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