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Your Home Is Not a Real Estate Investment

Home prices are rising again. Should bullish economic predictions bear out, this trend will continue, to the benefit of homeowners and the US economy at large. Rising home prices are good for your net worth, your ability to borrow, and your mental health. But before you rush to get in on this good thing, remember: your home is your castle and where your heart is. But it is not an investment.

Yes, Buying Is Better Than Renting.  But That’s Not What I’m Talking About

Let me clarify one thing first. I am not advocating renting over buying. In many markets – and most markets if you live in your home long enough – owning a home is far better in the long run than renting. Considering possible home price appreciation and the tax deductibility of mortgage interest, you will likely come out ahead if you buy, and the equity in your home is an asset you can access if need be.

What I’m talking about is whether you should consider your home an investment. The answer in almost every case is an emphatic no. All too often, I hear people say that they don’t need to diversify their portfolio with real estate because they are already “exposed” to it through their “investment” in their home. This is mistaken thinking. No professional real estate investor would buy a property with the economics of an owner-occupied single-family home.

“Wait a minute,” I can hear you objecting. “I bought my house ten years ago for $1,000,000, and now it’s worth $1.5 million! I’ve made $500,000 in profit!” If you think this statement is true, then you’re making a classic error: comparing the current value to the purchase price and declaring a “profit,” while neglecting to factor in the very substantial costs of owning a home.

As An Investment, Your Home is a Loser

Let’s imagine a couple that purchases a 2 BR/2BA apartment in Park Slope, Brooklyn, for $1,000,000.   The apartment appreciates at 4.7% a year, and after ten years the couple sells the apartment for $1,582,949. After deducting the remaining mortgage principal ($638,660) and 3.5% of the sales price ($55,403) for broker fees and closing costs, they’ve made a cool profit of $688,885. Right?

Wrong. Let’s assume the couple put $200,000 (20%) down and financed the rest with a 30-year fixed rate mortgage at 4.4%. Even at this historically low interest rate, their total interest payments alone would consume $319,390, or 46%, of their appreciation! And that’s not their only expense. Let’s assume that, after five years, they spent $10,000 on a new bathroom, and before selling they invested $5,000 to repaint. (These estimates are probably low for this work.) Along the way, they also paid $1,000 a month for maintenance (including physical upkeep of common areas, common electric charges, water/sewer fees, custodial salaries, and property taxes); $1,800 a year for insurance; and $2,400 a year for electricity and gas, all subject to 3% annual inflation. When all of these expenses are properly accounted for, the couple’s profit after ten years is a whopping $7,441. Calculating this as a return on the couple’s original investment of $200,000, it works out to a total return of 4%, or 0.4% a year over ten years.[1]

Here’s how it breaks down.

Sale Price $1,582,949
-Total Maintenance/Tax $(137,567)
-Total Repairs/Improvements $(15,000)
-Total Insurance $(20,635)
-Total Utilities $(27,513)
-Total Mortgage Payments $(480,730)
-Remaining Loan Principal $(638,660)
-Closing Costs $(55,403)
-Original Down Payment $(200,000)
=Profit/(Loss) $7,441

Fig. 1. Park Slope apartment profit/loss at 4.7% annual appreciation.

Even this meager profit, however, is probably unrealistic to assume going forward. According to The Economist, New York real estate did appreciate 4.7% annually from 1987 to 2013. But that period included an extraordinary boom from 1991 through 2006, when New York experienced a dramatic decrease in crime, rapid gentrification, a stock market boom, a real estate boom, and a relentless climb in prices that resulted in real estate values nearly tripling. But a $1,000,000 home purchased at the end of 2003 and sold in 2013 would have appreciated only 7.5% in total, to $1,077,583, resulting in an actual cash loss of $480,238, all other things being held equal. (And these examples assume the current low interest rates!)

Going forward, it’s far more realistic to assume price appreciation consistent with long-term inflation of around 3% a year. In that case, our homeowners’ would suffer an overall loss of $223,226, for a total return of -112%, or -11.2% annually:

Sale Price $1,343,916
-Total Maintenance/Tax $(137,567)
-Total Repairs/Improvements $(15,000)
-Total Insurance $(20,635)
-Total Utilities $(27,513)
-Total Mortgage Payments $(480,730)
-Remaining Loan Principal $(638,660)
-Closing Costs $(47037)
-Original Down Payment $(200,000)
=Profit/(Loss) $(223,226)

Fig. 2. Park Slope apartment at 3% appreciation rate.

Of course, both scenarios are still better than renting the same apartment. Assuming an initial rent of $3,000 a month, increasing 3% a year, ten years of renting the same apartment would cost $412,700, so you come out several hundred thousand ahead by buying in either case. But that still doesn’t make your home an investment. After all, would you invest in something practically guaranteed to lose money, simply because it was less bad than something else? Of course not! You’d put the money under your mattress or in a shoebox instead!

Renting Out Your Condo: A Long Wait for Your Returns

So what makes a property an investment? That’s easy: collecting rent! It may seem self-evident, but, in a home, cash only flows out. In an investment property, it flows in, too. The investor’s primary inquiry is whether cash in will exceed cash out by enough to produce an attractive return on her down payment.

Let’s explore how this works. We’ll use the same assumptions for down payment, mortgage terms, maintenance/taxes, insurance, closing costs, and inflation. Unlike the homeowner, however, the investor receives rent and can pass on utility costs to tenants. The investor will also have vacancy losses and incur costs in repairing the apartment between tenants. Since our hypothetical 2-BR/2-bath apartment is in Park Slope, we will assume the rent is $3,000 a month to start and will rise 3% a year from there.

Sale price $1,343,916
+Total projected rents $412,700
-Vacancy losses $(16,942)
-Maintenance/Tax $(137,567)
-Repairs/Improvements $(35,000)
-Insurance $(20,635)
-Utilities $0
-Mortgage Payments $(480,730)
-Remaining Loan Principal $(638,660)
-Closing Costs $(47,037)
-Return of Down Payment $(200,000)
=Total Profit/(Loss) $180,046

Fig. 3. Renting out the Park Slope apartment.

Looks much better, doesn’t it? Over ten years, the investor has nearly doubled her money – a profit over $180,000 on an original investment of $200,000, for an overall return of 90%, or 9% a year. Pretty good, huh? Where else can you get 9% a year on your money these days?

But did you notice anything about the calculation? Mortgage payments alone exceed total rents![2] And the investor must also bear the cost of vacancies, maintenance/taxes, repairs/improvements, insurance, and closing costs. On an operating basis, this apartment loses $278,174 over ten years. That’s $27,817.40 that the owner must pay out of pocket each year just to keep this apartment long enough to cash in on the appreciation – if there is any! This is what’s known as “speculation”: you’re willing to pay cash out of pocket now because you speculate that you’ll make it back later on the appreciation.[3]

Buying a Small Rental Building – A Better Financial Bet, But Worth the Effort?

If you’re like me, you probably don’t want to finance possible future appreciation with cash from your pocket. So, what are your options? The key to making money in real estate is economies of scale. As you add units, your total revenue goes up faster than your costs. In New York, you need at least three units for the investment to begin to make sense, and for the same $1,000,000, with a $200,000 down payment, you could purchase a brownstone in Bedford-Stuyvesant with three 2 BR/1 bath units, each renting for $2,000 a month. This works out to $72,000 in gross revenue in the first year. At this level of revenue, your returns would exceed the condo scenario and you would be cash flow positive (barely) from Year 1. Because 3-unit buildings are considered personal residences and appreciate at the same rate as single-family homes, we will assume the same 3% annual rise for both property appreciation and rental income.

Let’s see how it works in this scenario.

Sale price $1,343,916
+Total potential rents $825,399
-Vacancy losses $(24,762)
-Repairs/Improvements $(68,783)
-Taxes $(57,319)
-Insurance $(22,928)
-Utilities $(68,783)
-Mortgage Payments $(480,730)
-Remaining Loan Principal $(638,660)
-Closing Costs $(47,037)
-Return of Down Payment $(200,000)
=Total Profit/(Loss) $560,313

Fig. 4. Bed-Stuy 3-unit rental building.

This scenario looks much better, doesn’t it? Your total return of $560,313 represents a 280% (28% annualized) return on your original $200,000 investment. Best of all, rather than taking cash out of your pocket to pay for operating expenses, you would make $2,767 in the first year. What an improvement over shelling out $28,000 a year waiting for that Park Slope condo to appreciate!

This rosy scenario requires one caveat: it assumes that you are managing the property yourself. You have to collect rents, pursue deadbeat tenants, and take the 2:00 am phone calls when the upstairs toilet overflows into the apartment below! You may want to hire a management company to do all this for you, but beware: for a building this small, they are likely to charge 10% of top-line revenue, reducing your overall profitability by $80,064 over ten years. And, worse yet, all of this comes out of operating profit, meaning that you’ll be shelling out money to cover operating costs until Year 5, when you finally make a profit of $1,287 bucks for the year! But, for the price of about $8,500 over the first four years, you’ll have peace of mind from knowing that someone is dealing with the hard part of your investment. And, by year ten, even with property management in place, you’ll be putting almost $10,000 in your pocket each year without doing much of anything. If you now have an eight-year old child, that amount should just about cover the cost of their first-year college textbooks!

The Best Real Estate Investment Bet: Bigger Properties, Farther Away

In the professionally managed brownstone scenario, you would run small losses in your first few years and put extra money in your pocket after that. That’s better than paying money out of pocket for the entire holding period, but it would not be of much interest to a serious real estate investor. To produce the kinds of real estate returns that a professional real estate investor expects, you would need to buy a building with far more units, in a place where the cost of real estate is lower relative to rents than in so-called “gateway” cities like New York or San Francisco.

There are markets in the US, particularly in the South and Midwest, where you can purchase a 25-unit building for the same $1,000,000 as a Bed-Stuy brownstone. And when you own this kind of property, even with a management company in place – which will be necessary if you are owning property far from where you live – the expected returns will be far greater than you could ever get at the same price point in a gateway metropolitan area.

Let’s assume that you purchase a 25-unit property in South Carolina for $1,000,0000 with $200,000 down, and that each 2BR/1 bath unit rents for $600 a month. You will have additional expenses, like service contracts, payroll, and capital reserves imposed by the bank. However, not only will rents far exceed expenses, but you will also be able to pass back some expenses like utilities to your tenants. Over the same ten-year period, your returns will far exceed what you could expect to get on the Bed-Stuy brownstone:

Sale Price $1,132,154
+Total Rents $2,183,869
-Vacancy Loss $(109,193)
+Utility Chargebacks $53,737
-Contract Services $(286,597)
-Repairs & Maintenance $(143,298)
-Payroll $(338,184)
-Insurance $(114,639)
-Utilities $(214,948)
-Management Fee $(148,989)
-Administrative Expenses $(85,979)
-Capital Expense Reserve $(75,000)
-Total Mortgage Payments $(480,730)
-Remaining Loan Principal $(638,660)
-Closing Costs $(39,625)
-Return of Down Payment $(200,000)
=Profit/(Loss) $493,916

Fig. 5. South Carolina 25-unit rental property.

Look at your profit now: $493,916 over ten years. That’s a 247% return on your investment – almost 25% a year on an annualized basis. Even though your sale price is lower in this scenario (because operating income, rather than simple appreciation, determines the price of commercial real estate), your overall profits are far higher because your total rents further exceed your total expenses as a result of adding more units. You make a 7% cash-on-cash return on your investment in the first year – $13,843 into your pocket. And after ten years, in this scenario, you will put away $34,999 a year before taxes, an annual return of 17%. That would put a big dent in college tuition! And the best thing about this scenario: other than buying and selling the property, the hardest work you’ll do is depositing the checks from your property manager.

REITS, Private Equity/Hedge Funds, and Syndicators

Collecting checks on your southern property sounds great, doesn’t it? But there are a few drawbacks and obstacles to investing this way. You’ll need to develop relationships with brokers and local lenders, which could be hard at a distance. You’ll need to learn how to conduct due diligence and invest the time to do it thoroughly. You’ll need to hire experts to do building inspections and environmental reviews, and you’ll have to pay them even if what they find causes you to back out of the deal. Banks may require you (or your partner) to have a net worth of at least the amount of the loan – $800,000 in our example – not including the cash you’re putting down for the down payment. And, even if a bank will lend you the money, the loan application process is very time consuming.

If you don’t have the time, inclination, or net worth to do a deal by yourself, but you still want to invest in real estate, there are still many good options for you: REITs, hedge funds/private equity funds, and syndicators. In all three cases, you’ll be a purely passive investor with no responsibility for finding and executing deals, and, as with stock, your liability will generally be limited to the amount of your investment. Each type of investment platform has distinct advantages and disadvantages.

REITs are a good alternative for most people. REITs tend to invest in multiple properties in multiple locations to provide diversification, and some REITs further diversify across asset classes, such as multifamily, hotels, industrial, office, and retail. Many REITs are publicly traded, so you can liquidate your investment at any time, as with any other stock. Many REITs have long histories and public track records, giving you some comfort that you know who is getting your money. But there are downsides too. Once the REIT has your money, it has complete control; you can’t pick and choose among its properties. In addition, because REITs must quickly deploy the funds they have on hand, they sometimes cannot wait for the very best deals or market conditions. Overall stock market sentiment can also affect the price of a REIT share, so the value of your investment could decline even if the underlying real estate holdings retain their value. Like mutual funds, REITs charge management fees that can eat into your returns. And, finally, if you are the type of person who is excited by the idea of owning a building, you won’t find it much fun to own an infinitesimal piece of a building along you’ve only seen in an annual report.

Hedge funds and private equity funds specializing in real estate operate like much like REITs. They often invest across different geographic regions, and some further diversify by investing in multiple property types. Like a REIT, the investor lacks control over where their money goes. Unlike REITs, shares are not publicly traded and are not liquid assets. The funds charge higher fees than REITs, typically 1-2% of funds under management as a management fee, plus 20% of the profits. Finally, hedge funds and private equity funds typically require very large minimum investments of $500,000, $1,000,000 or more.

Syndicators operate like hedge funds and private equity funds, except that they typically do one deal at a time, so each “fund” consists of a single property. Syndicators have certain advantages for the smaller investor wishing to get into real estate. The minimum investment size is smaller than hedge funds and private equity, typically $100,000, $50,000 or less. Moreover, most syndicators do not look to their investors for funds until after they have found a property and put it under contract, meaning that investors can decline to invest in any deal they don’t like. Syndicators also often take the initial risk, putting up their own funds to pay for due diligence, legal fees, bank application fees, etc., meaning that if the due diligence turns up something bad or the bank rejects the loan, the syndicator is out of pocket. Because they operate this way, syndicators tend to be cautious about the investments they make, limiting them to assets that will be attractive to both mortgage lenders and their equity investors. Finally, some syndicators will provide investors with “major decision rights” over large events like selling or refinancing the property.

However, there are important disadvantages to syndications as well. Your money is tied up in an illiquid asset for 5, 7, or 10 years. In cases of extraordinary uninsured repairs to the property, the investors may be required to fund the repair costs through a capital call. Unless you invest in multiple syndication deals, your real estate investments will not be diversified. Syndication fees are comparable to hedge fund and private equity fees. And, because the track records of syndicators are not public, you won’t have a large company or a “brand” to rely on, so it’s important that you investigate the syndicator and feel comfortable with him or her before investing.

Real Estate Is a Great Investment, But Your Home Is Not

J.P. Morgan[4] recently concluded that, from 1977 to 2012, US commercial real estate produced “bond-like” stability with “equity-like upside.” Moreover, because properties collect rent even during downturns, $100 invested in commercial real estate for 5 years only during down periods would have grown to $110, while $100 invested in the S&P over its down periods would have declined to $94.  Because rents rise with inflation, commercial real estate provides an excellent inflation hedge, and it also tends not to be correlated with other assets: multifamily occupancies rose as a result of the Great Recession. For these reasons, real estate is an important asset to add to your portfolio.   But don’t let the real estate sirens seduce you into “investing” in a new home. There are many reasons to buy rather than rent, but never mistake a home for an “investment.”

 

[1] Even if the couple paid cash for their apartment, thus eliminating all interest payments, their total return after expenses would be $326,831, or about 3% annually.

[2] This is typical in the “gateway” metropolitan areas like New York, Boston, and San Francisco, where rents and mortgage payments are so far out of balance. It is not true in other metropolitan areas, where they tend to track each other more closely.

[3] Now you’re thinking, “Aha! What a juicy tax deduction!” But even if you’re in a 50% tax bracket, the government is only picking up 50% of that out-of-pocket loss.

[4] J.P. Morgan Asset Management, “Real Estate: Alternative No More” (2012).

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3 Comments
  • Giovanni Isaksen
    Posted at 00:28h, 01 December Reply

    Great post Jonathan, and nice looking blog. I found you via your guest post on Joe Stampone’s blog. Thanks for helping to stamp out the home as an investment meme, I wrote about this a while ago on my blog and built an Excel chart to put real numbers in it. If it will help with the cause I’ll send it to you: http://ashworthpartners.com/rent-vs-buy-and-the-great-myth-of-homeownership-as-an-investment/

    Congrats on launching the blog, looking forward to what you share next-
    Giovanni

  • Dhaval Patel
    Posted at 19:29h, 22 December Reply

    This is an excellent article. As a novice who is looking to make an informed decision with regards to his investments, I was curious about real estate investing. Your article is a great start and simplifies the information. I am going to re-read this article until the knowledge seeps in. Great job!

    • The Mortar
      Posted at 09:52h, 23 December Reply

      Dhaval, thank you very much. I really appreciate this kind comment!

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