Do You Really Want to Be a Landlord? (Part II)

For the first part of this story, see yesterday's post "Do You Really Want to Be a Landlord?"

Paul provided several other reasons why he wouldn't recommend buying an individual building. He pointed out that one consideration is when you invest in any of the three above vehicles, you own a highly liquid investment. However, when you purchase a single property, that is almost certainly not the case. At a minimum, there are very significant transaction costs that would be incurred upon sale. In addition, if the market were to be weak at the time you decided, or needed, to sell there would be a significant risk that it might be difficult to sell the property in a timely manner without taking a substantial markdown.

Paul added a third, and very important, consideration. He explained to Bob that when you purchase a property you become a landlord. And that entails all the headaches of property ownership. This is not a trivial issue. And the "costs" of the time you will have to spend renting out and managing the property should be factored into the net returns expected. He wanted Bob to be sure he understood that owning rental property means being in business for yourself-and having to deal with deadbeat tenants, plumbing problems on holidays, potential lawsuits and other assorted surprises. For most people, these are not pleasant issues with which to deal. Paul did point out that Bob could hire a property manager to deal with many of the issues. He quickly added that doing so would increase costs, thereby reducing returns, and it would not eliminate the headaches, only reduce them.

Paul went on to explain there was a fourth factor related to a psychological problem. He again pointed out the most common situation he saw was that someone was considering buying a local property. The issue is: Why is that property the best investment as opposed to properties in other geographic locations? Paul explained there were studies showing it was a very common error for individuals to believe something is a safer investment if they are familiar with it. For example, residents of Georgia own a disproportionate share of Coca-Cola (whose headquarters are in Atlanta) despite the fact that Coca-Cola clearly is not any safer an investment for residents of Georgia than it is for residents of any other state. And residents of St. Louis, also confusing the familiar with the safe, have owned disproportionate shares of Anheuser-Busch.

Paul added another point for Bob to consider-there is a significant difference between the stock market and the market for real estate. The equity market is highly efficient and highly liquid. Such markets prevent professional investors from exploiting less sophisticated investors because the price quoted is the one most likely to be the correct price. This is not anywhere near as true in the real estate market.

Paul explained there was yet a sixth factor to consider-a psychological problem common to investors known as recency. He explained that recency is the tendency to give too much weight to recent experience, while ignoring the lessons of long-term historical evidence. Investors subject to recency make the mistake of extrapolating the most recent past into the future-as if it is ordained that the recent trend will continue. And real estate had been a very hot asset class. For the seven years 2000-06, the Wilshire All REIT Index had returned 23 percent per year. These kinds of returns cause investors to think real estate investing is not risky.

Paul pointed out that it was not that long ago (in the 1980s) that there were many areas in the U.S. where property values collapsed and owners mailed in their keys to their mortgage lender because they had negative equity in their properties. He gave Bob another example of how risky real estate prices can be. After several decades of spectacular returns in 1990, Japanese real estate prices began a long and steady decline. It was only in 2005 that there were signs they may have finally stopped falling.

Paul concluded by recommending that since prudent investing is about taking only compensated risk, and the ownership of that single building would be taking uncompensated risk, Bob should not buy the property. However, he added that he did believe that including an allocation to real estate in Bob's overall investment plan was a good idea, as real estate was a good diversifier of risk. Paul recommended that Bob consider adjusting his investment policy statement to include an allocation of perhaps 5-10 percent to real estate. He recommended Bob look into the DFA, Vanguard and TIAA-CREF vehicles as the best choices to implement that strategy. Paul's final remarks were that before Bob made any changes to his current plan he should be sure he believed that including real estate in the portfolio was a good idea and that he was not making the mistake of recency.

Bob thanked him for all the good insights and advice, and also for preventing him from making a potentially costly error.

THE MORAL OF THE TALE Prudent investing is based on the principles of modern portfolio theory and prudent planning-the development of a carefully constructed investment plan. Having a well-developed plan helps prevent investment mistakes (Rational Investing in Irrational Times describes 52 such mistakes) such as recency, speculating on "interesting" investments and the taking of uncompensated risk.