This article was originally published on February 24th, 2007
Buying a primary residence is probably the single best decision someone can make for their financial future. However, when you get into second homes, vacation houses, rental properties, commercial buildings, and raw land held for potential appreciation, you are playing a whole new ball game. That’s because, over long periods of time, the real returns (net of inflation) offered by common stocks has crushed those available by real estate ownership.
Yep. You read that right. Americans have become so enthralled with ownership of real estate that they often don’t realize a property increasing in value from $500,000 to $580,000 within five years, after backing out the after-tax interest expense on the mortgage, additional insurance, title costs, etc., doesn’t even keep pace with inflation! That $80,000 gain isn’t going to buy you any more goods and services; the same amount of hamburgers, swimming pools, furniture sets, grand pianos, cars, fountain pens, cashmere sweaters, or whatever else it is that you may want to acquire. Assuming a full mortgage at 6.25%, during those five years, you would have paid $151,401 in gross interest, or roughly $93,870 after the appropriate tax deductions (and that assumes you are in the top brackets, the most favorable case.) Your mortgage balance would have been reduced to around $466,700, giving you equity of $113,300 ($580,000 market value - $466,700 mortgage = $113,300 equity.) During that time, you would have shelled out $184,715 in payments.
Factoring in property care, insurance, and other costs, your gross out-of-pocket expenses would have been at least $200,000.
This should illustrate a fundamental principle all investors should remember: Real estate is often a way to keep the money you would have otherwise paid in rent expense, but it is not going to likely generate high enough rates of return to compound your wealth substantially.
There are, of course, special operations that can and do generate high returns on a leveraged basis such as contractors with a low cost basis buying, rehabbing, and selling houses, hotel designers creating an exciting destination in a hot part of town (it must be pointed out that in this case, the wealth creation is coming not from the real estate, but from the business – or common stock – that is created through hotel operations), or storage units in a town with no other comparable properties (although, again, the real wealth comes not from the real estate but from the business that is created!)
What caused this great real estate myth to develop? Why are we duped by it? Continue reading for insights, answers, and practical information you may be able to use.
1. To Many Investors, Real Estate Is More Tangible than Stocks
The average investor probably doesn’t look at his or her stock as a fraction of a real, bona fide business that has facilities, employees, and, one hopes, profits. Instead, they see it as a piece of paper that wiggles around on a chart. With no concept of the underlying owner earnings and the earnings yield, it’s understandable why they may panic when shares of Home Depot or Wal-Mart falls from $70 to $33.
Blissfully unaware that price is paramount – that is, what you pay is the ultimate determinant of your return on investment – they think of equities as more of a lottery ticket than ownership, opening The Wall Street Journal and hoping to see some upward movement.
You can walk into a rental property; run your hands along the walls, turn on and off the lights, mow the lawn, and greet your new tenants. With shares of Bed, Bath, and Beyond sitting in your brokerage account, it may not seem as real. Even the dividend checks that would ordinarily be mailed to your home, business, or bank, are often now electronically deposited into your account or automatically reinvested. Although statistically over the long term you are more likely to build your net worth through this type of ownership, it doesn’t feel as real as property.
2. Real Estate Doesn’t Have a Daily Quoted Market Value
Real estate, on the other hand, may offer far lower after-tax, after-inflation returns, but it spares those who haven’t a clue what they’re doing from seeing a quoted market value every day. They can go on, holding their property and collecting rental income, completely ignorant to the fact that every time interest rates move, the intrinsic value of their holdings is affected, just like stocks and bonds. This mistake was addressed when Benjamin Graham taught investors that the market is there to serve them, not instruct them. He said that getting emotional about movements in price was tantamount to allowing yourself mental and emotional anguish over other people’s mistakes in judgment. Coca-Cola may be trading at $50 a share but that doesn’t mean that price is rational or logical, nor does it mean if you paid $60 and have a paper loss of $10 per share that you made a bad investment. Instead, the investor should compare the earnings yield, the expected growth rate, and current tax law, to all of the other opportunities available to them, allocating their resources to the one that offers the best, risk-adjusted returns. Real estate is no exception. Price is what you pay; value is what you get.
3. Confusing That Which Is Near with That Which Is Valuable
Psychologists have long told us that we overestimate the importance of what is near and readily at hand as compared to that which is far away. That may, in part, explain why so many people apparently cheat on their spouse, embezzle from a corporate conglomerate, or, as one business leader illustrated, a rich man with $100 million in his investment accounts may feel bitterly angry about losing $250 because he left the cash on the nightstand at a hotel.
This principle may explain why some people feel richer by having $100 of rental income that shows up in their mailbox every day versus $250 of “look-through” earnings generated by their common stocks. It may also explain why many investors prefer cash dividends to share repurchases, even though the latter are more tax efficient and, all else being equal, result in more wealth created on their behalf.
This is often augmented by the very human need for control. Unlike Worldcom or Enron, an accounting fraud by people whom you’ve never met can’t make the commercial building you lease to tenants disappear overnight. Other than a fire or other natural disaster, which is often covered by insurance, you aren’t going to suddenly wake up and find that your real estate holdings have disappeared or that they are being shut down because they ticked off the Securities and Exchange Commission. For many, this provides a level of emotional comfort.