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When is real estate a good investment?

In the long-run, houses can’t come close to the returns of stocks, bonds, and REITs. Don’t buy your home for future returns, but for an uncertain future.  

I’m often asked whether real estate is a good investment, even more often than I’m asked about the financial markets. Nonetheless, real estate nationwide is being rivaled by equities as the dominant asset class in household net worth, reflecting the high stock market valuations. This has previously happened in the late 1960s and late 1990s, two other periods when stocks traded at high multiples (of course these eras were followed by years of poor returns).

A family’s home is usually its most valuable individual asset, and the choice of where, when, and how to buy a home, second home, or vacation property carries greater weight than which equities to buy or sell. Aside from the size of the asset, it influences the friends you and your kids make, the activities you do, and even your family’s safety.

On paper, your home is probably a bad investment

It’s important to be clear on this: aside from what it contributes to your life, on paper, your primary home is likely to be a very poor investment. In your mental accounting, it should be treated far differently than a securities portfolio or even rental real estate. The reason is simple: the long-term return on real estate, once rents are stripped out, is vanishingly low. Robert Shiller is credited with the definitive work in this field, in which he tracks resale prices of the same properties over time, in the US and abroad. Real estate has on average returned less than 1% per year, and that is without accounting for property taxes, maintenance, and other holding costs.

This figure may be easy to dismiss if you live in a rapidly growing city or gentrifying neighborhood where properties have increased at double digit rates during this economic expansion, but as you can see in the choppiness of the curve above, such periods don’t continue ad infinitum. Even a 7% rate of growth results in a doubling every 10 years (Rule of 72: divide 72 by a percentage growth rate to get the doubling rate). The problem is that wages tend to increase at barely more than the rate of inflation. Lending standards and interest rates may make for a somewhat elastic tether, but the link can never be severed.

Another factor is that if home prices in an area become unaffordable for many, surrounding industrial land, farmland, or forest is developed. Construction is cheaper than ever thanks to technological advances and efficiencies of scale.

Low-end homes are a better investment than high-end homes

The cheaper a property, the higher the yield you can get from renting it out, and thus the stronger the case for owning versus renting your home. People with lower incomes are less likely to have the down payments and credit required to buy a home, so a landlord with such equity and credit is able to arbitrage the difference between his cost of capital and his tenants’ theoretical cost of capital. High end homes tend to have very low yields, sometimes none at all after taxes and maintenance, so the renters with the best deals are those who don’t need to rent.

This means that the best investments in real estate are the least glamorous: working-class housing or even government subsidized housing like Section 8 properties. Bear in mind that this isn’t a free lunch. When you buy such a property you are buying a job, as managing them requires constant attention, although this can be outsourced to a management company at some cost to your net yield. If you want to go this route, consider Roofstock.com or similar companies that simplify the process of selecting, buying, and managing rentals.

Ordinary rental properties have been the source of many substantial fortunes, such as that of the Kushners of New Jersey. Such a portfolio may compound over the generations, as its management requires less special skill than an industrial company or other highly specialized business, and far less discipline than a portfolio of liquid stocks and bonds.

Theory and practice are only the same in theory

This brings us to the main advantage of residential real estate. Unless you step into the development game, it is hard to mess up. Once you own a property, you only need to collect the rent, maintain the building, and pay your taxes and insurance premiums. If you diversify across different neighborhoods or regions, and don’t try to expand your empire too fast with excessive leverage, it takes a major folly to go broke. It has been suggested that Jared Kushner got in over his head with 666 Fifth Avenue, a debt-financed glamour purchase, just as Donald Trump got in trouble with casinos. Had they stuck with the kinds of properties their fathers had managed, their respective net worths would likely be much higher today.

The same logic applies to the decision of whether to buy or rent your home, and what kind of home to buy. If you are well-off and want to live in an expensive neighborhood, on paper you might be better off renting and investing the balance in a global portfolio of stocks, bonds, and income producing real estate trusts (ahem). That said, there is safety in owning your own home, especially once it is largely paid off.

Real estate’s advantage is that it is hard to mess up

Few people have the knowledge or discipline to actually achieve the high rates of return that are available in the liquid financial markets. The average DIY equity investor, for all his ups and downs, does little better than a savings account when all is said and done. And that’s the average – the left tail of the distribution is long and fat, meaning many lose virtually everything through bad timing, poor investment selection, and a general lack of risk management. Such risks may seem remote when the S&P has compounded at double digit rates for nearly a decade now, but those chasing tech stocks or the marijuana bubble may come to regret not simply accelerating their mortgage payments instead.

And once a home is completely debt-free, it becomes a refuge for the family, offering tremendous peace of mind and other intangible benefits. The cash-flow stress from such events as having children, being without a job, or simply retiring becomes far less if you can cut back your expenses to groceries, insurance, and property taxes.

In conclusion, if you are sure that you want to remain in one place for many years, there is nothing irrational about buying your home. Just don’t assume that it will appreciate above the rate of inflation. Far too many people are counting on continued growth in home prices to bail them out in retirement. Remember that real estate can stagnate or decline in real terms for many years, while owners remain liable for mortgages, taxes, and maintenance. If you don’t trust stocks and bonds, or wisely don’t trust yourself to manage them, consider investing in working class rental properties instead. Again, while buying a home can be a purchase of sovereignty and security, it won’t make you rich.

 

 

 

 

 

 

 

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