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.
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.