Do you need to invest in real estate for a diversified portfolio? If so, what kind of real estate do you need to buy? And how should you own it: directly, through a Real Estate Investment Trust (REIT), or via a broad market index?
Also, is your house just a home, or is it an investment? How do you know the difference? And how does the answer affect your other investments?
Having recently sold our home, I’ve been face-to-face with these real estate questions once again. I thought I had answered them long ago when I was first making asset allocation decisions for our investment portfolio. But selling our house has resulted in a 6-digit sum of cash sitting on the sidelines waiting to be invested. And these same old real estate questions came around again, looking for answers….
The Stock Advice
Many investing experts recommend having at least a portion of your stock portfolio in real estate because, historically, it has not been strongly correlated to stock market movements. When stocks are up, real estate has been down. And when stocks are down, real estate has been up. One study reported that stocks and REITs move in tandem only 7.1% of the time.
REITs are one of only two sectors that respected observer William Bernstein recommends in The Four Pillars of Investing. He thinks their historical and expected returns are “probably comparable to the market’s,” but observes that they tend to move differently than the stock market.
So how much should you have in real estate? There is no set answer. Bernstein recommends a maximum real estate exposure of 15% of your allocation to stocks. Others make similar recommendations. And that was the allocation that I targeted for the past decade and a half.
Home equity is the most significant asset for many U.S. households, making up about 67% of assets for the middle class. So, is your home a real estate investment? Should you count it towards your allocation to real estate?
Again, there is no right answer, but, for what it’s worth, I never really viewed our home as an investment. Because of our savings rate, we were fortunate enough to build investment assets aside from the equity in our home. Instead, I targeted 15% of my stock allocation to real-estate specific funds. I simply viewed our home equity as our allocation to shelter. That money was earmarked either for home ownership or for producing a long-term income stream that would pay for rent. I didn’t treat it as part of our investment portfolio.
The Rate of Return on our Home
Even though I didn’t view our home as an investment, on the surface it appeared to be a good one. We were in it for more than 16 years, including the recent real estate downturn during the Great Recession. But our state was spared most of the overbuilding and subsequent plunge in prices that plagued other areas. Our city was graced with a major new employer. And our geographically-constrained neighborhood remained one of the most sought-after in the city. Not only did our house hold its value, but as described in my earlier article, it grew substantially from our initial purchase price.
Here are the details: We paid $137,000 for our house in late 1996 and sold it for $245,000 in mid-2013, just last month. It appears we came close to doubling our money! Sounds pretty good. But when you run the numbers, that turns out to be only about a 3.6% annual return over the 16-1/2 years we owned the house. Not terrible, especially given the wild gyrations in the stock market and ultra-low interest rates experienced during portions of that period. But still nothing great. It would be tough to fund an extended retirement based on a 3.6% nominal (not inflation adjusted) return.
But wait, on closer inspection, the performance gets worse! That calculation ignores the substantial capital improvements to our property over the years. Though we have never had much interest in home renovation or keeping up with the Joneses, over the course of 16+ years we inevitably added to the value of our property. Things broke and we upgraded. Our lifestyle changed as our son grew up, and we modified the house accordingly. And there was a flurry of activity in the last few years of residence, as we made repairs and improvements with an eye to selling the house. Major improvements during our time there included a new alarm system, new roof, new windows, new tool shed, all new kitchen appliances, renovated bathrooms, new carpet, closing off an additional room, renovated kitchen, landscaping, and a new garage door.
How much did this all cost? Well, being a dedicated Quicken user, I have the numbers at my fingertips. The quick answer is about $37,000. However there is room for debate over how I categorized various things. Certain items are “maintenance” — necessary to preserve the existing value of the house. Other items are “improvements” — which increase the value of the house. So, looking over all of our house-related transactions, on the low end I’d say we made at least $30,000 of capital improvements during our tenure, and on the high end, possibly as much as $50,000. So approximately 30% to 50% of the “growth” in our property wasn’t really growth at all, but was just our additional capital investment.
To ignore those expenditures in computing our investment return would be to make a classic mistake, overlooking the money added to an investment account in computing its returns. But, once you know the amount, you can account for it easily enough using the relatively simple formula from Bernstein that I covered in my previous article on Computing Your Overall Investment Return.
Once I run those numbers, our return on the house was actually only about 2.5% on the high side, or about 1.9% on the low side. By comparison, according to the Bureau of Labor Statistics, inflation over the time we were in the house ran at about 2.4%. So, at best, we barely outran inflation!
Was our house a good investment then? Even though, at first glance, we nearly doubled our money, when you take a hard look at how much we invested in the property, plus the rate at which assets inflated during the period, we received essentially no growth from our investment. At best we got our money back. Yet, given what happened to so many others, we are grateful enough for that!
Our experience confirms an emerging consensus on real estate: in general, it probably won’t do better than keep up with inflation over the long run. A MarketWatch article last year opined that “Houses are ordinary consumable goods: wood, stone and metal bound together through labor. There’s no reason to believe they should enjoy a special rate of return distinct from those for, say, apples and shoes.”
Does this poor investment return mean our home ownership was a mistake? I don’t think so. We were fortunate to have other investments that grew nicely during that period. And our home provided safe and comfortable shelter for our family as we raised our son. We have many happy memories from those years. It’s possible we could have enjoyed a similar experience in a rental somewhere else, but that wasn’t the route we travelled. The house served its purpose well. It just wasn’t an investment.
My advice: evaluate your house on the basis of how well it serves your needs as a home. But don’t consider it, in any way, a substitute for investing. And definitely don’t confuse throwing money at home improvements with true investing for income and growth. In our experience, the returns on home improvements are negligible.
My Real Estate Value Holding
So if our home didn’t represent my actual real estate investment for the last 16+ years, what did? Well, for much of that period I’ve held the Third Avenue Real Estate Value Fund (symbol TAREX).
Third Avenue Real Estate Value is not my average holding: it’s an actively managed fund from the firm of legendary value investor Marty Whitman. Third Avenue defines value stocks as those from companies with a strong financial position, selling at a discount from Net Asset Value (NAV), with reliable financial statements and markets (generally meaning the developed world), and good prospects for dividends and growth in NAV.
TAREX has traditionally held REITs but frequently diversifies into private equity and distressed positions. In recent years it has made strong forays into international real estate, currently holding only about 40% in the U.S. As I write this, it is holding nearly 18% in cash, to take advantage of buying opportunities. It’s an eclectic fund for experienced investors.
TAREX performed poorly for many years but, as is usually the case with value investing, patience has its reward. Since its inception in 1998, the fund has returned about 11.5% annually. Stellar by any standard. How did the fund managers achieve that in an era where our own residential real estate barely kept up with inflation? It was classic value investing: buying assets on sale at distressed prices and letting them rise to full value over time.
As described in my Full Disclosure, I wouldn’t generally recommend TAREX. As an actively managed fund with an expense ratio of over 1% there are less expensive and equally effective choices for investing in real estate. TAREX is a holdover from my early days of investing — decidedly not my current preferred passive index approach. And yet I don’t sell it because I’m also a buy-and-hold investor, and there has been no compelling reason to do so. I still agree with the underlying philosophy being executed by the fund’s management. And, over time, it has indeed performed well enough to outweigh its high expenses.
I got into TAREX with a very long-term perspective and did well, but it’s not the approach I would generally recommend or take nowadays. Unless you’re a very experienced, patient investor with a long time horizon there is a good chance of getting burned.
A Modern Alternative
If an actively managed value fund like Third Avenue is not a good general choice for investing in real estate, what is? My blogging friend James Collins writes frequently about using Vanguard’s REIT Index Fund (VGSIX) as part of a simple passive index portfolio. He points out that REITs typically provide an inflation hedge as well as dividend income, though prices can drop during periods of deflation.
If you want one-stop shopping for real estate investment, you could do much worse than this Vanguard fund. Still, it’s good to understand what you’re getting. The traditional argument for investing in real estate, especially REITs, is that they are not strongly correlated to the stock market. Yet that truism could be changing, or may not hold over certain periods. Going to Yahoo Finance and doing a simple comparison graph of VGSIX vs. the Dow Jones Industrial Average over the last 5 years shows the two moving in virtual lockstep. The performance is not identical (the Dow beat REITs by more than 10% over that period), but the direction of the price movements appears highly correlated.
Also, don’t believe that a REIT fund is a drop-in substitute for home ownership. If you look at the holdings for VGSIX, for example, they are only about 17% residential REITs. (And those are likely apartment complexes.) The balance of the fund is commercial real estate — industrial, office, and retail properties. And commercial real estate does not necessarily perform like residential real estate. One source puts the correlation at only about 30%.
Lastly, do you really need to buy a specialized real estate fund if you already own a broad market index fund? Doesn’t it stand to reason that a broad index already includes a certain percent of REITs or real estate related stocks? Unfortunately, that’s a tricky question to answer. I’ve yet to find a reliable statistic. One problem is that many real estate operations are lumped along with the “financial” sector in portfolio statistics. Another problem is that many companies, from banks to large retail chains, hold substantial real estate assets, yet are not normally classified as real estate investments.
Putting Our New Cash to Work
So, if I have a legacy real estate holding, and I’m not sure another dedicated real estate fund — even a passive index one — is warranted, given that a broad index already includes some real estate, where should I put my “real estate” money now? Specifically, how should I invest the money that resulted from the recent sale of our house?
I put that question to two trusted financial friends, shortly before we closed on the house. Their advice: if I didn’t view my house as a real estate investment, then I shouldn’t put the proceeds into real estate. I should simply maintain my existing asset allocation.
And that’s what I did.
My go-to investment for many years has been Vanguard Wellesley Income (VWINX), a balanced fund. It’s a conservatively invested mixture of roughly 40% stocks and 60% bonds, with a many-decades-long track record of producing decent returns in good times and bad.
Wellesley has been my default choice when I didn’t have better ideas, which is usually. As described in my guest post for Oblivious Investor, I love this fund and have no regrets about the money I’ve put into it over the years. Nevertheless, as I consider what to do with new money, it suffers from at least three drawbacks:
- It’s actively managed. Even though the expense ratio is extremely low, and competitive with passive index funds, I cringe when I have to read in the semiannual report about the manager’s attempts at stock picking. I think that’s a waste of their time and my money.
- It has very little international exposure. This makes it less than ideal as a one-size-fits-all investment.
- We are approaching 30% of our investment assets in this single fund. Even with all the diversification and all the safeguards in place, my alarm bells start to go off when that much wealth is concentrated in a single fund.
So, given all the above considerations, what did we do? Last week, we moved about half the proceeds from our house sale into Vanguard’s LifeStrategy Moderate Growth Fund (VSMGX), which addresses every one of the concerns above. VSMGX is a fund of other passively-managed index funds. It is invested about 25% internationally — both stocks and bonds. And its management is distinct from Wellesley Income, though still under the Vanguard umbrella.
Though this particular LifeStrategy fund is 60% stocks — a little higher than my target allocation has been, I was comfortable with taking on a bit more in stocks right now, given the current prospects for higher interest rates and falling bond prices.
Though I can’t say for certain just yet, it is very likely that the balance of our house money will follow suit into VSMGX shortly….
Rental Real Estate
There is one last, very compelling, way to invest in real estate: rental property.
Since recorded history, people have owned property and rented out rooms, apartments, and houses. If you have some seed money, time, and the right skill set — for maintenance and management — then rental real estate could be a good investment for you. Just keep in mind that it’s as much a business as an investment. The drain on your free time and financial resources — for repairs, taxes, insurance and so on — can be considerable.
But the potential for steady income is appealing. Many people from all backgrounds have successfully built their financial independence using rental property as the vehicle. Before you make the leap, just be certain that you enjoy houses — building, buying, and maintaining them. Also be prepared to carefully qualify your tenants, and then deal with the difficult ones that slip through anyway.
So that’s my past and present experience with investing in real estate. I’ve done OK, but there is so much more that could be said by those with different experience:
- Have you owned and managed rental real estate as an investment? How has it worked out: What did you buy, how much work was it overall, and what kind of return did you get?
- If you are primarily a stock market investor, do you think real estate is an important diversifier for your other investments? If so, how much do you hold? What is your preferred way to invest in real estate? How long have you held it and how has it performed for you?
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