Rental Real Estate: Nature’s Small Loss Generator?

By Brad Thomason, CPA

 

Mebane Faber had Steve Sjuggerud on his podcast earlier this year.  As they were wrapping up at the end of the interview, Meb asked Steve if there was a common mistake that he saw investors making, one which could be easily avoided.  Without hesitation, Steve said that was an easy one, and it was something he saw again and again.  He said people let their losers run and cut their winners short.  He went on to reiterate the point that any number of successful investors – from Warren Buffet to George Soros – have made: you can’t let small losses turn into big ones.

One of the attractive aspects of rental real estate is that when you start looking at the list of things which can go wrong, you realize that a lot of them have some natural brakes built in.  Now, a person in my position should never make comments about some catastrophic event being impossible.  So I’m not saying that blow-ups in real estate are impossible.  But when you narrow the focus to rental real estate, and you look at the most common problems, what you find are situations which have a natural tendency to stay in the small loss category, and not morph into big ones.

If you own a stock, you have to worry about devaluation.  You don’t want the price to go down from where you bought it.  If you have to sell before it recovers, you could take a loss.  But what you really don’t want is something which causes the whole thing to implode, and the value of the shares go to zero.

If you buy a rental house it is certainly possible that the value might decline for some reason after you buy it.  If you had to sell while the price was depressed you’d be in the same boat as with the stock.  At least as far as the gain/loss part was concerned.

But even if the supposed value dropped, as long as you were still receiving the rents, you really wouldn’t feel the drop.  At least not until you sold.  Even then, the loss in value would be partially offset by the rents (Note: dividends for the stock would function the same; though few stocks these days pay dividends at all, and fewer still pay dividends with yields that match what the rents would equate to.).  So that’s sort of a built-in small loss.

The bigger issue is the question of whether or not the value of the home can go to zero.  We know the stock can (dozens do every year).  What about the house?  Maybe.  But most of the ways that I can think of that a house could lose all of its value are things against which you could buy insurance.  Could a house generate a total loss?  Yes.  But it would be hard and it would be rare: fire, sinkhole, asteroid…  With insurance, it might be approaching functionally impossible to lose all of your money, even if you do have a very bad day.  Think of it as a stop loss you don’t have to remember to place.

What value does that have?  Well, ask yourself this question: over a lifetime of investing, how many total losses do you have to avoid before it was worth the effort?

So something could happen to the house which could cost you money.  But if you had it insured, that should pretty effectively limit the downside.  Again, a loss which would tend to be small in nature, versus big.

The other concern with rentals is of course a disruption in the monthly cash flow.  Vacancy will occasionally lead to zero-income months, even if you never have one from a non-paying tenant.  Which isn’t great.  But to get some perspective on the severity of this problem let’s look at the situation through the lens of a bond.

If a bond holder encounters a break in interest payments, it usually signals that the issuer is having some significant problems, that the stream of income may be permanently impaired, and that the redemption value of the bond may now be less than what was paid at issue/acquisition.

On the other hand, a month of vacancy doesn’t necessarily indicate any sort of problem at all, just a natural part of the life cycle of the asset.  But more importantly, just because you don’t have rental income in March, that really says nothing at all about the asset’s yield earning capability for next month, next quarter, next year.  No money in March doesn’t mean that it’s a foregone conclusion that April and May and June will be dry, too.  Once again, not a big loss; just a small one.

When we go looking for reasons to invest in a certain asset, we typically focus on the strength of the pros.  We don’t usually come at it from the perspective of picking apart its cons.  But in the case of rental real estate, when we do, we find an asset which seems to have some real advantages in the field of keeping small losses from becoming big ones.  Given how often the most successful investors point to that as a key element of investing success, maybe we should spend more time getting familiar with the cons, after all.