What’s in a REIT?

Several years ago, during real-estate's glorious heyday, I was drawn into a lively debate about the economic logic of "investing" in a home versus stocks. Now, to put this conversation in its proper historical context, this conversation took place during an era of stubbornly buoyant housing values, which, in turn, had produced a bumper-crop of ardent 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 past is prologue) a home isn’t the best place to look for outsized investment returns.

Don’t get me wrong, a house can be a great investment; particularly if it's bought in a decent neighborhood that oozes suburban charm, is reasonably close to plenty of great high-paying jobs, has more than its fair share of honor-roll schools and is near essential shopping. The alluring prospect of homeownership is further enhanced by the cozy home and hearth amenities that a home is meant to provide. 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) on whatever money they borrow to buy a home. Needless to say, this translates to a sizeable tax break every April 15th. But wait, there's more... Homeowners are the direct beneficiaries of appreciating home values. What's more, they'll enjoy the economic satisfaction of knowing that they're slowly but steadily accumulating a thickening cushion of home equity (that is, the net difference between what a home will sell for less whatever debt is owed against it) as the mortgage on a home is slowly paid off as the years pass. And should unexpected circumstances arise that require a homeowner to relocate, it can usually be converted into an income producing rental for the duration of one's absence. Finally, there's the copious availability of taxpayer subsidized mortgage debt. Thanks to this powerful incentive, real estate can be acquired and/or encumbered for mere pennies on the dollar. In light of this exhaustive list of potential benefits, why then did I not 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 quality to it. Though a homeowner might mistake a dollar of home equity for one-hundred pennies in the bank, this can be a costly misperception. To understand why, let’s examine a bit of real estate history. Prior to the dawn of the Internet age, just about the only way a homeowner could turn their home equity into cash was to sell their house, pay off the outstanding mortgage balance, and pocket the proceeds minus whatever incidental expenses were incurred in the sale. These niggling fees aren’t exactly chump change; they can easily amount to thousands of dollars worth of closing costs, real estate agent fees and other related expenses that can swiftly eliminate five to ten percent of a home’s value. Nowadays, ingenious financial innovations like HELOCs (Home Equity Lines of Credit) enable people to treat their homes as gargantuan ATM machines. Although these newfangled instruments do indeed liberate homeowners from the traditional hassle of having to sell their homes to access the equity that's been painstakingly accumulated over a period of many years, their use is neither hassle nor cost-free. Homeowners looking to avail themselves of such options generally have to complete reams of paperwork, deal with lots of stuffy bankers and sign lots of intimidating legal forms that aren’t easily read or understood. Any way you slice or dice it, whether you sell a home yourself or rely on less conventional methods, extracting money from a home is a costly and time intensive endeavor. The bottom line: unlike pure-play financial assets like stocks, bonds and REITs (which can be quickly and inexpensively liquidated) the added difficulty of squeezing money out of a home automatically makes real-estate a less desirable investment.

Is a home a financial asset? To help answer this question, and to establish a framework for discussion, let's first define two relevant economic concepts. What is a financial asset and how does it differ from a liability? To keep things simple, let's just assume that an asset is something that puts money in your pocket whereas a liability does the opposite, it takes money away. Sounds pretty simple, right? Okay, let’s move on.

One of the most disturbing things about real estate is that, when viewed as an "investment," its status as an "asset" or a "liability" is frustratingly difficult to define. And this is because there are so many factors to consider when making the determination. No matter how you analyze the economics, it's widely recognized that a home purchase requires a sizeable outlay of cash in the form of a down payment. Typically, this initial installment can amount to anywhere from five-to-twenty percent of a home's asking price. So far, buying a home soundly qualifies as an economic liability because it involves the removal of a good deal of money from one's pocket. Of course, a down payment will be supplemented by an irksome series of follow-up payments as mortgage principal and interest are serviced. And while it's certainly true that the long-term economic benefits of homeownership can be substantial, they take years, sometimes even decades, to materialize. Meanwhile, this sizeable commitment will extract oodles of money from a homeowner’s wallet. But that's not all; there are other costs for a homeowner to consider. Property ownership is an arrangement that, once entered into, carries with it financial obligations that must be satisfied. And the failure to do so sets in motion a strange circuitous process that may 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 obviously one because it prompts foreclosure by a lender. Not paying one’s property taxes is another because it causes a home to be relinquished to its owner of last resort, which, as many of us know, is Uncle Sam. Our federal government rents land to its citizenry; short of a successful foreign invasion, no other entity will claim outright legal ownership. A close reading of the tax code pertaining to a homeowner's obligation to pay property taxes should dispell any confusion on this topic. Sadly, the economic burdens of homeownership don’t quite end there. In addition to all of the expenses mentioned previously, there's homeowner’s insurance and maintenance expenses to think about. After tallying all of these costs, and taking a thoughtful moment to consider the lifestyle implications of having to service them for one or more decades, it should become readily apparent that a home purchase is, without doubt, a tremendous financial 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 becomes an asset. But how can this be? How can a home start out as an economic liability, and then, poof, morph into an asset? At some point in the long and tiring process of paying down a mortgage, the amount of equity that’s built into a property will equal the amount of debt that's owed against it. Let’s call this miraculous moment the economic tipping point. When it is happily reached, assuming the value of one's home doesn’t decline, then and only then can a home become a financial asset. It‘s worth noting, however, that it usually takes many years of debt-service for real estate to shift from the liability to the asset column of a homeowner's balance sheet.

Now that we’ve explored the asset-liability duality of homeownership, let’s examine the opportunity cost of buying a home. When we crunch these numbers, you’ll see that it's enormous. What is opportunity cost? Economists define it as the highest foregone alternative. In other words, should you decide to part with your money, you’ll forfeit the right to invest that same money elsewhere. Makes sense, right? Now, when weighing the pros and cons of buying a home, it’s worth noting that this economic decision carries with it a series of potential costs and benefits. Though marrying a mortgage might seem like a can't-miss 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 transform a hefty down payment and a staggering amount of debt into an even greater sum of wealth somewhere down the calendar, it's worth considering the time value of money and thinking about how rapidly the money that's invested in a home might appreciate if it were allocated elsewhere instead. What could happen if the financial capital that's funneled into a home were to appreciate at a rate that's consistent with the long-term historical returns of the S&P 500? When we run these numbers, and compare the side-by-side returns of investing in a home vs. stocks, the long-term economic logic of buying a home becomes downright questionable.

To illustrate this point, we'll pit $500,000 invested in a home against $500,00 invested in the S&P 500 (with dividends reinvested) and examine the comparative returns of each over three different holding periods: five, ten, and twenty years looking back from July 2006. According to research conducted by Edward Jones, half a million bucks invested in a home over a five year period would’ve amounted to $730K, easily trouncing the S&P 500’s returns by a sizeable $155K margin. Over a ten year period, however, real estate’s luster dims considerably; $500K invested in the S&P 500 becomes $1.2 million whereas $500K invested in a home becomes $937K, a decisive $263K difference in the stock market’s favor. When we compare the price performance of real estate vs. stocks over a twenty year period, however, the disparity in returns widens even more aggressively; $500K invested in the stock market is worth $4.83 million whereas $500K invested in a home amounts to $1.5 million—a tidy $3.33 million difference in the stock market’s favor. Clearly, though real estate has proven that it 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. The fact that our government subsidizes interest on real estate debt distorts incentives and encourages people to take on bigger mortgages than they might otherwise be able to afford. Essentially, this gives consumers a powerful incentive to over-concentrate their wealth in housing. From a risk management standpoint, this can be costly. Disruptive events of natural and economic origins have had severe consequences for real estate values. The bay area's 1987 earthquake gave property values a nasty downward adjustment. What's more, home values in New Orlean's were hard hit by levee failures caused by hurricane Katrina. These and other events show how violently real estate values can fluctuate in response to a natural disaster. Economic events, which tend to be less visible in terms of their impact on housing wealth, are no less ruinous. Consider the market-wide adjustment in property values resulting from record foreclosures in areas like Detroit, a once vibrant and thriving metropolitan hub that was once home to a dominant and seemingly unstoppable U.S. automotive industry. More recently, during the 1990s, the loss of defense contracting jobs in parts of southern California depressed real estate for years. There's also the brutal economic aftermath of the 1980s Savings and Loan crisis to think about. This also had a chilling effect on home values. Clearly, economic and natural disasters both pose significant (but widely overlooked) risks to housing wealth. Those who’ve been adversely affected by these and other equally calamitous events realize—perhaps more keenly than most—the folly of concentrating so much of their net-worth in their homes.

Having explored 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 easier way to do it than to shackle oneself to the dubious privilege of a mortgage. As investments go, real estate is lovely. Happily, for people who don’t have oodles of spare cash or are appropriately wary of take on an astronomical amount of debt, there’s an easier way to cash-in on real estate. This brings us to Real Estate Investment Trusts; or REITs. These handy and easily accessible investments put the dream of real-estate ownership within reach by enabling people of even modest means to purchase professionally managed income producing commercial properties. Moreover, with REITs, the underlying asset is owned free and clear. Moreover, it generates income from the get-go without the subsequent hassle of having to pay a mortgage or fork over additional money for taxes, maintenance expenses and property insurance. Insofar as real estate investing is concerned, REITs are terrific and will be discussed in detail next.