April 18, 2023
Vermont Business Magazine this week named One Day In July the 2023 Best Investment Firm in the State of Vermont. While we now have clients in 31 states, it's fun to take the hometown honors. More on our awards page here...
You have, are, or should be wrapping up your taxes now. One of the benefits to public market investing is that in certain cases we can recognize tax losses, reducing your tax bills and improving your total return. When we do it for clients we do not give up exposure to the asset class for even a short period of time, and the transaction costs are zero or close to zero. Private investments do not allow this.
On the subject of private investments, today I'm going to talk about all of the reasons I don't like private real estate as an investment by a casual investor. It's popular - we get the question all the time, and many Americans participate in it. If you're buying it for enjoyment, that's one thing. If you're a professional real estate investor and you really focus on the comparative advantage you can bring, that's a different story. But I don't see many cases in which people buying second homes for fun or to lease outperform the index. Here are the issues:
1. Transaction costs are high. Getting into and out of properties is not a zero-cost trade the way it is with a public security. These costs can run 5% to 10% of the proceeds of a transaction, even before capital gains taxes.
2. Geographic risk. In a single property you have geographic concentration risk. It's impossible to know what real estate markets will have the highest performance going forward. While the index by definition also buys the worst performing markets, on balance this diversification reduces risk.
3. Taxes. Professional REIT managers work to classify distributions as return of capital whenever possible, therefore reducing dividend taxes to zero for that portion of the dividend. In contract, rents from private houses are taxed as ordinary income. Additionally, public REITs can be held in an IRA, shielding more taxes, at least in the near term. While this can be done with private real estate, it is difficult.
4. Tax-loss harvesting. As mentioned above, because the indexes are public and liquid, tax-loss harvesting can occur, which can raise your overall returns over time.
5. Interest rates. Until last year, real estate benefited from a forty-year decline in interest rates. This provided a boost to both private and public holdings. Should this trend reverse the capital value of the asset class will now face a headwind. The point here is that the returns many people made on houses were at least partially a function of interest rates being lowered, not the house being an unusually productive investment.
6. Financial leverage. Similar to #5, much of the return made in real estate is due to the financial leverage from the loan. While public REITs are internally leveraged as well, if you had applied the same leverage to the S&P 500 in the past 15 to 30 years as people applied to their houses, the returns would have been significantly higher.
7. Capital and maintenance improvements. To calculate the real return on a private house sale, you have to consider all property taxes, improvements, and maintenance that were paid into the house over time. If you owned a railroad you could not ignore bridge repair. In a similar way, you must calculate the time value of cash you put into a house.
Dan Cunningham
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