A reader asks:
We own a cash flow rental property with a less than 3% mortgage with 28 years remaining. On the Aug. 18 episode of Portfolio Rescue, Barry said, “Real estate returns more or less zero net of inflation.” However, does this statement take into account the leverage provided by a mortgage? Yield comparisons between equities and real estate seem to favor equities, but it’s unclear whether these comparisons take mortgage leverage into account. Also, how do you factor a mortgage rate below current inflation into the calculation? Over a 20-year horizon, would it theoretically be better to sell the property and invest the proceeds in a stock/bond combination? -Pseudo
Robert Shiller painstakingly created an index of US house prices dating back to 1890.
When he produced it, Shiller mentioned: “Surprisingly, it seems that no such long series of house prices for any country has ever been published. No real estate professor I spoke to could refer me to it.
Nobody really knew how the housing market was doing over the long term until Shiller compiled his real house price index.
Here is the updated number with the latest data from 2022:
It is important to note that this series uses real data, after inflation, for the returns.
Let’s dig into the numbers.
From 1890 to 2022, the US real estate market grew only 122% overall. That’s 0.6% per year above the rate of inflation.
And the majority of that comeback has been in the last 3 decades or so.
From 1890 to 1989, the US real estate market appreciated only 30% in total, or less than 0.3% per year. It went virtually nowhere for 100 years after inflation. Since 1989, it has increased by more than 70%, or more than 1.6% per year above inflation.
Some people may look at these numbers and think they are terrible. The long-term return of the stock market relative to the rate of inflation is more like 6-7% per year.
How could housing be so inferior?
Personally, I think beating the rate of inflation while maintaining fixed rate debt in the form of a mortgage and providing a roof over your head is a pretty good deal.
It’s also important to note that Shiller’s data here doesn’t take into account the actual experience of someone owning a home. These are just prices.
Let’s say you bought a house 10 years ago for $300,000 and put down 10% ($30,000).
Now let’s say you sell this house for $500,000 right now.
What is your return on investment?
Well, you made $200,000 off the purchase price, so that must be a 67% return, right?
Yeah but what about the leverage involved?
You only deposited $30,000, so was your return more like 6x?
Every month, you’ve paid your mortgage, home insurance, and property taxes. Plus you spent our money on upkeep, maintenance and landscaping. You probably bought furniture, decorated the interior and made some improvements to the house.
When you bought the house, you would have had to pay closing costs. When you sell it, there are realtor fees and more closing costs. Then you have to pay the movers and such to get out.
There is also the fact that you have to live somewhere. So, are you cleaning up your mortgage payments from what you would have paid in rent?
I’m not sure anyone knows what their true all-in costs are when they own a home, because housing is a form of consumption. Moreover, it is the most emotional of all financial assets in that it is where you live, sleep, eat and put down roots.
This is why it is so difficult to compare it to investments in the financial markets. You don’t just buy a house from a broker and pay an all-inclusive expense ratio every year.
Housing is a complicated investment where the calculation of return is often unclear.
Now, this reader is talking about a rental property, so it might be a little easier to determine the yield, but there are still a lot of unknowns. This 3% mortgage rate is certainly a considerable asset.
But the answer to this question will really depend on your tolerance for complexity.
Rental homes can offer a decent return on your investment. You have the flexibility to increase rents over time and your monthly payment is fixed, so there is good inflation protection.
Also, you expect the price of real estate to increase over time. Even if it’s only slightly above the rate of inflation, as Shiller’s numbers show, you’d be building equity through both appreciation and principal repayments.
There are also different risks associated with investing in rental properties:
- Concentration. It’s hard to diversify with just one property (or even multiple properties). You must manage both the macro (inflation, rates, economic growth, etc.) but also the micro (location, local economy and housing market).
- Illiquidity. You receive cash flow in the form of monthly rent, but you must deduct this from the shipping costs incurred. You can’t spend a house or trade it as easily as you can with stocks and bonds.
- Potential headaches. Owning a rental property involves finding tenants and fixing things when they break down. If you cannot find tenants for a few months, you must assume these costs. You can hire a management company to handle this for you, but that only reduces your returns.
It depends on how comfortable you are with those risks versus just investing your money in low-cost ETFs and not having to worry about anything beyond market volatility.
Your index funds will never call you in the middle of the night complaining that the air conditioning is broken in your rental unit.
On the other hand, there are advantages to owning real estate. Most importantly, you don’t get a quote five days a week like you do in the stock market. This greatly facilitates long-term thinking and action.
The lack of volatility could also allow you to sleep better at night.
As with any investment, there are tradeoffs.
Even though housing offers lower returns than the stock market, if it’s easier for you to be a long-term investor, it might be worth the trade-offs.
We covered this question in the latest edition of Portfolio Rescue:
Your favorite tax expert, sweet billwas back on the show, also covering questions about harvesting tax losses, lowering your tax bill, and how taxes change when your spouse leaves the workforce.
Why housing is more important than the stock market
Here is the podcast version of this episode:
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