Real estate investing has been lucrative for many since the 1980s. But until recently, interest rates were falling for decades, not rising. Over that time, you could buy a home, leverage it 5 to 1, hold for a few years earning decent rents, refinance periodically at ever lower and lower rates, possibly pulling cash out, all while benefiting from consistently rising home prices. Some of this is no longer possible today. Interest rates are rising, so you can’t refinance lower or pull cash out without selling until that changes. There’s most likely no property available (that you’d like to buy at least) that is going to generate anything close to the rent levels earned in the past. And everything now depends on very high home appreciation rates continuing indefinitely. Real estate investing does not appear attractive right now. Here’s how I see it:
Evaluating Real Estate Investing
In this article, I apply the same framework I use to evaluate stocks and bonds to residential property:
- Valuations (how much do we pay as real estate investors?);
- The economic environment (is it conducive to home appreciation and strong rental income?); and
- Price trends (are home prices structurally rising or falling?).
Residential Property Valuations
Historically on average, home prices have been 100x one month’s market rent. Today, they are over 130x. So property prices, in relation to rent, are over 30% higher than the long-term average going back to the 1970s. This data is illustrated by the chart here sourced from the OECD:
You would see something similar in terms of home prices compared to various income measures (such as median household or family income). Such common measures of affordability are off-the-charts expensive (not literally, of course!). This doesn’t mean, for sure, residential real estate is overvalued. Perhaps something has changed and investors are more accepting of a lower return. But it should give us pause. You might think it has something to do with lower borrowing costs, but mortgage rates have risen quite a bit and prices have not cratered as expected. With housing expensive and borrowing costs also high, a successful investment (one that exceeds its opportunity cost) depends greatly on high rates of home appreciation.
The Housing Environment
Price Momentum in Housing Markets
I look at price trends in the stock market and interest rate trends for bonds, so what’s the analog for real estate? Home price indexes. Below is a momentum map showing the S&P Case-Shiller National Home Price Index’s nominal return and excess return over cash over some recent lookback periods to gauge price trends.
While home prices have continued to rise, housing as an investment has not kept up with cash recently. I usually don’t want to borrow money to buy an asset that hasn’t historically generated a return higher than my current borrowing costs and hasn’t even beaten T-Bills lately.
Other Real Estate Investing Considerations
I’ve had multiple people, including fellow financial advisors, suggest my wife and I convert our current home into a rental property if we ever move. But then they all proceed to tell me horror stories about their experience as landlords: tenants from hell, calls about a leak or broken dishwasher in the middle of Thanksgiving dinner, and so on. I read between the lines and am very wary of ever becoming a landlord. Even property managers simply act as a go-between; they usually can’t make any executive decisions about the property. It’s all on you, and they still take a chunk of your rent. The “return on hassle” does not look attractive!
Not to mention, real estate markets are opaque (industry professionals have more knowledge than we do), illiquid (you can’t just sell a property with the click of your mouse), and transactions are expensive (realtors, lenders, appraisers, and other professionals extract exorbitant fees from real estate investors in my opinion.
I Can Help You Analyze a Property from an Economic Perspective
I’m specifically not leaving you any answers here, sorry! I’m just highlighting the real estate investing risks as I see them right now. Residential real estate, the only property asset class that’s easily accessible to the average investor, appears very expensive in the same way the US stock market does. Even after considering the potential tax benefits, hypothetical models I’ve built internally using example California properties show long-term economic returns not much higher than high-yield savings accounts (with much more operational and investment risk).
If you are ever truly considering purchasing a real estate property as an investment, I strongly encourage you to sit down with me and allow me to build one of these models using real inputs from the property you’re considering. Financial advisors paid solely or partially by assets under management, which may be our arrangement together, have a vested interest in recommending liquid financial market investments and not real estate investing. But I’m a sworn fiduciary and will always put your interest first and disclose this conflict. I just want you to compare your investment options on an apples-to-apples basis and make the right decision for you, especially when you don’t have to invest in real estate.
Considering a real estate purchase, either as a personal residence or an investment? Reach out to schedule a planning meeting to discuss it!
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