Real Estate Investing Analyzed The Right Way
- Learn why WSJ’s analysis of real estate investment is flawed.
- Discover the simple equation you can use to determine if a real estate investment is decent.
- Reveals all the factors you need to take into account when evaluating a real estate investment.
Brett Arends of the Wall Street Journal published an article yesterday claiming housing has been a lousy investment – all the way back to 1981. This article has been picked up by many media outlets, but unfortunately, it’s wrong.
Yes, believe it or not, even the venerable Wall Street Journal makes blatant mistakes by misusing statistics and applying false premises to data to derive completely incorrect conclusions.
The basic premise of the article is that housing has been a lousy investment since 1981 because the Case-Shiller index shows 4.1% growth in real estate prices, compared with consumer prices rising by 3%, leaving a paltry net return of 1.15%.
While Brett may have got the math right, the implied assumption behind the calculations is wrong, making the entire analysis wrong. There are two main flaws with Brett’s reasoning.
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The first flaw is that Brett assumes investment real estate is purchased for cash and owned outright. The truth is, investment real estate is seldom bought for cash – it’s usually financed – typically with leverage ranging from 4:1 to 9:1 depending on the credit cycle and the type of property.
Using 4:1 to keep the math conservative means your investment return results from 5 portions of growth for every one portion of inflation. Using the numbers from the article, a $100,000 house bought with a 20% down payment would grow in value $4,100 (100,000*.041), and inflation would cost you $600 in purchasing power (20,000*.03). The growth in “wealth” is effectively $3,500 on a down payment of $20,000, or roughly 17.5% return on investment – not the 1.15% that the Wall Street Journal claims.
In other words, investing in real estate is a leveraged play on inflation – it always has been, and it always will be, as long as people choose to finance their purchases. That’s why real estate investors are getting slaughtered right now – because we have deflation causing leveraged losses on the deflationary decline in prices.
It’s also the reason why real estate prices rise most of the time and only rarely decline – because inflation is so persistent and consistent, except during rare credit collapses, such as the one we’re living through right now.
Stated simply, if you want to figure out the investment return on real estate, you can’t simply subtract inflation from the price increase of the property as Arends attempts to do, because that ignores financing leverage. Instead, you must multiply the return by the leverage factor while only subtracting one part of inflation for the amount of down payment.
Using the above example, you multiply 4.1 times 5, equaling 20.5% return on your investment (down payment), then subtract 3% for loss of purchasing power due to inflation on your down payment. The result is 17.5% return just as shown above.
In addition, if you want to get fancy and look at the analysis from an investor standpoint, as opposed to a homeowners perspective, then you need to include multiple return streams from your real estate investment, and not just change in capital value.
That’s the second flaw in his analysis.
For example, you would want to include cash flows from rents net of mortgage, taxes, insurance, maintenance and other costs.
Arends attempts to correct his mistaken analysis on the WSJ site by claiming any leverage benefits are offset by financing costs, but once again, he’s incorrect.
Financing costs are typically offset by rent from the tenant for the investor (or imputed rent for the homeowner), leaving the above referenced leverage equation to stand on its own merit.
In addition, you must also include the tax advantages that accrue from real estate investment, equity built up from paying down the loan, and active appreciation from property improvements, to determine if real estate is a good overall investment (or a lousy investment as the Wall Street Journal incorrectly claims).
However, in all fairness, the original article doesn’t touch on these issues and merely draws its conclusions from comparing price changes to inflation – and that’s my point.
Because the analysis ignores these other essential aspects of real estate investing, including financing and the resulting leverage, it similarly ignores the reality of how most real estate investors build wealth. The article draws a flawed conclusion based on flawed analysis.
I hope this helps clarify.
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