The recent paper The Total Rate of Return on Everything 1870-2015 has some intriguing findings on housing as an asset class: Returns were approximately the same as stocks with less risk.
This defies conventional wisdom: Lower risk ought to make the rate of return less than stocks, because investors would be expected to pay more for lower risk. Also, it’s generally understood that real estate has a lower rate of return than the U.S. stock market. And it stands to reason: If housing price appreciation greatly exceeded inflation, eventually hardly anyone could afford to buy a home.
So is it worth it? Have we all been wrong? I don’t think so, but I do think there are some important exceptions to the rule.
Investing for Price Appreciation
In general, as an investment, residential real estate in the United States, considering only property values, performs about as well as inflation. It holds its value well, unlike cash. You may as well buy bonds and save yourself the trouble, except if you want to live in your investment. Once you own the home you live in, it’s hard to make the case for investing in additional real estate if you’re counting on rising home values to make you money. Of course I’m ignoring rental income, taxes, tax benifits and maintenance. I’ll get there.
The Case-Schiller index tracks home prices since 1890 and shows that over a long time period the values match inflation. The index looks at repeated sales of the same homes, so changing sizes of new homes isn’t a factor.
While Americans are spending more for housing, they’re not spending more in inflation adjusted dollars per square foot. Here’s a table from the U.S. Census for new home sales prices since 1963. Once you adjust for increasing sizes of new homes, price per square foot tracks inflation. (983 to 2657 square feet increase.) more details 4.2% increase in home price per square foot per year; 4.4% annual inflation over the same period.(See the BLS for the CPI) How can they afford these larger homes? I don’t know, but here’s an idea: The share of income needed to buy food and clothes has dropped during this same time period, making some room for more spending on housing.
Rental Income is Key to a Decent Return on Investment
In “The Total Return of Everything” they include rental income in the rate of return; no financing costs are included, nor property taxes. The fact that rental income is key to the returns means you need to compare investment property to stocks and bonds, and leave out your primary residence. The data came from many countries and it seems the rate of return in the United States considered alone was not as good, so don’t take this study to say investing in U.S. real-estate is a better deal than investing in stocks. But, it suggests conditions in the U.S. could change for the better; it’s happened elsewhere.
For thinking about your own home as an investment, a study in 2009 showed that return on investment, when accounting for imputed rent and tax breaks gave U.S. home-owners living in their homes a return of 6.9%, 0.4% under that of the stock market over the same period at 7.3%. Read the abstract.
The data end in 2005. If you owned your home after that, achieving a similar rate required you to have held the property to the end of 2017. Of course the stock market also dropped a lot, but it recovered more quickly than the housing market.
This is actually remarkably favorable as a return; but we’re not considering all those home-owners who lost their homes, and due to their default had subsequent negative financial outcomes because of bad credit.You don’t face a comparable risk with your retirement account, it can only grow or shrink.
A draw-back for investing in your own home is that it doesn’t easily scale: You can only live in one place at a time. It could be an expensive place, though.
### Ways to Enhance Return on Real Estate Investments
Buy Below “Market” Value
If you could somehow obtain real-estate below the current market price – after paying transaction costs of buying and the eventual sale – your rate of return would exceed the average rate of return when you sell. The real-estate market is much less liquid than the stock market, making buying and selling a lot of work. However the market is also less efficient, and local conditions can change: New zoning laws, new train lines, access to inside information may make a few properties here and there into fantastic deals for a short time.
Another scenario where you get a good deal is during a serious downturn. Of course the catch there is that during a serious recession like 2008, people have less money to invest by definition – the economy has gotten smaller, the stock market and housing market decline together – and you’re likely in the same boat, not excited to take financial risks, because everyone fears the market will continue to drop. Then, assuming you could invest, you’ll have to wait for an unknown number of years for the market to recover if you do make a purchase, tying up a lot of money in the meantime.
You might plan to make money mostly from price appreciation or mostly from rental income, depending on the situation. If you can buy significantly below market value – occasionally achievable even outside of a recession if you can pay cash, are persistent, and possibly unethical – you can maximize both.
In a weak market, the market value is hard to determine, and actual appreciation is unlikely for a while. However, you can still make sound purchase decisions based on how much rent you can collect from a property; and if the vacancy rate is extremely high, negatively effecting rental income potential, prices should partially reflect that fact, or you shouldn’t make the purchase. Put another way, both returns from selling the property and return on rental income are uncertain, but rental income has less uncertainty in the short-term. This means you should base your purchase decision on projected return on investment: You need positive cash flow.
Some houses in traditionally “expensive” neighborhoods may be temporarily cheap for their location – and it’s possible, though not likely that they are a good deal – but if they are too expensive compared to the rent they could bring in, take a pass unless you want to live there.
Buy During a Recession
The aftermath of the 2008 housing bubble was the environment in which I first invested. In a lot of ways it’s a best case scenario. We may never see such opportunities again. This is how the market looked in Minneapolis around 2011:
A regular sized 1910-1935 house in decent condition goes for $100,000. It requires $12,000 of repairs and $3,000 of improvements. You see similar houses rented out from between $1200 to $1650 per month. Vacancy rate is extremely low due to so many homeowners going through foreclosure and getting thrown into the rental market.
- Borrow $100,000 (essentially 3% down, but closing costs make up the difference.) Use cash for repairs.
- Put 20% down and borrow $80,000. Use cash for repairs and improvements.
- Pay all cash.
(1) Is nearly impossible for one of two reasons. Either you will have difficulty obtaining financing from a lender on these terms, or even if you do, purchasing a REO(bank-owned foreclosure) property will be hard since offers backed by unconventional financing aren’t strong. You would be ignored or lose out to stronger offers. (2 and (3) are realistic (assuming of course you have the cash.)
In some markets, where investors make up the majority of buyers, only cash offers get accepted as they are more certain to close successfully and go faster.
Remember you can, if you raise the cash initially, pay cash up-front and take out a loan against the property later. You’ll want to put that money into something that yields more than the mortgage interest rate. Buy another property and rent it out to pay off that loan and make extra money on top. But don’t think you can just repeat this process every month until you own the whole city. Banks strictly limit the numbers of loans they’ll make to new investors, and to approve the loan they use your income, which doesn’t include new rental income.
Think of buying an investment property as buying the rental income. During a recession, since you may be stuck with a property for a long time, it would make sense to commit as little cash as possible so all your resources aren’t tied up and you’re buying the most income for your dollar. The other side of this is that paying back a loan eats into your cash-flow.
The way to decide what to do is to think about your return on investment. With no loan it’s easy to get positive cash flow, but the rate of return won’t be great. With a loan you’ll bring in less money each month, but your initial investment will also be much lower.
Careful use of financing helps to maximize your return on investment. An all cash purchase in the example would get you an net income(after 45% income to expense ratio) of between $7920 to $10450 per year for $112000. Not too bad compared to other fixed income options.
On the other hand with 80% financing at low rates (still available today: 3.75% in this example) you are getting $3475 to $6005 for $32000 up front. Briefly:
initial improvements: $12,000 down payment: $20,000 monthly mortgage payments: $370.49, $4445 per year. on a 30-year rental income: $ $14,400 to $19,800 net income estimate: (55% * gross) $7,925 to $10,450 cash flow after debt service: $3,475 to $6,005
The financing took you from a 7.1% to 9.3% range of a possible return on investment to 10.8% to 18.8% range of a possible ROI. The leverage the financing gives you can help a lot if you can keep your income high. If it goes to zero you’re in more trouble than you’d be otherwise, because now in addition to paying property taxes and insurance you’ve got to make the mortgage payments.
In other words, financing is a form of leverage which multiplies both your risk and reward. The single property would be making you less income, but at a better return on your investment with the risk of losing the property if your income dries up. You can see with the large range of cash flow numbers when employing financing that your situation is very sensitive to changing rents. The more leverage you use, the more sensitive your situation is to fluctuations in income.
Use More Leverage
Using the example your $100000 cash could purchase between $9300 to $16000 income if you could find three additional similar properties and borrow for all three. So now you’d have four properties instead of one, and making a higher income. Pulling this off may be difficult unless you already have loads of money; banks usually won’t allow you to use relatively new rental income as part of your loan application and they won’t give one person multiple mortgages unless that person has a track record in the business. Another example of how it takes money to make money.
Believe it or not, the above example was a common price for single family houses available in Minneapolis during 2011. At this price they often required only $2000 of repairs, sometimes $10,000 to $15,000. Some were ready to move in, but were not typically the style of house that can get as much rent as needed for the example. There were enough rentable homes on the market to make this a reasonable strategy though. In fact, focusing exclusively on houses under seventy thousand or even sixtey thousand in decent neighborhoods would have been possible.
These days it feels as if we’re in a second housing bubble; prices are high enough that it’s going to be a lot harder to find deals where you can get a positive cash flow situation. In fact, though a collapse may be less likely, the current market is even worse than in 2007 because the total number of properties for sale is smaller, meaning you have fewer choices. That’s part of what’s driving up prices. If you’re considering jumping into the market to make money (why else would you?) you need to understand the math for evaluating if a deal can truly be cash flow positive, and how to weigh return on investment against return on equity. In the next post I’ll go into how to do this.
Finally, there’s another reason to invest in real estate: As a hedge against your other investments and to diversify your investments. I’ll look at this in my third post.