When I was a child, my mother taught me all sorts of life lessons and wisdom. Phrases that stuck in my head to this day and make me—as an adult and a parent of adult children myself—appreciate the wisdom of age and experience every single time. As I grew up, I chose a professional path in capital markets and economics—areas my mother was quite disconnected from (though I did inherit the entrepreneurial spirit from her). But—and perhaps precisely because of that—one sentence she taught me when I was young, in an economic context, took root in my head: “There are three parameters you need to check when buying an apartment: Location, location, and location.” True, she didn’t invent it, but she introduced me to the concept.
Fast forward several decades, and I must say that when I look back at all the real estate deals, I have encountered (mostly other people’s, and a tiny bit of my own), I couldn’t agree more with that assessment. True, there are types of real estate that will adhere more to this statement, and types of transaction motivations that will align better with this logic, but by and large—as long as the goal of purchasing real estate is to make money over time, there is no parameter more important than location to influence that variable.
There is a reason why real estate that is distant (even slightly) from centers of employment, housing, tourism, or academia will be significantly cheaper than an identical real estate unit in the “center of the action.” And this reason is not going to change anytime soon: human nature. Humans are social animals, gathering and needing interpersonal connections and mutual support. Physical proximity to shared hubs is a value reflected in real estate prices. And of course, until further notice, humans get around on their own two feet. And after hundreds of meters, or yards, this walking becomes a chore rather than something trivial, and this chore also has a price (in time, cost, logistics, and planning).
Thus, real estate factors two additional parameters into its price, beyond the structure itself: the ability to meet other people with a common denominator similar to yours, and the lack of need for any transportation from place to place. This premium—this price addition—is the gap you will find between an apartment on La Rambla in Barcelona and an apartment only 7 minutes’ walk away.
Another thing I learned is that even two different streets, in the exact same area (meaning, without these proximity gaps), can produce a justified price gap between them. You know it, you go just around the corner, but it’s a completely different neighborhood, with problematic neighbors or crumbling infrastructure. Often, investors are tempted and buy that proximity, betting that the problematic street will “catch” the good data of the more expensive streets on the other side. It’s a bit like buying startup shares – it can profit, but statistically, it is unlikely to happen. And if it doesn’t happen, the price gap will continue to widen, and not only will the investor not profit from the closing gap, they will lose out relatively on the price appreciation of any other deal they could have made during that time.
When can such a deal be interesting? Again, like a startup: if you have additional information beyond the market. For example, there is an urban renewal plan for the problematic street that will improve its bad elements and allow it to be branded closer to the successful area on the other side. If you have information about such a plan, or better yet—the ability to influence it—just like in a startup where you understand better than others how and why it will break through and conquer market share, and maybe even assist it in doing so—then the price you pay is cheap relative to the potential, because you know how to price it better than others. And that is a successful deal, not just in real estate, but in general.
I want to comment on the calculation of property yield, which is done by both residential and commercial real estate investors of all kinds. Property yield is a simple calculation of how much you receive in annual rent (net, after expenses), divided by how much it cost. If I received a net annual income of $50,000 on an investment of $1,000,000, I have a yield of $50,000 divided by $1,000,000, which is 5%. This yield should be like an investment in a bond with equivalent risk. For example, a residential apartment in a good neighborhood with high demand and strong infrastructure will be like an investment in a bond of a stable government, or a very large and strong company. An office with a bad tenant in a remote commercial center should produce the yield of a low-rated bond, or one with no rating at all, of a company whose future is unclear.
This calculation, even though it is clear and immediate for professional investors, can be very misleading and dangerous for the small investor. I suggest not relying on it, certainly not exclusively, in considerations for choosing a property. The reason is that you don’t really have a clue. If you paid too much for the property, paradoxically, it would lower the yield on it (because you will receive the same rent, but you will calculate it based on a higher cost. Mathematically, it will simply give a lower yield in terms of yield). So not only did you buy at a premium, but you also now mistakenly think that the property you bought is safer because the yield on it is relatively low.
Another example of distortion is on the income side—you bought an office with an excellent tenant who signed a contract with the previous landlord at a market price that is too high relative to the current market (maybe they made a mistake and understood it in hindsight, maybe overall market prices dropped, maybe the condition of the office was better), and upon renewal, you won’t be able to get the same price. Now the yield formula changes completely, and not in your favor.
There are properties that trade in a certain yield environment (i.e., next to other properties) but offer a specifically higher yield. For example, in a neighborhood where real estate assets of a certain type are sold for $1M and rented for $50k a year, there will be a property offered for sale for $850k. That is the market’s way of telling you—higher yield, meaning a riskier property. Find that risk. But maybe, after searching well and understanding the risk, you will decide that it might pay off for you, and you will buy the property even though its yield signaled you to be careful.
Should you buy real estate for investment, or not?
Over the years I have learned to understand that, in the end, the best reason—and sometimes the only one—to allocate resources to purchasing real estate for investment is healthy leverage. What is meant by healthy leverage? Let’s start with leverage. Leverage is the ability to receive a loan from someone else to invest it and enjoy the profits yourself. If you invest in a brokerage account in the US, you can get leverage on every dollar you invest in the broker itself, to purchase stock in an amount that exceeds your own funds. This, of course, creates a greater opportunity to profit, along with a greater risk of losing the money you invested. Leveraging to invest in stocks is a move that doesn’t suit most investors, for two reasons. The first is that the average investor might be tempted by risky stocks, or by unwise allocation of funds (I bought a “meme stock” with everything because it went up hard). In such a case, leverage can wipe out equity very quickly during the strong declines that will come. The second reason is that sometimes we need the money—or part of it—at a surprising time, and that is precisely when the big losses can come, and “lock in” the loss. We won’t be able to get more leverage later to try to turn the wheel.
Healthy leverage, in my view, is investing someone else’s money in a less volatile, income-generating investment that is harder to sell (and therefore “fixed” in our minds as a long-term investment), where a small profit becomes a large profit over time, at low risk. We all know this real estate exercise, it is called “mortgage,” and it rewards people well who persist in purchasing real estate for investment with other people’s money.
True, real estate value can also drop, and the property may stand empty without rental income, and those are risks that need to be priced, and that is what brings me back to the beginning—location, location, location. Investing in a property in an excellent location will allow us to avoid the lack of a tenant for a long time—there will always be demand for rent, even if at a lower rent. Better a little less than absolute zero. In addition, central real estate has the property of losing less value in bad times and recovering first to good times.
In addition—and this in my eyes is the key to investing in leveraged real estate, and what differentiates the people who somehow just get rich from real estate from those who sometimes don’t have this “luck”—the best option is not to build (only or at all) on current income as a mortgage repayment, but to finance it from the current income. True, it’s not always simple, but anyone who uses all the rent to pay back the mortgage can find that in the case of a breakdown, they fall into debt (or a loan to pay the mortgage, which will always be at a higher interest rate than the mortgage itself, or a refinancing of a mortgage with higher debt), and over time may lose money as a result of huge interest expenses, or from being forced to sell the property at a loss.
The biggest success stories I have seen were of those who were smart enough to pay back loans from other income (say, a salary) and accumulate assets that over time “break free” from the mortgage. If there are such assets, new mortgages can be taken out and more assets bought, and so on—and this, friends, is what makes real estate investment worthwhile. The thing is, this move requires planning ahead, having less in present time (to cover the debt repayment), and a lot of patience. And those are much rarer ingredients for the average investor.
And a short reference to stock markets, which continued to rise this week too. Why? The short answer—because. The not-much-longer answer—I have already explained in previous reviews that the long-term trend of the markets is upward. This trend relies on strong economic foundations, and any disruption along the way is just a stop for a rest. As long as nothing “disturbs” the market, it will go on upwards.
See you in next week’s letter, or during the week—if I can’t help myself until then...