1 June 2007 No Comment Print This Post  Email This Post

This morning I came across an interesting article on the front page of Yahoo Finance. This article was titled The Worst Investment Ever Guess what, this person was talking about real estate, specifically houses! Of course he was comparing the investment to stocks. This topic of stocks vs. real estate has been beaten to death. This one in particular is disturbing to me because it is extremely misleading and it’s central arguments are flawed. Lets dive right in to the article itself.

It does not take a genius to actually buy companies like Pfizer (NYSE: PFE - News) or Altria (NYSE: MO - News), consistently reinvest the dividends, and build wealth over the decades. Over the 50 years of data compiled, Pfizer and Altria returned 16.0% and 19.8% respectively.

Here the author picks out two fantastic companies who’s stocks performed very well over the past 50 years. He then compares it to real estate:

Looking at the index, from 1987 to 2006, we see that the overall average appreciation in the U.S. was only 5.6%. Even cities showing huge gains during the final years of the housing bubble — including San Diego, Las Vegas, and Washington, D.C. — showed gains slightly above only 7% for the 19-year period.

Ok. So on one side he mentions two above average companies and compares it to the entire US real estate market. He is comparing apples to oranges. Lets compare apples to apples. I can easily say look at San Francisco. I sold a home last year for $740K, the owners purchased it for $80K in the 80s. They only put 25% down. How’s that for a return?

Lets go beyond the superstar performers for a bit. I’ll pick out a property at random and do an analysis on it. I’m picking one in the Houston, TX area, since I’m moving there next year. This will show one of the reasons why I’m moving there by the way.

This property is in Sugar land, TX., a suburb of Houston.

Its listed for rent at $1300. The Zillow.com estimate for the home’s value is $140,000. Zillow is often above what the property would really sell for, but I’ll use the high estimate anyway for this analysis.

Price $140,000
Down Payment $14000
Loan Amount $226,000
Loan Rate 6.3% Interest Only (Eloan’s median rates for this scenario)

Annual Expenses:
Mortgage $7938
Property Tax $3900 (3% estimated annual tax)
Maintenance $1300 (1% of property’s value)
Insurance $600
Total $13738

Annual Revenue:
Rent $14,820 (adjusted 5% for vacancy)

Net Income:
$1082

The numbers above show an annual return of 8%. You invested $14,000 and you are getting $1082 a year back. That is a good return already. Wait! That is just the tip of the iceberg. What really skyrockets your return is potential appreciation. I’m going to be very conservative and estimate a 2% annual appreciation, which is below inflation. If your property appreciates 2% a year, thats $2800 a year. That is a 20% return. Combine that with your 8% return from cashflow, and you are making 28% return on your money. Please, Mr. Yahoo writer show me some stocks today with the same potential returns and I’ll buy them. This is just a random property on the rental market too. Imagine if you looked closer, or find someone who needs to sell their home quick below market price. You can find properties below market, there are many ways. Every time you buy a stock, you have to pay the market price at that given time. I won’t get cute and go into options, which you have to pay for anyway.

The key difference here is leverage. The annual appreciation belongs to you, not the bank, even though the bank paid for most of the house. Your return is calculated based on how much money you put in. In some cases, if you have cashflow with 0% down, you have an INFINITE return on investment. This is why 0% down has been so hot. I’ll post an example of this in my later posts. There is a reason that banks will gladly lend you money to buy a house. Try asking your banker for a loan to invest in stocks.

He also mentioned the high fees you pay at closing. That is true, but in this soft market you can get the seller to pay for some if not all of it. What if the market is hot you ask? Don’t buy real estate when the market is hot. He also talks about the sale of the house.

The big hit, however, arrives when you sell a property. Real estate agents will collect 6% of the selling price, while, lawyers, inspectors, title companies, and banks will collect additional fees.

6%? Where in the world are people still paying 6% to sell a property? I’d like to move there. There are many discount brokers now and online brokers that will sell your home cheap or even a flat fee. Plus, if you’re earning a good return on a property, why would you even sell?

Don’t get me wrong. The above numbers aren’t for every real estate market, but I used it to prove a point. Also, I am not anti-stocks. As a matter of fact I highly believe in asset allocation, spreading your money among many asset classes and I practice that theory. I own real estate and I own stocks. I just didn’t want these types of articles to scare people away from investing in real estate or even buying a house in general. Look at that scary headline, “Worst Investment Ever”.

He did, however specify that the article was talking about homes and not real estate in general.

This is not necessarily true for real estate as an asset class. Purchase a parking lot, apartment block, or strip mall, and you very well may find that the rents are higher than the cost of ownership. Real estate that generates positive cash flow can be a great investment.

I do agree with him here. A house would not be my first choice to invest in when it comes to real estate. If I had a choice between a house and a commercial property, I would definitely go commercial, but most people can’t start in commercial. Houses, like in my example above, are not as bad an investment that this article portrayed. If you can buy a second home as a starter investment, I say do it if the numbers make sense. Just don’t get too aggressive like me in my ‘going to lose money’ post and you’ll do just fine.