Diary of a Financier

Real Estate: The Great Lie

In Idiosyncrasy on Fri 11 May 2012 at 09:26

Real Estate & housing are not terrific investments.  Most suggestions otherwise are a huge lie, perhaps The Great Lie.  The Lie is perpetrated most in the commercialization of the “American Dream”: a white, picket fence for every man, woman, and family.  Non-income-producing, residential real estate is broadly a money pit.  For long-term holding periods (5-20 years), the value of this real estate is severely eroded by its cost of carry, including  Taxes + Insurance + Maintenance.  Let’s consider an example¹ though:

National Average Homeprice= $297,700 (average sale price, 2010)
National Average Mortgage Payment= $14,638.68 (annual, 2010)
National Average Real Estate Tax= $1,180 (annual, 2010²)
National Average Homeowner’s Insurance= $860 (annual, 2006)

Those $2,040/year in taxes and insurance premia are never recovered by the homeowner.  Theoretically, nor are the mortgage interest and origination fees.  While you can argue that the monetary value of a home discounts these expenses (which it certainly does), that discount is surpassed by the recurring expenses the longer a homeowner holds his asset.  In fact, that $2,040 eats away at your home’s fair market value at  a rate of 0.7%/year on average, almost like an internal expense on a mutual fund.

Obviously, your assumption for home price growth is the critical variable to equate a breakeven in the face of this erosion.  So, I ran a model.  Using national averages, I stacked up the major expenses associated with home ownership: Mortgage Interest, Principal, Insurance, Taxes & Down Payment.  Over time, my stacks show the cumulative expense of home ownership (“Cost of Carry”) against a curve of that Home’s Fair Market Value.  I’ve used different assumptions for the compound annual real growth rate of FMV, starting with a 1% rate:

Mind you, that 1% real growth rate is over & above inflation, plus it’s an geometric calculation void of any correction.  Regardless, the model shows homeowner’s outlays exceed his equity by $190,302 after 38 years of holding the asset.  Here’s a 2% real growth rate, for which the homeowners equity will exceed his outlays for the first time in year 38 (by $7k):

Finally, here’s the same model, except I incorporate a 2% first year decline in value:

I discussed reasonable, empirical, long-term housing growth expectations back in March 2011:

[Housing has a] 35% claim on our income.  (In case you were wondering how widespread the effect, the homeownership rate in America is about 70%.)  You can’t quantify the intangible qualities of a home.  You can weigh them against the utility of other spending nodes.  Quantitatively, I’m comfortable calling the “home as an investment” theme imprudent, albeit quixotic:

That flatness of long-term trend growth in US Housing really twists the knife in the “housing as investment” meme.  (Governments of the centrally-planned & “capitalist” breed should take note.)  In one of my least favorite finance books, Wealth, War & Wisdom, Barton Biggs argues that assets like land & real estate have proven the top bastions of wealth over millenia. He focuses on periods of stress for his examples.  More often than not, he looks at wars. (More often than not, these wars are in Europe.)  While other asset classes were laid to waste–most going to zero–real estate relatively preserved its value… unless confiscated.

The relevance of all this pertains to home affordability.  I get the sense that buyers’ interest in real estate has picked up as of 1q2012 due to the affordability of ownership vs. renting:

Mortgage cost is merely the headline cost of home ownership.  Incorporating the aforementioned extraneous expenses alters that affordability ratio.   When you and your family buy a home, you’re not making an investment or crystallizing your wealth.  What you are doing is pursuing an opportunity cost, building equity rather than paying rent into a black hole.  Your equity comes laden with requisite CapEx, depreciation, tax, insurance premia, specific & systematic risks.

While I’m not trying to ridicule homebuyers, I am suggesting that the affordability spread between owning & renting is currently tighter (or even inverted) than meets the eye.  Further, treating homeownership as an investment relies on that critical assumption of growth.  History has not honored that assumption–especially in real terms–with the exception of 1980-2006.  For the next 30 years, the aspiring investor needs only to ask himself: ‘Do I think demographics will shock the housing supply/demand balance, such that trend growth outruns a home’s cost of carry?’

–Romeo

¹ Of course, I could poke holes in the data set used here.  There’s likely a large standard deviation about the mean used here.  Some regions struggle with housing’s carrying cost, others don’t.  I wanted to use this simple sample as a baseline exhibit, one which cannot be accused of “cherrypicking.”

² Real Estate taxes in certain cities have increased since 2010.  With the City of Boston raising my Valuation and my tax rate/$1000 value in FY2011, my tax bill increased 30% last year.  I escrow my taxes.  Since my mortgage payments operate on a calendar year, and the city operates on a fiscal year, I had an escrow deficit to catchup with in CY2011, effectively raising my tax payments by 70%.  That could not have helped most homeowners.

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  5. Other than the first paragraph, you don’t mention maintenance. That would add, at least, another 1% per year to all of your calculations. Why didn’t you include it?

    Also, in the Milwaukee area, figure at least 3% of valuation, ($30/$1000) for property taxes, per year. Using your example, that would be $8931 on a $297,700 house. I don’t know what the median price here is, (its lower that $297,700) but even at $200,000, that would be $6,000 per year for property taxes, not the $1,180 you write about.

    • I do mention maintenance, but I just called it “CapEx.” You’re right though, I didn’t include it in my model. Your point is relevant still: maintenance adds a significant cost that rarely yields 100 cents on the dollar in terms of redeemable value.
      On the other side of the balance, mortgage interest is tax deductible, which I also excluded. I somewhat consciously went with the big ticket items to avoid such minutia.
      As I mention, there’s a huge standard deviation in those national averages. Regarding taxes, I have a client who owns a farm (non-operating) on the North Shore here in Mass. He’s paying $140/year in taxes on a $1.5mm property that’s all land. That’s not a lot as a percentage, but imagine blowing all that cash that you never get back? That’s part of why urban areas have such an efficient tax base; people living on top of people, more taxpayers per square mile of infrastructure, etc.

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