The Truth about Why to Invest in Real Estate
Updated: Oct 21
The trauma is officially over—I’m again seeing articles about real estate with outrageous claims.
“While prices fluctuate, over the long run real estate values have always gone up, always, and there is no reason to think that is going to change.” Says one blog. Yeah, right.
Also coming over the transom are claims about “passive income.” That is money you “earn while you’re sitting on the couch in your underwear, eating Cheetos.” I’m officially skeptical!
All the hype aside, there are great reasons to buy a real estate. Believing that values of real estate always go up just isn’t one of them. There are great reasons to buy rental property. Cheetos, underwear, and couches are not good reasons to buy investment property.
Inspired by a seminar I’ve been invited to contribute to (more details below), here is my list.
Four good reasons to buy real estate:
Protects Against Inflation When you buy a principal residence, you lock in your biggest monthly expense. Now, instead of paying rent to a landlord, you’re paying mortgage interest. The big plus of owning, though, is at the same time, you’re locking in that payment for the life of your mortgage loan. It’s like locking in your rent for the next 30 years. That means that no matter what happens with inflation, your biggest expense won’t go up. You can be spending more money on everything else, but your biggest expense is fixed. Your biggest expense isn’t tied to inflation any more.
An investment you can enjoy. You get to live in it.
When we put money in a savings account or retirement account, we can’t actively enjoy the money. We can’t sleep in our mutual funds; we can sleep in a house. We can’t decorate our shares in Google; we decorate our house. We can’t throw a party in our savings account, we can throw a party in our house. Rental real estate is tangible. You can see it, feel it, and kick it. That’s unique in your net worth. It’s something that you can really enjoy.
Can lead to meaningful community connections
People find their lives more meaningful when they are connected to organizations larger than themselves. Being involved in local communities brings meaning to people’s lives. Getting involved in your local community can help bring more meaning to your life, and it also may increase the value of your investment.
For instance, I’ve seen in community after community in Chicago, neighborhood groups get together and advocate for better schools in their neighborhood. Their efforts pay off. Pretty soon, other families are attracted to the neighborhood because of the good school. This increases the price of the original investment in houses and improves education of kids.
Research backs up what are known as the social benefits of real estate. Here’s a recent industry article which is consistent with an earlier article that is not from an industry source.
http://economistsoutlook.blogs.realtor.org/2017/10/24/highlights-from-social-benefits-of-homeownership-and-stable-housing/ This is consistent with an earlier paper that isn’t as recent that is from a more objective source: http://www.jchs.harvard.edu/sites/default/files/hbtl-04.pdf
Solid Component of Net Worth Don’t buy real estate because you think the value is always going to go up. It doesn’t. That being said, if you understand the risks when you buy, you can protect yourself against them.
With real estate, you get a mortgage, which means that you are taking advantage of leverage. Let’s go over a simplified example to illustrate the concept of leverage.
Mary and Jem buy a $200,000 house. They put 20%, or $40,000, down and get a mortgage of $160,000. That means Mary and Jem have spent $40,000 for a $200,000 investment.
In year one, the price goes up from $200,000, to $210,000. If they sold, theoretically, they would get that entire $10,000. That means they would get $10,000 on the $40,000 they put into the investment. Mary and Jem are happy. They’ve made 25% on their $40,000 cash outlay in one year.
As a lot of people learned in the real estate bust, there’s a big downside to leverage, too.
If the price of the house goes down to $190,000, they’ll get $30,000 back when they go to pay off the mortgage. So, they put in $40,000, and got back $30,000. They lost $10,000.
What happened to a lot of people in the 2008 downturn was this: They bought a $200,000 house, but they put 5% down. So, they put in $10,000 and they had a $190,000 mortgage.
When they wanted to sell, they could get $170,000 for the house. But they owed the bank $190,000. In other words, they’d have to pay $20,000 to sell their house. To keep things simple, this example doesn’t even include closing costs, which make the numbers significantly worse.
That’s why you want to protect yourself. Put 20% down and don’t buy unless you intend to stay in your house for at least 5 years. The vast majority of the time, this protects you against the risks involved in leverage.
What about buying a house outright? Without leverage, you miss out on the inflation protection. Also, real estate prices in general don’t go up enough to make it a great investment without leverage.
Be aware of the potential downsides. To protect yourself against the downsides of real estate, repeat after me: 20% down, 5 years.