When most people hear of “The Theory of Relativity” they think of Einstein and E=MC^2. As it turns out, there is another theory of relativity that investors need to know about. This relativistic view of the investment world can be summarized by the phrase: “Compared to what?”
When viewing income producing real estate as an investment vehicle, we must always ask what we are comparing it against. This is especially important in a zero percent interest rate environment where risk free assets provide almost no yield. All of this is juxtaposed against the fact that the zero percent rate of return on “risk free” assets like Treasury Bonds may carry no risk of default, but they carry a significant risk of having their real value eroded by inflation.
So what else is out there?
Stocks and mutual funds have historically produced a net return in excess of inflation, but the values have also been volatile. What this means is that success is highly dependent on “when” you buy and “when” you sell, since stock market returns are much more dependent on capital appreciation than they were in prior decades. With success in the stock market so heavily tied to successful market timing, it is not a reliable way for most people to build long-term wealth.
This is where income producing real estate comes into the limelight. There are certainly problems that can occur when you are a landlord. There can be problems with financing, problems with tenants, problems with realtors, problems with contractors, and problems with property managers. However, the theory of relativity says that these problems that are frequently associated with real estate investments still sum up to something that is better than the other alternatives for many investors in the marketplace.
As intelligent investors, there are ways that we can take this relativistic advantage of income property and pull it even further into our favor. One of the best ways to reduce the risk associated with owning real estate is to purchase in markets where the Land to Improvement (LTI) Ratio is low. The reason for this is because low LTI ratio markets have a high percentage of their value in the improvement value of the property. This protects the investor because the improvement value of real estate typically regresses toward replacement cost over time. As inflation pushes up the cost of construction, the replacement cost of real estate also tends to increase. Also consider that over time, commerce tends to shift from high-cost market areas toward lower cost regions. This helps to further reduce the risk of low LTI markets for income property investors.
In short, income property is one of many imperfect investment vehicles … it just happens to be one of the least imperfect investment opportunities that we have available.
