On the risk of investing in real estate for the long run

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unemployable
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On the risk of investing in real estate for the long run

Post by unemployable » Fri Aug 09, 2019 3:16 pm

One of the houses I grew up in is on the market.

It was purchased in 1990 for $450k (not from my family; we owned it before then) and is currently listed for $799k, call it an even eight. Yes, that was a lot of house in 1990. Dad did well to buy it when he did, but more on that below.

Right on 2% per year appreciation. Worse than inflation. Worse than gold. Worse than every developed and most emerging country's bonds of any maturity. Invest $450k in the S&P 500 in the summer of 1990 and within four months you would've been down 20%, but you'd have some $6.5 million right now. Remember to reinvest dividends at the index's rate of return.

But wait! Property taxes on the place are currently $15k/year. They would have been closer to 10k/year in 1990, so forking that over every year out wipes out every penny of gain. It's been sitting on the market for a couple months, so they won't get that $800k.

Meanwhile, from the pictures, they must have dropped at least $100k of maintenance and improvements in the place over the years. Not to mention utilities, insurance and selling expenses. At least it's not in an HOA.

Now the formative experience of growing up in that house was witnessing my dad's industry evaporating and our going from high on the hog to being forced to move because all the hogs had packed up and moved to Asia and we had to find a new hog somewhere else. This house is in one of the two or three best suburbs of Pittsburgh, bought when everyone was trying to get the hell out of the place, and sold after multiple housing bubbles and the systematic reduction of real interest rates to effectively zero. And still the owners are going to eat one or two hundred grand on the place. It's not just Italy.

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Re: On the risk of investing in real estate for the long run

Post by Seppia » Fri Aug 09, 2019 3:53 pm

We always hear the stories of those who become rich with leverage and luck in the real estate market*, but never hear the counter argument.
Real estate on average returns inflation plus a minuscule bit.
If some areas do great it means others do very bad, (because of demographic trends - what we saw recently) or it just means it’s unsustainable (2006 style)



*I think the all timer was that Mad fientist episode where this 29 yo guy was telling everybody how he got rich by buying as much real estate as he could afford in Toronto in the last 8 years. Yeah try do that in Detroit or Italy

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Re: On the risk of investing in real estate for the long run

Post by Bankai » Fri Aug 09, 2019 4:08 pm

'Investing' - yes. Buying cheap to live in is another story.

My back of the envelope numbers:

apartment cost £100k
interest & inflation both 2%
appreciation 1% above inflation
20% deposit

So, apartment going up by £3k means 15% return on £20k deposit - pretty good. The interest of £2k instead of £7-8k rent for comparable flat - even better. Total savings/growth per year ~£8-9k compared with renting. Deduct £1k for owner's cost - still very decent, £7k on £20k deposit is like 35% return. Hard to beat that, but you must buy cheap.

Edit: hmm these property taxes in US are ridiculous. Here house of similar value would be taxed maybe 1/4 of that.

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Re: On the risk of investing in real estate for the long run

Post by Dream of Freedom » Fri Aug 09, 2019 5:04 pm

You can't live in your stocks or even your gold. So if you are going to live there the appropriate comparison is to renting not stocks. Remember that rent often increases over time whereas mortgage payments stay the same. So from a cashflow perspective buying will often look better over the decades.

If you are really investing then you will be receiving rent or fixing it up and flipping it where you profit from the difference between a move in ready house and a fixer upper. In either case those are likely to be the main drivers of return.

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Re: On the risk of investing in real estate for the long run

Post by unemployable » Fri Aug 09, 2019 8:52 pm

I don't disagree with any of the responses. You have to live somewhere and wherever and however you do it has carrying costs. But the rent-versus-buy decision has opportunity costs in both directions. One of the carrying costs is the necessity to keep carrying the income that supports the payments on such an expensive house in the first place. And this particular example should have been generally favorable to buying, with a nice house in a nice neighborhood (those always do the best, right?) and substantial economic tailwinds in force without being cherry-picked.

Once can certainly do better than $15k/year in property taxes. The nicer US suburbs have somewhat of an arms race going on regarding who has the best schools, and for better or for worse my family bought into it. The places I'm looking at buying have property taxes closer to three percent of that.

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Re: On the risk of investing in real estate for the long run

Post by Seppia » Sat Aug 10, 2019 1:46 am

@Bankai that works if the return is 1% above inflation.
But in reality in many places on this planet real estate has had negative real returns.
Almost everywhere in Italy (maybe save downtown Milan and Rome) prices are nominally lower (20-30% lower, at times even 50%) than they were in 2007.
Almost all of Spain is cheaper now than it was 15 years ago.
Many cities in the USA, same.

I personally think it is much more conservative to strictly consider housing a cost, and run the rent Vs buy calculations, then decide based on those + personal situation (because it has a pretty big impact too).

In Hong Kong you can rent a 2br apartment in the prime location on the island for 40000hkd/mo (so around $60000/year), or you could buy it for 16.000.000hkd (slightly below $2.000.000).
When I was in NYC, my apartment in Battery Park cost $2600/mo. A similar one would be selling for $650.000, with $1600/mo expenses.

In both those cases, if you buy you’re either bad at math or you’re banking on selling the apartment for more once you move out.
Relying on the greater fool has never been a strategy I enjoyed.

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Re: On the risk of investing in real estate for the long run

Post by shemp » Sat Aug 10, 2019 2:16 am

OP's analysis is sort of like saying: Parents bought a business in 1990 for 450K, ran the business for 29 years, then retired and sold the business for 800K in 2029, so just 2%/year nominal return, not very good. OP is ignoring profits running the business for 29 years.

In the case of housing, those profits are equivalent to landlord profits: difference between total costs to rent and total costs to own. Normally, equivalent landlord profits (cap rate) will be about 5%/year real, on owner occupied housing in the USA, if you have a low-interest mortgage or no mortgage, which is about as good as stocks. In OP's case, you have to deduct a little from that 5% because the house price didn't quite keep up with inflation.

After taking other factors into account (tax advantages, lower volatility, etc) owner occupied housing usually better than stocks in most of USA. In very expensive parts of the USA, cap rates for owner occupied real estate can be much lower than 5%. That NYC example of seppia has cap rate of 12*($2600-$1600)/$650K or under 2%. With cap rates that low, and foreseeing zero real capital gains (the norm with real estate, since normally depreciation of buildings offsets appreciation of land), buying doesn't make sense.

Note that property taxes, repairs, insurance, buying/selling costs, etc are more or less a wash, since renters pay these costs indirectly through the landlord, though often landlords pay more because of special tax and insurance rates for owner-occupied housing. Plus landlords (and thus renters) have extra management and vacancy costs. No need to analyse all this, however. Just check market rents for house equivalent to OP's parent's house.

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Re: On the risk of investing in real estate for the long run

Post by shemp » Sat Aug 10, 2019 3:04 am

Bankai wrote:
Fri Aug 09, 2019 4:08 pm
apartment cost £100k
interest & inflation both 2%
20% deposit
£7-8k rent for comparable flat
Deduct £1k for owner's cost
Significant numbers are £7k rent versus £1k total ownership cost (disregarding financing costs). That means (£7-£1)/£100= 6% cap rate. Then he leveraged up, at zero real interest, by factor of £4 borrowed to £1 deposit, or multiplier of 5, which converts 6% to 30%. He actually wrote 35%, but he is assuming appreciation, which is never guaranteed.

Leveraging not very risky with good cap rate, since unlikely to see major changes in interest rates, rents or continuing ownership costs (assuming those ownership costs are accurately estimated). Buying with a good cap rate is indeed the key. My major concern would be accuracy of those ownership costs.

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Re: On the risk of investing in real estate for the long run

Post by Seppia » Sat Aug 10, 2019 5:01 am

@shemp: I’ve run the numbers in all the cities I lived in, plus many perspective places where I could/would move.
In my experience I’ve found zero places where cap rate is 5%, so much less so real landlord profits.

I’m sure those places exist (I would imagine mainly tier two cities), but in the most desirable cities renting seems to always be the better option (NYC, Paris, Stockholm, Milan, HK, London, Bangkok and almost everywhere in Italy among others)

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Re: On the risk of investing in real estate for the long run

Post by jacob » Sat Aug 10, 2019 7:12 am

IIRC (memory from 2007 during RE bubble1.0), US real estate had historically returned around the rate of inflation. That makes sense since houses are consumables that don't do anything. The expected economic profit is zero. As such financial profit would only be possible via trading wisely and leverage essentially setting up a carry trade using tax breaks (debt deductions, write-offs) to make debt cheaper.

From a personal finance community perspective, it's interesting to see that FIRE by RE achieved a peak around 2008 where people got really crushed (the equivalent of margin calls). We now have a new generation of FIRE by RE people who bought in early (around 2010ish) and started daisy-chaining their rentals get rich that way.

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Re: On the risk of investing in real estate for the long run

Post by IlliniDave » Sat Aug 10, 2019 7:22 am

For me rent versus buy is more of a lifestyle decision. I've known a fair number of people who hit the jackpot by buying in the right market at the right time, but when I looked at it I figured that I could sell the house for a zero percent real return and made decisions using that assumption. We'll see what happens next year but I'm think it's likely I'll get a slightly negative real return. That's just comparing price before considering interest, taxes, maintenance, and improvements. How those costs plus whatever capital loss/gain compare to rent of an equivalent property I don't know (equivalent rentals are scarce in the area). But even assuming I could have rented cheaper, in this case I don't mind having spent the money. I doubt any differential is all that large either way, and despite the headaches of ownership, I'm happier having title to the place I live.

I don't really consider my residence (nor my cabin) an investment but they do factor into my overall financial picture and provide an amount of diversification. The stash is all in stocks, bonds, and a little cash; but on top of that I've got another 25%-30% in RE. Or, looking at net worth, mine's about 20% RE. I don't think that's excessive for my temperament. To have more devoted to RE, and be counting on capital gains from it to fund my future, would potentially keep me up at night, as they say. Having 20% tied up keeping a roof overhead knowing there's a good chance of recouping at least most of it if need be, feels reasonable to me.

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Re: On the risk of investing in real estate for the long run

Post by oldbeyond » Sat Aug 10, 2019 7:39 am

Our cap rate is more like 3%. But that's comparing an apartment we could rent with the one we bought. The rental would not be in the same neighborhood as we'd only be able to rent new construction in certain areas due to housing market regulation (=long waiting lines for cheaper, older flats, say around 8 years and increasing at >1 year per year). Compared to an older flat in our neighborhood the cap rate is barely positive, but lacking connections or extreme luck that wasn't an option. So there's a bit more nuance in regulated markets.

I think there are good points all around. People tend to get caught up on nominal price increases, ignoring carrying costs and opportunity costs. But if you have a decent cap rate you can leverage it cheaply and reasonably safely (if you have a reasonably sized mortgage on a place you live in and some capital outside of your house, it'll take a lot to wipe you out. Compare that with buying stocks on margin).

Historically the "owners dividend" has provided a sizable part of the return from residential housing, see viewtopic.php?f=3&t=9597

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Re: On the risk of investing in real estate for the long run

Post by ether » Sat Aug 10, 2019 7:56 am

Single family homes will almost always lose money as a rental. The whole buy a McMansion and live off the equity is the classic american pipe-dream (it works some places but not everywhere). The real money maker is running a rental business thanks to the generous depreciation schedule (27.5 years USA) since most homes will not need the same amount of repair as it cost to build in just 27.5 years. Buying a discounted multi-family property with a federally subsidized interest rate and not selling before ~5 years will almost always return a profit. It's all thanks to government tax code, interest subsidies, and if you're in C class properties, the generous price floor set by the local government with section 8 housing.

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Re: On the risk of investing in real estate for the long run

Post by Sclass » Sat Aug 10, 2019 9:28 am

shemp wrote:
Sat Aug 10, 2019 2:16 am
OP's analysis is sort of like saying: Parents bought a business in 1990 for 450K, ran the business for 29 years, then retired and sold the business for 800K in 2029, so just 2%/year nominal return, not very good. OP is ignoring profits running the business for 29 years.
I’m kind of running a real time experiment on this. I did @unemployable’s simple calculation when I was getting ready to buy my first home in 1998. This was in Silicon Valley where real estate goes up at a high rate. And still I decided not to buy. Monthly rent is a lot less than monthly mortgage payments so in the very short term it is a no brainer.

I’ve tried to work out what “I wasted on rent” with varying degrees of success. It’s kind of hard to chase down all those dollars on paper.

I just got back from visiting all my old friends in Palo Alto last week and here is my take. They didn’t get rich buying those homes. Yes they went up. Yes they own places that are worth $1-2M at today’s prices. But for some reason they are a bunch of burned out, unemployable fifty something tech workers clinging to those things like they are a sole asset. Like a life preserver out in the sea. These people went all out for the homes and it is all they have. They still have mortgages and kids college to look forward to.

Then there’s my older relatives. They are dying. They have $3,000,000 homes they bought in the 1970s. Currently they are cash poor. These “lucky” people are penniless outside their house but have made 7-8% gains if you just consider the buy and sell prices and not imputed income from rent vs. interest payments. Not bad. They can sell and get a senior living situation which was what all of them were talking about.

For me I’m still doing my real time experiment. I can buy my peers’ homes in Mountain View cash and still have enough investment income to live. After hanging out with those guys and getting suffocated by their stress pheromones I won’t. Castro Ave was a pressure cooker Sat night with all the millennial software engineers running around like it was 1999 again. More on that later in another thread.

So I still rent at age 50. My friends treat me like I’m some kind of enigma. I’m a low class renter that can roll up their lifestyle and write a check for it. They finally decided to meet me for dinner and this was there take.

Admittedly my friends probably didn’t have the discipline to do as I did. That is rent the cheapest place I could find and invest everything into stocks. So YMMV.

It depends on a lot of small details like all things. I went home believing I’d rather be me. Retired and wealthy. But still a renter. I’m still trying to get my head around the whole thing. Am I really right? Was I just lucky? Can I still get the high stock returns? How about the social pressure of owning vs. renting? What exactly did I win given the trajectory of my life has put me far away from my friends and family? Will the stock and housing markets keep acting like they have in the past?

I certainly don’t want to trade places with my Silicon Valley peers or my geriatric relatives in Palo Alto but to them it’s a life and it has worked out.

It is clear that an 8% annual increase in housing cost can really put pressure on salaried people in Palo Alto or Milan. I wonder where this will go. Somehow the combination of tech work, Bay Area land shortage, and new blood has always made this work out for as long as I can remember.

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Re: On the risk of investing in real estate for the long run

Post by Seppia » Sat Aug 10, 2019 10:04 am

Sclass wrote:
Sat Aug 10, 2019 9:28 am
More on that later in another thread
Can’t wait for this other thread.
Thanks for sharing Sclass

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Re: On the risk of investing in real estate for the long run

Post by 2Birds1Stone » Sat Aug 10, 2019 10:42 am

Seppia wrote:
Sat Aug 10, 2019 10:04 am
Can’t wait for this other thread.
Thanks for sharing Sclass
^ This.

Also LOVE this quote. "I’m a low class renter that can roll up their lifestyle and write a check for it."

Many of our peers look down at us for renting a 1 bdrm basement apartment, while we have enough assets to write a check for their entire overpriced homes, which they struggle to pay the bills on month to month......

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Re: On the risk of investing in real estate for the long run

Post by anesde » Sat Aug 10, 2019 10:49 am

I see physical real estate investments as more of a way to diversify than anything else. I’m more focused on growing passive income vs. some arbitrary net worth number and so rental homes is a good way to add a portion of that.

The key difference I think is that you can easily buy an index of stocks, but you can’t do the same for physical real estate (I understand investments in REITs but not counting that as physical RE). So statistics that say “on average” are pretty much meaningless to me. What’s more important is where and what you’re buying. I don’t consider single family homes for personal use as investments.

I sold out some investments c. March 2018 to group enough for a downpayment + rehab costs on a 2-family home. It was a total rehab which was a great experience even though not everything went according to plan. It’s rented out now and would provide ~30% of my expenses with other passive income providing ~25% (I’m still working so just reinvesting this for now).

Now it’s possible that the $100k I sold out would do better over 20 years had I left it in the stock market. But it’s also possible that it might not. I felt better diversifying into physical RE - partly because I wanted the experience of rehabbing, partly because of tax and leverage incentives, and partly because of passive income. The house should appreciate but my investment decision was not based on that - rather on the cashflow and building equity through principle pay down (with the rental money).

In any case I don’t really think it should be one or the other. Both have risks and both have upsides.

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Re: On the risk of investing in real estate for the long run

Post by unemployable » Sat Aug 10, 2019 11:46 am

shemp wrote:
Sat Aug 10, 2019 2:16 am
OP's analysis is sort of like saying: Parents bought a business in 1990 for 450K, ran the business for 29 years, then retired and sold the business for 800K in 2029, so just 2%/year nominal return, not very good. OP is ignoring profits running the business for 29 years.
That is a fair point, but again, you have to live somewhere so some portions of your "real estate portfolio" can't be rented out. (You can rent out spare bedrooms or whatever, but then that portion you rent out isn't part of your primary residence anymore, and introduces externalities as well.)

Small clarification: We lived there 1981-88, current owners moved in in '90. Parents have moved three times since then and Dad is now dead. It's still where I grew up, so the whole issue resonates with me that way.

If I have a point is it driven home by Sclass. Your house, the one you live in, is probably not going to make you rich, regardless of the conditions under which you buy it and what happens with the local market. Maybe you'll make a lot in nominal terms, maybe you'll make a little in real terms, maybe you'll get creamed. But in any event it should be treated at best as another pie wedge in your overall portfolio. Part of my own analysis towards buying a place involves how much of my net worth I'm comfortable allocating thereto, and I'm gravitating towards 15-20%, certainly not much more than 25%. For most people with a mortgage though, it's more than 100% as they "own" more house than they are worth.

"Buy as much house and as little car as you can afford" is a popular personal finance aphorism. But I'd say a better one is "buy as little house and car as you're comfortable with".

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Re: On the risk of investing in real estate for the long run

Post by Sclass » Sat Aug 10, 2019 12:10 pm

Yeah, the low class renter thing came up at the reunions. I’m no psychologist but it seems to come from somewhere deep in the mind. Below the reasoning region.

I got some friction this week from a step mother, my sister and an aunt. It was subtle regarding success and financial accomplishments. Basically they’d drop, “But you don’t own a house.” So there is your social pressure. It’s just one of the many ways I don’t “measure up.” :lol:

Yeah there’s always a “but”. It is actually kind of comical. I guess I can buy one. Maybe if I go down to the car dealer and trade in my 1985 for something newer they’ll be pleased. :lol:

For the record, all these anecdotes about my friends are polluted with conflicting data. Some of these folks overconsumed. Some invested poorly. Some bought more home than they could comfortably sleep in. Others are just mentally incapable of seeing a year down the road. For a few, locking down their spare cash in their homes was the smartest thing they could do.

Again YMMV. All of these people have managed to survive and at the end of the day that’s the most important thing.

I will also say I’ve been lucky. I’ve made good trades and bad ones. Luckily I’ve made enough good ones to act and feel like I’m right when I very well could be wrong a lot of the time.

Paying the high monthly mortgage:monthly rent payment in Silicon Valley is kind of an option premium towards buying the property. As a renter I bet that the home would not significantly appreciate. Since 1998, that has been dead wrong. However I’ve managed to come out okay probably because my stock returns were sufficiently good to overpower even the 7% RE annual increase in Palo Alto Homes since then. Sometimes I feel I lived dangerously and sometimes I feel I played it safe. And perhaps the option to own is overpriced there.

On one of the Silicon Valley threads I’ll talk about what I observed up there recently. A lot changed since I moved out four years ago. According to my friends the majors have pushed out a lot of the older workers and there are not enough old folks workplaces (like Intel, KLA or Microsoft) to absorb them. You can see the demographic changing before our eyes. It takes a lot of income to keep the lights on up there and my tech peers (50 somethings) are having to sell out their homes and move to cheaper areas. Take the money and run so to speak. It’s not what we’d foreseen when we were in our late twenties starting out. A lot of bad things are happening at once. Friends cannot get the high salaries anymore. Their aging networks do not work anymore - they’re literally not working and they’re useless for making moves. The young are driving up the prices of everything that cannot be artificially locked down. Too much OT for here. But RE commitment is a big part of it.
Last edited by Sclass on Sat Aug 10, 2019 1:01 pm, edited 1 time in total.

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Re: On the risk of investing in real estate for the long run

Post by unemployable » Sat Aug 10, 2019 12:24 pm

Sclass wrote:
Sat Aug 10, 2019 12:10 pm
For the record, all these anecdotes about my friends are polluted with conflicting data. Some of these folks overconsumed. Some invested poorly. Some bought more home than they could comfortably sleep in. Others are just mentally incapable of seeing a year down the road. For a few, locking down their spare cash in their homes was the smartest thing they could do.
And these are supposed to be the smart, sophisticated, enlightened people!

It's not just Silicon Valley, either.

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