Where Real Estate And Stocks Collide: Investing Takeaways

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Research shows that roughly half of Americans own stocks in one capacity or another, with the majority of participants only owning stock through a retirement plan. However, when you take away retirement accounts (which most people only have because their employers opt them in), around 15-20 percent of Americans own stocks and/or ETFs. Around 10-13 percent of people have an ownership interest in a business, with a slightly smaller percentage (7-10 percent) owning investment real estate. I think that there are a couple of takeaways here:

1. Most people don’t play the stock market, and if they do, they tend to stop if they get negative feedback (losses). The people who tend to do well in stocks have higher incomes, more education, know more portfolio theory, and most of all, have more patience.

2. Empirically, it’s a lot more common to become a multimillionaire from having success in business or real estate than by investing in the stock market. More commonly, multimillionaires with successful businesses or high-paying jobs invest their extra money in the stock market where it grows even more.

Business/Real Estate vs. Stock Market Investors

In particular, what’s interesting about Fort Worth is the number of multimillionaires who have little to no money in stocks. The general consensus is that they don’t trust the stock market and they think that they get the short shaft by the financial industry and many of them don’t participate, despite their wealth. This goes for the handful of people I consult for as well.

My highest concentration of readers is in the New York metropolitan area, so this tends to be a surprise. The couple of years of work I’ve done writing for Seeking Alpha shows that the Texans may have a point. Stock markets are not fair or orderly, and you need a substantial amount of education to make more than mid-to-high-single-digit annual returns. A lot of my research is about getting people to the point where they have a level playing field where they’re able to express their ideas at wholesale prices for capital and without their brokers’ hands in their pockets. With proper education, you can get there, however.

What I’ve found though is that the world of small business and real estate has a lot to learn from people in finance, and vice versa. I’ll focus on the business of real estate for this article because it’s where the public markets intersect with a very traditional mom-and-pop business, which is the ownership of rental property.

The idea of rolling up thousands of rental properties is an investment banker’s dream because it’s a high margin business that has economies of scale. Warren Buffett famously said he would have bought “a couple hundred thousand homes,” if he could have in 2012, and that “if held for a long period of time and purchased at low rates, houses are even better than stocks.” That same year, Dallas-based Invitation Homes (INVH) was founded to do exactly that. So far, they own over 80,000 homes. The jury is still out on their business model, but it’s a fascinating experiment on what kind of return on equity they can get.

What Small Business/Real Estate Investors Can Learn From The Public Markets

1. The cost of capital is key. Large public corporations with good balance sheets are typically able to borrow more cheaply than individuals. INVH is able to borrow for around 3.5 percent, and likely will be able to borrow for even cheaper in the future if rates stay low. The actions of the Federal Reserve are just as important to landlords deciding whether to buy more property or small business owners asking questions like whether to purchase the real estate they’re renting as they are to speculators in the financial markets. Where a lot of people fail in small businesses is by trying to compete with businesses that have a lower cost than they have. The government actually subsidizes your first 10 loans through Fannie (OTC:FDDXD) and Freddie (OTCQB:FMCC) where people with good credit scores can borrow as cheaply or cheaper than the big boys, but the biggest challenge for landlords looking to own more than 10 properties is the gap between where government subsidies end and when cheap capital starts to be available again for large investors. When my family flipped houses, capital was our biggest constraint, so I found it interesting how the market has evolved.

2. Leveraging economies of scale and technology. To this point, there are economies of scale in running larger operations. A lot of small business people are afraid to grow because they’re worried about overwhelming their ability to handle the needs of their business. This fear is often misplaced because you can often use technology to improve your efficiency. I used to know a girl who drove all around town with a concealed handgun to collect rent in cash from her family’s tenants – their business was as old-school as you could get. Some realtors I know have a different approach – just use Venmo to collect the rent. Other expenses, such as insurance, fighting property tax appraisals, and property management can be more efficiently dealt with if you own more property.

Data by YCharts

What’s interesting about INVH is that when they started out, there were more kinks in the systems. My chart only shows their progress since 2016, but increasing gross margin a little bit drops down nicely into increased profit despite fewer amazing deals than there were in 2011 and 2012. A rule of thumb for small landlords is to have a gross margin of 50 percent or higher (our property taxes are fairly high here). If you’re a real estate agent or property manager, you can often do about 10 points better on your gross margins.

3. Diversification. Many small business owners and real estate investors have a significant concentration of risk. Finance people, at least if they’re smart, tend to spread their bets more. If you have a successful business, investing in the stock market is a great way to preserve liquidity and earn a higher return than you would by keeping your money in cash. As 2008 taught us, owning a bunch of different assets in one asset class does not necessarily mean you’re diversified. Business owners tend to have a harder time dealing with volatility than people with a finance background, but portfolio theory holds that if you are any good at managing risk, then the return you make will overwhelm market fluctuations over time.

What Stock Market Investors Can Learn From Small Business/Real Estate Investors

1. Life-cycle investing. I have a friend whose family lives by a well-known Texas billionaire here locally (among their other houses). Like many successful people here, they didn’t make their money in the financial markets but from success in business. His dad didn’t go to college but was street-smart. One key theme I see with the Texas crowd is taking a substantial amount of calculated risk when under 35 years old and then dialing back the risk when you have kids. This period of life is the best time to take smart risks, whether they’re in the financial markets or in business. I’ve written extensively about the benefits of life-cycle investing with rebalanced leverage up to 2-1 in the broad stock market indices, a strategy that has been endorsed by Ivy League economists. The best implementation is to use a combination of ETFs and E-micro S&P and Nasdaq futures, but leveraged ETFs and options can work well if you know the theory on volatility targeting.

2. Self-employment. Roughly 80 percent of millionaires in America are self-employed, versus about 12-15 percent of the broader population. When coronavirus broke out, many of my friends from college lost their corporate jobs and now are understanding the virtue of diversified income streams. I wonder if this crisis will pull forwards a decade of technological advances into a couple of years. None of the changes being put in place now are good for the prospects of labor. Working from home and digital technology likely will create additional barriers to moving up the corporate ladder, while increased unemployment reduces labor’s bargaining power against corporations, especially if some of this unemployment becomes structural. What’s likely to happen is an expansion of temporary and contract work, a shifting of healthcare costs from employers to employees (and the government), and a drop in wages. This will be partially offset by reduced commuting costs and not needing to pay rent in places like Manhattan and Los Angeles, but the net result is negative. It’s clear to me that the winners in the new economy will be the owners of assets that are neutral to the increased printing of money by the government.

Conclusion

Small business owners would likely do well to invest more often in stocks, while stock market investors would do well to learn from the successes of their counterparts in business. One of the ironies of the 21st century so far is how much wealth has been created while the vast majority of individuals have little to no stake in the system. I expect volatility to remain elevated relative to the compensation I expect investors to receive in the short run. But in the long run, I see virtual certainty of technology driving continued gains to GDP and corporate profits. Hopefully, if you’ve read this article there are some takeaways for your own investment process.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.