December 10th
Uncategorized

Investment Corner: Rates of Return

I recently spoke with an investor who said something that I have heard many times: “I can make 4% in a safe, conservative investment. So in order to invest in real estate, I need to do a lot better. I want a 7% cap rate. Otherwise I can’t justify moving my money.”  I don’t have […]

I recently spoke with an investor who said something that I have heard many times: “I can make 4% in a safe, conservative investment. So in order to invest in real estate, I need to do a lot better. I want a 7% cap rate. Otherwise I can’t justify moving my money.” 

I don’t have a response to that for several reasons.

  • First, I don’t like selling the idea of investing in real estate to people. That’s because I don’t have my sales hat on. If I am going to help them buy a real estate, I’m their fiduciary, not a sales person. Buying real estate is not like investing $2,000 in a Vanguard mutual fund. It will cost you at least between 600x and 1200x more. You need to be comfortable with it.
  • Second, I can only hang my head and say, “Well, in San Francisco, if you buy a condo, your cap rate will be somewhere between 2.5% and 3.5%.  If you buy an apartment building, you might get 5 percent. Once in a while, there’s a decent building with a 6 percent cap rate but you’ll need a lot more money.”
  • Third, and probably the most important, is that I have worked with many first-time investors and seasoned real estate investors. One thing they share in common is that they believe in real estate. I don’t make them believe in it. 
  • Lastly, it’s not good time to be talking about appreciation and “upside.” I generally tell clients that if they buy a property now, they may lose money if they sell over the next three to five years because of lack of appreciation and because they will incur costs to sell a property. As to upsides, the truth is that with San Francisco’s strict rent and eviction control laws, you need to be a very diligent, patient, hands on landlord with a bit of luck, extra cash and flexibility to capitalize on upsides.*

Still, we are on the west coast in a rather fashionable urban center where a duplex on the busy thoroughfare of Monterey Boulevard in the middle of the holiday season just sold for $789,000 (3% cap rate at best); and where an eight unit building on Union Street with an old boiler and no parking just sold for $1,900,000 (4.4% cap rate at best). I wrote three offers in three weeks and all were multiple offer situations. It seems that real estate must still be attractive on the west coast. 

Add just a bit of leverage, talk with your CPA about depreciation and expense deductions, and somehow other benefits of owning real estate begin to shine through.

I think what’s the real stumbling block for some investors is that they are just not comfortable with real estate.  That’s usually true for those who prefer stocks and bond investing.  Real estate investors seem to cross over to stocks and bond investing easier.  The very wealthy always cross over both ways because they need to diversify.  

Our recession is a great illustration of diversification.  During the darkest period around early 2009, equities lost between 30% and 50% of their values.  Many real estate portfolios were hit just as hard.

Here is the difference:  If you owned five multi-family buildings that were worth $10,000,000 in 2007 and only $6,000,000 today, you still received rent checks every month.  Your vacancy rate may have gone up (and then down this year).  You might have given some tenants temporary rent reductions.  You may have finally had to spend some money remodeling to make your units more attractive.  Still you had a pay check every month and the drop in rents never reached the huge paper losses of value.   

A good friend and client met with a team at Merrill Lynch last week. They wanted her to move her portfolio to them. They showed her a lot of charts and told her that she would get a 6% return with them. She asked if they could guarantee that. Their reply: when other portfolios lost 20 percent, they only lost 10 percent.

Where’s that rent check……

*Some challenges of being a landlord….


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