Should I Invest in Real Estate?
Client Question: Should I invest in real estate?
Advisor Answer: Real estate can certainly be a good investment; however, like all investments, one should be careful not to concentrate too much wealth in any single property or over-invest in real estate in general.
Should I Buy a Home or Continue Renting?
The logical first step in answering this question is comparing your current rent (assuming you’re renting now) against the payment that would be associated with a home purchase. For our purposes, we’ll assume you would need to obtain a mortgage to purchase a home instead of purchasing the entire place in cash. In addition to the mortgage payment (i.e. principal and interest), you should also consider the cost of property taxes and insurance. There are often Home Owners Association (HOA) fees that come along with owning a residence, but we won’t include those here. I recommend using the mortgage calculator on Bankrate.com, which you can access by clicking this link.
According to Bankrate.com, someone paying $2,200 per month in rent would also have a ~$2,200 monthly housing payment by purchasing a home for $400,000; this assumes a 20% downpayment of $80,000 and a mortgage of $320,000. One could look at this and say both cases are equal, but they are not. In the case of the home purchase, in addition to the downpayment, about ~$30,000 of equity would be accrued (this assumes the value of the home has stayed the same) after five years. Basically, the homeowner could sell the home after five years for the same price he or she bought it for and net ~$30,000.
The question then becomes where is the break-even point in the rent vs. buy decision? By purchasing a home with a large enough mortgage, the equity one builds in a home will be negatively offset by the additional interest payments made on a mortgage. After running the numbers on Bankrate.com, assuming five years of ownership, a 20% downpayment, no change in the value of the home, and a $2,200 monthly rent for comparison, the break-even point occurs when purchasing a $550,000 home with a monthly payment of ~$2,900. This is because you end up paying an additional ~$40,000 for housing (as compared to renting) over five years, but you would also have built up an additional $40,000 of equity. One could certainly make the argument that this excess $40,000 could have been invested and thus earned interest (and I would agree with that!), but I am not going to do a discounted cashflow analysis here!
Paying Down Your Mortgage
People often feel that paying down their mortgage is a safer alternative to investing in the stock market. I recently spoke to a client with a 15-year mortgage with a 2.9% interest rate. On one hand, paying down the principal of the mortgage will reduce the amount of interest payments made over time; therefore, accelerating mortgage payments would “earn” you the interest you otherwise would have had to pay. The overlooked aspect of this strategy is you would be concentrating your wealth into one real-estate property because what you’re really doing when you pay down your mortgage is increasing equity in your home.
While it’s easy for many to realize that investing a substantial amount of wealth into one stock isn’t a good idea, this isn’t always readily apparent when paying down a mortgage. The truth is that investing in thousands of companies through equity and fixed income investments (e.g. stock and bond index funds) should likely be considered safer than accelerating mortgage payments into an individual property. This same concept applies to the “Should I Buy or Continue Renting” question above. Sure, you could break-even by purchasing a property for $550,000, but you’re also increasing your concentration risk by allocating more of your wealth to your home and presumably less to thousands of companies through the publicly traded markets. The reality is that your home could also decrease in value, which means you may have been better off renting in the first place! This is why, like the stock market, it’s normally recommended to own a home for at least five years to decrease the chance you sell it for a loss.
Although you don’t see the value of your home changing everyday like you do with your investment accounts, that doesn’t mean your home is a safer investment. In fact, the very reason you can’t see the value of your home changing on a daily basis is because there isn’t necessarily anyone interested in purchasing it. In contrast, the reason you can see the value of your investment accounts updating everyday is because, in general, there are a significant number of interested buyers of your equity and bond holdings. This makes investments in widely traded stock and bond funds much more liquid than tangible real-estate properties.
Purchasing a Rental Property
Similar to purchasing a home and paying down your mortgage, purchasing a rental property will expose you to concentration risk. For example, if you purchase a rental property in addition to your normal residence, you’re even further increasing your overall wealth to real-estate.
What happens when a company comes in and builds a couple hundred brand new apartments right next to yours? Chances are the value of your property will drop and you’ll have to lower your rent. And while you may still be able to rent your place, a lower rent could mean you’re not earning enough to cover all the expenses of renting the property including maintenance and a potential mortgage.
If it’s exposure to real-estate and rental income you seek, you could invest in a Real Estate Investment Trust (REIT) that gives you exposure to thousands of real-estate investments. Interestingly enough, many people feel that investing the same amount of money they would have spent to purchase a rental property into a REIT would be risky. Again, we see there is a misplaced sense of trust in owning an individual property that is not publicly traded.
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