What’s in a REIT?

Years ago, during real-estate's heyday, while having dinner with friends I was drawn into a lengthy debate about the financial logic of "investing" in a home versus stocks. To put this conversation in its proper historical context, a relentlessly buoyant housing market had propelled real estate values into the statosphere, producing a bumper-crop of real-estate fans. So, it may come as something of a surprise, then, that I spent the better part of an hour explaining why (if the past ten or twenty years even vaguely resembles the next ten or twenty) residential real estate isn’t the best place to hunt for lofty investment returns.

Don’t get me wrong, a house can be a great investment; particularly if it's bought in a decent neighborhood that bursts with suburban charm, is home to lots honor-roll schools, is reasonably close to essential shopping, enjoys close proximity to a strong and diverse local job market, and is purchased primarily for the cozy home and hearth amenities that a home is ultimately meant to provide. In addition to these important factors, the rational for investing in a home is bolstered by the prospect of future appreciation if held for one or more decades. But, oddly enough, just because a home can be a great wealth-building tool doesn’t mean that it always is.

Why the ambiguity? To answer this question, let’s start by listing the financial advantages of homeownership. For starters, homeowners can deduct the interest (up to a million dollars) that they pay on money that's borrowed to buy a home—which generally amounts to a sizeable tax break every April 15th. But wait, there's more... Homeowners are the beneficiaries of steadily appreciating home values and a slowly thickening cushion of home equity (this is essentially the difference between what a home will sell for minus the debt that's owed against it) as a mortgage is slowly paid off over time. Additionally, should unforeseen circumstances require a home to be vacated, it can be converted into an income producing rental for the duration of a homeowner's absence. And finally, thanks to the copious availability of taxpayer subsidized credit, real estate can be acquired and/or encumbered for pennies on the dollar. Given this exhaustive list of benefits, why didn't I join my friends in toasting real estate as the king of all investments? There are many reasons.

For starters, home equity has a funny money taint to it. Though a homeowner might accidentally mistake a dollar of home equity for a buck in the bank, this can be a costly missperception. Let’s begin by reviewing a bit of real estate history. Prior to the dawn of the Internet age, just about the only way that a homeowner could convert their home equity into cash was to sell their house, pay off the mortgage balance, and pocket the proceeds minus whatever expenses are incurred in the sale. These niggling fees, mind you, aren’t chump change. They include closing costs, real estate agent commissions and various other expenses that, collectively, can eliminate five to ten percent of a home’s value. Nowadays, clever financial innovations like HELOCs (Home Equity Lines of Credit) enable people to treat their homes as gargantuan ATM machines. Although these new tools do indeed liberate homeowners from the traditional hassle of having to first sell their homes to extract equity, their use is not hassle or cost-free. Homeowners looking to avail themselves of these widely promoted services have to complete reams of paperwork, deal with stuffy bankers, and sign lots of legal documents that aren’t easily read or understood. Any way you slice it, whether you put a home on the market and sell it yourself or rely on less conventional methods, squeezing money from a home is a costly, laborious and time intensive process. The bottom line: unlike pure-play financial assets like stocks, bonds and REITs (which can be quickly, easily and inexpensively converted into cash) the added difficulty of monetizing home equity makes real-estate a less attractive investment.

Is a home a financial asset? To answer this question, and to establish a framework for discussion, let’s first define a few important economic concepts. For starters, what is a financial asset and how does it differ from a liability? To keep things simple, let's just say that an asset is something that puts money in your pocket whereas a liability does the opposite and takes money out of your pocket. Sounds simple, right? Okay, let’s move on.

Perhaps the most confounding thing about real estate is that, as an "investment", its status as a financial "asset" or a "liability" isn't fixed. It's status as one or the other depends on numerous factors. No matter how you parse the economics of homeownership, there is no disagreement that a home purchase requires a staggering outlay of cash in the form of a down payment. Typically, this ranges from five-to-twenty percent of a home's purchase price. So far, a home purchase soundly qualifies as an economic liability--money is leaving your pocket. Of course, a down payment will be followed by a series of follow-up payments as the principal and interest on the mortgage are serviced. Moreover, although the long-term economic benefits of homeownership can be substantial, they sometimes take decades to materialize. Meanwhile, homeownership will siphon a copious amount of money from a homeowner’s wallet. Meanwhile, there are other costs to consider. Property ownership is an arrangement that, once entered into, carries with it a series of financial obligations that must be paid. And the failure to perform sets in motion a circuitous legal process that, eventually, will result in a homeowner being forcibly relieved of his or her property. Essentially, there are two ways for a homeowner to go seriously wrong. Failure to pay a mortgage is one because it forces foreclosure by a lender. And not paying one’s property taxes is another because it causes a home to be surrendered to its true owner: Uncle Sam. You see, the underlying premise is that U.S. government rents land to its citizenry, nobody else can own it outright. A close reading of the tax code should dispell any confusion on this topic. Sadly, the economic burdens of homeownership don’t end there. In addition to paying a mortgage and interest on a monthly basis, there's property taxes, homeowner’s insurance and maintenance expenses for a would-be homeowner to consider. After tallying these incidentals, and taking a thoughtful moment to consider the lifestyle consequences of having to service them for many years, it quickly becomes apparent that a home purchase is, without doucbt, a tremendous initial liability.

But here’s the part where real estate fans will reach for their sparklers and break out their party hats, if a home is held long enough, it morphs into an asset. But how can this be? How can a home start out as an economic liability and then, poof, suddenly morph into an asset? At some point in the process of paying down a mortgage, the amount of equity that’s built into a home will equal the amount of debt owed against it. Let’s call this the economic tipping point. When it occurs, assuming that the value of the property in question doesn’t sharply decline thereafter, then and only then can a home become a financial asset. It‘s worth noting, however, that it takes many years of faithful debt-service for real estate to make this extraordinary transition and hop from the liability side of a one's balance sheet to the asset column.

Now that we’ve analyzed the eerie asset-liability duality of homeownership, let’s consider the opportunity cost of buying a home. After analyzing these numbers, we’ll see that it's enormous. What is opportunity cost? Economists define it as the highest foregone alternative. In other words, once you've parted company with your money, you’ve forfeit the right to invest that money somewhere else. Sounds reasonable, right? Now, when examining the pros and cons of buying residential property for investment purposes, it’s worth emphasizing that every decision carries with it a range of potential costs and benefits. Though marrying a mortgage might seem like an infallible wealth building strategy, there’s a minor (and frequently overlooked) fine point to consider first. If the sole purpose of buying a home is to parlay a modest down payment and a staggering amount of debt into even greater wealth somewhere down the road, it pays to consider the time value of money and to ponder how rapidly the capital that's invested in a home over time might appreciate if it were allocated elsewhere instead. Suppose that every dollar spent on a home were to appreciate at a rate consistent with the long-term returns of the S&P 500? When we run these numbers, and compare the side-by-side returns of investing in a home versus stocks, the logic of buying a home becomes downright shaky.

To illustrate this point, let's pit $500,000 invested in a home against $500,00 invested in the S&P 500 with dividends reinvested. We'll compare the side-by-side returns of each over three time periods: five, ten, and twenty years dating back from July 2006. According to research by Edward Jones, a half million bucks invested in a home over a five year interval would’ve amounted to $730K, easily trouncing the S&P 500’s returns by $155K. Over a ten year period, however, real estate’s luster dims appreciably; $500K invested in the S&P 500 becomes $1.2 million whereas $500K invested in a home turns into $937K, a sizeable $263K difference in the stock market’s favor. When we compare the side-by-side price performance of real estate vs. stocks over a twenty year period, however, the difference in their respective returns widens even more aggressively; $500K invested in the stock market becoms $4.83 million whereas $500K invested in a home becomes $1.5 million—a decisive $3.33 million difference in the stock market’s favor. Clearly, though real estate can outperform stocks over the short-term, it hasn’t demonstrated an ability to do so over the long-haul.

Another frequently overlooked risk of homeownership is that it concentrates a high percentage of one’s net-worth in a single investment. In part, government subsidies on interest payments distorts incentives and encourages people to take on bigger mortgages than they might otherwise be able to afford. The effect is that this gives people an incentive to concentrate more of their wealth in housing than anyplace else. From a risk management standpoint, this can be disastrous. Disruptive events of natural and economic origins have wrought havoc on real estate values throughout time. The bay area's 1987 earthquake, for instance, gave local property values a nasty shake. Even more recently, New Orlean's home values, which were hard hit by levy failures, demonstrate how violently real estate values can compress in response to natural disasters. Economic events, which tend to be less visible in terms of their impact on housing values, are no less disastrous. Just look at foreclosure rates in Detroit, a once vibrant and thriving metropolis. Furthermore, during the 1990s, the loss of defense contracting jobs in parts of southern California depressed real estate values in and around Los Angeles for years. There's also the aftermath of the Savings and Loan crisis during the 1980s, which depressed home values in areas that were most directly affected. Clearly, economic and natural disasters both pose significant but often overlooked risks to housing wealth. Those who’ve been adversely impacted by these calamitous events realize—perhaps more keenly than most—the folly of concentrating so much of their net-worth in their homes.

Having parsed the advantages and disadvantages of homeownership, I think it’s fair to say that a home (though it doesn’t offer the best long-term returns—those bragging rights go to stocks) can be a powerful wealth-building tool. When it comes to cashing in on real estate, however, it turns out that there's a far better way of going about it than to shackle oneself to the dubious privilege of a mortgage. As investments go, real estate is dandy. Happily, for people who don’t have oodles of spare cash lying around or are understandably reluctant to take on a whopping amount of debt, there’s an easier way to cash-in on real estate, which brings us to Real Estate Investment Trusts; or REITs. These investment vehicles put the dream of real-estate ownership within reach by enabling people of even modest means to acquire professionally managed income producing commercial properties. Moreover, with REITs, the underlying asset is owned free and clear. What's more, it generates income from the get-go without the subsequent hassle of having to fork over oodles of follow-up money to service a mortgage, taxes, maintenance costs and property insurance. Insofar as real estate investing is concerned, REITs are fantastic and will be discussed in greater detail next.