What’s in a REIT?

Years ago, during real-estate’s glorious heyday, I was drawn into a spirited debate about the economic logic of “investing” in a home versus stocks. To put this conversation in its proper historical context, it occurred at a time of stubbornly buoyant real estate prices. An overly frothy housing market that, for ten years, bubbled nowhere but up had produced speculative frenzy and a bumper-crop of ardent real-estate fans. With financing readily available to all, it seemed like everyone was eager to buy a first, second or third home. So, it may come as something of a surprise that I spent the better part of an hour trying to explain 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 has vaulted ceilings, a modern state-of-the-art kitchen, and is situated in an upscale neighborhood that oozes suburban charm. A home’s prospects for outsized future appreciation is further enhanced if it’s close to a diverse and economically vibrant metropolitan area that’s supported by a highly educated workforce and a diverse employment base. It’s equally helpful if the zip code you’re home-shopping in boasts higher than average median incomes and has plenty of distinguished schools. Lest we forget, the appeal of home ownership is further enhanced by cozy intangibles: the comforting home and hearth amenities that a home affords. Ultimately, though these and other selection criterion may significantly boost one’s odds of turning a prospective home purchase into a lucrative real-estate investment, 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 look at the financial advantages of home ownership. For starters, homeowners can deduct their property taxes and the interest (up to a million dollar mortgage limit) paid on money that’s borrowed to buy a home. This results in a sizable tax break every April 15th. But wait, there’s more… Homeowners are the economic beneficiaries of a strong historical precedent of rising home values. Thanks to this trend, people who’ve owned their homes for 20 to 30 years can usually sell them for far more than they paid for them. Additionally, a mortgage is like a forced savings account in that, over time, as monthly payments are made and the balance owed is gradually paid off, homeowners accumulate growing wealth in the form of an ever-thickening cushion of equity. This is the difference in value between what a home is worth minus whatever debt is owed against it. Should unforeseen events force a homeowner to vacate a property for an extended period, it can be converted into an income producing rental. Finally, there’s the copious availability of taxpayer subsidized mortgage debt. Thanks to this and other powerful economic incentives, real estate can be purchased and/or encumbered for mere pennies on the dollar. In light of this exhaustive list of potential financial and psychic benefits, why 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 fuzzy money quality to it. Though it’s easy to confuse a dollar of equity for a hundred pennies in the bank, this can be a costly miscalculation. To understand why, let’s explore a bit of real estate history. Before the Internet era, back when rotary dial telephones were commonplace, just about the only way that a homeowner could turn their home equity into cash was to put their house on the market, wait for it to sell, and use the proceeds to pay off their mortgage balance. After deducting real estate agent commissions, capital gains taxes and other miscellaneous expenses incurred in a property’s sale, whatever cash is left can be pocketed or spent. Collectively, these expenditures aren’t chump change; they can easily amount to thousands of dollars and consume anywhere from five-to-ten percent of a home’s sale price. So, that hypothetical dollar of home equity isn’t really worth 100 pennies, but rather, something like 92.5 cents. Fact is, this reduced figure is somewhat understated because it doesn’t reflect the transactional expenses that are incurred in the purchase of a home. Nowadays, ingenious financial innovations like HELOCs (Home Equity Lines of Credit) enable people to treat their homes as gargantuan ATM machines. Although these complex instruments do indeed liberate homeowners from the traditional hassle of having to sell their homes in order to access the equity they contain, their use is neither hassle nor cost-free. Homeowners looking to avail themselves of such options must complete reams of paperwork, deal with stuffy bankers and sign lots of intimidating legal documents that aren’t easily read or understood. Any way you slice or dice it, whether you sell a home yourself or rely on other 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 sold), the added difficulty and expense of extracting equity from a home makes real-estate a comparatively less desirable investment.

Is a home a financial asset? To answer this question, and build a framework for discussion, let’s define two relevant economic concepts. What is a financial asset and how does it differ from a liability? To keep things simple, let’s agree that an asset is something that puts cash in your pocket whereas a liability does just the opposite, it takes money away. Sounds simple, right?

The most perplexing thing about real estate is that, as investments go, its status as an asset or liability is somewhat elusive and hard to pin down. Fact is, a home isn’t permanently categorizeable as an asset or a liability; many factors go into making this determination. No matter how the economics of home ownership are analyzed, buying a property initially qualifies as a liability because it means parting company with a huge pile of cash in the form of a down payment. This sizable outlay, which amounts to anywhere from 5% to 20% of a home’s asking price, will be followed by a very long series of follow-up payments as the principal and interest components of a mortgage are paid off in monthly installments over twenty to thirty years. And while it’s certainly true that a home’s potential for long-term price appreciation is indeed substantial, this shimmering pot of gold at the end of the debt service rainbow often takes decades to materialize. Meanwhile, the outflows associated with a monthly mortgage payment will suck plenty of cash from a homeowner’s wallet. But that’s not all, there are other costs for a would-be homeowner to consider. Property ownership is an arrangement that, once entered into, carries with it additional financial obligations that must be satisfied. And the failure to do so sets in motion a strange circuitous legal process that eventually results 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 prompts foreclosure by a lender. Refusing to pay one’s property taxes is another because it causes a home to be relinquished to its default owner: Uncle Sam. Our government is in the business of renting land to its citizenry; short of a successful foreign invasion, no other entity will threaten to and eventually reclaim your property in event that these taxes aren’t paid. A close reading of the tax code relating to a homeowner’s patriotic responsibilities in this regard should dispel any confusion on this topic. Sadly, the economic burdens of home ownership don’t end there. In addition to these expenses, there’s also the cost of property insurance and ongoing maintenance expenses to consider. After totaling all of these costs, and taking a thoughtful moment to contemplate the lifestyle implications of having to satisfy them for several decades, it should be readily apparent that a home purchase is a tremendous financial liability. Basically, a newly acquired home with little-to-no equity is just a rental garnished with a heap of debt and a few other financial obligations.

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, become an asset? At some point in the long tedious process of paying off a mortgage, the amount of equity that’s accumulated in a property will equal the amount of debt that’s owed against it. Let’s call this eagerly anticipated and widely celebrated moment in a homeowner’s life the economic tipping point. At this stage of the game, monthly mortgage payments enrich the homeowner’s bottom line more than the mortgage originator’s. Once this delicate economic point is reached, assuming the value of the home in question doesn’t decline, then and only then can a home become a financial asset. It‘s worth noting, however, that it usually takes decades of faithful debt-service for real estate to shift from the liability column of a homeowner’s balance sheet to the asset column.

Now that we’ve explored the asset-liability duality of home ownership, 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, whenever you spend money you forfeit the right to invest that money elsewhere. By making an economic decision you’re passing up alternative choices for how you might have spent your money. Makes sense, right? Now, when weighing the pros and cons of buying a home, it’s worth noting that any 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 primary purpose of buying a home is to transform a hefty down payment and a staggering amount of debt into an even greater sum of money somewhere down the calendar, it’s worth considering the time value of money and thinking about how rapidly the cash that’s invested in a home might appreciate if it were allocated elsewhere instead. Suppose the financial capital that’s put into a home were to instead appreciate at a rate equal to the S&P 500’s long-term historical returns? When we run these numbers, and compare the side-by-side returns of investing in a home vs. stocks, the economic logic of buying a home is downright questionable.

To illustrate this point, we’ll pit $500,000 invested in a home against $500,00 allocated to the S&P 500 stock market index (with dividends reinvested) and examine the comparative returns of both investments over three different holding periods: five, ten, and twenty years starting 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 $155,000. Over a ten year period, however, real estate’s luster dims noticeably; $500K invested in the S&P 500 appreciates to $1.2 million whereas $500K invested in a home is worth $937K, a $263K difference in the stock market’s favor. When we compare the price performance of real estate vs. stocks over a twenty year period, the disparity in returns widens even more aggressively; $500K invested in the stock market amounts to $4.83 million whereas $500K invested in a home becomes $1.5 million—a staggering $3.33 million difference in the stock market’s favor. Clearly, though real estate has proven it can outperform stocks over a five year period, it hasn’t demonstrated an ability to do so over the long-haul.

Another frequently overlooked risk of home ownership is that it concentrates a high percentage of one’s net-worth in a single investment. The fact that our government chooses to subsidize interest on real estate debt distorts incentives and encourages people to take on bigger mortgages than they might otherwise afford. The tax code is one reason why consumers over-concentrate their wealth in housing. From a risk management standpoint, this can be costly. Disruptive events of natural and economic origins have, throughout history, adversely affected real estate values. The San Francisco Bay Area’s 1987 earthquake gave property values a nasty shake. Home values in New Orleans were similarly devastated by levee failures caused by hurricane Katrina. These and other disruptive events show how violently real estate values respond to natural disasters. Major economic events, which tend to have a less visible and dramatic impact on housing values, can be equally traumatic and damaging. Consider the market-wide adjustment in property values owing to deteriorating economic condition in hard-pressed 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 southern California had a chilling effect on real estate values in that part of the country for years. The economic aftermath of the 1980s Savings and Loan fiasco exerted downward pressure on numerous hard-hit real estate markets. Clearly, economic and natural disasters both pose significant (but frequently overlooked) risks to housing wealth. Those who’ve been adversely affected by these and other calamitous events realize—perhaps more keenly than most—the folly of concentrating so much of their personal net-worth in their homes.

Having examined the pros-and-cons of home ownership, 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 an easier way to go about it than to shackle oneself to a mortgage. As investments go, real estate is dandy. Luckily, for people who don’t have oodles of spare cash lying around or are unwilling to assume an astronomical amount of debt, there’s a much easier way to cash-in on real estate. Which brings us to Real Estate Investment Trusts (REITs). These financial instruments put the American dream of real-estate ownership within easy reach for ordinary folks by enabling people of modest means to acquire 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 greater detail next.

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