The Do-It-Yourself Mindset

What do E*Trade and Home Depot have in common? Between online brokerage services and big-box hardware supplies, these two companies couldn't operate in more dissimilar areas. However, they do have a common thread: Both businesses thrive on do-it-yourselfers.

As examples of the tremendous cost savings from doing things yourself, I cite recent experiences from my home improvement efforts. The day after we moved into our house a few weeks back, we had our air ducts cleaned and, during an inspection of the furnace by the same service professional, learned that our heat exchangers were cracked. As a result, our furnace was "red-tagged" (deemed inoperable based on safefy concerns), since cracked heat exchangers can lead to excessive levels of lethal carbon monoxide gas leaking into the air duct system. Luckily the heat exchangers carry a 20-year warranty. However, the cost of labor for a licensed specialist to spend three to four hours reaching back into the guts of the furnace (behind the electrical control panels, burners, gas intake, etc.) to pull out the heat exchangers and replace them is $500 to $600.

In an earlier post, I mentioned the fir tree in our front yard. It turns out that, after hearing from a tree-hugging neighbor, we decided to trim the tree rather than cut it down. As in stock investing, where for every stock there are numerous opinions on whether to buy or sell, so it goes with trees. Most of the professionals we have spoken to (particularly tree service companies trying to line up their next tree-cutting job) say that we should remove the tree. However, there are an arborist or two in our area who opine that "the tree can stay, unless we are very concerned about the proximity of the roots to the foundation and water and gas lines" (like economists and politicians, these arborists qualify their statements and refuse to offer a usable guessimate as to how many years we have before we experience actual damage from root growth). The arborists, however, like the tree cutters, are happy to give us firm estimates on tree trimming. Cost: $500 for trimming (mainly "defluffing" the limbs, as they call it), which is the same as the price we got from the tree cutters for removal of the tree.

In short, specialist labor is expensive. So, being of a do-it-yourselfer mindset, I spent a day or two of my own time on each job: Crash courses on furnace repair and tree trimming, trips to our local heating and air conditioning shop and Home Depot for supplies ($5 for high temperature caulking for the furnace and $30 for a tree pruner pole 12 feet long), plus a day with my head in the furnace and another day perched on the edge of our roof with a 12-foot pole in my hands.

As a do-it-yourselfer, I spent pocket money (just $35 total) and a few days of my time on jobs that I could have turned the pros loose on for $1000. Similarly, in my investing I have the option of hiring fund managers (i.e., investing in mutual funds and/or hedge funds) and paying 1% to 2% or more in management fees each year, which can easily run into many thousands of dollars. But, rather than hire the so-called "experts," I choose to manage my investment portfolio on my own, using a discount online broker like E*Trade.

I think that a type of 80-20 rule applies to professional services. 80% of the so-called "experts" do a mediocre job and 20% are exceptional. It is generally worthwhile to pay fees to the 20% high-quality performers, but identifying them is often a spotty, hit-and-miss process full of risks and uncertainties. So, instead of relying on the experts, I spend highly focussed periods of my own time educating myself and learning the basics to enable me to reach the 80% level very quickly. In so doing, I usually am able to achieve what I consider to be the high performance level (top 20%) on certain narrowly defined jobs (e.g., replacing heat exchangers). Further, as a do-it-yourselfer, I am pleased that I am able to avoid paying dear for services of the mediocre (bottom 80%).

A Tree with Negative Time Value

We have a beautiful fir tree in our front yard that provides shelter for birds in spring, shade for us during summer and pleasant greenery for the neighborhood year-round. It towers 60 feet above the ground and approaches almost two feet in diameter at its trunk. The value of the tree lies in the way that it adds a welcome bit of nature to our predominantly concrete and asphalt urban landscape.

However beautiful the tree is, it bears one fundamental flaw--it sits too close to our house, just six feet from the corner of our garage, where the main water line and gas line come in. Two big roots, one the size of my arm, the other the size of my leg, run alongside the concrete foundation footing, precariously close to the water and gas lines. To date, our utilities have not been disrupted, but it would not be surprising if one of the roots were to break a pipe this year or next, or the foundation were to crack the following year. The tree also sheds acidic needles onto our roof, causing premature deterioration of the roofing shingles, and fills our rain gutters with debris, leading to increased maintenance costs.

The cost of removing the tree today is $500. If we choose to do nothing and simply wait, we run the risk of a pipe breakage or, even worse, a cracked foundation, that would cost many thousands of dollars to repair. Since the tree is healthy and growing with ever-expanding limbs and roots, the likelihood that it damages our house only increases over time. Further, as the years pass, the cost of professional removal of the tree increases as well.

Investments--stocks, bonds, real estate, precious metals, even trees being grown for their timber--tend to increase in value over time, exhibiting positive time value. Our fir tree, on the other hand, behaves differently from a financial perspective: Its expected cost (not value) to us increases over time, having a financial impact similar to a capital asset like a car. The utility that a car provides as a means of transportation compensates for its depreciating value and maintenance costs, but there eventually comes a point when the car's reliability diminishes and/or the cost of maintaining it becomes too burdensome. In the case of our fir tree, we are arguably (i.e., some neighbors and arborists would disagree) at or close to the point where its beautifying value no longer is large enough to offset its expected cost to us, and the tree begins to take on what I would call "negative time value," i.e., the longer we wait, the higher our expected net cost (beautifying value minus expected cost of damage and removal).

The wise long-term asset management decision in this case is to pay the $500 for tree removal today, rather than wait and suffer from higher anticipated costs in the future. Just as a trader learns to cut his losses early on when a market begins to go against him, it would be prudent for us to cut down this tree now before it causes thousands of dollars of damage. If only the developer 26 years ago had planted the tree further away from the house, we would be able to continue to enjoy the tree indefinitely without exposing ourselves to the risk of a cracked foundation and disrupted utility lines. . . . But, hey, developers are often just as short-sighted as investors are.

In Transition

Due to a move during which I lost connectivity, I was unable to post to this blog during the past week or so. Also, as inevitably happens in real estate transactions, I have gotten entangled with all of the frictional effects of buying and owning real property, which I expect to interfere with my blogging for yet another week or two.

If You're Buying Real Estate, Don't Ignore the Frictional Costs

Over the past few years I have occasionally spent swaths of time examining potential investment real estate deals--apartment complexes, mobile home parks, office buildings, etc. More often than not, I have found that my walkaway price is somewhat away from (i.e., often about 10% below) what the highest bidder is willing to pay for the same property. The stock market analogy of this behavior would be entering good-till-cancelled buy orders at limit prices lower than current market, only to see the market run higher with the orders never executing.

While I do succeed in buying stocks, closing on real estate deals is a much rarer event for me. What's going on here? Is the gap between my bid and the market price in real estate deals just a difference in viewpoint on appreciation potential, or is another mechanism at work here? Having been through the lengthy due diligence process of buying real property a number of times, I am beginning to suspect that the answer lies in understanding so-called "frictional costs."

Generally, when I look at potential returns, I take into account frictional costs through what boils down to a very simple formula:

Net Return = Gross Return - Frictional Costs

To see how this works, let's compare a typical stock investment with a comparable real estate deal:

Stock Investment: $20 per share x 5,000 shares = $100k equity

* Trading commission: Discount broker commission is $10 per trade, or 2 b.p. round-trip on a $100k trade;
* Bid-offer spread: In a $20.00-$20.04 market, round-trip cost is 20 b.p.;
* Time: Company research (10 to 20 hrs.) and trade execution (1 hour) amount to about $1,600 (valuing my time at $100 per hour), or 1.6% on a $100k trade.

* Total Frictional Cost: About 2% of equity investment

Real Estate Deal: $1 mil. property - $500k loan at 50% loan-to-value = $500k equity

* Broker's commission: Seller pays 6%, giving round-trip cost equal to 12% of equity;
* Bid-offer spread: Not applicable in negotiated deal;
* Due diligence and closing costs: Inspection ($1,000), escrow ($1,500), transfer tax ($17,800), title insurance ($2,000), appraisal ($500), loan fees ($5,000), misc. ($200), giving a round-trip total of $28,000, or 5.6% of equity;
* Time: Market research (10 to 20 hrs.), property due diligence (10 to 20 hrs.), deal negotiation and closing (20 to 60 hrs.). Total: About 70 hrs. x $100/hr. = $7,000, or 1.4% of equity.

* Total Frictional Cost: About 20% of equity investment (or 10% of property price)

Assuming a five-year investment horizon (which is typical of the amount of time investors hold real property), the frictional cost of a stock investment is about 0.4% per annum, versus a hefty 4.0% per annum in real estate. If I desire a net return of 20% per annum, on a pro forma basis I need to "pencil out" 20.4% for a stock investment and a much higher 24.0% for a real estate deal on a gross basis prior to accounting for frictional costs.

(Tax advantages available through 1031 tax-deferred exchanges of real property help to offset the higher non-tax frictional costs of buying and selling real estate. However, even at a high capital gains tax rate of 20%, the savings approaches just 2% per annum (17% p.a. after-tax for 5-year taxable rolls vs. 19% p.a. for tax deferral over 25 to 30 years), when assuming 20% per annum pre-tax returns. At a lower capital gains tax rate of 15%, the savings is 1.5% per annum, again figured over a 25- to 30-year time horizon. In any event, the savings from deferral of capital gains tax is typically not large enough to make up for what is lost through higher non-tax frictional costs in real estate deals.)

My guess is that most real estate investors do not fully account for frictional costs, which I believe explains much of the discrepancy between my bid price and the (often higher) market price for real property. Particularly in the currently "hot" real estate market, investors are betting on continued appreciation in property values (10% to 15% per annum), significantly higher than historical levels (5% to 10% per annum). I am not here trying to predict when the current double-digit rate of real estate price appreciation will pause, but I do know that when the music does stop, there will be a lot of unhappy investors--especially those who have ignored frictional costs in figuring their pro forma investment returns.

Whoever Said There's Money in Real Estate?

Following up on a point I raised in my prior post (entitled What's the Likelihood of "Making It" as a "Pure Investor"?, April 29, 2005), I now focus on the real estate category. We have seen that only three (6%) of the world's top 50 richest people obtained their wealth primarily through real estate, and all three are Hong Kong citizens. Doesn't this seem a bit odd, since nowadays everybody (and his uncle!) who owns property, particularly in the U.S., is making gobs and gobs of "easy" money in real estate? Where are all the wealthy American real estate magnates?

For insight into real estate as a source of wealth in the U.S., I take a look at the Forbes 2004 list of The 400 Richest Americans. Below are the names of those Americans on the list whose net worth came from real estate:

Rank: Name, Net Worth, Residence

38. Donald Bren, $4.3 bil., Newport Beach, CA
74. Donald Trump, $2.6 bil., New York, NY
79. Leonard Norman Stern, $2.5 bil., New York, NY
87. Samuel Zell, $2.4 bil., Chicago, IL
97. Leona Mindy Rosenthal Helmsley, $2.2 bil., New York, NY
106. Richard Edward Rainwater, $2.0 bil., Fort Worth, TX
152. Melvin Simon, $1.6 bil., Indianapolis, IN
165. John Albert Sobrato, $1.5 bil., Atherton, CA
234. Thomas John Flatley, $1.2 bil., Milton, MA
260. Carl Edwin Berg, $1.1 bil., Atherton, CA
260. Edward P. Roski, Jr., $1.1 bil., Los Angeles, CA
260. Alexander Gus Spanos, $1.1 bil., Stockton, CA
278. John Arrillaga, $1.1 bil., Palo Alto, CA
278. Neil Gary Bluhm, $1.0 bil., Chicago, IL
278. Richard Taylor Perry, $1.0 bil., Palo Alto, CA
340. A. Alfred Taubman, $0.9 bil., Bloomfield Hills, MI
363. Marvin L. "Buzz" Oates, $0.825 bil., Sacramento, CA
389. Walter Herbert Shorenstein, $0.75 bil., San Francisco, CA

Perusal of the list reveals that:

1. We must drop all the way down to #38 (Donald Bren) on the Forbes 400 American list before we encounter the first person whose riches derive from real estate. (Incidentally, Donald Bren ranks #122 in the world. Among those with wealth from real estate on the worldwide list, he ranks behind five others--three Hong Kong citizens, one British person and one Japanese.)

2. Just 18 out of the 400 names (i.e., a scant 4.5%) on the Forbes 400 American list attribute their wealth to real estate.

3. The geographical distribution of these 18 people with real estate wealth is: nine in California (five of these in the Bay area), three in New York, two in Chicago, IL, and one in each of four other states.

How do we interpret this situation with only a small percentage of the wealthiest Americans having obtained riches through real estate, even though real estate has long been in a bull market? Assuming that the Forbes list is accurate (and I would guess that it is, because the magazine has been tracking America's wealthiest for many years, presumably refining their ranking and fact-gathering methodology along the way), I suspect that some combination of the following behind-the-scenes factors could be at work:

a. "Old" Asset: Real estate has been around forever (well, at least since European settlers introduced the concept of land ownership on American soil--or stole land from the American Indians, to phrase what happened another way).

b. Low Volatility: Being a "mature" asset, real estate tends to rise in value over time but has much lower volatility than individual stock prices, making it that much more difficult to amass a real estate super-fortune during a lifetime.

c. Generational Wealth Dispersion: With inheritance laws and generational wealth dispersion effects, highly concentrated wealth tends to remain in families only a few generations. Children of the rich tend not to be as financially successful as their more entrepreneurial parent(s), just as the children of the tallest people tend not to become as tall as their parents (a type of mean reversion phenomenon is at work here). One example of this effect is how the late Sam Walton's estate (Wal-Mart) has been divided five ways between his wife and children, who will likely divvy it up further among their children, without any one child or grandchild ever succeeding in realizing long-run returns comparable to founder Sam's.

d. Derivative Wealth: Real estate tends to benefit from wealth creation in other areas but has little to no intrinsic value per se (i.e., how much is dirt worth?). For example, so many of the real estate billionaires live in the Bay area and New York because their wealth is derived from property appreciation driven by wealth creation in the technology (Silicon Valley) and financial (Wall Street) sectors.

The result is fragmented ownership of a low volatility, old asset. Compared to concentrated ownership of relatively new companies in the hands of their founder-entrepreneurs--think Microsoft (Bill Gates, Paul Allen), Dell (Michael Dell) and Oracle (Larry Ellison), or more recently, eBay (Pierre Omidyar) and Amazon (Jeff Bezos), or even more recently, Google (Sergey Brin, Larry Page)--it is much harder for an investor to make a colossal amount of "quick money" in real estate.

So, yes, there is money in real estate. However, it seems unlikely that real estate magnates will ever (at least under the present form of American capitalism with its breadth of entrepreneurial opportunities in the manufacturing and service sectors) occupy more than 5% (or maybe 10%) of the top slots among the wealthiest people in America or the world. Instead, real estate will probably continue to "derive" wealth from other high growth areas such as technology, producing plenty of rich landlords but very few, if any, of the incredibly super-rich.