There are many discussions going around about real estate investments. This is true in Central Europe just as it is true anywhere in the world. But perhaps in Central Europe this is discussed extensively, because people tend to have the vast majority of their wealth invested in real estate. This is mainly because there is a certain reluctance from people in general to invest their hard earned money in shares or funds or similar assets for fear of losing the money (this had to do with recent history in the area which has not been necessarily the most favourable in terms of shares and funds, but we’ll discuss this in another article).
Let’s tackle this topic, then shall we? Investment in real estate… its main benefit is the fact that, in many people’s view, well… it’s real. It is called real estate for a reason. It is tangible, people can see it; once you bought it it’s extremely difficult for someone to defraud you of it, it will not go bankrupt like a business could; so when you put it this way, what’s not to like about it?
Well, the reality is that real estate as an investment has significant drawbacks when compared with other types of investments. First and foremost, it needs to be said that real estate has historically underperformed other types of investment by quite margin.
See below graph detailing the yield of various investments since 1975 comparing the US House Prices with the S&P 500. Needless to add which one performed better, the graph does not need and additional comments:
Well, this may surprise you. But let’s deconstruct this: it will make sense to you in a minute. The main reason of this underperformance is the fact that real estate has no “engine” to produce returns. Investing in shares of a company (or a fund which owns a piece of multitude of companies) means that you have a portion of a business. That business is set up with a clear reason: generate profit. Most business thereby have profit, which they either reinvest for the future or they return it to the shareholders in terms of dividends. Of course, this is a simplified explanation, but for this purpose it suffice to say that this relentless search for profit provides the company with an engine that allows it to grow. Owning a piece of a growing business means that the piece (the shares) are increasing in value, based on the profits raked in by the business. For the risk taken by the enterprise, it is typically rewarded with profit rates significantly higher than the market interest rates.
On the contrary, a piece of real estate is an asset that can be considered in two ways. It satisfies a social need (provides a roof over the head of certain people). If the people living in the property are also the owners, there is no investment return in the traditional way of defining this term. Of course, the value placed on the item is dependant of how much a group of people (through the mechanisms of market) are willing to pay for it in the case of an eventual transaction.
Secondly, If the property is rented, it indeed produces a return for the owner. But because it does not produce any added value, but merely satisfying the need for housing, its value will only increase as a result of market increase, not because of a compounding engine which a business would have (as we established above). Sure, if you invest in the property to make it more desirable (property improvements) this could yield a return, but this return on investment typically is quite limited.
Now, I am not saying that the property market should be completely ignored. It can make you a lot of money, depending on the timing of your investment, location, market conditions, and perhaps a bit of luck also. But understand that, ON AVERAGE, property investment is less successful than buying stocks.
I will show you one way in which the real estate property can bifurcate in the future and how one can make money by leveraging the ongoing trends.
A very simple way of categorizing real estate investments is by splitting them between investing in land and/or investing in buildings. Let’s take each one of them:
- Buildings, they depreciate. While in Central Europe this concept is fairly uncommon, in USA for instance, buildings are depreciated and taken as a cost during a period of 30 years. With the assumption that on average after 30 years, the building is being torn down. In Central Europe, if you pay for a building 500,000 Euros, and you get a rent of 1,500 Euros per month, you might think you’ve done a pretty good deal and you’ve insured yourself a good return for an indefinite period of time. But the 1,500 per month is 18K Euros per year. That means 540K in 30 years. However, when you consider that the 18K years you would collect 20 years from now means actually less today, the present value of the rent for 30 years is less than 540K. A lot less. It would be in fact in the region of 400K assuming even a low rate of inflation. So, the mighty investment of 500K Euro which seemed such a great deal with a perpetuity of 1,500 Euros per month is in fact an instant loss of 100K, judging by American standards. Of course, rental rates can increase thus making this calculation more favourable, but the point is the same: returns of real estate need to be considered by taking into consideration all aspects. We have not even discussed taxes, utilities, closing costs, empty periods of time etc.
- Land, pretty much everywhere in the developed world does not depreciate. It just stays as it is, because of course, land can be reused once the owner desires to change its destination. You just need to demolish whatever you have built on top of it and then repurpose.
Now, it is a clear trend in the future that the robots will take over many mundane repetitive tasks in the economic activity in the entire world. They are better, more efficient, they follow the script exactly as instructed, they keep the same standard every time, they do not strike, they are not late, they do not go through emotional stress and so on.
Already, in today’s world there are entrepreneurs and venture capitalists in Silicon Valley who are building companies with complete infrastructures to allow buildings to be built from a blueprint by independent machines. Basically this means that entire construction sites will be managed with much less human intervention. Instead of 10 bricklayers, one machine will do every bricklaying needed. No call in sick, no bad day at home, same standard every time. As these algorithms improve, the cost of building a building will get down massively. The standard and quality will be, at the same time, increasingly better.
Will the buildings perhaps no longer be unique? Perhaps, but most people will not be concerned by this aspect. They will be happy to pay less and live more comfortably.
What will this do for current buildings? Well, as you can imagine the prices for old, depreciated, no longer great to live in units will plummet. Also, buildings built at a low standard (as many Communist buildings are in Central Europe) such as tiny apartments crammed one next to the other, will lose their desirability very quickly. That means price will go down rapidly.
On the contrary, land will not be subjected to this risk. On the contrary, green clean land will be more desirable, as people will seek to expand. The avent of the mobility revolution, where people will travel quickly and cheaply thanks to electric self-driven vehicles will mean that the distances between people will become less relevant. Urban sprawl will increase.
You can judge for yourself how this will impact the cheap land that is surrounding big urban locations.
In another article, soon to come, we’ll deal with how you can combine the perceived stability of real estate investments with the flexibility of owning stocks.
Safe and Successful Investments to you!
FB