Introduction

Stocks and real estate are two of the most talked-about investments in the world, both accessible to the average person, yet both attracting a lot of controversy.

Among the stock bulls, one of the most vocal and respected voices probably come from Professor Jeremy Siegel at the Wharton School of the University of Pennsylvania, who condensed his view to a book called Stocks for the Long Run.

Real estate, on the other hand, tends to be associated with greed and lack of sophistication, to put it nicely. However, I’d argue that real estate offers some impressive characteristics that make it an extremely attractive asset class.

On Market Returns

Many compare property returns against share returns in the long run and conclude that property returns are not impressive at all. From what I see, there's a crucial oversight about this type of comparison: share returns often include dividends, while property returns are typically calculated based on capital growth alone.

To assess an asset's attractiveness, consider expected returns. For stocks, historical data suggests expected returns (including dividends) are around 6% over the cash-free rate based on some long term data captured during the establishment of CRSP. Assuming a 4% cash rate, the expected returns of stocks would be around 10% annually.

Property returns can be estimated by combining dividend yield (rental income) and capital growth. Conservative estimates suggest long-term capital growth in Australia is around 5-7% p.a., while dividend yield can range from 2% to 7% depending on factors like property type, location, and value-adding strategies. A simple yield-seeking property portfolio could readily achieve overall returns of 12% p.a. or more, even though only the capital growth component (typically 6% p.a.) gets referred to as "property returns."

So, the idea that raw property returns are lower than stocks may not hold true, especially for high-yield properties.

On Alpha

Alpha refers to returns generated through skill and not readily available for everyone. You can either pick a winner and ride along, or you can turn something into a winner. I would call the former the alpha of picking and the latter the alpha of making.

The Alpha of Picking

The alpha of picking is notoriously hard to get, especially for exchange traded assets like stocks. In the modern era, the wisdom of investing in stocks is simply to give up on the hope of finding alpha and just hold the index. This view is shared by many renowned investors like Warren Buffet and Morgan Housel.

Unlike professions where expertise makes a big difference (medicine, science), investment professionals often struggle to outperform the market. A well-accepted fact is that the entire active investment management industry's returns are essentially equivalent to stock index fund returns minus management fees. While exceptions exist, for the average investor, relying on others to pick stocks can lead to disappointment as often as delight. Picking a manager is no easier than picking stocks themselves.

The difficulty of finding alpha varies across asset classes. Certain asset types offer more opportunities to harvest alpha. For example, the Chinese stock market shows mutual fund managers with a stronger persistence of returns. Similar trends exist in private equity and venture capital, where winners have a slightly higher chance of continuing to win in the future. The key here is that these markets are not fully developed, allowing certain players to leverage information asymmetry or drive returns in ways unavailable to others.

Real estate is not exchange-traded like stocks. There's only one seller per property, and buyers typically number between zero and a dozen. According to Fischer Black, stock market prices can be between 50% and 200% of their true values about 50% of the time. Real estate prices can deviate even further. Several property selection theories exist, mirroring those used in the stock market: data-driven investing (quants) and special situations (behavioral) investing.

While I have reservations about most stock market investment theses (including unlisted ones), I believe both data-driven and special situation investing can work significantly in real estate.

In my previous article about the Momentum in the Property Market, I discussed the remarkable momentum prevalent in the property market, often taken for granted. This momentum exists because most participants are retail investors, and a step-wise price discovery process is necessary. High transaction costs further prevent rapid price discovery. A data-driven approach, if done correctly, can identify various "biomarkers" during property market rises and falls, potentially pointing you towards markets with near-term price gain potential.

Special situation investing is even more prevalent in the property market. The term is popularised by my favourite investors Joel Greenblatt, Jamie Mai and Jeremy Giffon. The essence of special situation investing is to focus on the situation surrounding the asset, not the asset itself. For instance, if a non-local agent selling a property needs to travel a long distance, they may be incentivised to sell quickly at a discount to reduce their workload rather than maximise the seller's profit. Other special situations include long listings post-auction pass-in, two-bedroom houses, overlays with little impact, divorce, deceased estates, and so on. When special situations occur, properties can be traded at significant discounts, with prices recovering once the driving force behind the situation disappears.

Overall, if you're looking for alpha, you're better off searching for it in the real estate market compared to the stock market.

The Alpha of Making

Value-adding to publicly traded stocks is nearly impossible for most everyday investors. Technically, some value-adding can occur in private ventures like startups through advice and introductions. However, the term "value-add" has become increasingly sarcastic, with the extent of its impact being questionable at best.

Properties, on the other hand, are quite amenable to value-adding strategies, and these strategies are generally not controversial. Value-adding examples range from non-structural makeovers to major developments. As a rule of thumb, common renovation and development strategies can generate a 30% profit margin over very short holding period, which can be eye-watering attractive even for private equity managers.

If you're thinking about creating value from scratch, property might be the most accessible and established way for everyday investors to do so.

On Leverage and Risks

Leverage and risk are not synonymous, although they are often lumped together. Leveraging up treasury bills a few times wouldn't make them any riskier than stocks. The perception of leverage as risky likely stems from its ability to magnify existing risks.

Generally, I discuss leverage and risk separately. However, property is a unique asset class where it makes sense to consider them together. Here's the gist: property combines many advantages of both private and public assets, while having few of their drawbacks.

The public market offers cheap leverage for some investors (aka sophisticated investors), with margin loan rates close to mortgage rates. However, the public market is marked to market, meaning a 20% price drop (which isn't uncommon) could wipe out an entire position due to margin calls. Leverage in the public market can be extremely dangerous for this reason.

Property investment is different. Even if a property's market price dips by over 20% temporarily, investors can keep the property and the loan as long as they can service the repayments. The risk of margin calls is practically nonexistent. As long as the market trends upwards in the long term (which is more likely than not), investors are likely to get their money back eventually, even if their initial property selection wasn't perfect.

If net equity is no longer the main risk consideration for properties, then what should we focus on? Cashflow management is key. Cashflow makes or breaks a property deal. If a steady stream of rental income can cover all the property's outgoings, there's very little risk left for the investor, regardless of the equity position. This is somewhat similar to private equity strategies that heavily leverage buyouts to acquire assets. The key difference is that individual residential properties are significantly more liquid than buyout assets, offering investors additional protection against liquidity shortfalls. Steve McKnight, author of From 0 to 130 Properties in 3.5 Years, is an early adopter of positive cashflow strategies in property investment. His goal was simple: buy properties where rent covers ownership costs. With enough such cashflow properties in a portfolio, income replacement can be achieved, potentially allowing investors to leave their day jobs.

Network Effect as a Risk Mitigator

In Australia, young property investors who build large portfolios (over 50 properties) often make headlines, and many might consider them reckless risk-seekers. To be transparent, I used to be one of those people who viewed property investors as such. However, I later realised I was neglecting a major factor that reduces property investment risk: time.

Time diversification is a well-established concept in portfolio management. Controversially, some argue that a balanced portfolio is less risky than an age-based portfolio precisely because of time diversification. Property portfolios can benefit even more from this concept.

Imagine investors as middlemen borrowing funds at 6% and investing them at a 12% gain. The 6% return comes simply from the ability to borrow. Borrowing capacity itself holds significant value. In such situations, a rational choice would be to borrow as much as possible. If there's a strong source of positive cashflow, it doesn't necessarily matter if the entire 12% gain comes from capital appreciation. Without a strong cashflow base, however, it's best to ensure at least a portion of the 12% gain comes from cashflow that can cover funding costs. Generally, investors' borrowing capacity will plateau at a certain point as income growth inevitably slows (unless specific structures are in place).

Here's where things get interesting: over time, debt goes down, rental income rises, and property values appreciate. Time acts as a magic ingredient for property portfolios, as risk naturally reduces over time. Cashflow strengthens, loan-to-value ratios (LVRs) go down, and what once seemed like a scary debt pool eventually transforms into a dream portfolio, practically taking care of itself with a built-in margin of safety.

Conclusion

Empirical evidence suggests that real estate offers a compelling avenue for long-term wealth accumulation - some even say it is the only repeatable pattern for the ordinary to achieve meaningful wealth. While not without its complexities, the potential for superior returns through a combination of capital appreciation and rental income streams merits serious consideration within an investor's portfolio. Strategic leverage, demonstrably effective when responsibly employed, can magnify gains, while the time factor inherently mitigates risk as the portfolio matures. Long-term holdings witness a natural reduction in debt burdens, alongside increasing rental income and asset value appreciation. Viewed through this lens, it is fair to say: real estate for the long run.