilience in an economic downturn.
Taking a view on the potential increases in rents and property prices. Understanding the attractiveness of the area and how it might change with any future public works or commercial developments.
Finally, once your offer is accepted, there’s the due diligence phase. You need to do a thorough inspection of the property itself as well as the tenancy agreements and the expense breakdown. And this is where it gets rather more complex vis-à-vis a standard residential property.
In one situation, we found out that the commercial tenant had actually terminated the lease a few months prior. I still don’t understand how the seller was planning to get that one past us (or our bank).
In another, we realized the plaza we were looking to buy was located across the street from a gas station with a questionable track record of contamination. The seller was facing a severe environmental liability risk which he was hoping to unload on an unsuspecting buyer.
As a result, we ended up pulling out of both deals. It was back to the drawing board.
Investors Are FAR More Irrational
When it comes to the stock market, institutional money managers tend to do most of the heavy lifting. Their fundamental analysis pretty much drives price formation given how much money they put to work.
Retail investors like you and I end up accepting the price on the screen. You don’t get to haggle over the price of the index or a specific stock. And as much as I dislike active investing, I’ll be the first one to admit – passive investing only works because active managers are doing all the analysis.
Things obviously work differently in real estate. Every property has a limited set of buyers. Most of them are individual investors with very specific views on the property’s risk-return profile. As a result, prices often follow an irrational pattern.
Some investors are happy to accept environmental risks like the one above. Others are content of being in the red every month because they are confident in price appreciation.
Incidentally, this happens much more often at the lower end of the price range. Once you go above $3 million or so, investors tend to get much more sophisticated and price formation is more rational.
Unfortunately for us, we were playing in the $1m – $1.5m range. As a result, we had to walk away from a few situations because our projected returns stopped making sense.
As an M&A banker, I thought I had seen all the tricks in the book when it comes to sellers playing around with their numbers. But even I was unprepared for the lack of transparency and accuracy when it comes to information provided in real estate deals.
What I felt like saying over and over again
Some sellers will ignore a bunch of the costs related to running the property (“ah yes, I forgot the snow removal company charges me two grand a year”).
Some others will tell you units rent for more than they do (“right now the rent is $800 a month but if you were to find a new tenant, you could surely get $950!”).
And in one situation, the selling agent added the expenses to the revenue to derive the property’s net operating income. He then told us he expects the property to price at a 6% cap rate on that made-up number. When my agent pointed out the mistake, he simply ignored it. That property is still on the market.
If you aren’t willing to get into the financial nitty-gritty, commercial real estate investing is probably not for you.
There’s A Massive Opportunity Cost
You can put your money to work in the stock market pretty much in real-time. It only takes a few minutes and a couple of clicks – and you can automate the process so that every time you get paid, you automatically top up your index fund holdings.
With real estate, you’ve got to have a sizable chunk of money sitting in your bank account so that you can pull the trigger as soon as you come across a suitable opportunity. And because it’s much tougher to get a deal done, your money will likely sit on the sidelines for much longer.
Our experience is as good as any. We had about $500k of cash sitting in our bank account, waiting to pounce on the right opportunity. With inflation of about 2%, we’ve lost about $10k in purchasing power in twelve months.
Then there’s the opportunity cost of being out of the stock market. In a year when the markets went up 30%, that’s $150k of forgone upside on a $500k investment.
Total opportunity cost? $160k, plus all the time and effort we spend looking for an investment.
Adding It All Up
All in all, it has been a somewhat frustrating year on the real estate front. At times, I’ve wondered whether I’m wasting the little free time I have. It would take me about 10 minutes to solve my capital deployment problem by loading up on a few index funds.
However, I’ve decided to persevere. Between debt paydown, ongoing cash flow generation and price appreciation, real estate remains one of the most powerful ways to build wealth.
The lack of correlation with the stock market is also appealing to me. And it will be nice to have a couple of properties that I can renovate or redevelop if when I’m eventually out of the investment banking game.
I’m also an optimist. Yes, we’ve had a number of deals slip away in 2019. I can capitulate and give up, or I can apply everything I’ve learned and focus on getting the next one over the line.
Having put in a solid effort over the past year, I have really beefed up my skill set when it comes to sourcing and evaluating opportunities – and I am keen to put it to good use.
Most importantly, I enjoy the process – so while it is time-consuming, I don’t consider that time to be wasted.
So I will keep trying. If deals keep slipping away, I might well look at real estate crowdfunding. Finally, there’s always the back-up option of buying another residential property.
In the meantime, I hope this post has been useful to those of you considering real estate as part of your own wealth-building strategy.
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Banker On FIRE is an M&A (mergers and acquisitions) investment banker. I am passionate about capital markets, behavioural economics, financial independence, and living the best life possible.
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10 thoughts on “The Challenges With Real Estate Investing”
Love the articles. Some great reading material. This one resonated with me.
I also looked at down commercial property. Similar sneaky marketing from the agents. The agent specifically told us the quite significant Expenses for site security etc were paid by the tenant of some warehouses. Eventually when we got the lease documents it specifically said these costs were the landlords responsibility. Knocking 30% of the expected return.
Personally having just sold a number of rentals properties I think private rentals is now not worth it. The tax changes meaning mortgage costs are not tax deductible means there is very little if any benefit in having a property that is mortgages.
The net yield on rentals now barely makes up for the hassle factor
Thanks for the blog. Very interesting.
Thanks Steve – and appreciate you flagging an issue with the comments function which is now fixed.
The fact that estate agents continuously misrepresent information like this tells me that at times, this approach works. Truly scary that some investors won’t do their diligence before putting so much money to work.
Agree with you re: mortgage deductibility. Thankfully our property is across the pond where we still get a tax break. That’s one of the key reasons I plan to buy the next one there as well.
The opportunity cost is the bit that keeps me from investing in btl or commercial. My isas are easy and I can add a few hundred a month at any time and get it out again barring disaster at any TIME. I can also leave myself relatively cash poor (I only keep about 15k in cash as most things I can cashflow)
If I owned property I’d have to keep alot more cash I think (for void periods) until I’d built a portfolio of say 4 houses where the income will cover the void periods.
Property as an income play does attract me but I’d have to take some of my investments and I’m not sure i want to reduce my exposure to the stock market in that way. And I’m not confident to do hmo where the yield is more worthwhile
Yes, that’s one of the biggest drawbacks. You sit on cash for much longer – and once you do deploy it, there’s a fair amount of legwork required to do the diligence, close the deal and get the property up and running smoothly. When it comes to speed and convenience, it’s tough to beat the stock market.
HMOs are a separate story… the yields are higher but so is the amount of work required. Not sure I’d ever do one unless I had a LOT more free time on my hands (and the property was nearby).
Where are you based by the way?
Reading. That’s the other thing yields are low locally. The name if that’s why you’re asking was simply a handle I used for travel reviews on trip advisor plus a desire to retire abroad at some point (pic is dad’s apartment in Spain)
Yes the handle threw me off!
Agree with you on yields. I think one reason investors are okay with such low yields is that mortgage rates are rock bottom.
So while you only get a 3% yield, financing at 1.7% gives you some room to squeeze out an equity return.
Definitely not something I would want to do.
I find you jump into commercial properties fascinating. I’ve never wanted to do it because I have zero knowledge everything involved (at least I’ve rented in an apartment and owned a house).
Seeing as it’s more complicated why not just diversify geographically and stay in residential real estate? You’d be diversifying somehow and it seems simpler than commercial real estate.
The biggest issue in residential at the moment is the yields, which are quite low (at least where I am looking) and therefore mean I need to rely on price growth to make a decent return. Commercial properties typically have higher yields which makes it easier to find something that cash flows.
By the way, commercial properties aren’t that much more sophisticated – just require a slightly different perspective. There’s also the advantage of having the commercial tenant deal with all the maintenance (other than structural).
But your point holds – if I don’t find anything that ticks the boxes I may well turn back to residentials.
Thanks for this, it’s a really interesting one.
Growing up in a place where the general population had less access (or knowledge of) alternative investments, most people either kept their extra cash in the bank or invested in property. When I came to the UK, I was actually surprised by the much lower interest your money gets in a current / savings account and how much smaller the yields on RE are here or in late-stage economies in general (I thought 2-3% interest and 7-8% yields were normal). As a side note, even being used to the property ownership obsession in my home country, I’ve always wondered why British folks have such a deep hatred for landlords – it’s not the hassle-free business it’s made out to be (“I’m paying the landlord’s mortgage”).
I’m personally more of a stock market kind of person, though I was now considering getting into RE in my home country where the yields are better, there’s less regulation around it, and it could give my restless parents something to occupy their time with as they are approaching retirement in 10-15 years.
However, the main reason I’m commenting now is to ask if you’ve ever considered writing something about the market for personal homes, or more specifically renting vs. buying in the current context. As my partner and I are looking at having a child in the next 1-2 years, we’re looking at the option of buying our first home. A small 2 bed garden flat (65-70sqm) with <35-40 min commute for both of us seems to have exploded to ~600k in a decent family area (e.g. Crouch End) since the stamp duty holiday. Even if the stamp duty holiday is offset by a price increase, it's still better to be able to roll it over into the mortgage, but what I'm worried about is the market tanking in 2021 when the holiday is over and the inflated demand drops.
How would you approach this sort of thing? The main issue is here is the time horizon, as we may want to move out of London in 5-6-7 years but the main reason to purchase is that the quality of rented housing is just so much poorer in general (although a bit cheaper than owning) and allows for much less personalisation. So I'm very aware that it's not a purely financial decision since I don't consider personal homes to be investments but I just want to make sure I've looked at everything before making a decision.
Thanks Adrian. All valid points you make.
My view is that you should only buy a house if you plan to live there for at least 5 years – unless you are planning to rent it out once you move and there’s a good market for rentals in the area.
That being said, there’s a ton of qualitative aspects one needs to think of as well.
Hadn’t thought about it as an idea for a post topic, but it’s a meaty one. Let me noodle on it and perhaps I’ll work something up!