Wednesday, February 11, 2009

Why Real Estate is a Horrible Investment

I am not one to kick an interesting investment opportunity when it's down - in fact, I think that the best time to buy assets is when their values have been dramatically beaten down, and if that's your line of thinking, real estate should certainly qualify. However, I still think that owning real estate for investment purposes is a horrible idea. I am not talking about investing in real estate through REITs as a method of diversifying your portfolio - that is actually a good idea, we invest about 8% of our portfolio in REITs for exactly this purpose. When I am talking about real estate being a bad investment I am talking about buying residential real estate for investment purposes.

I have previously written that buying a house is a bad investment, and I stick by that original statement. However, I am not against buying a house, just as I am not against buying cars, TVs or new clothes. A house is a place you where you live in, it is not an investment. Granted, houses tend to have a good resale value and if you are fortunate, the price may even go up over time. My point is that your residence is your home, not an investment. 

So why do I think that real estate is typically a bad investment idea? My argument can be summed up in a single word: leverage. Leverage is the reason that most people think buying a house is a great investment opportunity to begin with.  Let's say you are buying a house worth $100,000, and let's assume that you have 20% to put as down payment, i.e. $20,000, and the rest you finance using a mortgage. If the value of the house goes up 10% in  the fist year, it is now worth $110,000. However, your mortgage is still only $80,000, meaning that your equity is now worth $30,000. In a single year your house went up 10% in value but you got a 50% return on your original investment. Who could turn down such a wonderful bargain? You are using other people's money to super-charge your returns. What a brilliant idea! Isn't this the perfect money making strategy?

Of course, that's not the case, as our current economic meltdown has made abundantly clear. The cold logic of leverage, which does phenomenal things to your returns on the market upswing, has an evil twin that emerges when the market heads south. Same example: a 20% down payment used to buy a $100,000 house, only this time the house value goes down 10% in the first year. Now the house is worth $90,000 so your original $20,000 investment has been cut in half when the mortgage is accounted for. If the value of the house declines by 20% your investment is wiped out completely.

The bottom line is this: investing in real estate by financing the acquisition through mortgage, is exactly the same as investing in the stock market using borrowed money (investing on margin). While the market goes up, your returns are turbo charged, you feel on top of the world, but when the market starts to fall, the value of your investments quickly goes up in smoke. Now here is the crazy thing: the government would never consider encouraging people to buy stocks on margin, but they have made many policy decisions aimed to do just that in the case of the real estate market. Millions of Americans have allowed themselves to be duped by the fallacy of a real estate market that folks claimed could never go down. "All real estate is local" the saying went. Even the most naive real estate investors and home buyers no longer believe that there is any asset in the world that only appreciates in value without ever falling.

Remember this lesson when the next bubble starts to inflate.

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plonkee said...

At least over here in the UK the national boom bust housing market cycle is fairly obvious and well known. House prices falling in Aberdeen, probably means house prices will fall in Cornwall too. Real estate is local, but local is bigger than you think.

Leverage, is of course a way to inflate your risk.

Kirstz said...

Thanks for sharing this information and I am glad to know this better. All I know Real Estate Investment is a good idea but after reading your article I've got to think of it.

Gaile said...

Investing in Real Estate today is very in-demand. But we need to think twice before we put our money to invest real estate so that we can't encounter problem after.