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Investing in Residential
Real Estate

by David Stanowski
20 July 2007

All truth passes through three stages:
First, it is ridiculed.
Second, it is violently opposed.
Third, it is accepted as being self-evident.

- Arthur Schopenhauer, (1788 - 1860)

Residential real estate is probably the most widely held investment in this country. Many people grew up in a family that owned their own home, so they feel familiar, and comfortable with the idea of buying a home, and possibly residential investment property. After all, Mom and Dad didn't have to formulate an "investment strategy"! They just bought a house, owned it for 30 years, and made a lot of money; so it seems very simple. As might be expected, this common experience leads many people to believe that they can successfully invest in residential real estate with a "less than rigorous" analysis of this market, too.

Conventional Wisdom holds that investing in residential real estate entails less risk than other markets, like stocks and commodities, but this notion seems to derive from the fact that it is easy to ignore price declines, because there are no published price quotes for your properties! If you don't put your property up for sale, and you don't find out what price you could have received, during a decline; then in your mind, the price never dropped!

Many actually believe that the price of real estate "can't go down", because of the old adage, "they aren't making any more land". Of course, this is true, and it "seems to guarantee" that the price of land can't go down, but there will be more than enough land, in this country, for at least a couple hundred more years. Current tightness in supply, where it does exist, is only a function of location, and demand for specific locations can change.

If enough people decide that they don't want to live in Southern California, for example, there is plenty of cheap land, in more remote places. With changes in society, like the Internet, the idea of commuting to jobs, in densely-packed metropolitan areas is losing favor. At the same time, those people who choose to live in urban areas can decide to live in more densely packed arrangements (condos in cities instead of single-family homes in far-flung suburbs) which reduces the demand for land in those areas.

Likewise, demographics can change the picture. Without immigration, the U.S. birthrate is not replacing those who are dying, which would lead to a decline in population and demand.

In addition, during economic contractions, people create fewer households, so they need fewer housing units. Children move in with parents, or visa versa; and people find roommates. In fact, the first quarter of 2007 saw a 70% decline in new household formation versus 2006.

The Conventional Wisdom also holds that renting is, "throwing money away", so owning is always the better choice. This shows a lack of rigorous analysis, too! There are countless people, today, who are paying hundreds of dollars more PER MONTH, to own their house, compared to the cost of renting; even as others are better off owning. They didn't do a rent versus buy comparison, before they jumped in, and even if they had, they are betting on rising prices to bail them out of this bad decision. So far, prices are moving against them!

The final piece of Conventional Wisdom, about residential real estate, is that there are great tax advantages to owning your own home, and investment properties. This is usually true, although, there have always been people whose deductions, for their personal residence, did not exceed their Standard Deduction, so they received no benefit. Real estate certainly does receive "sweetheart" treatment from the taxing authorities on sales, and 1031 like-kind exchanges.

The great irony to the tax advantages, offered by residential real estate, is that they derive from two factors; mortgage interest, and property taxes paid. Throughout most of recorded history, debt was thought to be a form of indentured servitude. However, after WWII a "new way of thinking" began to unfold that looked at debt as "an investment"!

The more debt people took on, the wealthier they felt! It was this kind of Orwellian logic that lead to lower and lower down payments, and larger and larger mortgages, that finally ended in the recent real estate bubble. Unfortunately, with the new bankruptcy laws, that do not allow the discharge of mortgage obligations, and the new tax laws, that allow lenders to report "forgiven debt", as income to the borrower; a whole new group of people are going to learn the hard way why our ancestors did NOT see debt as wealth!

Mortgage debt, and all other consumer debt, was developed to fulfill the need to have something today that we have not yet earned; a house, a car, a boat, or other consumer goods. For the middle class, debt used to buy investment properties (that they don't actively manage) is a way to move into the "financial class", and earn passive income, before they have the means to do so.

The current mountain of debt, that the world has built, will end very badly!

Unlike those who feel most comfortable with real estate investments, I am just the opposite. I find the lack of up-to-date data, in this market, especially price data, most unnerving. The amount of debt that must be used for financing creates high leverage, high risk, and ridiculous prices. Transaction costs (commissions and closing costs) are way out of line with the costs to do business in other investment markets. Finally, the most negative aspect of the real estate market is its ILLIQUIDITY!

To me, there is nothing riskier than an investment that I can't price accurately, that requires payments, that costs thousands of dollars to buy and sell, and that I can't sell instantly, with a phone call!

For these reasons, the only strategy that makes sense to me is to buy and sell with a long-term perspective. This means buying, when prices are below measures of known value, and the sentiment is very negative towards housing. Then, years later, when the situation is reversed; selling. It isn't wise to try to buy at the exact bottom, or sell at the exact top. Just making these transactions in the right general time frame is usually good enough.

This strategy issued a STRONG SELL signal in 2005, and it will probably be at least five years before we are in buying territory, again.

I don't like the buy-and-hold strategy. It doesn't work nearly as well as many think. Those who bought stocks in 1929, and held on to them, took about 25 years to break even; and, that did not count the lost income during those intervening years. Buying stocks in 1966, and holding on to them, yielded about the same results. Investors who bought gold and silver, in early 1980, are still waiting to break even! At times, the same thing has happened in the residential real estate market, but without good price data, it is more difficult to demonstrate.

Of course, in the case of a property that you want to own/control, for an indefinite period of time; buy-and-hold may be your only choice!

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