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

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

Post by CS » Sat Aug 10, 2019 12:42 pm

I could go on with details about the horrifically poor state of these "rich people's" finances, but the larger point is that out of ALL the clients we had at this Lake Minnetonka bank, only...

2,
TWO,
T-W-O,
II,
1+1=2

were actually "rich." Let alone rich enough to live and afford a house on Lake Minnetonka.
Frickin' awesome. I know these lakes well.

I had a friend work in collections for a while. The WORST were the "rich" people. Never paid their d*** bills. The less well off tried hard.

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

Post by jacob » Sat Aug 10, 2019 12:46 pm

In terms of intangibles, I've found the benefits of "being a homeowner" to have a rather remarkable and almost magical effect on the apparent legitimacy of ERE in the the mind of the average person (as well as the general attitude from the family&friends who are unfamiliar with ERE). Back when we lived in the RV we caught a lot of shit for our choice of domicile: Not just that our version of FIRE didn't count w/o a stick house or that we were "homeless". There were even some online asshats calling us trailer-trash.

Arguing that the RV was just a smart choice given bay area real estate in our area---prices for the tiniest vinyl-clad apartments started in the mid 400ks when we arrived in 2007... and in the low 300ks when we left in 2011---and that our budget could afford the purchase of a house in cash in much of the rest of the country fell flat. Probably required too much system-2 thinking :-P

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

Post by CS » Sat Aug 10, 2019 12:52 pm

I guessing current homeowners gave the most grief and former homeowners the least (as in none). Crab bucket mentality in addition to not having good systems thinking.

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

Post by Seppia » Sat Aug 10, 2019 1:03 pm

unemployable wrote:
Sat Aug 10, 2019 11:46 am
how much of my net worth I'm comfortable allocating thereto, and I'm gravitating towards 15-20%.
It’s the exact same number I kinda came up to, without thinking in percentages but just as “this is how much I’d put in a place to sleep”.

My apartment play was basically a hedge (we don’t even live in it): I bought as small as I could live in permanently, 10 minutes from my hometown city center, connected by bus, where most of my family and friends still live.

My reasoning: I now have an above average salary, and I want to be very mobile to make the most of my career (and of my personal life).
Now I can pay for rent and it helps keep me flexible.
But what if I get terminated? These things happen fast.
I have a good social network (a real one) in my hometown, and with a paid off newly built place I could sustain my family with any entry level job.

It’s basically a downside protection instead of upside maximization play.

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

Post by unemployable » Sat Aug 10, 2019 1:08 pm

CS wrote:
Sat Aug 10, 2019 12:42 pm
Frickin' awesome. I know these lakes well.
So I take it you have purified yourself in the waters of Lake Minnetonka?

FIRE 2018
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Re: On the risk of investing in real estate for the long run

Post by FIRE 2018 » Sat Aug 10, 2019 1:23 pm

One thing I have learned and have been taught. To ever think about going to FIRE, be debt free and mortgage free before taking the leap. Helps me sleep better at night and limits the " what ifs". Owning and renting is never a sure thing so it is a personal choice.

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

Post by Sclass » Sat Aug 10, 2019 2:53 pm

Oops post got corrupted somehow. Sorry.

In short, the RV was brilliant. I’m impressed with the young guys doing this around Mountain View right now while coding for the mega techs.

Funny how getting the home validated your practices. It reminds me of feeding my mom off of my Goodwill China set and having her scoff “but we all know where you got this”. As if the meal lost its nutritional value because it was served on some divorcée’s throwaway wedding set.

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

Post by CS » Sat Aug 10, 2019 6:45 pm

unemployable wrote:
Sat Aug 10, 2019 1:08 pm
So I take it you have purified yourself in the waters of Lake Minnetonka?
Haha, no, but I've gone on the ritual "invited over by friend for a party and a ride on the boat" just like in the article. It's a rite of passage I think... everyone knows *someone* with a boat

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

Post by shemp » Sun Aug 11, 2019 5:22 am

Seppia wrote:
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.
Bankai gave an example of 6% cap rate, presumably in UK since his numbers £. Of the numbers he listed, the only one open to serious dispute is ownership costs. Cheap buildings sometimes are cheap because of deferred maintenance. 6% cap rate is not common nowadays because of low interest rates, but it was in the past.

If the case of the OP, I doubt cap rate was very good, because $450K in 1990 near Pittsburgh was very expensive, and expensive houses usually have low cap rates. You want working class neighbourhoods.
jacob wrote:
Sat Aug 10, 2019 7:12 am
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.
You're making the same mistake as the OP. Housing is a business and houses most definitely do something. Namely, they generate a stream of housing services which you can use yourself, in lieu of buying such services from someone else, or which you can sell, if you want to be a landlord. Expected economic profit is certainly not zero, though it might be less than other equity investments (ownership of businesses other than housing, education, buying an automobile to allow driving to a better paid job, career counseling, etc) because of less risk. Risk is low with housing because there is always a market for housing services, so prices are fairly stable. The 2008 collapse was an anomaly and even then most of the USA was only lightly affected.
ether wrote:
Sat Aug 10, 2019 7:56 am
Single family homes will almost always lose money as a rental.
Expensive McMansions yes, but not cheap houses.

Landlords get the depreciation tax break, but that's a minor factor with cheap houses because it only applies to the building, not the land. Plus, depreciation reduces your basis when you sell, so higher taxes on gains. Owner occupants can't deprecate but they get the much more significant break of no taxes on for first $250K capital gains ($500K if married couple). Owner occupants also get the very significant tax break of no taxation on imputed rent, meaning housing services derived from living in the house. For example, for a renter in the 25% income tax bracket to pay $12000/year rent, they have to earn $16000. Whereas an owner occupant living in that house is not taxed on the $12000 value he receives, so effectively a $4000/year tax break. This tax break is most applicable someone in high tax bracket with stocks/bonds throwing off taxable income, who can switch from stocks/bonds to owner occupied housing, thus saving taxes that would previously have been due on stock/bond income.

As for leverage, that's just a multiplier: it turns a good investment into a great investment (as with Bankai's example of 35% ROI) or it turns a bad investment into a disaster, but it never turns bad to good or vice-versa.
oldbeyond wrote:
Sat Aug 10, 2019 7:39 am
Historically the "owners dividend" has provided a sizable part of the return from residential housing, see viewtopic.php?f=3&t=9597
Under steady state conditions, "owners dividend" should provide 100% of return. Land should appreciate in line with nominal GDP while buildings depreciate, so the two more or less offset one another. Housing is a business and what matters most is the stream of profits (actual profits for landlords, imputed profits for owner occupants).
unemployable wrote:
Sat Aug 10, 2019 11:46 am
(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.)
Renting out rooms is exactly what many people should be doing if they are not rich. Of course it's a nuisance. So is almost everything having to do with making money in this world.
unemployable wrote:
Sat Aug 10, 2019 11:46 am
Your house, the one you live in, is probably not going to make you rich,
Bankai gave a example of 35% ROI, and that is not uncommon with real estate. (Though as I noted, maybe Bankai's estimates might be wrong, especially ownership costs and appreciation assumption.) You most definitely can get rich with real estate, precisely because it allows for high but fairly safe leverage.

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

Post by Jason » Sun Aug 11, 2019 6:11 am

jacob wrote:
Sat Aug 10, 2019 12:46 pm
There were even some online asshats calling us trailer-trash.
Sorry about that.

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

Post by shemp » Sun Aug 11, 2019 7:56 am

Numbers below representative of typical working class neighbourhood single family house in central part of USA. Comments:

* Property tax highly variable between states, but final conclusions regarding cap rates and ROIs will be similar, since high property taxes lower profits (reducing numerators) which tends to lower housing prices (reducing denominators).

* Repairs and insurance should be somewhat lower for owner occupants, which would strengthen conclusions, though I didn't make any adjustment.

* Buying biggest house possible is a great idea provided you rent out rooms. If you arrange with boarders to provide some rent via unpaid services like yard work, you do even better. (Technically, you should report such services as barter income to IRS.)

* Buying/selling transaction costs can ruin final results. Need to minimize these by reducing frequency.

* In a high interest rate and high dividend rate environment, tax break because of non-taxability of owners imputed rent can be very big. To reiterate, this applies mainly to people in the accumulation phase, with 25% or higher income tax bracket, who absent housing would have large stock/bond investments generating taxable income. By keeping savings as owner occupied housing, "income" on savings is tax sheltered as imputed rent. I will ignore this tax break here because it is small with just $32K house equity and current low interest rates.

* Leverage works wonders if cap rate greater than interest rate. Leverage with housing fairly safe assuming enough steady income to cover interest. In particular, people with secure jobs and no plans to move can and should lever big on housing, especially owner occupied housing. Viewed alternately, often better to take low paid secure jobs that allows leveraging on housing versus higher paid jobs that are unsteady jobs or require frequent moves.

* Buying for owner occupancy at low cap rates not necessarily dumb, assuming owner's imputed rent untaxed (true in most countries, Netherlands a notable exception) and low interest rates (true currently in most developed countries).

* Return to high interest rates would cause jump in cap rates and fall in house prices, wiping out accumulated yearly profits via huge capital loss upon final sale. So if buying at low cap rates, need to be sure interest rates will stay low for a very long time.

----

$12000/year rent ($1000/month)

$160K price (160x monthly rent multiple)

$8000 landlord expenses (67% gross rent):
$2400 property tax (1.5% price)
$3200 repairs (2% price)
$800 insurance (.5% price)
$800 vacancy (6.7% gross rent)
$800 management/legal/accounting

$4000 landlord profit (2.5% cap rate)

$6400 owner occupant expenses:
$2400 property tax
$3200 repairs
$800 insurance

$5600 owner occupant profit (3.5% cap rate)

Mortgage at 4% nominal = 2% real interest.
20% or $32K down, 80% or $128K borrowed. Hence $5120 nominal, $2560 real interest.

Owner's leveraged real ROI: ($5600 profit - $2560 real interest) / $32K equity = 9.5%.

Landlord's leveraged real ROI: ($4000 profit - $2560 real interest) / $32K equity = 4.5%. (There are some additional tax breaks for landlords which ether mentioned and I'm neglecting, notably depreciation, but not enough redeem this house as landlord investment. It only works for owner occupants.)

Nominal ROI below is for first year. Nominal ROI rises each subsequent year as profits increase with inflation but nominal interest is unchanged. Most of difference between real and nominal ROI is reflected in huge bonus gain when you finally pay off mortgage with inflated dollars. I'm assuming interest only mortgage. Same conclusions with mortgage that is gradually paid off, but much more complicated analysis. I only include nominal ROI for comparison purposes. Real ROI is what matters.

Owner's leveraged nominal ROI: ($5600 profit - $5120 nominal interest) / $32K equity = 1.5%.
Last edited by shemp on Sun Aug 11, 2019 11:01 am, edited 1 time in total.

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

Post by unemployable » Sun Aug 11, 2019 2:57 pm

shemp wrote:
Sun Aug 11, 2019 5:22 am
You're making the same mistake as the OP.
Neither Jacob nor I "made a mistake". What he wrote is borne out by quite a hefty amount of evidence, and I showed my work.
Bankai gave a example of 35% ROI, and that is not uncommon with real estate. (Though as I noted, maybe Bankai's estimates might be wrong, especially ownership costs and appreciation assumption.) You most definitely can get rich with real estate
I wouldn't count his experience so far as "getting rich". He made money for sure, assuming he can sell for what he thinks he can and accounting for selling and transaction costs. I'd rather have GBP 7000 than not have it but that's not my definition of getting rich.

You'll note I've stated the best idea is to buy as little house for your primary residence as you're comfortable living in, and that many people get this spectacularly wrong. Your focus of buying out lower-class housing to let is not inconsistent with this.

I stand by my statement that your primary residence is probably not going to make you rich. It may make your heirs sorta-rich, but you'll be dead by then.

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

Post by classical_Liberal » Sun Aug 11, 2019 8:51 pm

unemployable wrote:
Sun Aug 11, 2019 2:57 pm
You'll note I've stated the best idea is to buy as little house for your primary residence as you're comfortable living in, and that many people get this spectacularly wrong
This plus transactional costs, which was alluded to by @shemp. True transactional costs on primary occupied real estate is 7% on low end, 20% on high. Broken down averages of about 3-4% buy sided closing costs (assuming financing/leverage) and 4-15% sell side. This is for an average RE transaction where seller does not DIY, hires an agent, uses title company or attorney, and has to pay for "staging" improvements to the house they otherwise would not have done to max sales price.

So the biggest mistake is a combination of purchasing too much home to live in, in concert with moving too much. A quick google search showed the average person only stays in an owned home for ten years in the US. How would someone think of other investments differently if they had double digit transactional costs? The biggest advantage for an average person @sclass brought up, it's harder to spend your home equity than it is your other liquid savings.

I take the side of @seppia and @jacob. The true advantage to ownership for ERE'er is a) It "locks in" future housing costs in an area that is very attractive to you and others. b) It provides the social stability of ownership/validity of FI to social sphere. There are some financial exceptions with rentals in certain markets. Frankly, I've found it difficult to find anything available for purchase in attractive, at least semi-urban markets, that is small enough to meet my needs without exceptionally high ongoing costs (ie taxes & HOA near the levels of small/cheap rentals in the areas). The best I can find is smaller multi-units, but then I would have to be a landlord. Although today's interest rates makes it temping at times.

FIRE 2018
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Re: On the risk of investing in real estate for the long run

Post by FIRE 2018 » Mon Aug 12, 2019 3:42 am

It's GREAT to live in Florida. My home has more than doubled in value living in it for the last 20 plus years. Why it's GREAT. My property taxes that I pay annually for the last 20 plus years has been $1,300 a year give or take a few hundred dollars a year depending on the tax bill I receive every November. It's no big secret. Florida taxes the heck out of the millions of tourists that vacation in the Sunshine State ( look closely at your hotel and rental car bill as examples), and that's a major reason why mine and other Florida residents tax bill are so low. And Tourism is the #1 industry here. That and paying no state income tax is a big bonus too. And in FL, the wealthy people love it here using the state as a massive tax haven. The big state motto is VISIT FLORIDA and keep making my taxes low!😎

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

Post by tonyedgecombe » Mon Aug 12, 2019 5:50 am

classical_Liberal wrote:
Sun Aug 11, 2019 8:51 pm
This plus transactional costs, which was alluded to by @shemp. True transactional costs on primary occupied real estate is 7% on low end, 20% on high. Broken down averages of about 3-4% buy sided closing costs (assuming financing/leverage) and 4-15% sell side. This is for an average RE transaction where seller does not DIY, hires an agent, uses title company or attorney, and has to pay for "staging" improvements to the house they otherwise would not have done to max sales price.
Not in the UK, my last sale was 1.5% on the sell side, nothing on the buy side. There were conveyancing fees on top of that but they weren't very high. I'm surprised Americans put up with this.

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

Post by Ego » Mon Aug 12, 2019 6:17 am

Since about 1990 buying a house with a mortgage in the US was a cargo cult ritual. Today doing so even without a mortgage is for most tantamount to strapping on coconut ear-covers and pretending to waive in the imaginary plane.

Today homeowners move so frequently (5-7 years on average) the transaction costs, amortization schedule, taxes, maintenance, insurance and HOA fees kill them. Those who refuse to move often forgo the benefits of job change or suffer life-killing commutes.

Neighborhoods, cities, states and countries are changing faster than ever and the rate of change is accelerating. There are pockets where change happens slower but they are so overpriced that the initial outlay to lock in future housing costs is insane.

Where the past worshiped stability the modern world demands resilience and reinvention. Anyone living a post-1990 lifestyle with a non-government-esque job is locking themselves to their current circumstances. That may work for someone with a few years to Social Security. For everyone else it is buyer beware.

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

Post by Bankai » Mon Aug 12, 2019 6:31 am

tonyedgecombe wrote:
Mon Aug 12, 2019 5:50 am
Not in the UK, my last sale was 1.5% on the sell side, nothing on the buy side. There were conveyancing fees on top of that but they weren't very high. I'm surprised Americans put up with this.
Agree, these costs in US look insane. When we bought last year, our only cost were conveyancing fees of <£500, so 0.5% of purchase price.

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

Post by Riggerjack » Mon Aug 12, 2019 8:56 am

Wow. Lots of people talking past each other here.

The OP compared consumption vs investment, and concluded that investment works better, long term. In other news, comparing apples and bananas make for some odd conclusions...

The long run take away is that appreciation really only helps those with multiple properties. See Silicone Valley examples.

But what I really wanted to address was shemp's assumptions. As a landlord, getting out of the business, I agree with all he said, with one huge objection.

All of his assumptions are based on the appreciation caused by relatively stable demand that urban markets continue to enjoy.

But this hasn't always been the case. RE is very local, and so long as the local market is tied to production, prices are as stable as he says. But national GDP means nothing, it's the local GDP that counts.

But when the plant closes, or whatever the local industry is dries up, the Ponzi scheme falls apart, and everyone takes their lumps. Those owning on margin take the most lumps.

Try running the numbers again, considering drops in rent and property values; as those who can leave for greener pastures, do so, leaving far less demand. This was alluded to in the OPs post.

Sometimes change happens, and then the choices get less appealing. Sell to minimize future losses in rent/appreciation, or try to ride it out, hoping for a return to better times. And how does the tenant pool change during this time? Maintenance costs are strongly correlated to the tenant pool, how did that change? Strangely, when the tax base shrinks, the tax bill... Doesn't. How did that change the numbers?

And as we saw in 2008, it's those on margin who liquidate. These liquidations flood the markets when you may need to get out.

None of this is meant as a critism of RE as an investment, I have done just fine, myself. Rather that it is an industry geared to attracting and sometimes destroying ambitious people who see upsides, but rarely account for the very significant risks, since they rarely see the bear markets that wiped out the previous generation of ambitious investors.

There is no return without risk. The low volatility of RE, plus the transaction costs, hide the risks. That's not the same as reducing the risks.

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

Post by Gilberto de Piento » Mon Aug 12, 2019 8:59 am

Bankai wrote:
Mon Aug 12, 2019 6:31 am
Agree, these costs in US look insane. When we bought last year, our only cost were conveyancing fees of <£500, so 0.5% of purchase price.
Yes, while buying a house I was thinking I can't believe no one has 'disrupted' both the realtor and the mortgage industries yet.

Another thing to think about with home ownership: the opportunity cost of the time and energy you spend on repairs. DIY can be fun but it can also be a massive sink for time and energy. Even hiring contractors can take up a lot of time. I haven't had that problem with index investing.

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

Post by 7Wannabe5 » Mon Aug 12, 2019 11:44 am

Does anybody know how detailed the grid on real estate derivatives is these days? I'm wondering because it came up in a futuristic novel, "New York 2140" I just finished reading. In the novel, one of the main characters has created an Index which tracks the value of post-global-climate-change-water-level Intertidal Property.

Anyways, I would guesstimate that my investment in vacant lots has appreciated around 1000% over about 5 years. Of course, this is more an example of Trading rather than Investing, because I am not including the value of my garden which is significantly greater for me than for the general market. Same skill as buying a book for $1.50 at a library sale and then selling it for $30 a few years later.

Kind of apples and oranges to compare real estate to index fund, because you are paying somebody else a little bit of money to trade for you exactly like everybody else is trading with an index fund, whereas the real estate holding situation is imagined as static with the market moving around it. Also, stuff vs. paper. Stuff vs. paper is an important consideration, because, for instance, when I shipped my books to Amazon's Warehouses, they transmogrified from pure Stuff into part Paper, and that turned out to be a problem, because I didn't quite realize it.

One of my ex-BF's suffered through bad divorce combined with bottom falling out of real estate market, because the rental duplex he owned in a pretty terrible neighborhood was Stuff, at least he could move himself into it when everything else in his life fell to crap.

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