The Old Question: Real Estate or Equities

A buddy of mine has been getting into buying real estate to use as rentals aggressively over the past year or so. Generally, I tell people that they're better off investing in the market for any number of good reasons (plenty of WSO discussions on it). But, he's something of a special case as he has access to VA loans, which offer fantastic terms, making his choice perfectly reasonable. However, after reading a couple of articles on Bloomberg, it appears that the tide may be changing. First up, we have Bill Gross, giving us some seemingly wise advice:

“Markets are reaching the point of low return and diminishing liquidity,” Gross wrote today in his investment outlook for December. “Investors may want to begin to take some chips off the table: raise asset quality, reduce duration, and prepare for at least a halt of asset appreciation engineered upon a false central bank premise of artificial yields, QE and the trickling down of faux wealth to the working class.”

Assuming one agrees with Gross, what is one to do with the chips you've pulled off the table? Well, in the second piece, it looks like the law of unintended consequences has struck again, this time in bubbly real estate appraisals:

Since the housing boom ended, mortgage volume has dropped by two-thirds and home sales are still about 30 percent below the 2005 peak. Meanwhile, the number of licensed and certified appraisers, now about 100,000, has fallen at only half the rate of home sales and much less than the drop in mortgage-origination volume. The result is an oversupply of appraisers, with more of them willing to come up with valuations to make a transaction work.

This combination is why an estimated one in seven appraisals is inflated by as much as 20 percent.

How do you monkeys read the situation? Is now a good time to start pulling money from the market and dropping it into real estate?

 

VA loans are only available for primary residences, so that's kind of a bizarre way for him to acquire investment real estate. There's probably some miscommunication between you two on how he's acquiring the real estate. Either that or he's BSing you or committing mortgage fraud. I'm guessing miscommunication. That or he's acquiring 1 property a year and claiming it as a primary residence while he lives there. But the underwriters will catch on VERY quickly about what he's doing and nip it in the bud.

Nevertheless, real estate can be a great investment because of margin. Most people don't invest in the stock market with margin. But if you're leveraging your investment real estate at 60, 70, 80% margin and you're at least breaking even on cash flow, then you're getting at least leveraged capital appreciation and principal repayment returns.

For example, if you invest $100,000 to buy a $200,000 property (50% margin) and the property appreciates at 3% a year then you're getting a 6% return on your equity investment. If you're paying principal on a 20-year schedule on a break-even cash flow then your principal payment acts as an additional return--over 20 years that's about a 3% annualized return (just ball-parking it), so that's 9% annual return, give or take, combined appreciation and principal repayment. If you receive any positive cash flow then you're really in the money. If you leverage it up higher (70-80%) and you're at least breaking even then you could easily be getting double digit returns each year, on average.

In my view, real estate is usually a good investment if you have a long-term view on it. If your holding period is relatively short then you are at the mercy of unforeseen macro and micro-economic circumstances.

Array
 

I think I understand what you mean by putting money into RE, in that you sell a place quickly (volume) since appraisals are being inflated? But if prices are being inflated, then wouldn't you rather just wait until you see some big declines?

EDIT: Nevermind, I read too quickly through the first sentence in the second piece. So what are you thinking of for a time frame?

I'm too drunk to taste this chicken -Late great Col. Sanders
 

My folks were invested in the market up until the crash in '07. My dad invested mainly for the tax savings (interest is tax-deductible) short-term, with the appreciation coming over the long to very long term (ie 10-30 years).

To put some numbers on it, $1,000,000 in property will net about $10,000 a year in tax-savings (assuming break-even, with the rent covering the principal, interest, property taxes, and maintenance.) They were invested with 10% down, so they were making a 10% return every year, and had all the upside of the long term appreciation.

Of course, that's assuming assets are fairly valued and rising in value every year. When houses were massively overpriced, the assumption was blown out of the water. Caveat emptor.

"Everyone has a plan until they get punched in the face."
 

My folks were invested in the market up until the crash in '07. My dad invested mainly for the tax savings (interest is tax-deductible) short-term, with the appreciation coming over the long to very long term (ie 10-30 years).

To put some numbers on it, $1,000,000 in property will net about $10,000 a year in tax-savings (assuming break-even, with the rent covering the principal, interest, property taxes, and maintenance.) They were invested with 10% down, so they were making a 10% return every year, and had all the upside of the long term appreciation.

Of course, that's assuming assets are fairly valued and rising in value every year. When houses were massively overpriced, the assumption was blown out of the water. Caveat emptor.

"Everyone has a plan until they get punched in the face."
 
Best Response

edit: I thought this was a general discussion, not a specific timing question. short answer: no, "now" is not the time because you should never time the market. agree upon your net worth's % of real estate and stick to that. I realize all of my below comments are irrelevant but I wanted to leave them anyway :)

this is the age old question, but I don't think it's an either or, it's both. I struggle with this with our clients all of the time, because we're in a rapidly growing metro area with suburbs that are still growing with relatively cheap property values. the question they have is "I've got X, should I put that in a balanced portfolio (boring), or should I invest in some new construction and hope it grows?"

there are pros and cons with each, I could go into more detail but this will be a cursory overview. for stocks, the answers are simple, you get wealth creating rates of return if you're diversified, rebalance, and stay invested over many decades. you should also get some cash flow over that time period in the event you bought during a lost decade. if you reinvest the dividends and dollar cost average during your working years, the odds of you having a bad return over your lifetime are very small. look up any study you want, there will be instances where a 10y return will be bad, but for most people on this site, look at 40 year numbers, that's more relevant. I'd be shocked to see a 40 year time period post WW2 where stocks weren't the best asset class.

the cons for stocks are that there are tons of ways to do it, so many people suffer from analysis paralysis. there are literally millions of iterations of what your portfolio could look like. domestic, int'l, emerging, large, mid, small, dividends, low pe, garp, etf, mutual fund, individual names, equal weight, cap weight, conviction weight, there's tons of ways to do it and many people have been successful in each of those ways. my opinion? if you have money, get a good broker (there's a post I authored somewhere out there on how to find one). if you want to do your own research and you're good at it, go for it. if you work at a fund, invest there, just make sure to dial down the equity exposure as you near retirement, there's less time for you to make up for mistakes unless you want to work longer. if you don't want to do the research, don't have the time, AND don't want a broker, do the low cost ETF thing. in my opinion, you will not be as good off as someone who has a good broker, you will likely make emotional decisions that will wreck your long term performance.

for real estate, the pros are obvious: leverage baby. you can buy a large property for a little money. they kick off tons of cash flow (if rented or REITs), and it goes up forever (right?). plus it's safe, it will always be worth something (right?), and its value is less volatile than stocks (more on that later).

full disclosure: we own REITs for clients, we are not bears on real estate if properly diversified. tons of misconceptions about real estate, and obviously this depends on your locale, but here are some things I've noticed.

rental properties are only worth if if you get at a steep steep discount, like 40-50% off comps. the market for rents is like this: they have to be competitive enough to deter people from getting a mortgage but high enough to provide a positive cash flow. here's an example:

on a $350k house, a mortgage payment at 4.5% for 30y assuming you put down 20% (so 280k mortgaged) will be $1,400 (roughly, I'm not going to exact pennies for those of you checking my work). The real cost will be something like 1700-2000 after taxes & insurance. If you charge much more than that, the house won't rent, people would rather buy. let's say you got the house years ago and only mortgaged 200k but keeping the rate & term the same. that's about $400 less altogether, so even if you charge $2000 a month in rent, you're still making $400/mo or $4800/yr, pretty great huh? let's say you only put 50k down (20% of 250 would leave you with 200k mortgage), that's a 9.6% return gross of expenses.

here's where it gets not so great. the fridge breaks, that's at least a grand. washer & dryer? another grand. real estate agent fees for helping you rent it? depends on your area, but these could range from a couple hundred bucks to a couple grand. you can easily see how that 9.6% return gets whittled down if you concentrate in one property. also if it doesn't rent, that's a sunk cost for you, a negative return. plus you have the headache of having to deal with tenants. this depends on your clientele, but if you're busy working, it's got to be a headache dealing with all of that. unless you hire a property manager, but that only decreases your return because of their fees. no idea what these are like, if it's equivalent to a 1% fee from a broker or if it's more like 5%.

you all can do the math if the rental was cheaper then your return would be higher. the point is if you concentrate in one property, you are still very much at risk just like you would be if your investments were all in one stock.

however, if you have a professional picking several properties in real estate with good characteristics (a la REITs), your odds of it blowing up are slim. plus, you don't have to contribute any capital beyond your initial investment if you don't want to.

real estate is not the end all be all of investing. it sounds sexy because you can touch, see, feel it and leverage magnifies your returns (in both directions by the way). additionally, it's more easily understood by lay people (at least they think so) and there's no liquid market for it so it's perceived as less volatile. imagine if home prices were published by the second and deals didn't take underwriting, if you could trade shares of property like you can companies in the stock market? prices would be far more volatile. but because real estate is appraised privately and subject to haggling, comps, etc., it's much less volatile than stocks and so it's perceived as safer.

that's another thing, I put a premium on liquidity. granted, most of WSO is younger and will be invested for many decades, but at several times during the years and especially during retirement, you need to be able to access your money, which is why liquidity is good. it could take weeks, months, even years to sell a piece of property at a good price (if you can ever get one). with the exception of lower volume issues, you can trade stocks any time you want, meaning you can quickly take advantage of dislocations in the market if your antennae are up. like when V was down to 200 mid-October. did you buy it then? too bad if you didn't, it's up 30% since then. if you have cash, you can quickly deploy it to other properties but if you don't, then you're at the mercy of the market at that point so you may not be able to sell quickly and reinvest in another property. REITs can do this, which is why I advocate those.

personally, I prefer stocks because of liquidity, what I believe to be better performance, more easily analyzed, and easier to diversify. I realize though that real estate has its merits and deserves a place in a balanced portfolio, but that does not mean 1 rental apartment, that means REITs or funds (40 act, private, whatever).

sorry that was so long, hope it was helpful.

 

For the pros out there, how do you go about formally evaluating a real estate investment (residential). Let's say you buy a $500K place, 20% down, that's 400K mortgage. You are paying 3% interest on 20 year mortgage term, total payments (not including tax etc) are ~2200. Let's say you can rent it out at 2300 and assume appreciation of 3%/yr.

What is my return in such a case? I think part of my confusion stems from how to think about the return I'm getting by paying down the mortgage where over time the payments don't change but the ratio of principal to interest does change. So over a given time frame, how would you value it? Technically a property can make sense even if you are at negative cash flow as long as the cash flow coming in covers interest and taxes etc. so that the amount you are out of pocket for goes to principal (viewing the principle similar to how you'd view a savings account). I wouldn't recommend it neccasarily, but it does make the valuation more nuanced...

 

I will give you a simple answer, RE pros will give you one that's more complicated/better.

look at it in terms of cash on cash return. you are getting 1200 per year in rent profits plus 15k/yr price appreciation (3% of 500k). that's 16200 on cash down of 100k or 16.2% return per year. because the renters are paying the mortgage, you should only look at your total cash in. if it doesn't rent for a year, your contributed capital goes up to 126,400, but even with the price appreciation you still get 12.8% return per year not including maintenance. not bad.

look at it in terms risk, alternatives, and returns. if you have a couple million and either a decent cash cushion or enough income to replace lost rent, a 500k house is reasonable. where it becomes unreasonable is where you cannot pay the mortgage out of your own income with no rent. similar to the reason why you don't invest your emergency fund in stocks, you shouldn't take out more real estate debt than you can shoulder out of your cash flow assuming 0% rent.

alternatives are stocks in this case (feels weird saying that, RE is a traditional "alternative investment"). stocks have good long term rates of return, require no maintenance (physical maintenance, like fixing a HVAC), have no capital calls (lost rent, maintenance), and are liquid. I put a premium on all of those as well as the "hassle" factor. If you're DIY with a stock portfolio the hassle factor could be the same but not if you are in a fund or have a broker.

admittedly those are difficult to quantify so much to the dismay of WSO aspiring preftige whores, you can't plug this stuff into a spreadsheet, you have to use your judgment.

 

I would argue that the amount your principle gets paid down by should contribute to the % return, which makes that number even larger. If you calculate simplistically, 3% interest would cost 12K and the rental total is 27.6K leaving a 15.6K return (the 1200 rent profit plus 14.4K to principle). Along with 3% appreciation of 15K you have 30.6K return on your 100K down, giving you 30.6% return.

This was simplistic because you would have to look at an amortization schedule to truly determine how much is going to interest vs principle. And of course it's hard to monetize this return because selling comes with significant friction costs whereby it probably costs you at least 4-5% of the property value (say 25K) to sell. So to make it worthwhile you need to hold for the long term (and potentially use refinancing to monetize and re invest in other properties / equities over the medium term)

Everything regarding maintenance and tenant headaches are true, but I think that's what contributes to the higher return. Agreed you shouldn't over leverage yourself, but maybe instead of saying you have to be able to carry the full property on your own, we can risk it by saying you should have x amount of months coverage or assume it's rented only 50% of the time etc. The difference between real estate and equities is that you have to manage real estate, similar to how you manage a business. I think most businesses that require large investments cannot be fully carried by the owner and is usually justified by 'risking' the income expected from the business...

Thoughts?

 

good point, but just remember you can't bake in the principal return into long term return assumptions because of the way mortgages amortize (but I'm sure you knew that already). we're on the same page there but don't get greedy. now, in 30 years when the property's paid off and worth 1.2mm, and you're collecting 5k/mo or more in rent, that's a 60% return on initial investment. HOWEVER, you HAVE to adjust for inflation. let's say inflation stays at 3%, well now that return doesn't seem so great, does it? you have to look at real returns with any investment, RE included. so cash on cash may look good (just like stocks, if you bot MO 20 years ago, you're getting a 50% cash on cash return in dividends alone, but in terms of purchasing power not so much), but you have to account for inflation.

I disagree on the 3rd paragraph, but I'm inherently more conservative than other posters here. I ask people if they would want to change their lifestyle to pay the mortgage on their rental property, most do not. I also advocate against withdrawing from other investments to float a non rented investment property. this does 2 things, it means you're likely spending that $ sooner than you thought, and it skews the % of your net worth to that single investment.

I'm a pragmatist, and I know for a fact that after all expenses, you're not getting a 30% yoy return on rental real estate, unless you bought it at foreclosure and it's constantly rented. I know it happens, but you can't assume it will happen all of the time, I don't have any data other than experiential data with clients and colleagues.

investment properties and a small business are 2 different things, I see your point but I think you're a bit off base.

 

Appreciate the comments. SB'd

I take your point about adjusting for inflation and agree that 30% is unlikely after all expenses and adjustments. This is another reason why so often it's hard to realistically model these kinds of investments when in fact it's experience that ends up being the best indicator.

Regarding the principle, the amount of positive cash flow can be quite different on a 20 year term vs a 30 year term, where you might only break even on 20 but be cash positive on 30 which skews your cash on cash return towards the 30 year, yet you are further ahead economically by only paying 20 years and saving the additional interest (all things equal assuming you do not invest the positive cash from the 30 year term elsewhere)

Either way, I think all asset classes have value for different reasons. I prefer equity for the liquidity and real estate for the leverage. As with all things, it pays to do your research, focus on your investments and be diversified. In the end a lot of it depends on what you are exposed to, where you live and what industries you work in.

 

Most real estate investors just use the cap rate as a quick and dirty way to get a feel for valuation. Cap rate being rent minus expenses over costs, on an unlevered basis. In other words, you pay $1,000,000 for a property, rent it out for $100,000 per year and taxes, insurance, and maintenance are $50,000 per year. That's a cap rate of 5%. ($100,000 - $50,0000)/$1,000,000 = 5%. Cap rates on prime buildings in Manhattan are trading for a lower cap rate than than that right now. Stocks are cheaper than real estate in Manhattan. People are assuming price increases to justify those purchase prices right now, as far as I'm concerned. Other areas in the country surely have better cap rates than here, many of my real estate buddies are telling me this.

@"thebrofessor" made a point that if you buy a $350,000 home, you need to keep the rent low enough that the person renting from you does not consider buying the property himself. I think this is true for properties where the people renting have the means necessary to make the down payment, which would be most middle class and above neighborhoods. If you as a regular person want to make money in real estate, you'll need to be able to rent to people where that person does not have a realistic possibility of buying on their own. This means renting to students (who will move shortly with nearly 100% certainty) or lower income or working class people (who can't afford the down payment).

In the mean time, get long stocks in a big way.

 

good point about the college kid stuff, I'm in sort of a college town, but most of our clients don't want the hassle of renting to college kids (and understandably so), so I sort of had blinders on to that possibility. you can definitely squeeze above market rents out of people who don't have the ability to stay long term either from means or from time constraints.

 
thebrofessor:

good point about the college kid stuff, I'm in sort of a college town, but most of our clients don't want the hassle of renting to college kids (and understandably so), so I sort of had blinders on to that possibility. you can definitely squeeze above market rents out of people who don't have the ability to stay long term either from means or from time constraints.

That was sort of my point, but I realize it probably wasn't clear. Renting profitably to a couple who makes $150,000 per year with great credit and no criminal record is not very likely. More likely, you'll need to rent to working class people with spotty credit histories, moderate (being nice here) incomes, and other problems in order to make it profitable. They have to rent so they have to pay higher rents than they might have to if they could afford a down payment and qualify for a mortgage. Unless you get into real estate in a big way and can start hiring property managers, it's probably not worth the headache for most people. Students will likely year your place to shreds, so you need to budget pretty high maintenance costs. Nightmare.
 

Guys, I don't think the inflation example you're giving is very relevant, because you should expect that your rent, expenses, and property values should rise with inflation over time. That is one of the true beauties of fixed long-term leverage. Your debt payments remain constant while your rents increase. In order to make significant money on rental properties you need to find something where rents aren't at market rates and you have a way to get them to market.

Most people can't do that.

 

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