Thread by @ReformedTrader

A few real estate investors made a lot of money in 2009 and 2010, but they didn't do it because prices rebounded quickly from a low. (In the U.S., prices peaked in 2005 and went into a six-year downtrend.)

They did it by buying houses at large discounts of 30% to 50% + repairs.

There is momentum in real estate like in everything else: trends from last year tend to continue.

But even where we do see mean-reversion (one-month time frames in individual stocks), it takes a portfolio of hundreds of positions to capitalize on this statistically weak effect.

I don't know of any trading strategy that can generate reliable returns by trading a single, individual asset (one stock, one house, etc.) using its past price data.

Real estate investors get around the lack of diversification by getting huge discounts.

https://twitter.com/ReformedTrader/status/1399891647287029760

Once you've taken the discount into account, additional profits are subject to predictions about price movements (e.g. momentum) and valuations (e.g. cap rates) that are not statistically reliable unless you diversify noise away in a large, geographically spread-out portfolio.

Since the discount is the only statistically reliable return driver for 1 house, a small investor should try to reduce other factors:

* Hedge away the beta
* Turn the portfolio over to buy more discounted properties
* Avoid market predictions
* Add diversification (risk parity)

You may think that a fixed-rate loan buys time for a house's price to "come back" after a crash, but the actual tendency (momentum) is for the price to keep crashing.

You're also paying interest on a loan that may be larger than the value of the house itself; that is costly.

The benefit of avoiding margin calls isn't mainly for the price to quickly "come back" (this tendency only exists for a few assets, like individual stocks, and is statistically weak).

The main benefit is in avoiding drawdowns, which lead to negative compounding.

If you have a 75% drawdown, you still need to make 300% to get back to even regardless of whether you get a margin call.

The assets that can make you this 300% may not be the same assets that generated the margin call. You probably need a *different* mix (rebalancing needs).

The best thing to do is to plan ahead and avoid the drawdown in the first place.

A fixed-rate loan will not avoid drawdowns, just margin calls. Default happens with loans too, just in a different way.

Drawdowns are avoided by diversification + tail hedging, not loan terms.

The fixed-rate loan may even exacerbate drawdowns because of the nature of selling an illiquid asset into a market when there is a demand for liquidity.

When a house has to be sold fast, you typically have to accept a 20% to 40% discount.

That's more painful than a margin call, but you may have a bit more control over the timing.

That control is only helpful if you have a statistically powerful way to predict a price comeback. For a single house (and given the existence of momentum), this is unlikely.

This brings us full-circle: an investor that can avoid drawdowns and has liquid capital (which means capital not tied down in private real estate) is able to take the other side of the trades in which other investors are selling at those 20% to 40% discounts.

It's not a price comeback that generates profits during real estate recessions. It's having money available during those tail events to buy at large discounts. This means you want cash at those points rather than previously leveraged property.

https://twitter.com/ReformedTrader/status/1399901739428454400

If the return driver is mostly from buying at a discount, it makes sense to turn your properties over every year or two in order to get capital to buy again.

Sitting on houses for years waiting for them to come back means not being able to buy when the opportunities are best.

It's true that a margin call reduces your leverage, making it less likely to get the 300% return you need to get back to even in the short term. But the leverage would also have dramatically increased your risk of ruin and lowered your long-term geometric return to zero.

Total return volatility (considering dividend & rental yields), Kelly, & risk of ruin matters for all assets, but being close to ruin is psychologically easier for a house b/c the cost is interest on a loan higher than the value of the house rather than a forced margin call.

It's probably true that the lack of MTM & illiquidity can help you avoid panic selling. But they can also create a false sense of complacency when you do need to de-risk.

Even if your portfolio doesn't go to zero, having too much risk will reduce your compounding rate.

If you consistently buy at 30% discounts, you get a higher return by turning the portfolio over. Noise in home values reduces your confidence that you will successfully get that alpha.

You WILL capture this noise with the high turnover you need to maximize your compounding rate.