Investing in real estate? Read this before you do it!

The lack of financial literacy can prompt people to consider investing money in real estate. This is a provocative statement, so let me explain.

When considering your finances, there are three aspects: how much you earn and the stability of your income, your expenses and how to manage them, as well as the steps you take to plan for future expenses, including retirement. The younger you are, the more you should invest in yourself: education, training, expanding your network, etc. As you age, you should start saving money for retirement and major expenses, such as buying a car or a house, etc.

As you approach retirement, the main thing is to have the ability to generate income from your investments, maintain your lifestyle, and minimize potential losses, as there will be less time to recover.

What role does real estate investment play in this context?

Real estate is illiquid, has high management and ongoing costs, and if you plan to use credit for the purchase, it comes with the risk of fluctuations in credit markets, meaning changes in interest rates. Therefore, it is not suitable for elderly people approaching retirement age or for those just starting their careers who need to focus their money, time, and attention on education and expanding their networks (which also means flexibility in choosing where to live).

Those in the age group of 35-45 years (or even 30-55 years) should consider investing in real estate only if they have utilized all the tax benefits provided by the government for retirement savings (which is essentially free money), have significant savings in international stocks and bonds, and have an emergency fund equivalent to 6-12 months of expenses. If these conditions are met, they may consider real estate as an investment option, provided that this investment does not exceed 10-15% of the total value of their portfolio (this ratio is used by pension funds and other social security funds, etc.).

But what kind of real estate are we talking about? Not apartments with one or two bedrooms! No. No. No. Investing in real estate through an ETF (Exchange Traded Fund) provides the owner with liquidity, diversification, and less time needed to manage investments.

An ETF is a type of investment fund that is traded on stock exchanges, similar to individual stocks. It includes various types of real estate, such as residential, office, shopping centers, etc., which are professionally managed and can be bought or sold through a brokerage account.

Let's take a closer look at "liquidity" and "the ability to choose a winner."

When does a liquidity problem become a solvency problem? A liquidity issue in real estate investments means difficulty in quickly converting assets into cash without a significant discount. For example, if an investor needs to sell a property quickly but the real estate market is slow, they may have to sell it for a lower price than expected.

On the other hand, the issue of solvency relates to an investor's inability to meet their long-term financial obligations, such as repaying debt or securing a pension. For example, if an investor took out a mortgage to purchase property and the value of that property significantly decreased, the investor may owe more than the property is worth. In this case, the investor may face difficulties selling the property and repaying the mortgage, ultimately risking default or eviction.

Does this remind you of what we've been experiencing in Southeast Europe since 2008?

Most people approaching the "real estate investment age," that is, 30-35 years old, do not have such memories because they were in school or university during the Great Financial Crisis (GFC). Some current examples include the blocking of withdrawals from some of the largest real estate funds, such as BREIT Blackstone ($69 billion), and a (funny) reference in the Norwegian Sovereign Fund's presentation on the 2022 results, which states that the value of real estate in publicly traded funds (i.e., those traded on the stock market) decreased by 31%, while the value of non-traded real estate (i.e., those whose prices are determined based on appraisers' opinions) remained stable/unchanged.

What about your ability to "pick a winner" thanks to your connections and deep knowledge?

In 2008, Warren Buffett made a $1 million bet with some of the best hedge fund investors on Wall Street. He wagered that over 10 years, a simple index-tracking fund would outperform the best hedge funds. The results were astonishing, as Buffett's stocks yielded an average return of 7.1%, while the hedge fund portfolio only returned 2.2% after fees. Buffett won the bet and donated his winnings to a nonprofit organization. He advised both large and small investors to stick with low-cost index funds, stating that when managing trillions of dollars, and with managers charging high fees, it is usually the managers who profit. Standard & Poor's tracks the performance of active managers and found that 84% of them underperformed expectations after 5 years, and 90% after 10 years. The performance was "worse than what could be expected from chance." Despite the poor results, large fees are still deducted.

Direct investments in real estate are amazing! You can see and touch your investments, obtain loans to finance them, earn rental income, and then sell them when prices are high. At the same time, it limits your flexibility, requires significant management costs, is subject to high taxes, and you won't be able to outperform simpler and more liquid options available in the market. But no one listens to this advice. That doesn't stop me from giving it.

About the author: Pavlos Loizou, CEO of Ask WiRE.