The Right Reason for Real Estate

The misconception for a lot of people is that real estate is an investment. Real estate does not grow in value on its own. In fact, you have to continuously put money into it just to maintain its value. The price appreciation you experience with real estate is really only the result of inflation.

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Real Estate as InvestmentsI was recently speaking to a group of people planning to retire in the next five years. There were a lot of questions about investment strategy and gold in particular. Afterward, a man explained his strategy for investing in real estate. He reasoned that, with the exception of the past five years, real estate has always been a great investment. He pointed out that the currently depressed real-estate market made it an ideal time to load up on property. This gentleman was not asking my opinion on his strategy as much as he was trying to get me to confirm his foresight.

Unfortunately, real estate is not an investment. I’m not saying that money cannot be made in real estate, because developers do it all the time. However, it is very difficult for the average person to make money owning real estate. The argument that “they aren’t making any more land” or that “eventually the price has to go up” just doesn’t hold water.

My dad never owned a stock in his life. He believed owning real estate was the best investment ever (except for the 18-percent CDs he had in the early 1980s). He often talked about the property he bought in the early 1970s and how much it had appreciated.

If you hold this same opinion, let’s take a look at that great bargain back in the 1970s. The median price of a home in the United States in May 1971 was $25,500 according to the U.S. Census Bureau. Forty years later, the median price of a home in May 2011 is $222,600. That’s about a 10-fold increase, which works out to 5.6% annually. Certainly not a home run, but the appreciation is better than inflation over that period of time.

Here’s the part that most people forget – you had to continually put money into the property for it to maintain its value. What was the cost to replace the roof, paint, maintain the interior, upgrade electrical and plumbing, etc. over the past 40 years? Most real-estate professionals advise budgeting 1 to 3% of the cost of the home for annual maintenance.

Property taxes are another big annual expense that could easily shave another 1% per year off your return. There is also the cost of buying and selling real estate, and financing costs for those not able to pay cash. When all costs are figured in, the average property did not even keep pace with inflation over the last 40 years.

I also took issue with the statement that real-estate prices are currently depressed. This viewpoint relates to prices in 2007, when the real-estate bubble was at its peak, and comparing them to today. Census information shows the high median home price was $262,600 in March 2007. When compared to today’s market, it appears that today’s average price is down 15%. This would be a valid argument if home prices were fairly priced in March 2007. I believe they were extremely overpriced and that today’s home prices are now back to where they should be.

I believe that over time, the average home price will keep pace with its replacement cost, which is basically the rate of inflation. The median price of a home has risen 2.4% annually over the past 10 years, which is about the rate of inflation. Going back 20 years, the median price has risen 3.3% annually. Anyone waiting for prices to return to 2007 levels is going to have to wait awhile, because home prices are currently where they should be based on inflation.

I am not trying to say that you should never own property. In my opinion, owning property is a great idea if you are going to live in it, run your business from it or even use it for a vacation home. The biggest value for my dad over the past 40 years was not the price appreciation, but rather the fact that he lived there. Owning your home is part of the great American dream and the satisfaction that comes from home ownership is valuable, even if it is hard to quantify.

The current tax code has many significant tax advantages for the homeowner. Property taxes and mortgage interest are both deductible to taxpayers who itemize. The capital gain on your residence is tax-free up to $250,000 once you have lived in the house for two of the last five years.

Homeownership also has its disadvantages. Owning a house is usually more costly than renting. Replacing the heating system or roof entails expensive repairs that may come when you are least prepared to pay them.

If your job requires you to relocate to accept promotions, homeownership restricts your flexibility. You may also be required to move when conditions are less than ideal to sell a home.

Business ownership is the only true investment that grows. The easiest way for the average person to own multiple businesses is through the stock market. The value of your shares increases as the companies find new ways to make money and improve their manufacturing methods.

With the economy’s ebb and flow, the value of your shares will rise and fall as the outlook changes, but over time, businesses grow their earnings and their value appreciates. Obviously, not all businesses are successful, which is why diversification is important.

This article originally appeared in the October 2011 issue of Lancaster County magazine

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