Most millionaires are real estate millionaires and we would expect that real estate will continue to be an excellent investment vehicle.

Real estate is an important part of a diversified portfolio and should grow as stockholdings grow.

Investors should buy real estate – but not all real estate is created equal.

Real Estate Can Offer Superior Returns to Stocks

When financial advisors put out investment return surveys over time, generally real estate does not perform as well as stocks. We would caveat that “good” real estate is generally a lot easier to find than picking the right stocks and has generated strong returns over time.

However, the fact that stocks have (these are fake numbers) generated 10% annually over time and real estate let us say 8% is misleading.

The equity actually invested in real estate have historically and will continue to offer returns that are far more impressive than stocks.

Real Estate and Levered Returns

This is because of leverage improving returns. While a house worth $500,000 may be $550,000 in one year, the reality is that the owner put down $125,000 in the house.

There is no upside for the banks in terms of providing a mortgage. They know exactly what they are going to get – so the $50,000 in appreciation goes straight to the equity holder.

The return on assets is $50,000/$500,000 or 10%. The return on equity is $50,000/$125,000 or 40% in one year.

This is a simplification as money has to be poured into servicing the mortgage as payments are required for both interest and principal – however, should the property be rented out the rent can go a long way in covering interest payments. In many jurisdictions, mortgage payments are tax deductible against income, so it works out very well from a capital allocation perspective. Real estate mints millionaires.

Now assuming that the property is meant to be residential and not just an investment property, the investment thesis is still valid. Although salary (and accordingly equity) is spent paying down a mortgage, this has to be compared against the real economic loss in paying rent every month.

Real estate is a solid asset that banks will give an appraisal value for and lend against. This value tends to be sticky – especially if you work in finance where the population of the city you live in generally grows. Banks can offer leverage above 50% for residential mortgages (with insurance, possibly above 90%, depending on your jurisdiction). For commercial mortgages 65% loan-to-value is possible.

This cannot be emulated with stocks. Stocks are volatile securities and the market price that the bank can realize fluctuates daily. Banks will require overcollateralization when lending against liquid securities – for instance a portfolio with large blue chip stocks that is fairly well diversified may only get loan approval for half of the portfolio that is put up as security. This also leads to undue risk of liquidating in dire situations, leading to enhanced and permanent loss of capital. For instance, if a 2007 financial crisis event occurs, the stock portfolio can drop to close to 50% of value and the bank can sell them at bargain basement prices to satisfy their loans.

Additionally, real estate also sees better returns owing to liquidity. Stocks are small and liquid – anyone can buy stocks. Not everyone can front $125,000 for a 25% down payment on a $500,000 condo. This narrows the buyer universe materially.

Uncorrelated Returns for Real Estate versus Stock Markets

Market timing matters for real estate – but market timing does not matter as much in real estate as it does for stocks unless you live in a boom-bust city.

A tenet of investment theory is that volatility (as a substitute for risk) is bad. Stocks can go up 40% one year and drop 30% the next. Real assets tend to not exhibit such violent market behavior. Real estate tends to go up more consistently, as population grows and incomes rise.

Real estate also does not transact nearly as much as stocks due to the illiquidity of the asset. There are much larger selling frictions such as hiring a real estate agent, lawyers and running a sales process – even if certain technologies are lubricating these frictions such as Realogy or Redfin.

Real Estate and Real Yield

With real estate, the capital appreciation is nice, but also nice is the consistent returns from rental income. Real estate naturally services the debt.

Rents tend to rise with inflation, so being in the right city means that rent will increase annually subject to whatever local laws there are.

Again, the rental income is amplified by leverage.

Bullish on Real Estate

Urbanization Trends and Real Estate Values

A major theme in human demographics that has been widely publicized is the urbanization of China and India. While previously a large proportion of the population lived in rural areas, more and more people are moving to cities.

Does this matter if we are not living in China or India? It does, because the overwhelming trend is towards population density. The age of the suburb is dying, and the benefits from clustering are evident as we move towards knowledge centers and demand for convenience and coveted items in a globalized world increases.

If you work in technology, you will move to San Francisco or New York because that is where jobs are. If you are starting a technology company, you will open in San Francisco or New York because that is where the talent is. This is a virtuous cycle – there are economies of scale.

Density density density is the new bedrock of location, location, location. The modern man demands the latest fashions and best food in a consumption driven society – if they can be accessed quickly either through brick and mortar stores or via online shopping or an app such as Foodora or Doordash as fulfillment centers are close by, the modern man is happy. Time is increasingly valuable and networking effects will cause these benefits and the attractiveness of living in a dense city jump.

Many short trips = data for companies with logistics arms and operations such as Alibaba and Uber (although we expect Uber will be run out of town once Waymo ramps up). Big data, artificial intelligence, the cloud and the internet of things are all connected as we move from dumb cities to smart cities and smart machines.

Investing in Pittsburgh with a thriving economy driven by health care and financials has turned out much better than investing in Detroit. However, it is much easier to spot secular declines in real estate versus stocks. If everyone is leaving a neighbourhood, you should too! If the neighbourhood is getting gentrified and people want to live there, strap in. To put another way, cities that have been thriving will continue to see the momentum pay dividends. Towns and villages, tough luck.

Shrinking Land and Buildable Area

Over history, major cities and throughfares have been constructed next to rivers for transportation and fertile land. Natural geography is key to understanding real estate. For example, industrial land is running out in Vancouver – this can only mean that industrial prices per square foot are rising.

Cities that have hit city limits can only grow vertically and not horizontally. Some cities are smart with this – Asian cities such as Singapore are starting to build underground instead of just putting up skyscrapers.

Institutional Demand for Real Assets – Implications for Real Estate

Institutional money continues to flow into real assets such as real estate and infrastructure – these assets are continuing to make up a larger percentage of their ideal asset allocations owing to the same reasons as above – bets on urbanization and a desire to get stable, uncorrelated returns.

Pension funds, real estate firms and private equity funds are clamoring to deploy capital after successfully raising large amouts of money in their real estate funds. Investors want to see better than bond like returns, especially in a long-term bull market where stocks have continued to rise and people are fearful of frothy valuations.

In this article we somewhat conflate residential and commercial real estate but it does not really matter