Is Real Estate a Good Investment?

by Antar Salim on 16 September 2010 14 comments

Currently, we find ourselves in an economic quagmire with many investors ferreting opportunities to grow individual wealth. Unlike Baby Boomers, the need to search for personal wealth opportunities are particularly important for young investors, as we need to ensure that enough money is put into retirement "piggy bank." If you consider the general economic trend, young adults have to work longer into retirement years than previous generations in order to sustain a standard of living they were accustomed to in their working years. Consequently, young investors need strong investment returns that exceed the rate of inflation in order to avoid working in later years.

In lieu of our insatiable appetite for moderate to high rates of return, young investors know that traditional bonds won't meet our needs, as they normally return 5% per year. Consider that inflation is normally 3%, which leaves us with a real rate of return of only 2%. To be exact, it's slightly less than 2% based on the Fisher hypothesis, a theory where interest rate is independent of monetary measures, particularly the nominal interest rate. Hence, a real rate of return of a paltry 2% won't afford a 20-something the desired monetary growth for their long-term personal investment portfolio.

If bonds don't give young investors a high rate of return, many economists would suggest investing in stocks. The basic theory of stocks is that the greater the financial risk, the greater the reward. Most young investors know about those who have made a great sum of money in the stock market. We often overhear our friends and colleagues discuss how they made thousands of dollars in the market over a short amount of time.

But let's check the facts…

Consider that 10 years ago, the S&P 500 hovered at approximately 1,400. Today, it's at approximately 1,100. That's a decrease of 21% — an unpalatable figure for those who want to eat in retirement. Not only has the S&P declined, but the Dow is down by 3%. Again, it's not a return needed to prepare a young person for a decent retirement. Net takeaway: stocks.

After examining the investment opportunity in bonds and stocks, the next stop on our journey is real estate. I have often heard that real estate — particularly buying a home — is an investor's best asset. Let's see if this is a valid claim.

ARTICLE CONTINUES BELOW

Depending on your sources, the average home price in the U.S. at the beginning of the millennium was approximately $160,000. Today, that same home will sell for approximately $200,000. Before we attempt to determine whether real estate is a good investment for a 20-something, consider that home prices rose considerably during the first half of the decade. If we explore the change in home prices, the average home increased by $40,000, or 25% over the decade. If you do the math — considering present value, future value, and time — this equates to a 2.2% compound increase year over year. Congratulations, we're now in the positive rates of return.

Just one moment. We haven't considered the rate of inflation, which we know historically is greater than 2.2%. Not only that, we haven't taken into account that it cost us approximately 5% to 6% a year to borrow the money to purchase the home.

Granted, we all have to have a roof over our head, and I'm not suggesting that real estate is a bad investment, but it is my personal opinion that if your home is your best and biggest investment, then you may be in trouble. Young investors need to undergo a paradigm shift in which they view real estate as a place to live and not as a money generating asset. It is vital to our long-term financial success that we understand that homes are not a money machine that will make us all rich, but a place to live that affords us the ability to raise children and keep us warm during the winter months. A home may be your biggest investment — but it may not be your best investment. In my opinion, diversifying your personal portfolio and including a healthy blend of stocks, bonds, and real estate is the best way to go.

This is a guest post by Antar Salim, MBA. Antar serves as a coordinator for Rasmussen College School of Business, at the Eagan, MN college campus, where he teaches business degree-seeking students.

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Guest's picture

Completely agree, Antar. I too, totally bought into the "truism" that real estate is a wise investment. I'm sure it was a sound and sure investment strategy in the "old days" when homebuying was something you did just once or twice (and saved up for for years), because you planned to stay in the home your entire life. IF that is your strategy, it probably still makes sense in the long haul. The trouble is, very few people buy homes for the long term anymore; they intend to continue "trading up" every few years.

Now that I am a homeowner and have experienced first hand how many other expenses it introduces, like tax, maintenance, and insurance, I'm inclined to believe renting might be the better way.

Guest's picture
Guest

Hi Stephanie,
thanks for your input and support of the paradigm. I'm curious to know what constitutes a wise investment for you?

Antar

Guest's picture
Veritroth

The only real estate that should be considered an investment is from a rental that is cash flow positive. A person's primary residence should in no way be considered an investment. Common sense dictates that housing values can only rise sustainably with rising wages, making real estate an inflation hedge at best and outright liability at worst (interest on mortgage, insurance, taxes, maintenance, etc.)

Too bad for most people, their house is, by far, their largest "investment."

Guest's picture
Guest

Hi Veritroth,
I agree - assuming it is cash flow positive after you take into account risk. For example, if I can only generating 5% return in real estate - I would agree it is a poor investment compared to stocks that generate 4-5% dividend yields.

Antar

Guest's picture

I think you're missing the key point of considering real estate to be an investment. You're investing a ton of money that you're borrowing, rather than money you already have. If you have $200,000 cash in your hand, then it may or may not be a good investment to buy a house. However, if you borrow $200,000 from the bank, paying a low interest rate, getting 2% back through appreciation, a significant amount of money back through income tax deduction, and differencing out the amount you would have paid through rent by renting, you might just be making quite a bit of a profit.

If you're renting at $1,000/month, then you are giving away $12,000 per year with no hope of recovery of any of it. You started with no cash, so you're making no money on other investments.

If you buy, and your mortgage interest is $1,000/month (ignoring principal since that's not truly an expense), then you may get back $200/month ($2,400/year) through income tax deduction, and your home value increases by $4,000/year (2%), for a total of $6,400/year increase, which even that number increases every year. A $6,400 "profit" for "zero" initial investment is pretty darn good.

Of course, in real life, there's a down payment (not truly an expense but a big out-of-pocket event), property tax, closing costs, commission, home repair, and a ton of other expenses, which eats away at that $6,400 pretty fast. So the true question about whether home ownership is a good investment is whether or not your ownership expenses outweigh the return, and how long you live there may be the biggest factor in that question.

Guest's picture
andyg8180

An investment is something that has value and returns capital either in the form of interest income or appreciation. So, no, a single home is definitely NOT an investment unless youre flipping it or renting it out to someone else.

So people have to look at Rent vs Buy scenarios.

Guest's picture

Real estate can obviously be a good investment. But like any investment, timing is everything. Don't just think that because you invest in something it should always go up in value.

Guest's picture
Guest

With all due respect to this learned college "coordinator", this is a very poorly written, poorly contemplated article. On one hand, you seek to demonstrate in your article that stocks, bonds and real estate are poor, insufficient or losing investments, yet on the other hand you conclude that "diversifying your personal portfolio and including a healthy blend of stocks, bonds, and real estate is the best way to go." Your premises do not lead to your conclusion. And frankly, your conclusion that people need to diversify is not very original.

Moreover, the article fails to give "real estate" investment a fair shake. Generally speaking when "investors" invest in real estate, they are either flipping that property or renting out that property. Most people would not consider their residence as an "investment" per se, but rather it is a strategic decision between renting vs buying.

It is worth noting that if an investor did indeed purchase the house at the beginning of the millennium for $160,000, sells that same house now for 200,000 and only breaks even on the value of the house (considering inflation, etc), the investor would still walk away with 10 years of rental income (minus various costs, vacancies, etc)! Or alternatively, as the article suggests, if the investor financed the house, then he will have only contributed $32,000 as a down payment on the house (20% of purchase price), would likely have had a renter covering most if not all of the mortgage costs on the house for 10 years, and then sell it for $200,000. After paying off the remaining mortgage balance, the investor still walks away with a nice return on his initial $32,000 investment.

And the beautiful thing about real estate is that if you can afford to purchase the property in the first place (either outright or financed) you generally have the freedom to sell that property at whatever time it makes sense to do so. So, if the investor was so inclined, he could have pocketed even more profit if he elected to sell at the high points in the housing market between 2004-2006. Otherwise, he could simply wait a few more years until a more opportune time, all the while he is collecting rent and having someone else pay the mortgage for him.

Guest's picture

Aaaah .... have you considered that you put in only 20% of the home price? So the return on YOUR investment (i.e. in cash) is considerably MORE than 2.2%?

Also, I would argue that most people are better at picking which real-estate will grow above average (i.e. merely investing in most metro areas and avoiding most rural areas will take you above the 2.2% average that you quote) than in picking which stocks will grow.

Guest's picture

"Is Real Estate A Good Investment?" That's like asking, "Is clear liquid OK to drink?"

Assuming that you're talking about single-family homes, you're not looking at opportunity cost. Rent still comes with a -100% rate of return, regardless of market conditions.

If there was a practicable, actionable piece of advice or information in this post, I'm too dumb to glean it.

Guest's picture
Guest

I own around 50 condos in the Columbus OH area and currently live in one. I will not plan to buy a "nice" house till the condos are paid off.... A big fancy house before you can afford it is a nightmare. By afford it I mean be able to pay for it without having a paycheck for an extended period of time! Just because you have a big paycheck today don't bank on it tomorrow!

Guest's picture
arthur garcia

This was terribly done. You are viewing a primary residence as an asset, which it is not! I would encourage you to run the numbers again with the focus of an investment property. The largest factor you are not considering is the power of DEBT/leverage! When you purchase a investment property you you usually only have to put 20%-25% of the total value down. So, if you purchases a 100K home, you only need 20K. In most markets you could probably rent it out and obtain cash flow each month. Let's say you even manage to break even each year, if you just held the house for 10 years, even if the property doesn't appreciate you would realize equity growth (tenants paying off your loan debt), tax breaks and the house would appreciate or adjust to inflation. This means even if the house didn't go up in value, your initial investment of 20k would have realized a 50-80% return - not including the monthly cash flow.

Guest's picture

True but isn't exuberant leverage what caused the mishaps of 2008 in the first place? And an expectation that prices will always go up?

Guest's picture
Guest

The issue here is managing debt. The real key to investing in real estate (rental income property - not primary residence) is understanding how to manage cash flow and expenses. The beauty of real estate is that the investor is in CONTROL, not some fat cat in NY picking which company he thinks will go up in the near future. If an investor takes time to understand how to acquire property, rent out the unit for more than the mortgage, the owner will absolutely realize equity. Let me be again refer back to my original example, if an investor buys a rental property for 100K (puts 20K down, bank finances 80K) they will probably have a mortgage of $500, in most markets this house will rent for $850-$1000 per month. If you keep 6 months worth of reserves per property and 10 years later the property is still worth 100K, you will probably have 15-20K (on top of your initial 20K down payment) new equity just by nature of the tenant paying down your loan. The example I have just given doesn’t even take into account tax benefits, depreciation, possible appreciation, inflation and yearly net income from cash flow. Again, over-leveraging is dumb and can absolutely be avoided. If people don’t take time to understand what they are investing in, they might as well hide their money under a mattress. I will say this in closing, if someone made poor choices with their investments and over-leveraged, then they were the direct result of their circumstance and I can except that. However, what I can’t except is throwing away money into the stock market hoping my diversified portfolio will grow based on another person's understanding of the “market”.