Real estate vs. the market. The age old struggle. We have had advocates strongly supporting both sides, such support likened to political affiliation (no joke!). Many planners will admonish investment in real estate; their core competency lies in the market, and many cannot see the value of real estate. We understand that there is value to be had in both, but you need to first understand what you are getting yourself into. To do this, you need to understand the pros and cons of both sides of the table. In this two part series, our goal is to help you do just that. In this article, we will first explain the benefits/drawbacks of investing in real estate, and in Part II (next month) we will do the same for investment in marketable securities. By the end of this series, you will (hopefully) have the necessary information to make an informed decision prior to making an investment. We would note that this discussion is regarding an investment in real estate, not necessarily the purchase of property as a primary residence or vacation property, which has a very different value proposition.
Real Estate – Advantages
We are going to discuss real estate first, and the net positives of property ownership. The first pro of home ownership is a bit conceptual, but still a very positive attribute – ownership of real property, feels, well, real. You can point to a piece of property and know that you physically own it, and that does matter to people. In the end, other property ownership, particularly liquid assets, only have paper wealth to some extent (which we will get into more below). You know that no matter what happens in the financial markets that you own a particular piece of real estate so long as the United States is still alive and kicking.
Another very important benefit of property ownership is the rent one receives. There is the potential that you can receive a very nice piece of income each month, and if we compare such income to the yield you receive from a straight bond portfolio or a 60/40 (stocks/bonds) mix, it could be higher. For instance, let’s assume you purchase a home worth $500,000 with cash, and receive $2,500 in rent each month. That is an annual cash flow of $30,000. If we assume property taxes of $6,000 per year, that is an annual rate of income of 4.8%; today in 2016, that would be a very good yield on a traditional investment portfolio of stocks/bonds. If you have tenant certainty, you will be able to increase your income each year as well (without the fluctuation in bond prices).
That is, of course, not all. You also have an asset in real estate that can increase in value and add to total return. This, of course, is not different than the stock market, but the benefit of real estate is not necessarily just the fact that the market value can increase, but more so that real estate is not correlated to the stock market. According to data by Robert Shiller (the Yale University professor and Nobel Prize winning creator of the Case Shiller Home Price Index), in the previous 14 of 15 US stock bear markets (going back to 1956), the home price index actually rose. Thus, residential real estate can be a really nice hedge against the stock market.
If you are leveraging the property (via a mortgage), you are utilizing the bank’s money to build equity and can potentially utilize the rent you receive to cover the mortgage payment. This can be very beneficial in a rising real estate market. For instance, let’s assume you purchase a piece of property for $100,000, putting 20% down and mortgaging the rest, and let’s also assume you have a renter that is covering the mortgage/property taxes/insurance. If the real estate grows by 5% year over year, that is a 25% cash on cash annual return ($5,000 growth/$20,000 cash invested). Not too bad in a single year!
There are also tax advantages that you simply do not have with stock market investing. First, there is the deduction for mortgage interest, whereby you can deduct any interest on mortgages or home equity of up to $750,000 of debt. You can also depreciate the property (the property only, not the land) over a certain period of time (generally 27.5 years). For instance, let’s assume you purchase a home with a value of $200,000, and you have rental income of $1,000 per month. You can depreciate this piece of property over 27.5 years, thus the annual depreciation is $7,272. You would be able to net your $12,000 in rent against this depreciation, and only pay taxes on $4,727 (we will get into recapture a bit later). You can also deduct several costs of owning real estate as well, including insurance, repairs, property taxes, etc. Thus, the income tax you may owe may not be as substantial as you initially think.
Real Estate – Disadvantages
However, the picture is not completely rosy when it comes to owning real estate. There are several drawbacks to owning real estate that you should take into consideration before you purchase.
First, there is a question of which has a better return over a long time horizon. If you Google the comparison, you will see strong opinions on both sides. There are literal millions of ways to compute this type of inquiry, and there really is no “perfect” analysis. It depends on what costs you include, whether you take into consideration taxes/inflation, etc. The best study we saw was by the consulting firm McKinsey in May of 2016. If we look at recent history (the past 30 years from 1984-2014), the S&P 500 has increased on a “real return” basis (taking into consideration returns above inflation) of 7.9% (A 2017 Federal Reserve of San Francisco study found result over a similar timeframe). Over the same timeframe, real estate increased by 1% on a real return basis. You may say that this is purely the increase in home value and it is not taking into consideration rent. If we assume a mortgage of 80% loan to value, and the mortgage payments are treated as the equivalent of rent, the real return is 6.6%. The market still outperforms.
Another large drawback of owning rental real estate is lack of liquidity. How exactly do you get money out of your home? Two ways – first, if you have equity, you can take a home equity loan/line, but of course you would have to pay interest on any money you pull out of your property, and you may need to worry about fluctuations in interest rates. You could sell your property, but if you are cash strapped, it may not be the most opportune time to sell.
Leverage is also a double edged sword – it can be great in a real estate boom, but it can also hurt in bad times. There are a confluence of issues that can occur in a recession. First, there can be potential issues with renters, either not being able to rent the property, dealing with tenants who can’t pay the rent, or charging less than optimal rent due to market conditions. Your property may also drop in value, and suddenly you may be underwater with your mortgage (just ask people who bought rental property in 2007 and wanted to sell 3-5 years afterwards), which means you may have to come to the table with money if you wanted to sell. Having a mortgage on a piece of property is a socially accepted type of debt, but leveraging your stock market investments is not – is it that much different?
Another large potential drawback really comes down to one word: time. Owning a piece of rental property can be a time drain unless you hire a management company which has its own drawbacks. You have to worry about everything from a potential call at 2 AM regarding a toilet leak, chasing down tenants for rent, or the police calling you about noise complaints from your tenants. From choosing reliable tenants to maintenance issues, being a landlord can be a time drain. Your other option is hiring a management company to handle all of these things for you, but be prepared to be charged 8-12% of the rental value, which may very well wipe out your profit.
Finally, a question – if you owned $300,000 of GE’s stock, and it made up a quarter of your net worth, my guess is most advisors would tell you to sell off three quarters of it to diversify. Why? Because of concentration risk. Why is owning a piece of real estate property any different? You are buying a piece of property in a particular state, in a particular neighborhood, on a particular street. It is one of the least diversified assets you can purchase, and with lack of diversification comes increased risk.
As you can see, there is real value in having real estate as part of your overall net worth. The hope is that you realize both the good and the bad with owning real estate. We will discuss marketable securities in next month’s article – stay tuned!
Karen DeRose and Anthony DeRose are registered representatives of Lincoln Financial Advisors.
Securities and advisory services offered through Lincoln Financial Advisors Corp., a broker/dealer (Member SIPC) and registered investment advisor. Insurance offered through Lincoln affiliates and other fine companies. DeRose Financial Planning Group is not an affiliate of Lincoln Financial Advisors.