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Saturday, September 20, 2014

The Siren Song of Real Estate

I'm constantly astounded by how frequently people tout real estate as a great investment. Take a look at this example from Quora, for instance:
Buy a single-family, 3 bedroom rental for $180,000. Rent = $1,200/month. That's about 7% rate of return on your investment. Here's the good news: after depreciation, you net income is practically zero (on paper).
Where do I begin? First of all, don't forget maintenance, insurance, and taxes on the home!  If there's a HOA, add that monthly fee in there as well. On average maintenance costs about 1% a year, and property taxes eat another 1%. Add to that insurance, which is another 2.5%. Now that's $4,500 / year.

There's also costs of acquiring a renter, as well as the possibility of not being able to rent out a house for a while. (If your 3 bedroom house rents for $1200/month, it's not in a strong market like the Bay Area) John T Reed uses a 95% vacancy rate as standard, which means that you lose about 2 weeks of rental income a year due to moving people in and out.

So now your numbers look like this: $13,846 in revenue, $4500 in costs, which is $9346, or a 5% return, give or take a bit. But you also paid a real estate agent about $5400 to buy the home, and you'd have to pay the same to sell it, assuming no appreciation. (Typically real estate appreciates 0.4% a year after inflation, and if you're getting a house for $180,000, it's not in a high growth area like the San Francisco Area)

Note that the above numbers from Quora are doctor'd! In other words, good luck buying a house for $180,000 that can rent for $1,200/month, which would imply a price to rent ratio of 12.5. In most parts of the country, price to rent ratio is 15, which means that you'd have to pay $216,000 for that same house. Your property taxes, insurance, and maintenance costs go up proportionately, and you're down to less than 4% return, even assuming you didn't pay brokerage fees for buying the house.

What about depreciation? Well, if you depreciate the property, you have to back that out when you sell, so your capital gains would register that much higher.

(Just in case you were wondering, the price to rent ratio in the Bay Area is currently at least 20, probably approaching 25: it really isn't a good place to buy a property to rent)

Are there any mitigating factors? Yes. If you live in the house for 3 out of the past 5 years, capital gains are exempt from taxes. So if you moved every 4 years and bought a new house each time, and real estate kept going up, you could come out ahead with respect to housing versus saying, buying an indexed fund. But you hardly see any one except John T Reed telling you to do that. Most people, especially families, don't like moving that often.

If you can do exchanges, then trading up is essentially tax free, enabling you to defer paying taxes. That's also nice. But you'd be tying up your wealth in increasingly large amounts of real estate as you do so.

The big reason why most people think real estate makes a huge amount of money is because of personal experience. They put 20% down on a house, watch the house go up in value, and walk out with a ton of money due to the use of leverage. As folks found out when the housing bubble crashes, leverage hurts you a lot as well when the market goes down.

There's no free lunch in investing. Unfortunately, there are lots of people who like to tell you that there is, and they'll make money selling you books, seminars, and other content doing so. Real estate investing has just as many people like that as the financial services industry, so if something you hear (or read) sounds too good to be true, it probably is.

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