Jan 2023
“Human nature will not flourish, any more than a potato, if it be planted and replanted, for too long a series of generations, in the same worn-out soil. My children have had other birthplaces, and so far as their fortunes may be within my control, shall strike their roots into unaccustomed earth.”
– Nathaniel Hawthorne
“Do the difficult things while they are easy and do the great things while they are small. A journey of a thousand miles must begin with a single step.”
– Lao Tzu
I’m often asked why I like real estate better than any other asset class like equities, bonds, crypto, startup shares etc. Beyond that I think the returns are better, every time I’m asked this question I think about it a little bit more and develop the answer further and I finally think I’ve got something comprehensive that is a good answer. Property doesn’t work for everyone but this is why I like it.
Leveraged Consistent Returns
Borrowing money to invest is the best way to get a better return in any asset class you invest in because the borrowed money amplifies the return of the money you originally put into the deal. This is why it is called leverage because of the cantilever affect of raising your returns artificially by using money that isn’t yours. This increases the risk but also the reward.
The way leverage works in real estate is you borrow money against the equity of a property at an interest rate. The interest rate is the cost of capital to borrow. Then you invest the whole amount. Usually you’ll invest 10% – 20% of your own money as a deposit and borrow the remaining 80% – 90% of the money to close the deal and buy the property.
When you borrow money it’s kind of like renting money from someone and the interest rate is the rent you pay on the money. But borrowing money, apart from the obligation that you have to pay it back is kind of like creating money out of thin air. If you then use it to invest in an asset that grows in value, it’s like taking money you didn’t have to create more money that you didn’t have.
When it goes right, this is just about the easiest way to get ahead in life because it skips the part when you have to save this amount of money. But be careful because if it goes wrong, you will owe the bank money that you don’t have. This is a recipe to wreck your life so if you’re going to borrow money, make really really sure that you’re not wrong.
In Australia, the return in property generally looks like a 2% – 4% rental yield and 2% – 4% growth of the property for a 4% – 8% total return per year. But the long term average return in many capital cities in Australia is closer to the 8% gross return per year so we’ll use that. Sometimes the yield is higher and growth is lower and sometimes the growth is higher and the yield is lower but that’s about an average gross return per year. Generally CBD apartments have high yield and low growth and suburban houses have high growth but low yield.
But because you’re using leverage to buy it, with a 10% deposit and 90% borrowed money, a 8% gross return per year is actually a 80% return per year on the 10% deposit that you invested. That’s called a cash on cash return and is outrageously good when you consider that long term index fund equities returns are about 8% – 10% per year.
This is all compounding growth as well. So the return is better per year. It just front loads the returns at the time of purchase. But you then need to subtract the interest rate from your returns because that’s what the bank charges you to borrow money. If the interest rate is 4% per year, then your 8% gross return is actually a 4% gross return.
With a 10% deposit and 90% borrowed money, a 4% gross return per year is actually a 40% return per year on the 10% deposit that you invested. Both of these numbers are still exceptionally good because it is a repeatable rate of return every year. Some properties you can even get more than an 8% return on.
Leverage is easy to get in property because there is a core asset that you mortgage to the bank to borrow against. Banks don’t like lending against most other assets except for property because they’re too volatile. So you can’t get access to a large quantum of borrowed money from a bank as easily in anything except for property.
These leveraged returns also go in reverse too and is why leverage can be especially dangerous. If you have 10% and you borrow 90% and the market goes down by 10%, you’ve lost all your money basically. But the volatility you expect in property is very low.
There’s only half a dozen times in all of history where Australian property values have gone down by 10% or more in a year. Whereas equities will often go down by more than 10% at a given time every year. This is called volatility.
Low Volatility and Supply VS Demand
In just about every asset except for property, there is a ton of volatility where the value of the assets fluctuate wildly up or down in a given year because of factors outside of your control. A stock can change in price per day for reasons that seemingly have nothing to do with anything. A key executive quit and bang, the stock loses 20% in value that day. The swings up or down are much higher.
This generally doesn’t exist in property. In property markets will track the fundamentals at all times because it’s a physical space that people will physically live in. This means that prices will be higher wherever people want to be living. If an area is desirable and people want to live there, the prices of real estate in that area will be stable and grow. If people don’t want to live there and leave, prices won’t be.
This is why New York is more expensive than Newcastle. Because more people want to live in New York than they do in Newcastle. If people don’t want to live in an area then the property values there become unstable.
For example a lot of people have been completely ruined by investing in mining towns and other areas that have transient populations or temporary residents. Where demand is really high one minute only to disappear the next. But generally the gains and losses are within a tighter band of predictability than other asset classes because the asset is less volatile. This helps you plan your life better.
I find that you can read property markets in a way you can’t read the market for anything else. Because the story of property is the story of people. People who are optimistic and believed the future would be better invested their life savings to put up these forever structures that they’d live in. I like it as an asset class because there is an inherent belief in optimism. You have to believe in people to believe in property because the values follow the story of people.
Another way of saying this is Supply and Demand. The Supply is houses. The Demand is people. Where there is not enough houses but lots of people wanting to live, prices will follow. But people make living decisions very slowly so you can see the changes in living through the changes in population, immigration, demography and society. As well as the physical space that exists and finance available for people to dream and build what they want. The 3 big gears turning are population growth, housing supply and finance availability. Reading those 3 things tell you everything.
Maybe it’s because I’m the son of an immigrant family that lost everything but there’s something that really resonates with me about that. Immigrants and families settling in new places; kids being born and families being created, people working hard and getting wealthier and upgrading their quality of life are all the core drivers of property wealth. People optimistically dreaming that the future will be better than the present drives individual real estate decisions and creates the market.
Idiot Proof Wealth Building
Despite what most people think about me, I’m actually pretty bad with money. Any time I have any excess funds in my bank account, my wife and I will usually spend it. It means we’re very good for the economy but very bad savers. I don’t think we’re particularly atypical in that sense, I think a lot of people are bad at saving money.
But that is why I particularly like property. Because when you borrow money the bank sets a repayment schedule on the loan. Repaying a loan is actually the same thing as saving money, the money just then exists in the equity in the property. All you have to do is make your payments each month and this forces you to save money. Each payment puts aside a big chunk of money into savings.
This is different to say investing the same amount each month in an index fund. Because I don’t know many people who have the discipline to both save lots of money and also the discipline to invest in steadily and consistently every month. But even then that person will do less well because of the lack of leverage. But with a bank loan, you have to make the payment each month or you get in a lot of trouble and the bank comes and takes your house.
This is really useful because it runs in the background of your life and you don’t need to actively think about it or do anything. In that sense it’s wealth creation for idiots. You just make your monthly payment and that forces you to save and not do dumb things with the money. Years go by and you turn around one day and there is hundreds of thousands of dollars in equity that has built up and is sitting there in the house.
Having the capital in bricks and mortar gets it out of our hands where we can spend it. This also as a byproduct means you’re less able to be scammed and attacked. Lots of people are randomly scammed out of all their money because they have it liquid or in something they can sell quickly like stocks. We physically can’t be because the wealth exists in equity in physical spaces. It’s then a huge process of refinancing to get that equity out of it. That effort barrier prevents you from making rash and bad decisions.
But just because the money is in the house doesn’t mean it’s gone, the equity built up in a house is able to be accessed and used again. If you save money and pay off a $200k house, that means you have $200k in equity in the home that the bank can lend you against the home value and is called an equity release. This can sometimes turn into a snowball where a person owns a house and pays it off then uses the equity from that house to buy their next house without selling the old house.
But here’s the secret weapon, the property is also growing. If the value of the house grows to $400k it’s the same thing as having $400k in savings in home equity that can be released into cash if you need it. This is how a home can turn into a cash machine. Sometimes the growth of a home per year can be more than the people living in the home can save. It’s like the home is a secret extra person in a family earning and saving money for you.
Because the other secret is that this growth is after tax. So to save that much money in income, you’d have to earn the same amount plus whatever tax you’d owe the government to be left with that difference. If a property grows from $200k to $400k, it’s the equivalent of having saved $200k from your income. But to save $200k from your income might mean earning closer to $300k in income because the tax might be 33% and the government takes 1/3rd of it.
The growth of the asset is after tax and is tax free each year while it’s growing. You only pay the tax when you sell the property. Paying tax each year vs once at the end makes a huge difference to the growth of an asset. It’s something of a super power especially when you layer on the ability to be able to release the equity from a property and also investing using a large amount of leverage.
This is something that can be done in real estate but no other asset class has that ability. At least not for people at the lower end of the pool. Wealthy business people dealing in millions of dollars get different banking rules than regular people. For a regular person if you have built a business worth $200k, a bank isn’t going to release the equity in the business and convert that to cash for you. But it will for a property. The reason is because property is a real thing.
Fundamentally a business or a company is just a concept, it doesn’t actually exist. It’s the word we give to a relationship or a group of people getting together to work on a goal; it’s not real in the same way. But a house is a physical real thing. That’s the banks rule and is why they lend against houses but not against a company or business. Because a house is real but a company isn’t. You can’t touch a business.
This is the biggest frustration to every business person I know. They have built so much value and equity in their business but they can’t access any of it as cash without selling parts of the business. The only capital available to them comes from the cashflows of the company so they can be very wealthy on paper but have pretty bad liquidity. Especially considering the income gets taxed first before they get it. Whereas borrowing against home equity isn’t taxed because officially it isn’t income, it’s debt. It has to be paid back.
Predictable Life and Cashflow Snowball
Leases are usually locked in for 12 months at a time and interest rates don’t change very frequently, usually a few times a year. Loans terms are often locked in for anywhere from 3 years – 30 years. This means there is usually predictable cashflow, you always know what the incomings and outgoings are going to be, often a year or more in advance. This makes planning for the future really easy and straightforward. You know most of what’s going to happen to you.
Conversely, my dad had a friend who was a big equities investor. He had a diversified portfolio of index funds which is just about the safest thing you can own in stocks. He was nearing retirement when the 2008 GFC happened and his portfolio lost almost 1/3rd of his money. Suddenly his whole life plan changed and he couldn’t retire anymore and he kept working for another 5 years before retiring again where he could draw down on his equities investment. His life is less predictable because the equities generally don’t have any cashflow coming in from it.
One of the big benefits of property is the rent that tenants pay. This provides consistent cashflow and income. If you can build a big enough property portfolio then you’ll have a lot of sources of cashflow that is coming in. I’ve always imagined this as having little cash machines that are working hard for you to bring in money so that you don’t have to work as hard. Every additional property is another cash machine and it all creates a big cashflow snowball that both compounds in equity over time but is also giving you compounding monthly cashflow per month as it’s doing so.
But this snowball can literally run forever. Every additional property adds X amount of extra monthly cashflow. You just keep adding them and the cashflow keeps building. This completely detaches your labour from your capital where you don’t have to work very hard to build up large income streams and equity bases. You need to make very good decisions and think clearly, not output large units of labour. Making good decisions is something I think is within my circle of competence while working very hard I would say isn’t.
Concentration of Decisions
In property there’s a natural limit to how much money you can borrow because at some point the banks will stop lending to you. This means there’s a natural limit to how many deals you can do and decisions you can make. This makes it so you might go your whole career while only making a couple of big property decisions in your whole life.
This means you have to be right every time. Because you just can’t afford to make a bad decision if you’re only going to make a few decisions in your lifetime. That means spending the effort and time to think about and research everything more thoroughly. So you think a lot about a property before you invest in it. In practice, this means saying no to 99% of the things you see and yes to something only 1% of the time. You don’t have to do anything in the meantime.
Which means you’re only swinging at the ball when it’s in your sweet spot and you think you can hit a home run. You’re not even bothering swinging every other time. If you’re someone who prides themselves on making good decisions, then this is a good thing. It means you only do a deal when it’s amazing and you can wait around for years until the next amazing deal comes around. You literally can do nothing else the rest of the time.
Because of this effect I think it’s an achievable path to wealth for everybody. You don’t need to be a genius to do it or need to do anything fancy or complicated or have superior knowledge. You can make 1 or 2 good decisions in your whole life by just buying a property that you think is nice and you’d like to live in and end up a millionaire someday. It doesn’t even have to be a particularly excellent property, just an average one in a lot of Australian suburbs. I think that is just about the lowest risk you can find in the world.
Anxiety Alleviating and Irrational Markets
Something that used to cause me a lot of anxiety when I owned shares was that the number used to change thousands of times a day and every time it changed, it represented me having made or lost money. It was intoxicating and I could never quite get that changing number out of my head. I used to think about it and check it every day and became completely obsessed with watching those shares numbers change.
This was becoming very unhealthy and bad for my mental health. I would feel happier because a random number went up and I would feel sad because a random number went down. But the worst part is I had no idea why the numbers would change each day because they were being effected by things well outside of my control. I wasn’t able to influence at all how much money I was making and this made me feel very powerless and I didn’t like it.
Property on the other hand makes me feel like I’m in the drivers seat. If you buy a new couch for an apartment and paint the walls, you can charge $50 per week more in rent and that materially changes the return you are getting. So by putting in work, you’re able to affect the outcome of the returns you’re getting.
You can see first hand the impact that you can have. In that sense I think every property investor is an activist investor. Because you feel like you can be active in influencing the value that materialises from your investments. You have the ability to materially improve the value of your holdings through your own effort and decisions.
But because of that value materialising affect, it also means people are willing to pay for intangible things. You can’t live in a share certificate. You can’t make memories in a crypto token. You can’t fall in love in a cap table. So in that sense it is a very emotional thing. You can live in property and see and feel it the way you can’t with other asset classes because it’s a physical space that people will live in.
This causes people to fall in love with it because most people don’t think about it as an asset class, they think about it as their home. Which means they’re willing to pay a lot for it and also means you can do things to create value. It’s the movie stereotype of children never wanting to sell the family home because it’s where their memories are even if it might be the best decision that nets their parents millions of dollars.
This irrationality to the market displays in lots of other ways too. If you’ve ever been to an auction, you know how people can get very emotional and start making emotional financial decisions. If you’re selling at that auction, you can benefit from those emotional decisions. As a buyer, sometimes the seller is going bankrupt or getting divorced or just plain is scared and is willing to accept lower prices than you think their property may be worth.
I like operating in an irrational market. Efficient markets make me feel like I have no control and like I need to be smarter than I am. But in irrational markets you just need to make something that people fall in love with and are willing to pay more for. You win by being likeable and having the better product not by being clever or smart. You can also win by just getting lucky in a way you can’t with anything else.
Sometimes unforeseeable things like rain or how hot or cold a day it is can influence everything about what happens in a deal. You can just dumb luck your way to super profits. I once went to an auction where it rained on the day so nobody came to it and as a result it sold for 20% less than what the owner wanted. I’ve been to auctions that were held on the same day as a sports Grand Final and so nobody came to the auction.
I’ve seen people petition councils for rezoning resulting in value uplifts of 50%+. I’ve seen sales campaigns run on sunny perfect day that resulted in hundreds of people showing up and outbidding each other to sell for millions over the asking price. I like operating in a field where you can manufacture luck in your favour by being prepared to go the extra mile. By standing out in the rain at an auction. By petitioning councils for changes they don’t want to give. I like being able to make luck by being resilient and persistent.
Low Competition and Timing
The realm of people you’re competing with is so small sometimes that over a given deal it may be just 1 other party, sometimes nobody at all except for you and the buyer or seller. If I have to compete with thousands of other people over a stock as happens in the stock market, I don’t think I can do that and come out ahead. But put me in a one on negotiation with a buyer or seller and I think I can win almost any day of the week.
One of the big reasons there is sometimes such little competition is because of how specific a thing it is, it is a physical space in the world and the world is a big place. The realm of people that are even interested in the same slice of the world that you are is rare to begin with. Of all the capital in the world, the person has to want this particular house in this particular part of the world at the exact same time as you. When they have the whole rest of the world to pick from instead.
Another reason is timing. You can self select away the competition by picking low competition areas or low competition times. So you can really time the market in real estate in a way that you can’t in any other asset class. Because the market moves so slowly and you have direct influence on your deal. You can buy a property and negotiate a 30 day settlement or a 300 day settlement. Creating timing windows that are good for you. Sometimes people get nervous and don’t want to invest their life savings during elections or periods of uncertainty when the economy is bad. So if you’re active then, you’ve effectively cut out all your competitors.
A really common property development strategy people use to do with timing is negotiating an option on the land or a clause where they can pull out of the deal if they can’t get their permits approved. So they say a 3 month settlement with the option to terminate if council rejects their proposal. They spend 3 months filing the documents, then if they get approved, they buy. These are just things you can’t do with other assets.
High Barriers to Entry
Property has high capital requirements to enter. You need to have at least 10% of the property value to get a loan and have a high income for a bank to lend to you. This removes most of society and randomness from the process since it means having the capacity to get over a threshold of capital to even contemplate entering the market. It creates a lag, a person may decide they want to buy a property, from that point years may go by before they have saved enough money to get a loan for it.
So it takes a long time to enter the market but a short time to exit the market. Because of the same affect where people make a few purchases in their lifetime, it means once a person purchases they then often leave the market altogether and aren’t back for many years. Whereas in equities a trader may make hundreds of buy or sell decisions a day. They just about never leave the market. So the amount of competition is always growing, never decreasing in equities.
But after a family buys their family home, they’re not going to buy another one for maybe a few decades. So there is this self knocking out effect of people leaving the market. Eventually sometimes the market just runs out of people altogether who have enough money or borrowing power to buy a property so if you show up with any money at all, then there’s nobody except you that they can sell to.
Macro Risk Minimisation
When you have a lot of cash it can sometimes make you a target. You’re more susceptible and able to be scammed or stolen from because digital attacks are a real thing. Scams, hackers, identity theft, all these things are just the wrong click of an email away and if someone is able to get access to your bank details, then you’re totally screwed. But when you keep all your funds in a house, it’s very difficult to steal it because it’s a big physical thing with lots of checks and balances to move. But there are no such checks and balances when you transfer large sums of money.
There’s also the risk that comes from the bank itself. In the United States since 2000 there have been 563 bank failures, the most famous recent example of which being in 2008 when Bear Stearns and Lehman Brothers collapsed. That’s about 25 bank collapses per year which makes the cash in the bank itself susceptible to being lost.
Something most people don’t realise is if you deposit a dollar in your bank account. Do you legally own that money? Or do you have a legal contract with the bank that they’ll give you back that money? The answer is that the moment of deposit, the funds become the property of the depository bank.
Thus, as a depositor, you are in essence a creditor of the bank. Once the bank accepts your deposit, it agrees to refund the same amount, or any part thereof, on demand. If the bank collapses you may not actually get your money back. Governments in the western world generally insure bank accounts upto $250,000 but any more than that is sometimes gone for good.
But this isn’t unique to banks. It’s common for share market brokers, exchanges, insurance companies, pooled funds, and any kind of financial institution to collapse, leaving millions of people who had all their capital stored in their accounts unable to access them anymore. In the crypto world it’s almost comical how often these brokerage or exchanges or wallet companies go under.
Businesses too can randomly go bankrupt because of macroeconomic factors or you can have catastrophic business falls. Recently in the stock market most of the top tech companies lost 80% – 90% of their value. The same companies that are posting record growth rates. Which sounds ridiculous but that isn’t even the first time this has happened. Every 10 – 20 years or so this happens. Whereas in property a decline of that magnitude is incredibly rare, like every 50 years or so.
The reason that doesn’t really happen in property because there’s a minimum floor of value which is the replacement value. It always costs at least the land value and the cost of materials to replace the house. So whatever that number is you almost can’t lose more than that amount. Whereas businesses are inherently fragile in value. Real estate insulates you from this sort of risk.
The type of risk that comes from large institutions and is completely out of your control. It’s a big institution making a mistake and going under but you taking the brunt of the losses. Anytime someone else is holding your money, be it a brokerage or a bank account, you don’t really have control of it anymore. But a house with a title that’s yours is something that is hard to lose when it’s paid off.
Big Markets, Unconventional Wisdom
Because the market is so big in property, it’s more forgiving to people who don’t know what they’re doing. I like that a lot. This is why conventional business wisdom is to operate in big markets. It reduces errors and increases luck. The bigger the market, the more money there is to capture and the luckier you can get. The bigger the pie, the bigger any individual slice of it can be.
This is why I like Australian property, despite the small population, it’s a $10 trillion dollar market. It’s easy to get lucky in a market that big but also your mistakes are easier to be forgiven. Just in a place like Sydney and Melbourne, within a 30 minute drive, you can see trillions of dollars worth of real estate. The market is so big and so concentrated that it actually becomes easier to operate in it.
It also makes the wisom and lessons unconventional to learn. The momentum of the market helps you. For example a lot of people think real estate markets work the same way as share markets. So they bring ideas that are correct in that market into this market even though they don’t apply. This is probably the number one thing that trips people up and is easy to extract value from.
Past performance isn’t an indicator of future performance. This is true in shares but is not true in property. In fact in property past performance is usually always a predictor of future performance because the things that led to that performance, such as population growth, land supply, finance availability and construction activity are static factors that don’t change much year to year. The basic supply and demand imbalance that leads to prices growing are macroeconomics so don’t change very much or very quickly.
Timing the market doesn’t matter. This makes sense and works in shares because nobody knows where the individual momentum of price changes in a stock is going to go in any given day. Sometimes companies can even be doing very well but the stock price falls or vice versa. But in property timing is almost everything. You can time property transactions because property markets are cyclical, they go up and down in waves that go for a few years at a time per wave.
For example you would do very well if you bought a property every recession and sold one every boom. For no other reason than timing. Similarly if you bought a property every time interest rates were high and sold it every time interest rates were low. Because property prices are directly affected by interest rates, which themselves are something you can time very effectively.
Reasons I Don’t Like Property
A list like this wouldn’t be complete without also going into the aspects of real estate that frustrate me and the things I don’t like about it. But they basically only stem from 3 big things that can sort of fall like dominos after each other.
The same amplification effect that leverage has on your positive returns it also has on your negative returns. So there is always a nagging feeling in the back of my head that I’m 3 bad decisions away from losing it all. If a black swan event occurs, you can get into a really bad situation pretty quickly. Essentially arising if 3 things happen at the same time, 1) You lose your income and ability to make the repayments, 2) The value or equity in your property goes down by a lot in a crashing market and 3) You can’t find anyone to rent or buy your property.
All 3 things have to happen at the same time and is exceptionally rare. But it can and did happen in the GFC in 2008 when a lot of people lost a lot of money in real estate. It also means you’re at the mercy of macroeconomics. If interest rates change a lot, this materially affects your payments and cashflow. If something really bad happens like a pandemic and people leave the city, all the city rents drop dramatically to follow it. If Russia invades Ukraine and you own Ukrainian real estate, there’s just about nothing you can do but watch your life savings get destroyed when a missile fires into the building.
That is the next problem I have with property. Being a physical thing, over time it breaks down and needs maintenance. But also it’s able to be completely destroyed by something unforeseen and crazy like a fire or a flood. Or the property can have defects that you only discover later but cost a fortune to fix. A fire in an apartment building can wipe out an insane amount of wealth in an instant. I think this is less rare and able to be prepared for better than say a market crash. But it is still very destructive and unpredictable. Being a physical thing it can be physically destroyed and you can’t get your money out of it until you sell it.
This stems from the fundamental problem of lack of liquidity that exists in property. In stocks, you can sell it in an instant if you think something bad will happen. In property it might take you many months of advertising to find the right buyer and put together a deal. If you know a cyclone or flood or fire is coming you can’t get your money out, you just have to prepare for the natural disaster as best you can. It’s more liquid than startup or private equity but still this inability to get out of the asset at short notice can cause massive problems if you’re not able to sensibly forward plan your life. Whether something like climate change makes this more frequent, I don’t know, but I’d err on the side of being able to prepare.
The final problem I have with property is that it is a physical thing which means it ties you down to a specific place. It’s complicated to own a property in Australia if you plan on moving to France. The ownership of property physically ties you to a place so it takes away your flexibility of choice and freedom of movement. I think that’s why property is generally an older persons asset class once they’re stable and have put down roots and know where they will be for the rest of their life and get old. If you are good at planning for the future and are attached to a part of the world, then these don’t really matter.