Real estate investing in its simplest form entails buying residential properties or commercial properties. And from an investment standpoint, an investor expects a rental or leasing income and eventual capital appreciation over a long periods of time. It’s a very straight forward market where any person doing some basic analysis can get into buying or selling and obviously there are licensed agents or intermediaries to assist, search and/ or settle the transactions between a buyer and a seller. Purchasing a home is a major commitment for anyone since one might be paying towards mortgage for around 30 years if one take out a loan. This means an investor is selling his or her future life by next 30 years due to this financial commitment or liability binding.
Per statistics 80- 90% of the home buyers take out a mortgage loan which means getting funded for their purchase by a financial institution. Home buyer will have to repay the mortgage to the financial institution over the next 25-30 years at an interest rate and retain ownership at the end of the payback period. Interest rate for mortgages are based on the Prime rate, also called prime lending rate defined as rate at which banks loan customers for mortgages, personal loans and credit cards. Home buyer obviously needs to put an upfront investment which is called the equity portion of the mortgage which keeps building up as the mortgage balance is paid incrementally as well as due to capital appreciation of the property. This concept of equity build up is somewhat similar to the stock equity in businesses.
When is real estate a good investment?
Power of Financial Leverage:
Financial leverage simply applies to every aspect of investing whether it’s running a business or buying a real estate property. Financial leverage means buying an asset with debt capital and benefiting from the capital appreciation of the asset. For instance: John buys a home worth $100,000 by putting in his initial capital of $20,000 and rest $80,000 funded by a bank. And let’s assume he bought this in 2008 when asset prices had hit the rock bottom. Assume in 2014, the home price has appreciated to $300,000 and John decides to sell the house. He would have paid off approximately $10,000 towards the debt and his outstanding debt after 6 years in 2014 was $70,000. Now when he sells the house for $300,000 he has to pare off remaining $70,000 debt but rest of the $230,000 will be his money. So he had put only $30,000 (including $10K debt pay off) but his wealth approx 7.5 times. Although the whole property fetched only $200,000 profit on an outlay of $100,000, John`s capital multiplied by 7.5 times. In addition, John would have saved on the rental expenses over 6 years plus he would have reaped the Tax savings due to the home buying benefits. So that would make his wealth multiply by almost 9-10 times.
Now this looks great in paper theoretically but when is financial leverage really safe and powerful in real estate investing? The housing prices don’t usually multiply 3 times over 6 years unless there is so much of demand in certain cities. From the last quarter of 2008 to the first quarter of 2019, the average home sale price nationally has risen by nearly 50-55%, according to the latest U.S. Department of Housing and Urban Development statistics. So brace for an average returns of 50-60% over 10 years period in real estate which keeps in-line with inflationary rise in US. But the average returns can really go up to even 3-4 times in emerging economies prime areas due to the high demand and persistent high inflationary scenarios.
It is beneficial when we buy assets at the bottom or lower end of the cycle. Good part is one doesn’t have to get the exact bottom right but even if one buys around the lower end of the cycle, he will do great since timing the exact bottom is close to impossible. Investing during lower end of the cycle or distress reaps the maximum returns as is the case almost with any forms of investing. One can especially use the power of financial leverage in real estate since the real estate property is collaterized by the financial institution as a back for the debt. So there is downside protection to some extent. Most important point that favors the investor is typically interest rates are also in the rock bottoms during the lower end of the cycle. So that augurs well to invest during depressed times since both property prices as well as interest rates are at the lower end.
Rental yields and other positive metrics of real estate investing:
Rental or leasing yield is another advantage of real estate investing which ensures consistent cash flow for an investor. It is important to see how much rental yield the property is going to fetch. Ideal rental yield should be around 7-8% on an average. Rental yield is calculated as total rental income from the property less expenses divided over total gross property value that one is invested in. An 8% yield is a good return considering the property related maintenance expenses are already covered and this can compound over a period of time in addition to the capital appreciation of the asset itself.
Home buyers always contemplate between renting a property against buying a home to stay. This can be best decided by arriving at price-to-rent ratio which entails comparing total costs of owning a home versus total costs of renting a similar property. The cost comparison typically considers total rental costs to include rent and renter’s insurance, while total property ownership costs include mortgage payments, real estate taxes, household maintenance costs, closing costs, homeowner’s insurance. Both real estate websites Zillow and Trulia provides baselines and calculators of Price to Rent ratio. Trulia’s price-to-rent ratio is arrived by taking the listed property price and dividing it over the average yearly rental price. Trulia established baseline for the price to rent metrics. For example a price ti rent ratio of 1 to 15 indicates it is better to buy than rent; a price-to-rent ratio of 16 to 20 indicates it is a good idea to rent than buy; and a price-to-rent ratio of 21 or more indicates it is much better to rent than buy. So if you get a good price to rent ratio of less than 15, go for the investment.
Like any other investments, real estate investing also brings in some qualitative advantages which are usually hidden and more behavioral in nature. Let’s look at some of those:
Discipline – This behavioral attribute is the core in wealth creation process whether it’s investing in stocks, bonds or real estate. When there is a financial binding commitment for 25 plus years due to buying a real estate, it forces one to stick to the stricter expense management. Money goes out of the take home pay bank account in auto pilot mode towards the mortgage loan and after couple of years it becomes a normal cash outflow or even considered as savings thereby building equity.
Illiquid Market – Real estate buying and selling are not so liquid considering the long gestation period to do a transaction. Its not always easy task to get buyers at the price you want and so people hesitate to flip in and out of their real estate investments frequently. Although this is a big disadvantage compared to other investments like stocks, it forces people to stay through with their investments for long duration of time. Staying power in investments for long periods is the key to wealth creation and indirectly the lack of liquidity in the real estate markets helps investors achieve this.
Although it has been proven over decades that equity investing in stocks outperforms real estate investing by a huge factor, it still holds up as a great investment idea when done at the right time and with the right temperament.