We share Mariano Capellino’s article in Apertura.com on whether financial investments are more profitable than real estate investments.
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Much is discussed in the investment world about in which proportion capital should be distributed in financial investments and real estate investments.
If we listen to financial advisors and real estate advisors, we see that each of them defends its work and interests. Anyway, there is a myth with the belief that financial investments are always more profitable than real estate ones.
We believe that an investment portfolio must always include financial and real estate assets and the percentage thereof will depend on the preferences of the investor involved, its risk profile, objectives, past experience and advisors.
But the idea is to dispel the myth that financial investments always generate better returns while the real estate investments only generate low returns but they are safe.
Even though it is true that the traditional real estate investment, the so called passive investment by experts, generates low returns, it is important to understand that there are sophisticated methods through which large investors can achieve returns higher than those obtained from financial assets and with a level of risk quite lower.
Let´s see some advantages of the real estate investment compared to the financial investment and some myths in this regard.
- Price: In a real estate operation, it is possible to acquire an asset under the market value while in the financial investment all investors – the ones investing 1 dollar or those investing 1billion pay the same value for shares and bonds every day. Nobody can get a Telecom or Apple share at a price lower than the listed price. However, it is possible to buy a property at a lower price than the one established at the market in some situations.
- Correlation: Real estate investments tend to resist more during strong crisis periods suffered by the markets while the financial assets are generally corrected significantly, including funds and shares from real estate companies.
- Real estate transaction cost: the real estate transaction cost is very high, no doubt about it, but when investing in real property stock or funds, that cost is already included in the operations and, also, there are additional financial transaction costs as well.
- Liquidity: Undoubtedly, financial assets have more liquidity than real estate assets. But if you operate in international markets such as the USA or Spain, it is possible to have access to mortgage loans at low rates. In just 45 days you can obtain immediate liquidity through the financing of the assets in portfolio. This is the ideal option when you have a specific need and have decided to keep the assets and when you seek to maximize returns.
- Risk-Reward Ratio: By operating real estate assets in suitable markets during the recovery phases, when there are many distressed assets under the replacement cost and market value, it is possible to obtain returns without leverage of more than15% annually and more than 30% with moderate leverage of 60% and low risk of capital loss. In order to obtain these returns in financial assets, you must be willing to operate in assets which entail high risk of capital loss and high leverage levels as well.
- Forecasting risk: Forecasting corrections and changes of cycles in real estate markets and assets is much more predictable than in financial assets. Through a control board with macro and micro variables of the sector, it is possible to predict quite in advance when the growth curves will start flattening out and when the correction process can be initiated and therefore a change in the cycle phases. Instead, in the financial sector, despite you can foresee when the market will be ready for correction, you can never estimate the moment, to which extent and the reason behind such correction.
- Exchange rate effect: In general, when investing in the financial sector without exchange rate coverage, the exposure in the event of a strong change is very high in the case of financial assets. Instead, even though real estate assets are also affected in that kind of situations, the correlation is different.
- Market Risk: When the financial market is faced with a crisis, it generally affects all markets. Instead, in the case of real estate, the effect is usually manifested only where the correction is made. An example is the Argentine real estate market which was not affected during the 2008 crisis.
- Projected returns forecast: In general, the projected returns of real estate assets are more certain than those of shares and with much lower risk and, in many cases, with higher returns.
- Diversification: The financial investment makes it possible to invest in different industrial sectors and markets and the same happens with the real estate sector. It is also possible to make investments by forming different types of portfolios and asset categories in different markets.
Now, let´s review some statistics. Research has been published by Credit Suisse showing that from the year 1900 to 2016 shares experienced 5.1% return annually while sovereign bonds had 1.8% returns and Treasury Bonds 0.8% with an annual inflation of 2.9% during that period.
Such research also indicates that in a mid-term view which includes the period between 2000 and 2016, shares only obtained 1.9% return annually, compared to 4.8% obtained, on average, by sovereign bonds. Also, there are many examples of financial collapse experienced during the last 100 years and which led many investors to bankruptcy, especially those who got into debt to purchase shares.
Furthermore, another research shows that investors who implemented an active strategy, i.e. buying and selling at the “most convenient” time during the last 40 years, were not able to exceed the returns generated by the market through the passive strategy (keeping assets in portfolio) as previously mentioned.
Instead, if we take a look at the situation of the real estate sector, according to a study conducted by JP Morgan, we can see that if a passive strategy was adopted between 1900 and 2012, the annual average appreciation was just 3.1% with an annual inflation of 3%.
Instead, with an active strategy, i.e. taking advantage of the recovery and expansion phases of the real estate cycles in different markets, we can see that only appreciation exceeds 2 digits. There are too many recent examples of this: Argentina from 2003 to 2008 and the USA from 2009 to 2014 are the closest and well-known cases. To this, we can add rent incomes plus the applicable discount at the time of purchase compared to the market value, if the investor is aware of this.
If you had the idea that investing in real estate is not so profitable, you can change your mind. But, of course, all this works only if the investor removes its No. 1 enemy of real estate investment: buying property and keep it in portfolio forever. Even though this looks as a safe thing, it is not business. Business entails an active strategy. In this way, large investors obtain high returns, higher than those obtained with financial assets and with a much lower risk level as well. That is, ultimately, the business.