Real Estate Dogma: FACT or FICTION - A Retrospective Analysis

[Jon Licht]

Five years ago I began my journey as a real estate investor.  Since then I have also branched out into other assets such as angel investing, note investing, and fund investing.  In comparing common "real estate dogma" to other professional investing circles, it seemed to me that real estate was behind the curve.  My gut instinct told me that much of what I was 'taught' was wrong.

To confirm or deny my gut instincts, I conducted a retrospective analysis of my portfolio against three common tenants of real estate that I was 'taught'.   The results of that analysis and implications are listed below.  To be clear, the scope of these findings are specific to my properties over a 5-year time horizon.  I am not saying these findings apply to all properties (yet).  My OBJECTIVE is to meet other investors who want to excel and grow this dataset to achieve further-reaching conclusions. 

1. Real Estate Analysis 'Calculators' provide a reliable way of estimating future cash flows (and valuation)

Finding: FALSE.  I ran a correlation analysis comparing the projected versus actual NOI for my three properties.  For the portfolio, the R2 value (correlation) for monthly cash flows was .006 percent, meaning there is no correlation.  In lamens terms, the 'calculator' was completely wrong.  An easy justification here would be to say "ok, maybe you need a better calculator".  However, that misses the point.  The point is that actual cash flows are volatile and it is silly to attempt to predict a single numeric value projecting cash flow or ROI.  Doing so, to me, reflects a fundamental misunderstanding of the asset.  It's lazy.   From a simple math standpoint, PROFORMas should be providing investors a range of possible cash flows based on a 95% confidence interval & comparable data.  So, the projection would say 12% ROI +- 10%.  This data suggest that any calculator or analysis that does not provide a margin for error is horrendously erroneous.

2. Real Estate provides a steady stream of cash flow that can be used for 'financial freedom' planning

FALSE.  Due to the volatility of actual cash flows, it does not make sense to estimate a single projected 'monthly cash flow' value.  Some may say "ok, great, but when you have more properties, volatility goes down".  My answer... maybe.  If you take a look at this data, the portfolio R2 is worse than two of the properties.  .006 is also abysmally low.  My suggestion - run this analysis for yourself to understand the volatility of your portfolio before making any estimations on 'financial freedom' numbers.

3. Real Estate Investing outperforms the S&P

TRUE.  But, barely.  Note in the images below that Cash flow from Financing (refinances) was 10X Cash flow from operations.  My CoC was approximately 3%.  What this means is that my portfolio ROI is highly dependent on the housing price index.  If I did not refinance all of my properties, my ROI would be terrible.  This suggests a few things.... 1) if I had 40-50 properties, this would be a nightmare... Every 5-8 years I would need to refinance everything.  2) In current market conditions (with the risk of a correction), this suggests that less volatile assets such as multi-family are a safer bet.  

[Greg Scott]

Quote from @Lee Ripma:

@Jon Licht

Love this! I find both cash flow and cap rates in MF to be total BS. Buy good locations at decent prices - the results take care of themselves! 

I'll take the counter-argument 100%

Nice charts and graphs but my experience is very different.  (Are you really using a sample size of 3???)

1) Reliable forecasts relative to what?  I have underwritten hundreds of real estate deals.  The ones we bought, my underwriting year 1 was always very close.  After that, because I used conservative assumptions results were higher than forecast.  What is your ability to forecast the returns from your stocks?  The only investment that you can probably do a better job forecasting is putting money in a savings account.  Then your correlation will be really high because "almost zero" is easy to predict.

2) Did you pick poor investments or poor operators?   Out of about 35 multifamily and 15 single family deals, cash flow projections were pretty dang close for most.  About 10% of the deals the operator undercalled returns and about 10% were completely sandbagging and crushed it.  On average, my investments significantly exceeded pro-forma.

3) The last decade I've averaged about a 35% annualized rate of return on my real estate investments.  As I've gotten better, my returns have improved.  If you factor in that I've been able to defer all capital gains taxes and recaptured depreciation taxes into the future, real estate BEATS the S&P 500.  In 2019 my wife became a real estate professional and we haven't paid federal taxes since then, which CRUSHES anything you can possibly do in stocks.

Deciding an asset class is bad because of your returns on three properties is quite a stretch. It also ignores where and with whom you chose to invest.