Robert Shiller purports to explain “Why Land and Homes Actually Tend to Be Disappointing Investments” (nytimes). Given the number of rich people wandering around who say that they made their money in real estate, I’m wondering if Shiller can be correct. What do readers think? Suppose that the rent on a commercial property covers the mortgage and other expenses. In that case 1 percent appreciation will become 10 percent per year if buyer has made a down payment of 10 percent and used leverage for the rest. Suppose that Shiller is right about the average but it is a volatile market and the buyer typically unloads any big losses onto a bank while keeping any big winnings?
Maybe real estate is a bad investment if bought for cash and then left to sit. But an individual real estate investor is probably not doing things that way. There will be a mortgage and the bank will take on much of the risk. If it is a commercial property there is rent received. If it is a residential property in which the buyer lives there will be rent not paid somewhere else.
At a wedding in Paris this summer the groom’s father chided the “boy” (over 30!) for not being a property owner. The dad talked about how, even with an entry-level job at an investment bank in London he had been able to purchase a flat while still in his 20s. We dug into this a little and found out that the flat and the entry-level jobs were still available and easy to price. The dad paid a little less than one year of pre-tax income for the flat. Today the same flat would cost nearly 20 years of income for an entry level banker. With that kind of appreciation in any of the places around the world where a person might actually want to live, how can Shiller be right? And with the world population continuing to grow while the number of desirable places to live remains relatively fixed, how can Shiller continue to be right? (It is possible that, compared to 1900, the U.S. actually has fewer neighborhoods where people can walk to shops, friends’ houses, social events, cultural events, essential services, etc., yet the population has grown from 76 million to 320 million. This has got to put price pressure on real estate in the handful of desirable neighborhoods, no?)
Related:
- “Universities and Economic Growth” (see the minute-by-minute analysis of an Econ 252 lecture by Shiller)
“At a wedding in Paris this summer the groom’s father chided the “boy” (over 30!) for not being a property owner. The dad talked about how, even with an entry-level job at an investment bank in London he had been able to purchase a flat while still in his 20s. We dug into this a little and found out that the flat and the entry-level jobs were still available and easy to price. The dad paid a little less than one year of pre-tax income for the flat. ”
You touched on one of my pet peeves, old people believing or pretending to believe that the world has not changed from when they were in their twenties.
“Maybe real estate is a bad investment if bought for cash and then left to sit.”
Leverage does not turn a bad investment into a good one, even non-recourse leverage. In fact, leverage makes a bad investment worse.
“And with the world population continuing to grow while the number of desirable places to live remains relatively fixed, how can Shiller continue to be right?”
He can be right because market participants believe this to be the case, and adjust their prices accordingly.
The Case Shiller index may actually overstate returns to residential real estate, simply because it confuses upgrades with appreciation. Most homeowners make improvements on their houses; the CS index will record these value increases as total return, without taking into account their cost.
Real is an IDEAL investment:
I -Income
D – Depreciation
E – Equity
A -Appreciation
L – Leversge
As they say in the business it’s location, location, location. I know several people who were able to retire early mostly because they bought cheap houses in Long Island in the 60s and sold them 30 years later at ridiculous profit and moved to Florida.
Related about the location from 538:
“New Yorkers Will Pay $56 A Month To Trim A Minute Off Their Commute”
http://fivethirtyeight.com/features/new-yorkers-will-pay-56-a-month-to-trim-a-minute-off-their-commute/
Let’s work to shrink the population. That should take some of the steam out of the real estate markets.
@superMike – who wants to be first?
And as Tekumse says “Location location location” – there’s still lots of opportunity out there. The price of income property is a function of cap rate and as Phil suggests, buy wisely: rents rise, at least by the rate of inflation; micro manage (keep units attractive and desirable), pay off your mortgage in 15 years. The mortgage payments then become your income and you make more $ if/when you sell as the capital value has increased. Can you make a fortune? maybe, is there any risk? yes. I have retired – living now on the rents/profits from a modest 38′ x 120′ property in a small (desirable) Southern Ontario town. That was, however, after owning it for 26 years and taking good care of it. I always have a waiting list for tenants.
I’m looking forward to hear more of your thoughts on this. Israeli real estate prices have been rising for quite a while (crashing in 2000 but not in 2008), and unfortunately Israel doesn’t have REITs (actually the first is about to IPO right now) so to invest in real estate, you ought to buy a unit, maintain it, etc., which I loathe. And I wonder whether I’m smart or stupid in my reluctance to do this.
You already figured it out. Shiller isn’t counting the property’s cash flows from rent. Shiller’s a smart guy and he was way ahead of the curve on both the dot com bubble and real estate bubble, and uses impeccable logic and data. But for some reason he’s been repeating this same error for years now.
He only looks at the change in price of a property and calls that the return. It’s an argument against buying a house and letting it sit vacant in the hopes of flipping it in the future, or against buying more house than you need under the mistaken belief that it’s an investment. I think the second argument is really why he does this. To knock some sense into folks who are rationalizing buying an expensive house.
But any true real estate investor would never value a property based on a hope of price increases, with no consideration of cash flows. You value real estate the same way you value all investments: discount expected future cash flows. Which means for real estate you look at your net cash flows from rent and apply a so-called cap rate. And to be conservative assume little or no capital gain.
Take everything Shiller says with a grain of salt. As a Nobel laureate (despite there being no Nobel prize in economics) and frequent tv pundit/analyst, I used to pay heed when he spoke. But then I saw him giving a lecture to finance students, and awkwardly trying to explain to them how technology was used in their field. He went on in a convoluted manner about a software tool used for financial modelling, but he seemed completed flummoxed by the computer jargon. It took me a while to realize he was talking about plain-old spreadsheets! Then he went on about the history of how spreadsheets were invented and evolved (VisiCalc, 123, Excel), except he got all the dates and names of the people/products all wrong.
I’ve purchased two Florida foreclosures for all cash since the real estate meltdown and have seen total appreciation of 50% over the past three years since making the purchases. I live in one house, 2/2/2 2000sf, on a golf course three miles from the beach, and enjoy a $600 annual property tax as a FL “homestead” resident. The other property is a beautiful 2/2/1 1900sf waterfront condo on the FL Intracoastal. I’ve been able to keep it rented w/ a delightful retired couple for three years at $1400/mo w/o raising the rent. However, my property taxes and maintenance have increased by 10% per year. I’m $500 per month positive cash flow. I purchased the waterfront condo with the plan to eventually retire there, but the increasing property taxes and maintenance costs might interrupt that plan.
Don’t forget to factor in what your time is worth to you. You can invest in an index fund with a few mouse clicks and be done in ten minutes. You start earning dividend income in a few months without lifting a finger.
For real estate, you must visit the properties, negotiate the purchase, maintain the property (or spend time hiring/managing people to do same), collect rent, etc.
Peter Schiff’s take on Buying a House as an Investment:
J. Peterson nailed it. The value of your time should be factored in just as cash flow should. That leaves us with leverage as being the sole differentiator between investing in the market vs real estate.
Interesting, one would expect the author to follow his own advice in real life and be renting instead of owning. However, a comment reveals that the author of the paper bought a house in 1989 for $62k and it is now estimated to be worth $800k. So in this particular case it was a good investment for the individual (ie. the author!)
I think people underestimate how unpleasant tenants can be.
Also, with leverage, the bank isn’t lending you that money for free, so the interest has to be factored in as well.
haha… buying a flat on one year’s income is a good joke. Can I have a few and just retire tomorrow? I’d be looking at 10+ for anything approaching minimal standards, let alone something I might actually want.
If you want a nice Victorian house on a cute street lined with trees near a subway and shops in a city like Toronto or SF, there are a limited number of houses like that and you will pay an astronomical price. They are the equivalent of old master paintings and the scarcity value will only increase.
As a resident of Vancouver, where real estate prices have gone up 40% in the last year, I’ve been following Shiller’s arguments with great interest.
Shiller’s argument goes something like this. The US has lots of land. (Canada has even more.) So nationwide real estate prices aren’t going to get driven up by a fundamental shortage of land, as they might in France. They can be temporarily driven up by a speculative bubble (see Kindleberger’s Manias, Panics, and Crashes), as people see their friends and neighbors getting rich by buying houses; but in the long run, people can always move to places where houses are cheaper, e.g. from California to Colorado or Texas. The recent spike in Metro Vancouver house prices has resulted in homeowners selling out and moving to towns elsewhere: Vancouver Island, the Sunshine Coast, the Interior.
Of course if you own a house there’s a financial benefit from the “imputed rent” that you don’t have to pay, and that isn’t taxed. So it can still make sense to own a house. You just shouldn’t assume that house prices will always go up. Shiller points out that between 1890 and 1990, after inflation, they were basically flat. Graph. Interview.
Bjk in Toronto and can confirm. My parents recently sold their house in one of those desirable neighborhoods near a subway.They got 2 million for it and were *shocked*… 1 year later it was appraised at 2.6 million and shows no signs of slowing down.