There are plenty of reasons to argue why real estate is the best investment to make: use of leverage, cash flow, appreciation, economies of scale (for us multi-family folk), etc., etc. Investment real estate is owned by the majority (maybe all?) of the richest people in the world. Real estate creates wealth, shelters wealth, and provides for a means to pass on wealth.
But there is something else that makes real estate worthwhile. This “something” is what creates the potential for building and generating wealth via real estate investments. It isn’t discussed often, but should be understood as I think it’s the main reason investors can prosper: market inefficiency.
Market inefficiency is the theory that the market prices of similar securities are not always accurately priced and tend to deviate from the true discounted value of their future cash flows. The phrase can also be used to refer to a market that is not operating efficiently — for example, markets where relatively low volume is traded.
Stock exchanges enable efficiencies in the buying and selling of shares of stock, and bond exchanges provide efficiencies for the buying and selling of bonds; then we have derivatives markets, futures markets, currency markets, and many more. Heck, even the markets for shares in private entities are relatively efficient due to secondary exchanges.
The real estate market is relatively inefficient compared to markets for other investment vehicles, but in my mind, the inefficiencies provide for the best reason to get into real estate investing. Leverage is a tool, and cash flow and appreciation are the result, but market inefficiency allows for investors to find profit opportunities, exploit these opportunities, and create value.
How to Analyze a Real Estate Deal
Deal analysis is one of the best ways to learn real estate investing and it comes down to fundamental comfort in estimating expenses, rents, and cash flow. This guide will give you the knowledge you need to begin analyzing properties with confidence.
Before the Information Age, Warren Buffett Generated Substantial Returns
You see, Warren Buffett rocked it before the information age dawned on the United States. Buffett was an absolute genius at finding companies with a stock price way below market value. But the key piece of information that not many people know is that he was utilizing information and connections that not everyone had access to. This allowed him to identify value gaps between current market price and actual “book” price months, sometimes years, before Wall Street and the rest of the world’s investors caught on. Buffett was able to consume information about a company and determine the company’s strengths and weaknesses, as well as how he could potentially improve upon those weaknesses.
Once the information age rolled around, access to information slowly eroded Buffett’s ability to generate substantial returns. Don’t get me wrong, I still think Buffett is brilliant, and his funds perform quite well. But there isn’t much room for substantial value-add opportunities in the stock market today, mainly due to the fact that so many eyes are monitoring and consuming every piece of information released by companies.
Once people were able to access real time information for little to no cost, the value-add picking ability practically vanished. People still make great returns in the market, and analysts still have great picks. But now that everyone can easily gain access to the same information, the ability to identify a company whose stock price is substantially below its actual value becomes exponentially harder.
And this is one of the main reasons I love real estate. It’s a complicated business to learn, there are plenty of moving parts, financial information is difficult to consume and further understand, and you have very few eyes monitoring any one transaction. Not everyone has access to the same information, and even if they did, they don’t know how to digest it.
You Control the Analytics and the Operations
Being a thorough analyst in the real estate world will allow you to find deals where you can add a ton of value. Where other investors see substantial risk, you see a value-add opportunity. You may know how to manage the property and turn it around. You may know how to add curb appeal and command higher rents. You may have a better exit strategy mapped out. You essentially have an edge over everyone else. If this describes you, you are fundamentally doing what Warren Buffett was doing 40 years ago with stocks. You are in a position to create substantial wealth.
In any given real estate transaction, there is one (maybe a few more) “shareholder” selling to one (maybe a few more) potential “shareholder.” The seller is trying to make the property look as good as possible without the need to adhere to public accounting or SEC standards. At the same time, only a few people (buyers) are diligently analyzing the financials. This practice can leave a lot of room for errors and misunderstandings.
Compare the typical real estate transaction with any company listed on a major exchange and you will see my point – companies have thousands of people analyzing their regulated information and producing reports, ultimately making the market for the company’s shares efficient because almost all data is known, reported on, and consumed. Millions of shares are traded daily, and the bid/ask spread is generally only a fraction of a cent. These markets are operationally efficient, and value-add opportunities are hard to come by.
While there are many factors that make real estate appealing (use of leverage, cash flow, appreciation, economies of scale, etc.), the most attractive factor for me is the inefficiency of the real estate market. The inefficiencies allow savvy investors to find substantial value-add deals even after other investors have passed on the opportunity and to ultimately build wealth.
I must admit that I fear the day when the real estate market becomes efficient. Margins will shrink as competition rises. I personally hope real estate always stays “behind the times.” Can you imagine what the real estate marketplace would look like if someone were able to devise a way to create an efficient exchange (like NYSE) for real estate transactions?
Don’t forget to weigh in: Do you agree? Disagree?
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