Thursday, April 8, 2010

Comparing Apples and Oranges - Follow Up

Thanks for the input from all of you.


I did this comparison so as to get a better understanding how real estate and other investment classes compare in terms of financial performance. It finally dawned on me, that many such comparisons are not correct and that the above results get closer to reality.

When dealing with real estate, a major issue is the division of strict investment returns versus returns on the work you do. As said before, investing in my opinion represents the return on your money, i.e. your money works for you.

Real estate investing has two components of income: return on the money invested, but also compensation for the work done, whether this is done by a rental manager, a renovator or by the real estate 'investor'. To truly compare investment returns you should look at what a passive JV makes, because he/she is the only true investor dealing with return on money invested. So here, one can compare with the performance of other investment classes.

When looking at 'normal investment returns', Return on Investment is not often used; a better basis for comparison is the 'time value of money calculation' and the there from derived compound rate if return, yes the same one used for many GIC investments.

The other issue when comparing investment returns is risk/reward. Stock market returns are looked upon by many successful investors as long term investments. Jeremy Siegel is a big proponent of this. But many others as well. Over the long term (last 200 years), after inflation stocks returned 6.5 to 7% and including inflation around 11.2%. In terms of risk, I came across the following, very interesting statistics - Time (horizon) of investment and the probability of Loss in the Stock Market (W.J. Bernstein):

Time horizon     Probability of Loss

One hour                      49.58%

One Day                       48.80%

One Week                   47.36%

One Month                 44.51%

One Year                   30.85%

Ten Years                  0.59%

100 Years                 0%

Stock markets are obviously volatile hence many perceive it riskier. But over the long term, as you can see it is one of the most profitable ways of investing and yes, returns of the last decade on average were poor, but the table above shows that it might have been even a loss. This does not make these poor investments. And I can tell you that my stock market returns over the last ten years were a lot higher than I ever made in real estate.

When investing in stocks, your liability is restricted to the money invested. Even a passive JV investor, using leverage, can lose a lot more than the money invested. On top of that, there are operational risks as several investors in Grand Prairie experienced. The 'finder' may turn out not to be very experienced; JV investors may have a fallout and the JV collapses, the rental market turns sour. Then there are liabilities, environmental liabilities, safety liabilities. Do I have to go on?

So the risk, even for a passive JV investor is considerably higher than investing in the stock market. Hence the returns need to be better to compensate for that. The expectation by some budding JV investors here on this forum, that a not guaranteed return of 8.8% should be adequate is, in my opinion' ludicrous. But a friend or relative may go for it because he/she knows the budding investor personally and is full of trust and love. But a true investor would likely not go for that.

I calculated using a typical two bedroom apartment in Calgary with low cap rates and high appreciation that the passive JV investor may walk away with a 14% return. And by massaging the numbers using a cap rate of around 6% and appreciation more typical for Canadian properties on average, the compounded return would be 15%.

This is definitely better than 11.2% for the stock market. However, when adding in the higher risk level and the liquidity of the investment, I gather that most investors would be reluctant to do a JV unless the 'finder' has a lot of real estate experience.

As to only investing in the real estate because the investor feels that he/she is not knowledgeable in the stock market that is completely justified. But... such an investor accepts the higher risk levels by not being diversified.  Someone only investing in Alberta Real Estate would count on the fortunes of the oil industry and maybe a few other local industries. Calgary's economy seems to be more diversified than 10 or 20 years ago. But, I would not count on it.

Investing is all about risk management and asset allocation. In other words: "not putting your eggs in one basket". Having said that, a number of investors (Bill Gates) have become very rich sticking with a portfolio that was not very diversified (Microsoft).

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