When it comes to real estate, most people have an anecdotal story of someone they know (or, better yet, someone they know who knows someone) who “struck it rich” by investing in property. While these types of self‐made real estate tycoons exist and one may make profits in real estate, making a fortune investing in real estate is certainly the exception as opposed to the rule. Most who make outsized profits owning real estate usually have some sort of competitive advantage typically not available to the average person. For example, professional home builders and experienced property improvers can buy undervalued homes, improve them and sell them at a profit. In this essay, we will address the myth that owning property is an easy path to riches and also discuss the conventional wisdom that owning a home is always a good investment.
Let’s first state with some very interesting data points from the famed Yale economist, Robert Shiller. One of the most shocking facts he points out is that residential real estate prices (adjusted for inflation) from 1890 to 2012 were virtually unchanged. For comparison sake, the S&P 500 (also adjusted for inflation) increased 2,000 fold during that same 122 year time period. Yes, 2,000 fold (or 200,000%).
Shiller goes on to say “If you look at the history of the housing market, it hasn’t been a good provider of capital gains. It is a provider of housing services.” Essentially, he is saying that a home gives you a place to sleep, a place to store your goods and, generally speaking, a place to live. It is not something to be looked to as a place to bolster one’s investment returns.
We simply have to realize what a home does provide and readjust our expectations in regards to its purpose in our “productive capital” bucket. A home usually provides emotional stability, peace of mind, a place to spend holidays with family and things along those lines. In most cases, it does not provide a high positive real return. This long‐term trend suggests that, unless there is another speculative bubble akin to the one we saw in the early 2000s, or an unexpected real estate crash, your home will most likely be worth something close to what it is worth today (in future dollars, of course).
When one considers the mechanics of how and why home prices fluctuate, it actually makes sense that over long periods of time housing barely keeps up with inflation. For instance, homes are manufactured goods, so it only makes sense that technological progress sometimes renders certain aspects of older homes obsolete. Technology is anti‐inflationary. When one realizes that homes have technological components to them, it only makes sense that prices would not increase and could potentially go down.
Additionally, certain homes don’t necessarily age well. Specific aspects of one’s home that may seem luxurious now, may become standard in 5‐10 years and perhaps even outdated or out of style in 15‐20 years. With the rapid technological advances that we’ve seen in recent years, we wonder if anyone can accurately forecast what types of homes we will see in 20 years. Homes may come standard with built in hi‐speed Wi‐Fi services and kiosks for tablets and laptops (will we even be using these things in 20 years?!). More likely, they’ll have a number of amenities unimaginable in 2014.
Additionally, the unique upgrades and particular customizations that make everyone’s home special, typically only make the home “special” to the current owner. To prospective buyers, the Star Wars light saber light fixtures installed throughout one’s house are more of an eyesore, nuisance and extra cost to replace than it is something that makes the house a “home.” In his book Predictably Irrational, Dan Ariely refers to this as our “high cost of ownership.” The high cost of ownership explains the fact that we often overvalue that which we own. This leads to questions like “How can the person who just looked at my house not want a massive granite wishing well in their backyard?”
As far as real estate as an investment is concerned, there are some advantages, but there are also many disadvantages. The common line of thinking usually goes something like this: “I am going to buy a property and rent it out so that someone else pays down the mortgage on this property. Then, I will be gaining equity on this property with no effort.” Well, let’s take a closer look at the mechanics of this strategy to determine the economic costs and benefits of this type of investment approach.
In this example, let’s assume one buys an investment property for $400,000. The down payment is $80,000, and the mortgage is $320,000. At an interest rate of 4.25%, the monthly payment over 30 years would be approximately $1,575. Let’s assume real estate taxes of 1% of the value of the home, or $4,000. The rule of thumb for home maintenance is between 1‐2% of the value of the home. Let’s assume only 1% maintenance costs on this home. This would mean that to break even every month one would have to rent out this home for about $2,240/month. This may be achievable in the open market, but there is also the chance that it’s not. There is also the possibility that one must hire a property manager to help find tenants and keep up with the management of the property.
Therefore, in most cases there is a gap between one’s monthly cash inflows and cash outflows. The gap may come in the form of a fee to the property manager, it may come in the form of higher than expected property taxes, or it may come in one of countless different forms of unforeseen obstacles. Whatever the case may be, as a (part‐time) investment property owner it is quite difficult to find a property that “pays for itself.”
In the long run, the investment of time or the investment in a property manager needed to make the endeavor profitable also makes real estate investments less appealing, and often, less lucrative. The many ever‐changing variables that can be unfavorable for an investor in residential real estate have to be carefully considered before entering into such a venture.
Lastly, I’d like to point out the powers of compound interest and inflation when considering how profitable one’s investment actually is. We recently had a client tell us how great he did because he bought some property for $200,000 in 1988 and sold it for $600,000 in 2014. He was thrilled to tell us that he tripled his money over the span of 26 years. Well, keep in mind that is a before-inflation rate of return of only 4.32%.
And according to the Bureau of Labor Statistics inflation calculator, $200,000 in 1988 has the purchasing power of $400,798 today. This means that inflation has averaged 2.71% over the past 26 years. Therefore, the annual real rate of return for this individual was only 1.61%. Averaging a real return of 1.61% sounds much less thrilling than tripling one’s money. This example helps to point out not only the power of compounding over the long‐term, but also the insidious effects that inflation has on our purchasing power (and our investment returns!).
Obviously, the above paragraphs are just a brief analysis and one that deserves many more layers, which would be deeper than the scope of this article. As previously mentioned, there are plenty of folks who have amassed a great deal of wealth through investing in real estate. That said, one should be very aware of the many risks of such an investment. One should also set expectations appropriately as (even with the power of leverage) it is quite difficult to achieve outsized returns in real estate investing when not inherently possessing a competitive advantage.