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Two Roads to Dynastic Wealth, Part III


row_houses.jpgHere’s a riddle worth solving.

How can real estate qualify as one of the two perpetual sources of family wealth, now that reckless real estate lending has crippled the global economy?

There are two prisms through which we can examine real estate:

  • Single family housing versus income producing real estate
  • Private ownership versus Wall Street ownership

We all know what happens now, when unqualified buyers used liar loans to buy houses they could never afford.   This was insanity on a colossal, global scale.

The damage is exacerbated by the fact that a detached, single family home straddles two markets.

  1. First is the intended use as shelter for a family, where the imputed rent (i.e. the rent you would have paid if the house were a rental) is the return on ownership.
  2. Second is the acquisition of houses for the express purpose of investment, either by long term rental and appreciation gains, or immediate turnover (flipping houses).

Just as prudent owners who did not overpay, and used conventional financing will escape the crash unscathed, so also will the prudent investors who have sufficient rental income to service their debt obligations.

The second filter is the form of ownership.

When Mom and Pop buy real estate, there is no unwieldy structure of ancillary payments to promoters, syndicators, packagers, brokers, managers, and other such unsavory hangers-on.

Nothing chastens our improvident impulses quite so much as when we spend our own money on our own behalf…the foundation of private ownership.

Unfortunately, Wall Street got involved.

When they discovered the unique attributes of investment real estate (almost a hybrid of a bond, due to steady rental income, and a stock, due to potential capital gains) Wall Street reverted to form, and stuffed their offerings with an outrageous superstructure of fee income.

These include brokerage fees for selling partnership interests, fees for collecting and investing the cash proceeds, acquisition fees in addition to normal brokerage fees, partnership management fees, and worst of all, the infamous 2 and 20 fee structure,  bleeding the underlying investments of 2% annually, in addition to a 20% slice of the ultimate profit.

Quite simply, these parasites designed an investment structure that sucked so much money out of these public and hedge fund partnerships that little or nothing remained to the hapless investors.

What happens when you kick these bums out, and only buy what you can afford and understand?

You then have stumbled on to the most widespread wealth creation asset class available to private individuals and families.

Yes, you’ll get stuck with collection and maintenance chores.  But what makes real estate work is that leverage is alive and well, and your rental income will eventually retire the mortgage.

Your tenants will ultimately pay long enough so that you can own the property free and clear.

It doesn’t get much better than that

1 Response to Two Roads to Dynastic Wealth, Part III

  1. Toli

    Another way to view real estate as a component of dynastic wealth is from the viewpoint of a start-up business.

    You borrow money, which you invest in something (a house) that produces adequate income to cover the lending costs (paying the mortgage), operational costs (repairs, taxes, insurance), and staffing costs (cleaners, personal time to manage it), and, in due time, provide a profit.

    So, how does real estate compare to other start-ups? Easier to get a loan that some (all too) innovative idea: mortgages are standard fare, and easier to convince a loan officer to give you a loan for a house than to mass-produce your Widget-A++ invention. Lower-risk: most of the capital goes into an asset which tends to hold its value (esp. if wisely acquired at below-market prices). Mid-skilled labor: you don’t need a college degree to be a landlord; it does take some study of the law and dilligence, but it’s not rocket science. Add the tax-advantages associated with (some forms of) real-estate ownership, and it’s a very accessible type of start-up business with good chances of success.

    Hence its popularity. Not just in the US, but across the world, for centuries. Properties in downtown Athens, Greece have been in the same families for generations dating back to the formation of the nation in the 1820’s; large tracts of Texas have also changed hands very few times since the Republic of Texas joined the Union (check the deeds in courthouses, esp. in rural counties). They most often change hands when a property is given away to charity (oftentimes the church), or the government (failure to pay taxes, often inheritance taxes, or eminent domain is applied), or when the heirs squabble.

    And here is one of the disadvantages of real estate as a portion of dynastic wealth: it’s hard to split it up among heirs. There are other disadvantages: being a landlord is serious work, and there is absolutely no guarantee the children will care much for that line of work. It is also the kind of business that is not trivial to dismantle, due to the kind of assets it holds (you can’t sell real estate for a decent price just like that). And, in the context of a mobile workforce, it can tie you down geographically (esp. if you have to litigate against a tenant). Finally, expect there to be times where you will not be able to find tenants but still be stuck with fixed expenses; or having set no cash aside for inheritance tax, thereby damning your children into a forced sale of the assets; so advanced and careful budget planning (and tax-advantaged legal structures behind ownership) is essential.

    Anyone who believes that real estate is a good investment should consider whether they enjoy the long-term commitment to the part-time job of landlordship, not just the low-risk, potential returns, and low barrier to entry (which are certain positives of real estate). And, if it’s about dynastic wealth and they are advanced in age, whether their children would enjoy inheriting such a job. If not, it is possible to have indirect real estate investments through REITs or investing in stock of public companies that dabble in construction or real estate; the returns will be lower, the liquidity and overhead will be higher, the management control pretty much gone. But, for some who wish to partake in the expected real estate upside but don’t really like to get a new part-time job, this may be a better option than landlordship.

    On the flip-side, if you are older and retired, and lived in the same place for a while, then your personal life experience and familiarity with local real estate can be a huge asset: you don’t travel much, you have free time to devote to landlordship, and you can smell trouble tenants a mile away. If you also have a pile of cash set aside for your children to cover inheritance taxes, then landlordship may be a fantastic way to grow and prepare an inheritance. One bit of advice: unless your children are real estate professionals, be sure to leave behind an owners’ manual on landlordship, or dissolution instructions. Otherwise, your inheritance will be eaten alive by taxes, and “advisors” who will dupe your children before they can say “I trust you”.