I cringe whenever I hear someone say ‘the price can only go up.’ I’m immediately reminded of the pre-financial crisis models built by rating agencies and investment bankers in which home prices never decline. Their assumption, of course, was that since prices had never gone down, there was no reason to believe they would in the future. Even though we’re less than a decade removed from one of the worst recessions in U.S. history, I’m amazed at how quickly these miscalculations have been forgotten, especially in the Bay Area. With home prices rising to new heights, you might think Bay Area residents would be cautious about getting into the market right now but this doesn’t seem to be the case at all. In fact, optimism abounds among many of the home buyers I meet. People seem quite comfortable stretching their finances in order to buy bigger homes and even second homes. The prospect of making money in real estate is so luring that people are willing to throw caution to the wind. To be fair, there are certainly life circumstances (starting a family for example) that necessitate buying or upgrading homes, but many homebuyers seem unaware of the risks associated with putting so much of their wealth into real estate. The goal of this article is to offer a more balanced- and maybe even a tad pessimistic- view of the housing market in order to dispel what I’ve noticed are some commonly held misbeliefs about real estate as an investment.
Real estate as an investment – the real growth story
Over the last five years, San Francisco home prices have increased by more than 11% annually (1). This recent growth story is very compelling to people looking for a place to store wealth. With interest rates at historic lows and stock valuations reaching new highs, traditional securities may understandably look less attractive than real estate. But, this is where taking a broader perspective is important. If instead of looking at the past 5 years, we looked at closer to 30, home appreciation rates are much more modest. Since 1988, San Francisco home prices grew by just about 5% per year (1). And while this may still seem like a good rate of return, it pales in comparison to stock market returns. The S&P 500, for example, returned roughly double that amount or about 10% annually during the same period. It’s also worth noting that this time period – 1988 through the present – was an especially good period for the San Francisco housing market in particular. San Francisco’s 5% growth rate bested the national average by about 2%. For most of the country, home prices didn’t increase by much more than the rate of inflation.
All of this isn’t meant to suggest that the local housing market is about to collapse. As we found out during the financial crisis, it’s very difficult to identify bubbles and predict their corresponding crashes. It is, though, important to acknowledge that in general you should expect to earn less on your real estate than you do on your stock portfolio and, yes, this is even true for Bay Area homeowners.
As a real estate investor, leverage can both help and hurt you. Homeowners with big mortgages fared particularly well during this most recent period. The average San Franciscan who bought their home exactly 5 years ago, can now sell it for about 70% more than they originally paid. Now, let’s assume that same homeowner only put 20% down and financed the remaining 80% with a mortgage. In this case, the homeowner wouldn’t have earned just 70% on their original investment. They would have earned more like 250% (ignoring financing costs)! This would, of course, be a fantastic rate of return, but it’s important to realize that leverage can also work the other way. While big mortgages provide higher potential returns, they’re also inherently more risky. If you own a $200,000 home free and clear and home values fall by 10%, you lose $20,000 or 10% of your investment. If instead you made a $200,000 down payment on a $1M property (and financed the rest through a mortgage), you would lose $100,000- or half of your original investment- with a 10% decline in home values.
Mortgages are helpful products for people who are looking to buy homes they plan to live in long term, but having a lot of debt on more speculative real estate investments can get you into a lot of trouble. If prices start to fall, you risk losing most– if not all– the money you’ve invested. Most people wouldn’t borrow money to invest in the stock market and while home prices can be less volatile, borrowing a lot of money to invest in real estate might also be a fool’s errand.
Diversification and liquidity risk.
The very nature of investment real estate also poses diversification and liquidity challenges to investors. Unlike stocks which are typically priced anywhere from a few dollars to a few hundred dollars, real estate purchases are generally bigger ticket items. This means that unless you’re investing in REITs or other pooled vehicles, you are limited as to the number of properties you can own directly. In addition, rental units require maintenance making it more difficult to own properties that are geographically dispersed. The net effect of these issues is that many investors have difficulty diversifying their real estate portfolios. Instead, they own relatively few properties, all in the same or nearby areas.
Liquidity risks are also inherent to real estate. While stock holdings can be turned into cash within days, it usually takes months to sell a house or condo and the transaction costs are significant. Selling $1M holding in a mutual fund generally costs the seller $25 to $50. Selling a $1M property typically costs the seller closer to $50,000 to $60,000 between broker commissions and closing costs. These liquidity restrictions and transaction costs make real estate a far less flexible investment. If your life circumstances change and you need cash or even if you just want to readjust your overall investment portfolio, you can move much more quickly with stocks and bonds than you can with real estate.
Historically, real estate has been a good way to shelter income from the IRS. A lot of the tax benefit for real estate investors comes from the ability to deduct depreciation (which is a non-cash expense) from rental income. Here’s the basic idea. Let’s say, for example, you own an investment property that generates $40,000 in rental revenue and has $30,000 in rental expenses, netting $10,000 of income each year. Because the property is held for investment purposes, in addition to being able to deduct the direct expenses, you can deduct depreciation. By allowing the deduction of depreciation, the IRS is recognizing that rental buildings won’t last forever. If depreciation on your property was $15,000 for the year, then you would actually have a taxable (or paper) loss of $5,000. In other words, not only would the $10,000 of net rental income not be taxable, but you would actually report a loss on your tax return.
While depreciation rules continue to make real estate investing attractive, the IRS has limited some of these tax advantages. For example, a taxable real estate loss– like the one described above– is generally considered a passive loss and there are restrictions on your ability to deduct passive losses from other sources of income, like wages and capital gains. To be more specific, taxpayers with modified gross adjusted income of more than $150,000 cannot deduct any rental losses from their wages or investment gains. In addition, all positive rental income is taxed as ordinary income, while capital gains and qualified dividends have lower preferential treatment and are taxed at lower rates. So, while depreciation is still a tax benefit for real estate investors, it may not be the panacea it’s sometimes made out to be.
We all need a place to live and it’s important to many of us that we love where we live, but it’s dangerous to blur the lines between buying a home and making an investment. Purchasing a primary residence is a consumption purchase. It’s not an investment. Sure, the value of your home may go up, but you will only benefit from this appreciation if you sell the home, and ultimately, you still need a place to live. If you’re truly looking to buy an investment property, do your homework. Understand the cash flows and taxes. Model scenarios where prices don’t just continue to march upward by double digit percentages every year. Be realistic about how much you can afford and how much debt you’re willing to take on. Investors do get paid to take risks, but not all risks are good risks. Diversification is critical to limiting losses in an extreme downside scenario. Putting all your eggs in one basket, whether it’s a single stock or a single family home, is unwise. The amount of real estate you own should instead be consistent with your complete financial picture.