Real Estate Investing
You can open almost any old book on wealth management, investing or smart capital allocation and you would find the same idea that seems to be extremely popular at all times: investing in real estate is a great option. Most of those books were written a while ago, has the situation regarding investing in real estate changed in these days?
Robert Kiyosaki, a famous writer, and speaker on the importance of financial literacy said repeatedly that rich people get even richer partially because of the smart real estate deals they make. Time has passed since his first book “Rich Dad Poor Dad” and the world saw the Great Recession of 2007 - 2008 which showed that property doesn’t always grow in value.
In this article, we’ll try to figure out if real estate is still a great choice for equity allocation, and if it is so, what should we be aware of before considering betting on real estate value to go up.
Table of Contents
What Is Real Estate?
The term “Real Estate” is quite old. The Latin root here is “res”, which generally translated as “things”. So the real estate meant something physical: a piece of land, a horse or even a castle.
At the same time, “personal property” meant some things as well, but those which could be physically carried from one place to another (clothing, jewelry, etc.). There is another questionable theory that the “real” actually came from “rex”, i.e. “king”, thus it could mean something royal, which makes sense because for many years only wealthy and royal families could own property.
These days, luckily for many of us, any person living in a developed country can buy, sell and own property, although, if we dig a bit deeper, we can find out that only in a few countries you can have 100% right to do anything with your real estate.
In some countries, you rather buy a right to own a particular piece of property and this right is not even permanent. For instance, such property can be taken away from you if you break a law. Another interesting fact is that in some jurisdictions, even if you buy a house, it might appear that you didn’t buy a land which it stands on and the land might belong to someone else.
A Little Bit of History
From the times when ordinary citizens won the basic human right to own, buy, sell and manage property, this was a great investment, especially in big cities. However, the right to buy something doesn’t guarantee that everyone would have enough money to purchase it at its market price, so the owners of the high-tier real estate were (and are) wealthy.
For a long time, it didn’t even make sense to think or discuss publicly a property as an investment, simply because most of the people weren’t rich enough to purchase it anyway. Now, we have a lot of people who belong to the middle-class and they are able to consider such an investment.
There is a very simple explanation behind the fact that most of the houses and apartments in cities, particularly in places close to the downtown, tend to grow in value. The land and space are limited, but all cities tend to grow as more people from nearby towns and villages come there in search of a better life.
Now the urbanization rate is getting close to 100% which means that our cities are packed and all of the best lands are already captured. People are still coming to cities, especially to the most successful ones, but there is no place for new buildings, thus it’s not a surprise that the property prices are going up.
The main question is: Is there a limit on real estate price?
At which point are we going to say that the price is too high? Is it possible to calculate it? As long as people are willing to purchase a property, prices are expected to move higher and higher.
2007 - 2008 Financial Crisis
The main cause of a devastating financial crisis of 2007 - 2008 was, at its core, a subprime mortgage crisis, caused partly by a constant rise of real estate prices in the US. Most of the people were sure that buying a property is a great investment, so they have done it, and banks made the situation worse by giving out cheap and easily accessible mortgages.
After the crisis, real estate prices dropped, but just after a few years, they started to recover.
There was a colorful scene in the movie “The Big Short” (2015), when a group of analysts was looking for a proof that the real estate market is overheated. They went to a neighborhood in order to speak with some locals and they discovered a horrible picture: landlords don’t pay their mortgages, many houses are on sale and even a young girl dancing in a strip club had more than one mortgage, and on top of all of that, realtors were getting an approval for anybody who wanted to purchase a house. We all know the end of this story: millions of people lost their jobs as a result of the market crash that followed.
There are some reasonable people who are predicting the next real estate bubble burst in the next 3-5 years although its nature wouldn’t be the same as last time (because banks now are a bit more careful with mortgages), but the effect of slashing real estate value might be seen.
Property as an Investment
It would be wrong to talk about real estate as of something standard and simple because there are many kinds of it and location might play a huge role. A small old house in a village is one story, and a modern apartment near a subway is another. In one country, property might be a great investment opportunity, while in another this wouldn’t be a good idea.
Why do people keep buying real estate as an investment?
It’s true that real estate is a stable option compared to stocks or investment funds. While the stock market goes crazy with its bears and bulls, property value tend to stay strong because people still need a place to live. Even if an index, say S&P 500, falls, property might not follow its path.
Even if the property prices fall along with everything else, they tend to recover faster than other companies and their stocks. Property is real, it stands there and it doesn’t care about its current price. As long as you own it, it will worth something - that’s what many people strongly believe in.
Two Ways To Make Money Of Property
As with many other types of investments, real estate investment can have two main goals:
- Capital gains (growth in value)
- Passive income (rent)
In this sense, property is somewhat similar to a stock which pays dividends.
What Determines Property Price?
Here are some basic price factors for a particular piece of property:
- When was it build? (age)
- What is its current condition? Does it require additional investment?
Also, there are few additional factors which determine if a real estate market in a country would grow smoothly for many years:
- Stable political system
- Property rights are well protected by the law and institutions
- Developed and modern infrastructure
- Healthy ecological environment
- Availability of jobs nearby
Interestingly enough, high property taxes do not scare some investors, as long as other factors are checked, taxes may be seen as a necessary evil.
Entry Level Problem
With all these positive ideas about real estate in mind, why don’t everyone is investing in it? Well, you know the answer - the entry-level for such a purchase is high. To buy even a cheap and old house in America, you might need at least $200,000 - $300,000, and what’s the point of buying a bad house? Most people don’t have such money so their only option is to take a mortgage.
But, with a mortgage contract, you not only going to end up paying much more in addition to a face value, you probably would be living in this house, therefore you wouldn’t be able to collect rent from your new house or apartment.
High level of entry complicates things: if you make a bad investment decision and buy a house which will fall in value, you can’t get out of the deal quickly without taking damage (mortgage makes it even worse). Real estate is not an easy and fast investment, it’s close to impossible to find a new buyer for a property on a falling market and get a decent price from the deal.
Real estate is also not very liquid type of asset even in good times and its liquidity drops substantially during a recession so you would need to wait a long time to secure a fair deal. Buying and selling a property is also slow and hard from the legal point of view.
People often forget to take into account various hidden expenses when they consider buying a piece of property. They are not technically hidden, those are property taxes, maintenance fees, etc., but those fees are often overlooked and they can cost you a lot.
Another issue with those fees is that an owner has little control over them. If a city decides to increase taxes, you pretty much can’t do anything about it.
Property causes a lack of mobility, you stuck with it for a long time.
As soon as you decide to do anything with your real estate, you would probably need a lawyer and a realtor to properly arrange a deal, and they, of course, do not work for free.
0% Historical Returns
It’s a very common misconception that real estate investments are always profitable, it’s not true at all. According to the research from Wenli Li and Fang Yang (Harvard Business Review) the real rate of return on housing from 1975-2009 was actually negative. They are not the first serious researches who came up with this conclusion, real estate returns were analyzed by many others, for instance, American economist Robert J. Shiller in his book “Irrational Exuberance” presented a set of data which proved the same conclusion.
This doesn’t mean that a property is a bad investment, it’s just a safe and very conservative investment option, but it’s far from the most profitable one.
REIT stands for real estate investment trust and this tool allows people with limited financial recourses to enter the real estate game. This is an interesting and flexible option to own a part of a property market without the need to buy any buildings. A big advantage of REIT is that it allows to diversify a portfolio and decrease the entry barrier for owning real estate.
An Option Only for Wealthy?
It might seem strange that real estate is still considered to be something that only rich people can invest in, but it isn’t far from the truth.
If you buy your first house as an adult and live there, it’s hardly can be considered as an investment, because it keeps draining money for maintenance fees and taxes, not to mention the case when this property has been purchased with a mortgage (which is very common).
Even if the value of this house goes up, nobody can guarantee that one day it wouldn’t fall by a lot and you’d lose all those potential capital gains. To capitalize the gains, you’d need to sell the property but where would you leave in this case and what about the mortgage?
Therefore, only a second piece of property can be fully considered an investment, but who can afford it? According to the 2016 Census by Statistics Of Canada, only 67.8% of Canadians owned a house in 2016, so others didn’t own any property at all, they were renting it.
If such an unfortunate situation persists in a relatively rich country such as Canada, we can fairly say that a 2nd home or apartment could be an option only for a very small number of rich people.
Real estate can be a good conservative investment for a wealthy person, but it has its downsides: high capital requirements, relatively low returns, and unpredictable taxes and maintenance fees. Many people still think of real estate as of the best investment option, yet there are many other tools with similar risks and higher potential income which should be considered as well.
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