The InvestMentor

April 9, 2003

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Real estate, as investment, is all the rage. That's understandable. Stocks have stunk for three years, bonds now yield what money markets used to, and gold is falling faster than Baghdad.

Real estate, seemingly, is the only thing that increases appreciably. So naturally, I'm being asked if real estate should be where new capital is best invested. My answer? Maybe—depending on a lot of things (...I'm not about to make it that easy for you).

Stocks vs. Real Estate

Most often, people that are considering real estate are doing so with money they would have earmarked for stocks three years ago. Hopefully that's long-term money, and if so, a sizable real estate investment is a nice compliment to an equity portfolio. That was true three years ago, is true now, and will be true three years from now. The two investment choices are not mutually exclusive. Even though "stocks" is a four-letter word to some (actually, it's a six-letter word), the case must be made for both assets in the growth portion of an individual's saving pool.

The mistake is to invest while looking in the rearview mirror. Naturally, real estate is much more enticing than stocks given what we've been through recently, but even an elemental understanding of investing enlightens you to the oldest trap in the book: buying high. Real estate's most compelling quality is that it provides diversification first, along with growth and income potential, second.

You're Probably Already a Real Estate Baron

Chances are that real estate is already your biggest investment. If you own a home, the equity in it—current market value minus your mortgage—is probably as large if not larger than the money you have in stocks, bonds, and cash.

The risk, then, is inadvertently over-allocating to real estate, because you've left your house out of the asset allocation picture. Investing in real estate above and beyond your residence should be considered in the context of your overall allocation, and the amount of other assets you own. Thus, if three-fourths of the value of your assets is your home equity, I'd advise first looking away from real estate, or at least avoiding residential real estate investment, particularly in your geographic area.

Will Real Estate Continue To Rise?

It's the wrong thing to buy real estate because you think that's the only place with appreciation potential. Will real estate continue to appreciate? Who knows? That you "think it will" or have "heard it will" should hearken you back to the outlook for stocks in 1999. Recall how prescient those forecasts were, and try and remember your thoughts at the time.

In aggregate, real estate has been mostly on the rise over the past few years. My concern stems from the second derivative—the change in the pace of the appreciation. When you find that prices are increasing at a faster rate than they did the year before—regardless of the asset we're talking about—it's usually an ominous sign. Again, go back and look at the slope of the chart of stock prices from 1997-2000—notice the steepening that led to the zenith for stock in March of 2000.

For real estate, it's easy to envision a scenario over the next few years that sees a recovering economy...that begets rising interest rates...that begets rising mortgage rates...that ices property value increases in most places. The trend in real estate prices is always a regional phenomenon, unlike stocks. Some places have risen faster than others have, and will be better insulated against a back-up in mortgage rates. And some price ranges, and property types, are less elastic than others. Nor am I implying that we would see an implosion of property value, but it could mean sideways pricing for a decade. Don't think that could happen? See: California in the '80, Texas in the '70s, or Asia for the last two decades.

The Nuances of Real Estate

As an investment, real estate is more often viewed on its income producing ability, which is driven by myriad of factors. There are a number of other complexities to real estate investing including the type of real estate (land, building, or both), the use of the real estate (commercial or residential), the difficulty in being diversified, the tenancy of the real estate (single unit vs. multiple, lease vs. rent), the illiquidity of real estate, and the tax and zoning laws. All important things to consider.

As I forewarned new investors to the stock market in the '90s, "it's not as easy as it looks." Get good help if you're going to do. And go in with both eyes wide open—learn the lesson of cycles and diversification that stocks taught you—that's perhaps the greatest return you've earned as a stock investor.