Last week my colleague Mark Ferguson posted an article on this blog which argues that real estate investments are a better and more effective vehicle for achievement of financial success than stocks for most of us.
While the article was good, the comments were absolutely priceless.
Interestingly, if I were to describe the spirit of the comments I would have to use the word Emotional – people are seemingly deeply committed to their point of view on both sides of the issue. Fitting – our beliefs define our reality, and we should be committed to them. However, all of us must realize that perception of reality is somewhat different from reality…
I promise that if you read this article to the end you’ll have no choice but to accept that estate is a much more viable investment vehicle for vast majority of people reading. You won’t have a choice, because regardless of your feelings on the matter I am going to provide you with a chain of logic based on universally accepted truths, even laws – realities that even stock investors generally do not dispute and you won’t be able to ignore.
And may be then we can put this argument to bed. Ready or not, here it comes:
Efficient Market Hypothesis
I’ve spoken about this in the past, but it seems appropriate and even necessary to do a little review. The Efficient Market Hypothesis is a theory that has been around since the 1960s, which states that the price of any security at any given time reflects all of the available information that is pertinent to the setting of value of said security. It is presumed that in an efficient market all of the information which must be known in order to valuate an asset is freely and equally available to all of the participants in that market.
What this means is that in an efficient market there is an assumption that at the moment you purchase the asset, the price that you pay reflects the true value of that asset as set by the marketplace at large and based on all of the pertinent facts – price setting is efficient.
Ever seen that tape at the top of your TV screen which shows price of stocks? I haven’t had a TV in the house for about 4 years, since I discovered that it neither helps me get smarter, more informed, or more rested, but when I did have it I could spend hours glued to that tape.
Well – guess what? If I wanted to pull the trigger on any of those stocks scrolling across the screen, the price that I would have to pay would necessarily have to be the very price on the screen at the time my order went in. Importantly, every other participant in that marketplace wishing to take action on the same stock at the same moment in time would necessarily have to pay the same exact price. There simply is not a legal way to achieve a better strike price than that which is set by the marketplace at large in an efficient market. This is the essence of the efficient markets – efficient price-setting.
This Seems Fair – Does it Not?
It certainly is the indented effect – fairness. However, this “fairness” comes with the un-intended, or intended (depending on how cynically you look at this) consequence of the individual investor being unable to perform any better than the market as a whole. This is why Mark wrote, and a lot of comments corroborated, that if the market went up so did his portfolio, and visa versa – this is a design feature of the efficient marketplace. And this effect is further amplified with the use of the popular diversification strategy. It does limit the risk of loss to an individual investor, but also effectively precludes the possibility of getting ahead of the marketplace in a substantive way.
Diversification, by the way, is not the strategy of choice for successful equity investors – they FOCUS. This is to say that they evaluate companies, and when a good opportunity is spotted they allocate a very substantive portion of investable capital toward that opportunity. This means that if they lose – they lose big; but if they win – they win very big. This strategy hinges on an investor’s capacity to accurately analyze all of the pertinent data. The term is Focus Investing and I believe it was coined by Warren Buffett who certainly is the most notable contemporary exponent of it.
If you don’t know who Buffett is, he is the guy who said “Diversification is protection against ignorance”. Translation – if you don’t know how to invest (do not have access to or don’t know how to analyze pertinent data) then you should diversify.
Do you diversify…?
On to Real Estate
Real estate markets operate on principals that are the polar opposite of efficient, and is indeed inefficient in nature. To start, price-setting in real estate is a function of something we call the “meeting of the minds”. Ultimately, the strike price is that which the seller and the buyer agree upon; the two people (entities) who make decisions based solely on their respective circumstances, and having very little if anything to do with the market at large. That last part is very important – having very little if anything to do with the market at large. You make me an offer, and if I agree then we have a deal…
The above condition of the marketplace inherently means that a skilled negotiator may be able to negotiate a price which is considerably below the intrinsic value of the asset and below that which the market establishes – price-setting is inefficient, unlike the stock market.
More importantly, the inefficiency of the real estate market allows the investor to apply principals of strategic management and expandability to increase intrinsic value, something I’ve written about before on this blog, and something that is not possible in an efficient market – there, you are simply going along for the ride.
What all this means is that inherently and by definition it is more advantageous to invest in an inefficient market such as the real estate market, as opposed to the alternative. This is especially true for a small investor. You see – when Warren buys a stock, he takes a large enough position (focus investing) that he is able to affect change from inside the company. You, as an individual investor, are not able to do this in the stock market, but you certainly can in the real estate market. So, you can pay less, and then you can force value – making real estate market a much better opportunity for all of us reading this.
Here’s What I Want You To Do
I want you to go out into the world and buy a 6-plex for $200,000 which generates NOI of $1,800/month and is therefore worth $216,000 at a 10 CAP. I want you to spend $15,000 on upgrades over the course of 45 days and bring the NOI up to $2,100/month, which would justify a value for the building of $252,000. I want you to do this – but do it even better; spend less and do it faster!
I promise – if I can do it, so can you! Yes indeed, I wouldn’t dream of telling you something that I haven’t done myself and this was a deal I did 2 years ago. The deal was 100% financed (it wouldn’t be me if it weren’t), and after 45 days it put close to $700/month of cash flow on my income statement and some equity on my balance sheet to boot. Actually, after 45 days the bank valued the property at $275,000, but this is closer to a 9% CAP and I don’t want to be as aggressive as that although this particular sub-market likely supports it…
What made this possible?
Simple – the real estate market is an inefficient market, which comes with inherent advantages over stock market. I was able to pay lower than the intrinsic value and I was able to force value from there.
Understand, these advantages are inherent within the design and structure of the marketplace itself – Fact, not opinion!
Are you convinced?
Photo Credit: David Paul Ohmer