Real estate investments: basic principles, opportunities, pitfalls and the limits of private capital investment

When you look at how useful an investment in real estate for private investors is, it is helpful to first understand the basic relationship: In all forms of investment, be it bonds, stocks or real estate, there is a so-called inherent return. This means that there is a basic salary for giving other people living space orprovides commercial space. This remuneration is expressed in the form of rental income or leases, which are regularly paid to the owner. The central consideration is: Why not try to share at least a share of your assets in this fundamentally existing return? If you look at the historical development, it will be shown that residential real estate inIn the past, over a period of about 120 years, taking inflation into account, an average return on inflation-adjusted average yield of around 2.5 percent per year could be generated – a figure that at first glance seems quite attractive when looking at the long-term perspective and the global averages.

The practical relevance of real estate returns

It is probably not a big surprise for most readers or investors: If you look at the diverse possibilities of investing in real estate, it shows that there are essentially very few sensible alternatives. With the exception of minimal, hardly significant exceptions, it usually makes no sense to invest in complex financial products that are based on real estatebased. These include, above all, so-called closed real estate investments or securitized real estate constructs that are offered in the form of certificates or funds. These products are considered non-transparent and often expensive in the professional world, which makes them hardly attractive for private investors. They are primarily used to serve the sales structures of the financial sector, andNot in the interests of investors, especially when tax advantages or other so-called “incentives” are brought into the field for such products, one should be very careful. Do you remember the so-called Ostimmobilien in the 1990s? It was a real madness – objects that were already too expensive for the tax advantages at least when sellingbrought to the man. Banks, brokers and distributors earned strong commissions at the time, while investors often had no opportunity to inspect the properties in person at all. The result was mostly a long-standing dry spell that either ended at a standstill or in total loss. Tax models are less common today, but they still exist:Investors who hope to zero out on real estate transactions often invest in so-called 6b funds, which offer attractive short-term advantages in the long term, but often only represent another form of risk in the long term – a kind of toxic waste in the cloak.

Risks of operator and special properties

Another segment that is often advertised is operator or special property, such as supermarkets, nursing homes, old people’s homes or retirement homes. A few months ago, I had a conversation with a doctor who had acquired a assisted living project in a small town in a rural region a few years ago. Such ready-made objects are gladly witha positive story that emphasizes the demographic development and the increasing aging of society. The goal behind it: For the seller, the advantage is to enforce higher prices and commissions because the lack of transparency of such objects is often high. To get a feeling for it, I asked my interlocutor: “Where is the nursing home exactly?Do you hear the main street in the rooms? Is there a café, restaurant, cinema or theater nearby? How often does the bus go to the next largest city? Isn’t the regional district town much more attractive, and how much does a comparable nursing home cost there?” The answers were sobering: The investor had never visited the property himself. The advisor who gave him thatProject recommended, was invested there even there – that is the classic sales argument that is omnipresent in the industry. It shows how much the sales side is geared towards sales success, while actual performance is hardly transparent to the investor.

Open real estate funds: opportunities, risks and the risks of liquidity

Open-ended real estate funds, where investors have access and exit opportunities, are also associated with significant problems. Although there are a few products that are basically justifiable, these are difficult to recognize for private investors and are usually difficult to access. The cost is high, and the real property value is only visible whenone is sold. The market values are determined at longer intervals by experts, with a tendency to smooth up or down valuation changes. Unfortunately, conflicts of interest are the rule in this form of investment: For example, problematic objects are often moved from one fund to the next or merged into the nextto avoid a single fund. It becomes particularly problematic if too many investors want to sell their shares at the same time. Then there is a so-called “run” situation that presents the fund with existential challenges. I myself experienced such situations up close when I was still working at a large bank: Sales departments had to do everything they could to create new onesto win investors to support the existing investments. This is unpleasant for consultants, but even more so for investors. After the financial crisis in 2008, many open-ended real estate funds resulted in forced settlements, which led to significant losses. Although the legal framework conditions have been improved by the introduction of notice periods for the sale of such funds,But the basic risks still exist.

REITS: Investing in real estate stocks – a bridge or speculation?

Another way to get involved in the real estate market is to invest in so-called REITs – Real Estate Investment Trusts. These are exchange-traded companies that are active in the real estate sector. A lot can be discussed whether an investment in REITs is more of an industry speculation or a real investment in real estate. For private investors:If you don’t necessarily want to invest in this industry, you should only do so with measure and goal, and above all only if it fits your own risk profile.

Own real estate as an investment: opportunities and risks in detail

In the end, the question remains whether you should buy a property directly. At first glance, this sounds like a good alternative: You have a physical thing to touch and there is a possibility to earn regular income by renting. However, the way there is associated with considerable additional costs: Depending on the federal state, you will be buying a propertybetween 8.5% and 11.5% in costs for brokers, land register, notary and real estate transfer tax. This corresponds to a significant financial burden comparable to the expenses for an independent fee-based advisor – and that with a term of at least ten years. In addition, there are ongoing costs: repairs, maintenance, administration, tenant search, official requirements and theenergetic renovation. These costs add up significantly over the years. One should not underestimate the wear and tear on nerves and one’s own working hours: change of tenants, disturbing repairs, official requirements, rental price regulations and the pressure from energetic specifications constantly require attention. All of this adds up, and in practice this means: oneReal estate is not a passive investment, but a permanent project.

The big risk of risk and its consequences

However, the biggest vulnerability in real estate investments is not only in the costs or market fluctuations, but above all in the high proportion of debt. Many investors finance the acquisition of their property with significant loans, often with considerable debt. The problem: The property must either function, i.e. generate rental income that covers the running costs- Or it becomes a risk. In the worst case, the property becomes worthless or hardly for sale. It is amazing that many investors hardly take this risk. I remember an investor I would like to call “Mr. G.” who had invested the majority of his assets in a commercial property in a outskirts of a large city. For years he was on the verge of bankruptcy,But in 2019, he saw a chance to sell the property at a great profit and pay off his debts. This was salvation for him, but the risks he had taken were barely visible. What Mr G. did back then is called action bias: He did everything to stay active, although the situation has hardly improved. Flyers, ads, try to find tenants- All in vain, but he felt “still master of the situation”. This behavior is typical for many investors: They put everything on one card because they hope it will get better at some point and ignore the actual risks.

Long-term consideration and the risk of blistering

Real estate is still very popular in Germany. Especially in top locations like Munich, Hamburg or Frankfurt, many investors experience enormous increases in value. But history shows that such expectations are not always justified. For example, between 1991 and 2007, real estate in Munich lost around 40 percent in value adjusted for inflation – and that in one of themost attractive cities in Germany. Despite high lending interest at the time – sometimes over 10% – these losses were only visible after years. Those who persevered in such phases were often rewarded – but the result was based on luck, not on a rational decision. This shows that real estate can also be subject to considerable fluctuations in top locations. It’s an illusionTo believe that real estate values are constantly increasing. The reality is that the markets are volatile, and patience alone is no guarantee of success.

The real estate paradoxical: subjective security versus objective risk

Although the objective risk analysis speaks against real estate, many private investors still feel subjectively very comfortable when it comes to investments in property. The so-called endowment or possession feels a central role: the house or apartment becomes a personal legacy, a manifestation of one’s own achievements, a symbol of family heritage. Especially in inheritances, it is increasingThis emotional bond is considerably – often so much so that it suppresses the rational view. An example: An experienced real estate investor, whom we call “Mr. L.”, has inherited a property that has gained significantly over the years. For him, the object is more than just an investment – it’s a monument to his family. This leads to the idea of the housesell, almost perceived as betrayal. In heirs’ generations, conflicts often arise between emotional connection and economic reason.

Tax privileges and design options for real estate

Another reason for the popularity of real estate is the multitude of tax advantages and legal options that this form of investment offers – often compared to securities or other investments. For example, owners can claim tax losses on listed properties annually, and when selling real estate, the rule applies that profits afterare tax-free for a period of at least ten years. In addition, owners can transfer their properties within the family tax-free, for example by reserved a usufruct or a housing right. The possibility of splitting property between several people, for example through donations or usufruct rights, also offers considerable tax advantages. This allows theSharing succession of assets individually and flexibly without completely giving up control of the property. The land register system ensures legal certainty. In addition, real estate for banks is very attractive: They can be easily, cheaply and legally secure, or used as security for other purposes. This is much more difficult with securities.

Emotional bond and the danger of self-deception

In addition to the purely economic aspects, the emotional connection to the property influences the decision to keep it or sell it. The so-called “endowment phenomenon” describes the tendency to hold on to property because it is already owned. These effects are particularly strong in real estate: Your own house, especially if it has been in the family for a long time, gets onePersonal personality, a kind of aura that makes a rational assessment difficult. Many owners develop a strong imagination to secure the property even after death – for example through complex inheritance contracts or real estate funds, which are intended to secure the property. For the potential heirs, the thought of having to sell the house is often associated with a guilty conscience – asBetrayal of one’s ancestors, of one’s own history.

Inheritance Assets: Curse or Blessing?

Especially with inheritances, this emotional bond can mean that the inherited assets do not lead to a better quality of life, but rather become a burden. This is shown by the example of a Munich teacher who inherited an apartment building that has increased significantly in value in recent years. Initially, the value was around 12 million euros, now 30 million.Inheritance tax attributable to the value amounts to several million euros. Although it could cover the running costs by renting out the apartments, the high taxes, the ongoing renovation, the administration and the rent limits make the assets difficult to use.

Even if the property is sold, the big question remains: What is the actual value?emotional attachment is not also a form of self-deception – the “clinging to property” for emotional reasons.

Real estate is not a panacea – but a complex investment

Despite all these risks and pitfalls, it remains to be noted that real estate can be more successful for private investors in certain situations than most other investments. The so-called “real estate paradox” describes the fact that it is precisely the tax privileges, the legal options and the emotional connection to property that create the actual added valuemake out.

Nevertheless, real estate is not a panacea. They are inflexible, elaborate, expensive and barely transparent. The risk of manoeuvring yourself into a difficult situation due to bad tenants, regulatory requirements or location weaknesses is high. Therefore, one should always keep in mind that a property – similar to a share – is ultimately only an investment that has been made by the market,location and long-term development. If you are aware of this fact, you can use your assets wisely and protect yourself from making the wrong emotional decisions.