Risks & Returns of Real Estate Investing | AWM Insights #112
Enjoy AWM Insights? Leave us a 5-star rating & review to help others like you discover the show!
Episode Summary
Real estate is a popular asset class and a huge wealth builder for many people. What are some ideal ways to approach investing in real estate? What can you expect for returns and what are the risks?
If you are directly buying properties and expect mailbox money without any work, you are in for an unpleasant surprise. A common misconception in real estate is the idea of this passive income. However, owning properties is akin to running a business, and you will either have to do the work or you will receive below-market returns.
If you don’t want to be a landlord (and have to deal with clogged toilets) but still invest in real estate, there are a multitude of vehicles that satisfy the objective. Real Estate Investment Trusts (REITs) are the simplest option and can deliver truly passive income.
There are also private funds for real estate that require adequate due diligence but offer the possibility of higher returns than public market options. There can be tax benefits built into these funds as well.
Returns in private real estate are nowhere close to venture capital, but the sources of returns are also different. Over the last 25 years, those returns have averaged 8.12% annually.
In this week’s episode, Brandon and Justin discuss all things real estate investing and detail the avenues you can use to invest in real estate and what your expectations for returns should be.
Have questions for an upcoming episode? Want to get free resources, book giveaways, and AWM gear? Want to hear about when we release new episodes? Text “insights” or the lightbulb emoji (💡) to Brandon at (602) 704-5574 to join our new AWM Insights Network. On an iPhone? Click HERE to join.
Episode Highlights
(1:05) Is the only way to invest in real estate to go out and buy a property and manage it myself?
(1:19) There are many options to invest directly and indirectly in real estate. There are many vehicles and different options for accessing this asset class with some requiring zero work.
(1:32) Real estate investment trusts are the simplest and least complex way to invest in real estate. A REIT has a ticker symbol just like a stock and trades on a market exchange.
(1:51) REITs generally have a niche or focus of their real estate strategy. It could be a specific area like industrial, office, commercial, residential, or multifamily.
(2:24) There are also private market REITs. The only material difference being they are not publicly traded. This makes them less liquid.
(2:42) Real estate funds are another option to invest in real estate. There are a lot of options in this area due to the size of the global real estate market.
(3:38) Everyone wants passive income and a lot of people think real estate is the only way to create passive income. Going out and buying a property and managing that property isn’t very passive.
(4:07) Buying a REIT ETF or individual REIT in the public market is actually passive because you don’t do anything and just collect the income and price appreciation from the investment.
(4:44) Most real estate is an income-producing investment. Income is the primary goal and price appreciation is secondary. Real estate doesn’t hold a monopoly on passive income and many other assets produce reliable income.
(5:40) The misconception about directly investing in real estate is that there is no work involved and once you own the property you can collect the “mailbox money”. This isn’t true and the work involved is akin to running a business.
(6:10) Being a landlord and managing an efficient operation takes time, effort, and capital.
(6:21) Real estate can be a form of passive income. Investing overall for the long-term, no matter the asset class is passive income. It’s building an investment asset base for the future to create income.
(7:10) Passive income or passive growth of your investments is found in many places. If you buy a stock in your brokerage account like JP Morgan. They pay you a dividend every quarter and you didn’t have to do any work but buy their stock. Their share price is also expected to increase, which you could then sell when you need the cash.
(9:07) Residential real estate investing includes single-family and multifamily projects. Multi-family is usually apartment buildings or houses with multiple units.
(9:45) Industrial real estate can be anything from Amazon warehouses to the many storage unit operations. These are very large properties and a competitive market.
(10:20) Commercial real estate represents both retail and office space. This encompasses shopping centers all the way to massive skyscrapers full of offices.
(10:38) Evaluating whether an investment is worth it involves boots on the ground and projecting the costs that will incur to get a building up to code or navigating environmental issues to get the rents to satisfy investors' required rate of return.
(12:11) How should you look at the rate of return you deserve when investing in private real estate?
(13:06) Cambridge associates puts together a private real estate index and over the last 10 years the index has returned 11.2% annually and over a 20-year time frame, it has returned 7.8% annually. For 25 years the return is 8.12% annually.
(13:50) Private real estate is not the best performing asset class. The data and evidence is clear on this.
(13:58) Real estate is very dependent on leverage. You borrow money to purchase a property. This means taking on debt to boost returns. This is a double-edged sword because when returns are bad the leverage boosts them to the downside.
(14:39) Most people think it would be ridiculous to take out a loan to invest in the stock market. But that’s exactly what you are doing when you get a mortgage and invest in real estate. If things go poorly, the bank takes your real estate.
(15:40) If you’ve decided to invest in real estate, start with the public market premium of a comparable REIT index. You then should be compensated if you make a private deal for an illiquidity premium. This is extra compensation for tying up your money for a long period of time. Going through this exercise will help you decide if a property is a worthy investment.
Stay Connected
AWM Capital: IG | LinkedIn | Facebook | AWMCap.com
Justin Dyer: LinkedIn
Brandon Averill: LinkedIn
+ Read the Transcript
Brandon Averill (00:00): All right, Justin. Time to talk about everybody's favorite. It's real estate time, baby. Yeah, so last week, obviously, we wrapped up private equity, went into a little bit of a deep dive there. We teased out the fact we're going to come over to real estate today. So I know there's going to be what 4,000 or 5,000 people listening this week.
Brandon Averill (00:19): But in all seriousness, real estate's a fantastic asset class, huge wealth builder for a lot of people, and generally, I think, just an interest of everybody. So this will be a lot of fun. We'll jump on in. We're going to talk about different ways to invest in real estate, what we can actually expect. Where does the power of real estate actually come into play? And then we will get to the end. We'll talk a little bit about the different ways that you can actually access real estate. And we might even do a follow-up episode of how to go about doing due diligence on those investments. But as we get kicked off here, Justin, maybe just start to lay the land for us a little bit. Just would love to know, is the only way to invest in real estate to go buy a property and manage myself? Can I do it in the public markets? Just give me the lay of the land.
Justin Dyer (01:15): Short answer is no. Actually there are some great vehicles, and there's a number of different vehicles in which you can invest either directly or indirectly within real estate. But a lot of real estate is actually held in vehicles that are called real estate investment trusts, REITs for short. And those are generally, not exclusively, but generally publicly traded. They have a ticker, or a CUSIP if you want to get technical, just like a regular old stock is, and you can go to the market and buy a REIT. That REIT can represent a number of different underlying holdings. It can be specific to a specific area within real estate, whether it be industrial, commercial, office, residential, multi-family, et cetera, et cetera. The list goes on. So that's one way. That's the common public market way. It's not the only public market way. REITS aren't the only things. There's some other nuances, but REITS by and large are the main way to get access in the public markets. They are a big way you can get access in the private markets, as well.
Justin Dyer (02:25): But I think the most common assumption or familiarity, if you will, within investing in real estate in the private markets is probably buying a piece of property yourself. There are also funds which, little teaser here, it's probably a little bit better to go to the fund route, because we talk a lot here on the podcast about diversification, and one of the hurdles from an analytical standpoint, if you will, or if you're thinking about real estate really from scratch is, it's hard to get diversification, especially within the private market side of things. And we'll talk a little bit about that, I'm sure, in the coming weeks. But you can go buy a property yourself. You could bring together a handful of investors and the four or five of you go and buy a property together, or you can go to a fund. Those are the most common ways, I think, in which you can get access to real estate, both in the public markets and the private markets.
Brandon Averill (03:30): All right, I think that's a great lay of the land. And one thing that I hear a lot when I'm talking with clients or just out there, is passive income. I want the passive income. It's a passive investment. Real estate's a passive investment. And I would love for us to spend at least a few minutes just talking about that, because I think a lot of people think real estate's the only passive way to go about generating wealth. And when you start to actually think about it like you just laid out, if most people are actually going out and buying a property, managing that property, trying to collect rents, I don't know how passive that is...
Justin Dyer (04:04): That is not passive.
Brandon Averill (04:06): Versus going and buying a position in equity or an ETF on the public markets. That's a heck of a lot more passive if you asked me. Hit the button, now you own equities in a bunch of different companies. So I think there's some nuance there, but why do people think that real estate is such passive income? Is it just because you set it, forget it, once you get a renter in place? In theory, you just start to see this mailbox money, these checks coming in?
Justin Dyer (04:37): I think so. I think it has a lot to do with that. Most real estate is an income-oriented asset, meaning, let's just say it's a multi-family apartment building and those tenants pay rent, or it's a retail building or strip mall or something like that, the tenants, those businesses are paying rent. Now, you have expenses to deduct from that rent, and hopefully those expenses are not more than the rent you're collecting. But just by the nature of real estate and how it operates as an asset, I think, income is very much directly associated with that.
Justin Dyer (05:18): However, you mentioned, you alluded to, and we're saying a lot of this with tongue in cheek, because it's a very, very common misconception, and it doesn't mean real estate's a bad asset. I really want to make sure we hit on that. It's a very, very good asset to hold in a well-diversified portfolio. It's not this only asset you should hold, but there's a lot of misconceptions around real estate, and this passive income piece of it is one of them, because if you are doing it directly and maybe you have five, 10 properties even, and starting to make an actual business out of it, there's a lot... Just by the nature of what I'm saying, it's a business. There's a lot of work that's involved with it. I've never met anyone who actually says they like being a landlord either. And typically people get into a single property or two properties and really reconsider things.
Justin Dyer (06:13): But I would say real estate, first to directly answer your question, real estate is a form of passive income, although again, if you're doing it in the wrong way, it's actually a lot more work than I think people generally set out with the idea of. But investing overall, especially investing for the long term for your goals, et cetera, et cetera, that is all passive. It's all passive income, and we're not talking about active management versus passive management in this sense. There's some relations to that, but really in the sense, and Brandon, you really alluded to it, you go buy it. Let's just say you go buy a stock, in the very simplest example here. You go buy a stock, go to your brokerage account, type in Apple, as an example, or let's say J.P. Morgan, maybe a better example. J.P. Morgan pays you a dividend and guess what? You don't have to do anything for that. You have to go into your brokerage account and hit buy, transaction happens, and you get money into your account every time it pays a dividend. That is pure passive income. And so, there are multiple avenues, multiple channels, within a really well-built investment portfolio that passive income or passive growth, let's even redefine this as passive growth, comes from because that's the better way to think about it.
Brandon Averill (07:40): Yeah, we're going to get into that in a second here, what types of returns should we expect. But I think you've alluded to it several times, so probably time to start to put some clarification around this, but what are the different areas of real estate? We've got residential, we've got multi-family, commercial, industrial. Maybe just give us the one, two second explanation. What are these different areas? Who are the competitor, because this is still a pro's game, especially on the private side. If you're one to come and compete here and really get the return that you deserve, there's a lot of diligence that goes into this. We talk to a lot of very professional real estate investors that have made a lot of wealth investing in real estate, and it is not simply the, "Well, I'm getting a thousand dollars a month in rent. My mortgage is 900. I'm in the black here." It's a pretty sophisticated way to go about it. So maybe just define some of these more common types of real estate, and then also maybe the landscape of who you're competing against when you go to invest here.
Justin Dyer (08:53): Sure. So like you mentioned, I alluded to some of these residential, and you hit on quite a few as well. Residential, the names are self-explanatory, but let's really define it. Residential, from an investment standpoint, it's not, generally speaking, just building one house. It's probably building a development of single family homes. Multi-family, which is generally, just a little teaser, it's where we like to go within private real estate specifically. But multi-family is something like an apartment building that has a number of different units in it. Ideally, it's a decent size because you just get built-in diversification through multi-family that way. Industrial, think something like... Industrial could be anything from industrial scientific to...
Brandon Averill (09:52): Big Amazon warehouse.
Justin Dyer (09:54): Yeah, Amazon warehouse, things of that nature, and you're playing with very large properties, generally speaking, within the industrial space. Again, there's always different flavors of this, and you can find a small little industrial warehouse somewhere, but typically speaking, in the industrial, really competitive, good returning part of the market, there's some big players in that space. And then commercial. Commercial, you have retail as a subset within that, and then also, office space. So we're in an office building right now that would fall in your office commercial in a sense. Justin Dyer (10:32): And, yeah, to your point, I'll just touch on briefly, the due diligence. That's part I was talking to a friend, who is in the real estate space, actually yesterday and it's getting boots on the ground. It's looking at the actual quality of the asset. If we buy this, do we have to put a significant amount of money into it to bring it up to code? What about the environmental regulations on it? This particular property actually had some issues, and they were going to have to potentially put in a million and a half to $2 million to get it back up to code essentially. Now, the purchase price was potentially attractive enough for them to even consider that. Don't know if it's going to happen, but just to give you some flavor.
Justin Dyer (11:16): You got to go through all the leases that are existing in place on that property. It depends on where you are and what the tenant protections are, but you can't just come into a property that is a clean slate, unless it is completely new construction, which we'll touch on, too, phase of real estate and whatnot as well. So just a little bit of a flavor on all of those things.
Brandon Averill (11:40): I think that's really helpful. And as we can tell here, I think this is definitely going to be a multi-episode deal because we haven't even touched on how do you calculate returns, how you do due diligence. But I do think a good place maybe for us to spend a little time is, as we likely wrap up here to keep it within time, is what type of return, and I'm speaking mostly obviously on the private market side, but if I'm going to go invest in private market real estate, I want to make sure as an investor, I'm getting what I deserve. And I think this is where people get tripped up quite a bit, but how should you look at that? What should you deserve if you're going to tie up your money, you're going to put the effort in to doing the due diligence on a property specifically, or maybe even a fund. We haven't even hit on how to do that yet, but broadly speaking, how do you start to construct an equivalent of like, "Hey, I deserve 10% or 12," or whatever it might be, but how do you get to that number?
Justin Dyer (12:44): Well certainly, you alluded to it, it depends on the stage and the risk and all that stuff. But there are actually really well-constructed sources out there to get somewhat of a ballpark or approximate expectation. I've just pulled it up. So Cambridge Associates is a big research provider within the private market arena, both private equity, venture capital, real estate as well. They put together a private real estate index. And just to give some flavor of numbers here, over the last 10 years, their index has done 11.27%. Over 20 year period of time, it's a little bit less. 7.68, or 7.88, excuse me. 25 years is 8.12. So it's been a good last decade for real estate, but real estate in general is not the best performing asset class. I think that's another misconception that happens out there.
Justin Dyer (13:47): The other piece of it, it's really important, and this is very much specific to a deal or a property or an asset, is real estate is very conducive to using leverage on. And that really changes your return profile, or can really change your return profile, and risk profile for that matter. Risk and return are related, so that's a big thing to keep in mind. A lot of returns within real estate do come from that leverage component. Let's be super clear. What I mean by leverage is, everyone here or most people listening is familiar with a mortgage. That is leverage on an asset. You are borrowing money to purchase property and real estate. It's very much conducive to that type of transaction, which can help returns, but can also hurt returns.
Brandon Averill (14:37): Yeah, it can be done very safely. And I think the equivalent, and just to put some perspective, is I think most people would think it would be absolute... Well, not everybody, but most people would think it would be ridiculous to take out a loan and go invest in the stock market.
Justin Dyer (14:51): Right.
Brandon Averill (14:51): But that's essentially what you're doing in real estate. And you've got the backing of the property if things go poorly, et cetera, but things do occasionally go poorly. And so you want to make sure that you're right sizing your debt when you're going to purchase a property. But in reality, that is what's going to generate a big part of your return within real estate. So it's definitely on the evaluation table. There's no doubt about that. So if those types of returns are what... For instance, that benchmark, those are average returns, so it doesn't mean you go buy a property, you're going to get that return every time. You want to make sure to build out a portfolio. You want to make sure that you're hopefully getting at least that or looking at even the public market equipment, like we talked about.
Brandon Averill (15:44): You can invest in the public markets in real estate, so let me look at what that return has been. And if it's been 8% over the last 10 years, and I'm tying up my money, I want what's called an illiquidity premium. I deserve to get a little bit more because I'm tying up my money, so maybe I'm looking for 10%, for instance. But I think you have to go through that exercise when you're putting your models together to figure out, "Hey, is this a property worth investing in?" So it's not simply just going and covering some of the expenses, covering the mortgage, et cetera.
Justin Dyer (16:20): Right, exactly.
Brandon Averill (16:22): Well, Justin, that was a lot of fun. We got a lot of follow up still to this episode. I think we're going to have to get into some due diligence. How are we going to go about this process if we're looking at a fund, if we're looking at a property? We've talked about maybe the return that we actually have to achieve, but definitely warrants a follow up here.
Brandon Averill (16:42): But as we close out, just wanted to remind everybody, you can shoot me a text. I'm sure there'll be lots of questions coming out of this. We got more real estate coming. So shoot me a text at (602) 704-5574. We'll get to all those questions and definitely look forward to that follow up. But until next time, own your wealth, make an impact, and always be a pro.