“Real estate is not a commodity. I think it tends to be more accurately priced most of the time. Under most conditions, it’s hard to find real estate that’s mispriced,” Warren Buffett (Trades, Portfolio) once explained at a Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) shareholders meeting.
Real estate is one of the most popular investments for everyday folks. The logic seems simple – use the bank’s money to buy a property, collect rent to pay off the mortgage and watch the value appreciate over time. Rinse and repeat to build a rental empire. Unfortunately, as Buffett explains, it is not quite that easy.
While real estate investing may work for some, there are good reasons why Buffett himself steers clear of it. Here is why the world’s greatest investor believes real estate is a “lousy” investment for most people and corporations.
Lack of pricing inefficiencies
Buffett built his fortune by buying high-quality companies trading at significant discounts to conservative estimates of intrinsic value. He seeks a margin of safety to minimize downside.
But real estate does not provide many such opportunities. As Buffett notes, real estate “tends to be more accurately priced most of the time.” There are not many chances to buy properties far below a rational estimate of fair value.
Real estate is more straightforward to analyze than multifaceted businesses. Cash flows are stable and intrinsic value is straightforward to calculate. This makes mispricing less likely.
Of course, the market is not perfectly efficient. Occasionally, forced sales like foreclosures allow investors to scoop up real estate at fire-sale prices. But outside of crises, cheap properties are hard to find.
No competitive edge
The guru also avoids businesses where others have a leg up. He said, “We don’t have any competitive advantage over experienced real estate investors.”
Specialists like real estate investment trusts and private equity firms dedicate their efforts exclusively to real estate. They hire top talent and forge the best industry relationships.
Scaling up also provides a significant edge. Outfits like Blackstone (BX, Financial) can negotiate bulk discounts on materials and leverage centralized operations. Small-time landlords cannot match those advantages.
For idle investors, it makes sense to piggyback off the expertise of seasoned real estate operators rather than compete against them.
Tax headwinds for corporations
Real estate income flows through to an investor’s personal taxes. But at corporations, profits face “double taxation” – once at the corporate level and again when distributed to shareholders.
As Charlie Munger (Trades, Portfolio) noted, “By its nature, real estate tends to be a very lousy investment for people who are taxed under sub-chapter C of the [tax] code.”
Most corporations pay taxes under sub-chapter C, including Berkshire Hathaway. So real estate is at an inherent disadvantage for Buffett’s company compared to other entities like REITs.
Burdensome management
Bookkeeping, maintenance, tenant headaches are only the beginning with regard to management. Rental properties require significant oversight. As Buffett said, “management makes it impossible” to efficiently invest in rentals at scale.
Unlike stocks and bonds, real estate is not a passive investment. Landlords must contend with bad renters, leaky roofs, clogged toilets and a myriad of other issues.
All this work has a cost. For do-it-yourself landlords, it comes in the form of time and stress. As investments balloon in size, most people max out their management bandwidth.
Smart investors like Buffett avoid businesses that distract them from more profitable opportunities. For him, real estate falls into that bucket.
Exceptions to Buffett’s real estate rule
Under certain conditions, Buffett is open to investing in real estate, such as during a crisis or by using public real estate vehicles.
He pointed to the RTC crisis in the 1980s and 1990s as one example. The Resolution Trust Corp. was formed to liquidate assets of failed thrifts, including thousands of real estate assets.
With the RTC desperately selling off properties and buyers scarce, pricing became disjointed from fundamentals. Buffett said that “you had a lot of mispricing then.”
Some opportunistic value hunters scored deals on distressed properties at fractions of fair value during this period. Even Buffett dabbled in a few. But outside of severe financial crises, these kinds of mispricing opportunities rarely present themselves.
While Buffett tends to avoid direct real estate investing, he has occasionally invested in publicly traded real estate vehicles like REITs.
For example, he has previously bought shares of Tanger Factory Outlet Centers Inc. (SKT, Financial), STORE Capital Corp. (STOR, Financial), Seritage Growth Properties (SRG, Financial) and others.
Why does he allocate capital to public real estate instead of physical properties? There are a few reasons. First, REITs provide instant diversification across sectors, markets and properties. They also offer liquidity, enabling Buffett to move in and out of positions quickly.
Next, managers with specialized expertise handle all the burdensome tasks like leasing, maintenance and so on.
REITs sometimes trade at discounts to net asset value, providing a margin of safety. So when they become significantly undervalued, Buffett views them as an efficient vehicle to gain exposure to real estate. He can outsource the management while profiting from irrational discounts caused by the stock market.
But he does not depend on these episodic opportunities. REITs remain a small part of Berkshire’s vast portfolio.
Real estate has major drawbacks for most investors
While rental properties might seem like easy money, they come with pitfalls. As Buffett and Munger have explained, real estate has disadvantages for large corporations and passive investors like themselves.
If you are an ace property manager with inside industry connections, you may succeed where Buffett fails. But for the rest of us, real estate investing requires feats of hyperactive management and negotiation.
Meanwhile, buying shares of high-quality businesses allows passive investors to compound wealth simply by shrugging through temporary price changes and reinvesting dividends.
Most investors are better off avoiding the alluring trap of real estate speculation. Find excellent companies at fair prices and watch your wealth grow while their management sweats the details and you relax with a cup of coffee.
