Fall 2014 3

Real Estate: A Commodity Worth Renting

by A. Scott White, CFP®, ChFC, CLU

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Someone recently told me that investors should think of real estate as an asset class on par with owning stock in a company. When I hear comments like this, I can understand why it is so difficult for the average person to make intelligent investment decisions, simply because of the sheer volume of misinformation that exists. I believe this misinformation is intentionally disseminated by our financial media—whose advertising support is provided by the very companies that would like to see you move your money from wherever it is now to what they are selling.

This distinction is important when you are trying to determine what an investment might be worth. If you are trying to place a value on a stock, you are trying to value its future profits. If you are trying to place a value on a bond, you are computing the value of the income stream you’ll receive, plus the amount you’ll get back at a maturity date.

But what about real estate? How would you value it as an investment? There are several ways you might try to place a value on real estate. First and foremost at the basis of most valuations is the value of the ground that is attached to the earth. And the value of dirt—like any other raw material or commodity—is based on what you suspect someone would pay for it in the future. To be fair, real estate is more complicated than other commodities because one must consider things like location, zoning, property taxes and demographic shifts. But at its essence, those are the factors that lead one to believe that the price would be more or less in the future. That anticipated change in price is the essence of the definition of speculation, not an investment.

The next aspect to consider in a valuation for real estate is the use of the dirt. Is the ground put in service in some manner that will produce an income stream? If so, then more careful examination of the income stream is warranted. If the income stream is derived from farming activity, producing commodities to be consumed, price will ultimately be determined by supply and demand. When supply of a commodity is short, prices go up, and higher prices provide the stimulus for more farmers to plant the commodity in short supply, typically to the point that the shortage fades and prices go back down. To guess when the supply points will have enough of an impact to cause prices to rise or fall should be left to the speculator’s game, not to the investor. After all, as soon as you think you may have it figured out, all you need is a drought or flood to make your predictions immaterial.

Or perhaps you want to build a building on the real estate to improve its value. This makes the real estate seem much less like a commodity. Buildings take two broad forms: you can build a house on your dirt for yourself or someone else to live in, or can build a building a business is willing to utilize for commerce. Let’s assume if you are building this building for someone else to live in, it might be valued in a similar manner that one might value use for any other commercial purpose.

How do you value a house that you will live in as your residence? Some people believe that your house is an investment, but I disagree, because no matter how much your home appreciates in price, you still need a place to live. So the only way you can “cash out” your investment is to sell your home and buy a smaller home, or one that costs less. And no matter how good your intentions are, in my experience that rarely happens. People may buy a smaller home after the kids leave, but often this seems to be a nicer home in a nicer neighborhood, and hence no investment value is realized from the original home’s purchase. But assume you are one of the rare ones and do buy a smaller, less expensive house later in life. What assurance do you have that a lot of other people aren’t trying to do the same thing you are at the same time?

In the United States there are 76.4 million baby boomers—people who were born between 1946 and 1964.1 Whatever this group does as a whole has dramatic consequences for everyone else in the country because of the sheer number of people in this age group.

Most people typically can afford and want to buy their largest home in their late 40s or early 50s while their children are still at home. And people may be looking to downsize their home as they reach their late 60s and early 70s. In other words, now they are ready to “cash out” when they enter retirement after their children have moved away.

USPopulationChart

According to the graph to the right, in 2008 there were approximately 4.25 million 50-year-old people in the U.S.2 By 2030, estimates show there might be slightly fewer, or about 4 million, 50-year-old people. To determine the age group of those potentially going to “cash out” their home, in 2008 there were about 2 million 70-year-old people. By 2030 that group is estimated to double to 4 million people. So the number of people most able to purchase a nice, large home stays the same, while the number of people potentially looking to sell their nice, large home doubles. That investment strategy does not seem to make sense.

Perhaps the structure built on your dirt would have commercial value so the building could generate income. In the simplest analysis, you could analyze the potential income stream you will receive in rent payments in the coming years and place a value on that amount, much like a bond investment is valued. However, there are differences in valuing a bond’s income stream and a real estate income stream. Bonds have a maturity date when principal is returned, but real estate does not. Bonds have a credit rating based on the credit worthiness of the issuer. A real estate income stream would logically have a credit rating equal to the credit worthiness of the entities paying rent, unless the building suffers a defect that voids a lease. And therein is a dilemma. How do you do a credit analysis on all your tenants? What is their ability to pay rent during an economic crisis?

In my mind, an investment is like a garden in which you plant seeds, nurture over time and harvest the fruits of your labor in a predictable fashion. That’s the way I search out investment opportunities in some of the world’s most profitable companies, try not to over pay to own their stock, realizing that over time the profits these companies can generate will have a high probability of pushing stock prices to higher levels.

We should never confuse real estate as being on par with a common stock. Real estate cannot pull off a hostile takeover of another piece of real estate, take market share away from another piece of real estate, or create the goods and services that people will pay a premium for like a well-run company can. And whether a stock trades on a stock market or its goods trade on the black market, it is simply hard to imagine anything on this planet that is more valuable than the value of the stock going higher over time as it produces more goods and services each year at a profit. So regardless of real estate’s true investment worth, let’s call real estate what it is – an alternative to stocks or bonds – similar to commodities, hedge funds, currencies, and other alternatives.

1 Kelvin Pollard and Paola Scommegna, April 2014 update of a 2002 article by John Haaga, former director of U.S. Programs at Population Reference Bureau.

2 Created by Mark Schill, Praxis Strategy Group, August 25, 2008.

The information contained in this report does not purport to be a complete description of the securities markets or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing materials are accurate and complete. Any opinions are those of Scott White Advisors and not necessarily those of RJFS or Raymond James. Expressions of opinion are as of this date subject to change without notice. Past performance may not be indicative of future results. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Strategies discussed may not be suitable for all investors. Investing involves risk and investors may incur a profit or loss regardless of strategy selected. Diversification does not ensure a profit or guarantee against a loss. Commodities and currencies investing are generally considered speculative because of the significant potential for investment loss.Their markets are likely to be volatile and there may be sharp price fluctuations even during periods when prices overall are rising.