You Don't Own Real Estate - It Owns You

Many Americans believe that real estate can do no wrong as an asset class upon which they can build wealth. I disagree. Building wealth through real estate depends on your ability to distinguish among the three types of real estate ownership – investment, speculative, and personal. If you don’t know the differences, you may soon discover that you don’t own real estate, real estate owns you.

Investment Real Estate Puts More Cash in Your Pocket Than It Takes Out

Investment real estate refers to the ownership and operation of income-producing real estate whereby the income generated by the property – usually, rent payments from tenants – more than covers all the costs of owning and operating the property. If the income is high enough to cover all the costs of ownership and operation plus leave cash left over for the property owner, the property is said to be cash flow positive. If the income fails to cover all the costs of ownership and operation, the property is said to be cash flow negative, whereby the property owner must dig into his or her pockets to come up with the cash to pay for the remaining, uncovered costs.

A bona fide real estate investment puts more cash in your pocket than it takes out, on a repeatable, consistent basis. As such, a cash flow negative investment property is really not much of an investment at all. If you continue to hold on to a cash flow negative investment property out of pride or any other emotional attachment to the property, you are not maintaining an investment; you are maintaining a hobby. A rational real estate investor would put a stop to the repeated, consistent cash drain ASAP. In many cases, it is simply best to swallow your pride and sell a cash flow negative investment property. That way, you can let a new owner cope with the income shortfall each month while you put your sale proceeds to work in a cash flow positive investment property you can find elsewhere.

Speculative Real Estate is a Bet Against the Odds

When buying real estate at or near the prevailing market price, many people firmly believe they will make a profit upon the future sale of their real estate. Unfortunately, there is wishful thinking and there is reality. Wishful thinking plays a prominent, defining role in speculative real estate. A new property owner may hope to sell his property at a higher market price in the future, but in reality, he has no idea what the future market price will be. Nobody does – all future market prices are unknown to everyone. That is, until the future arrives.

In the face of such uncertainty at the time of purchase, all the new property owner  can know is that there are three outcomes for a future market price: significantly lower than, similar to, or significantly higher than the current market price. In other words, unable to know at the time of purchase what future market prices will be, the new property owner has only 1 in 3 outcomes where he can sell his property at a future market price significantly higher than the current market price. If each outcome is equally likely, the new property owner's odds of selling his property at a highly inflated market price are low.

Unfortunately, the odds of making a profit on a property purchased at the prevailing market price are made even worse by the high transaction costs of buying and selling real estate. Even if a new owner sells his property at the similar future market price, he still loses money thanks to brokers’ commissions, legal fees, and other closing costs incurred to sell the property. He also loses money selling the property at a significantly higher future market price if that future market price is not quite high enough to cover the high transaction costs. Clearly, the odds of making a profit are against those who buy real estate at the prevailing market price and hope to sell later at a higher market price. Such is the nature of speculation and the wishful thinking that leads to it.

Personal Real Estate is Simply a Purchase, Not an Investment

Personal real estate is real estate you buy primarily because you believe you and your family will enjoy living there. Making money, if at all possible, is secondary. In fact, it is hard to make money with personal real estate. To make it your home, you must take cash out of your pocket each month to finance it, insure it, maintain it, fix it, furnish it, and pay property taxes on it. Unlike investment real estate, your home generates no income to offset these out-of-pocket expenses. So, while you likely derive much pleasure from owning your home, you lose money on it every month. Don’t fool yourself – your home is not an investment. It is simply a purchase.

Nevertheless, despite draining you of cash every month, owning personal real estate generally beats renting a house, condo, or apartment for an extended period of time. Owning personal real estate gives you at least two options that renting does not. These options provide you with real value.

First, unlike renting, ownership of personal real estate gives you the option to keep more of your income out of the hands of career federal politicians in Washington, D.C. Current U.S. federal tax laws allow you the opportunity to deduct mortgage interest and local property taxes from your taxable income. This helps reduce your U.S. federal income taxes. So, when you own personal real estate, more of your outgoing cash ends up helping your surrounding community, its schools, and its hospitals instead of largely going to waste in Washington, D.C. This is especially true if the investors in your mortgage are also local and in your community; such investors are more likely to reinvest your interest payments locally as well.

Second, if you ever have to move due to a job change or relocation, personal real estate ownership gives you the option to hold on to your personal real estate and rent it to tenants after you move out. Exercising this option gives you the opportunity to turn your personal real estate into investment real estate. Of course, exercising this option might not make sense given your personal interests or financial situation at the time of your move, but it is an option you would not have had if you were simply renting the roof over your head. When moving out of a rental unit, despite all the monthly payments you made to your landlord, you walk away with no ownership in any real estate asset whatsoever. The advantage goes to personal real estate ownership.

You Don't Really Own Real Estate If It Can Be Taken Away From You

The differences among investment, speculative, and personal real estate ownership are clear. However, you don’t really own real estate. You only think you own it. Even if you have paid off your mortgage in full, a county, city, or local public school district can still take your property away from you. Just stop paying the tax bills these governments send you each year and you will quickly discover who really owns your real estate.

Paying property taxes is all you need to do to keep your real estate out of government hands, right? Sorry, but no. You could pay property tax bills in full year in, year out for decades and still lose your property to eminent domain, whereby a government expropriates your real estate to use it for what it claims to be society’s “greater good” – your personal property rights be damned.

Clearly, while many Americans believe that real estate can do no wrong as a way to build wealth, it sure is hard to build wealth with real estate when, in so many different ways, you don’t own real estate, real estate owns you.

Comments

[TonyCinTX:]

Personal real estate is not just a purchase.

My wife and I retired to a garden home in a great neighborhood about fifteen years ago. I still keep up with apartment rents as part of my investment research, and our mortgage payment, property tax and maintenance average about 70% of what we would be paying for an apartment of equivalent size. And because we bought in a prime residential "triangle" servicing medical professionals, university workers and a large local employer, our property has had real (post-inflation) appreciation.

Putting money in your pocket is not the only hallmark of an investment. The difference between an investment and a purchase is whether the item can be expected to increase your net worth or decrease it. All investments have some risk, a successful investment increases your net worth.

If I buy a car or TV for personal use, that is a purchase. The only reasonable expectation is that it will decrease my net worth the instant the check is signed, and depreciate in resale value every month thereafter.

Renting an apartment is a purchase. My house is not a purchase because my alternative is renting. The house increases my net worth by several hundred dollars a month, every month. Since I build equity it increases my long term net worth. The interest payment tax reduction also increases my monthly income, since the alternative would be to pay that interest as rent and get no tax deduction.

The fact that the money in my pocket comes from savings does not prohibit this from being an investment. Home builders rightly consider pneumatic nailers and hydraulic lifts and even circular saws an investment, but for all of these the payoff is strictly savings on man hours, they put zero cash in the pocket, and eventually the equipment becomes worthless junk. But they are an investment because the only alternative to the equipment is hand tools and time-consuming muscle work.

We do enjoy the use of our home and neighborhood, but it was a relatively low risk investment in 1993 and remains one today. It has increased in value since we bought it (despite the RE crash) and continues to put money in my pocket every month, compared to any comparable benefit alternative.

2008 Jul 13 08:43 AM

[John Lounsbury:]

If you average residential real estate appreciation over the years, the return is about 3%. This is close to the average rate of inflation. Real estate owned for a long time always has maintenance and repair burdens that a renter doesn't have, so the average annual return is actually lowered by those expenditures. Therefore, as an investment, owning your own home is comparable to keeping a savings account in your local bank. Investing in CDs will, on average over time, give a higher return.

For those like TonyC-SA who bought in a prime location at the bottom of the real estate cycle, their home is a investment yielding a positive return greater than inflation. For those that bought in higher points in the real estate cycle, late 1980s or 2004-2007, they would have made more money in a savings account. For the latest cycle, 2004-2007 buyers may not have a positive for many years, if ever in some locations.

2008 Jul 13 10:14 AM

[carey_jim:]

For the last thirty years, American real estate has been rising faster than most other commodities. During the last ten years the rate of increase itself accelerated.

From 1930 until 1950, the value of American real estate was flat or falling. After World War II, real estate values rose either modestly along with other goods and services or were, essentially, flat until the mid 1970's.

These price patterns were easy to see by most people and were factored into real estate purchasing behavior. A residential house, vacation home or apartment building simply became a very large personal investment that was supposed to last a lifetime and even be passed on to the next generation as part of a family identity.

Real estate became a speculative market only during the last few decades when it was perceived by most people that the value of real estate was rising faster than most other markets.

Because the price of homes was about four or five times the annual salary of most households, it was necessary for most people to purchase homes on credit with down payments representing about 20% of the value of the home.

As the rise of real estate values accelerated, this financial mechanism became a method for the average person to speculate in real estate. Margin requirements were relaxed and a housing bubble was produced.

Many people think the value of real estate will continue to fall or remain flat for the next few years and that this is necessary so that the residential real estate markets can return to "normal."

It is possible that an entire generation will suffer from the sins of the previous generation with flat or falling real estate values. Not a pleasant prospect, but seeking alpha is about facing possibly unpleasant truths not about wishful thinking.

2008 Jul 13 10:29 AM

[Deb:]

You have to live somewhere. If you own a home that in all of its costs is not too expensive for your means and you work at paying down the debt over the term of your mortgage (Meaning: No "home equity loans" or "prem-a-debt") eventually your home is paid for. With that formula, your home is an asset-in-the-making while you enjoy living there.

2008 Jul 13 11:11 AM

[bluesmoke:]

"It is possible that an entire generation will suffer from the sins of the previous generation with flat or falling real estate values. Not a pleasant prospect, but seeking alpha is about facing possibly unpleasant truths not about wishful thinking."

Well said. I constantly marveled at how fast real estate was appreciating - given the fact each year fewer and fewer would be able to afford it. Now that we are at critical mass and have to come to terms with inflation via higher energy costs, it's hard to justify a 1500 sq ft house being worth 1/4 million dollars. But that's just me.

2008 Jul 13 11:45 AM

[Tom Lindmark:]

jlounsbury59 said:

"If you average residential real estate appreciation over the years, the return is about 3%."

The ability to leverage real estate and receive a tax deduction for the carrying costs substantially increases the return.

2008 Jul 13 12:22 PM

[ArtfulDodger:]

Well said, er written. Very good points. Thank you for the article.

But you're not likely to convince real estate fanatics no matter what you tell them.

Their old grandpappy told them "Son, they ain't making no more land, so you better buy you some."

They're stuck in that frame of mind; no way to get them out.

However, I will say that out of the other baby boomers my age, the ones in my home town that have made the most money have done it in real estate, i.e., commercial developing --- not residential.

These fellows own very little property, however, and treat real estate only as something to sell and trade.

Most folks I know have not done very well trying to make money in real estate, because they fall in love with the idea of owning something tangible.

Many, many residential real estate developers have had to declare bankruptcy over the years.

It's much like trading futures; about 98% of all who try it lose.

2008 Jul 13 12:26 PM

[romorris:]

Hmmm. That 1.2 million dollars burning a hole in my pocket came from 6 years of riding up and bailing at the peak of the real estate market here in Southern CA. My personal residence was the opportunity of a lifetime. A million bucks the green from using other people's money. That's pretty good evidence that you don't have it all right. You can make a fortune in personal real estate if your timing is right. I wish all my investments performed at 1/10th of that rate.

2008 Jul 13 12:49 PM

[Ron Abate:]

When I arrive back in the country in 2005 after 15 yrs. living and working overseas, I needed a place to live. I rented a place in LV and then started looking at the purchase of a house. I constructed a lease versus buy program on Excel taking into consideration all the costs of ownership. As for the tax deduction I receive from the federal government for the mortgage interest and property taxes, the first $5,000, now $6,000, doesn't count because I automatically get the standard deduction. In 2005, I had the gut feel we were nearing the top of a bubble. Anyway, assuming my rent increased a 4% p.a. and home prices also increased at 4% p.a. renting was a better alternative. I used a discount rate of 8%. What people fail to consider is that money used for the down payment and the monthly principal portion of the mortgage can be invested in other asset classes.

I am still in my rented apartment. My rent has not gone up in 3 years, and after the first year it went up by $25 per month (on a base lease cost of $1,350 per month. I rent 1,300 sq ft. (3 bedrooms, two car attached garage, LR/DR/K combined) facing a well maintained swimming pool in a guard gated community. I continue to look for a house and still the NPV cost is negative to renting. I refined my lease versus buy worksheet. What I found was that the NPV for 1,300 sq. ft. was now competitive with leasing. What made owning uncompetitive with leasing was the additional 1,000 to 2,000 sq. ft. of a minimally acceptable house. This is my quandary. I like nice things like quality appliances and bathroom fixtures, moldings and flooring, educated neighbors with professional occupations, etc, but you don't get them in a 1,300 sq. ft. home and it does not pay to upgrade.

I have also done quite well with my overweigh energy portfolio (even a money market fund out performed residential real estate) versus what I would have invested in a down payment and the principal portion of the mortgage payment.

I may still purchase a house if the prices gets cheap enough and the incremental enjoyment of more space and a more pleasing ambiance offsets my current enjoyment of having money to invest in the stock market (there are places where you can still make money) and the enjoyment I derive from much greater disposable income renting, which allows for a very high grade diet of prime meats and fish, organic fruits and vegetables, fine wines, more dining out and first class vacation travel.

Have to go. If I have time I will post another comment about a study I just completed.

Cheers

2008 Jul 13 01:14 PM

[WJM1998:]

An excellent distinction between the various types of real estate "ownership". As a real estate developer, I see many "wanna-be's" jump in and pay market price and more for a project. They don't understand that, at best, they only have a 33% chance of making a profit, as your article points out. This assumes that they don't run over budget in their construction which may put their investment costs beyond the project's future market value. Any fool can pay retail and work for nothing. An intelligent investor buys at a discount to the current market value because he or she recognizes that you've made or lost money the day you close escrow.

2008 Jul 13 01:25 PM

[mallarde:]

carey_jim, I think you are might be missing something on future generations being "condemned" to falling prices. Younger people have been badly hurt by real estate speculation. Many have put off family-formation or lived in less desirable places because of it.

Housing is in a way a natural resource with a flat demand curve -- like electricity or oil. People have to buy housing -- or rent it. When young people have to contend with very high-priced housing their cost of living has gone way up.

Like in a pyramid scheme, the people that benefit are the older people that already have their real estate and can cash out. But that is about all the baby-boomer generation can comprehend -- what helps themselves.

I think the country would be best served with housing that keeps pace with inflation and that is about it. But with our immigration policy the way it is, we can presume demand will increase and prices will go up over time. Maybe not like a bubble, but the real cost of housing will go up.

2008 Jul 13 06:30 PM

[el prospector:]

Yes, eminent domain might be used by that nasty ol' gubbmint to take away your real estate and use it for something other than what you want to use it for. Our government took it all away from the Indians and gave it to white folks in the name of public good (all the while protecting the white settlers with a gubbmint-subsidized military force), so they can certainly take away a few piddling acres from you, too. The Indians didn't even get fair market value.

2008 Jul 13 11:07 PM

[Nick@CA:]

RE must be really a local business. Here in the SFBA there have been only marginal changes in prices of houses in decent white suburbs.

From what I know in SF prices are at worst flat, in Silicon Valley at best probably 100K down in the cheapest areas. But somehow I don't think that 750K+ is truly affordable for middle class families with income of only about 200K.

2008 Jul 13 11:14 PM

[goganidse:]

The old indians were right: the land owns you , not the other way around.
Here we see a good example of "the invisible hand" of Adam Smith and its results. Bubble here , bubble there- it depends, in some counties it got to burst in others where prices were more "normal" the decrease is not so hard or even nonexisting.
Hmmm
one should think a lot before renting or buyng a home.

2008 Jul 14 05:27 AM

[Jane:]

Excellent explanation of why your house isn't an investment! I still keep seeing ads on TV saying this is a great time to buy, and how a house is an investment, blah blah blah.

2008 Jul 14 12:30 PM

[working_class:]

I was wondering, did the government orchestrate the bubble on purpose? The same dynamic has happened before and it goes something like this... A politician declares that they will make it possible for everyone to have a house by providing easy credit to underserved people. As a result the market is flooded with borrowed money, and prices respond naturally to the laws of supply and demand. The same thing happened with education. The price naturally and unsurprisingly has to rise. Politicians who come up with this stuff *had* to know they were forcing higher prices. They claim to be helping the hard-working masses, but the people who were benefited were speculators. The rest of us are left with spectacular life-time debt for education and housing. I wish all creditors would go away, all of them so that prices would be back in line with what a working person can save. But that's completely unrealistic, and so is owning a home debt-free.

2008 Jul 14 12:40 PM

[ScottC33:]

Did Tony C (above) really say that renting an apartment is a purchase? I think his exact words were: "Renting an apartment is a purchase. My house is not a purchase because my alternative is renting." I'm sorry, what?

Stay in school, people.

First of all, renting an apartment can not, by definition, be a purchase. It's a RENTAL. Look it up. Buying a house is a purchase, of sorts, albeit on a long-term basis. Whether it is an investment in the truest sense is up for debate. But most people certainly like to think they will make money off it, so who cares what name you put to it. For purposes of this discussion, let's call it an investment. It's intended as a money-making effort over a period of many years.

The point is -- and a well-made one at that -- that a home purchase is not the great money-making venture that most think it is.....that is, unless you bought in 2001 and sold in 2004 (or so). In the TYPICAL real estate world, houses go up in value slowly over time, but you get killed in transaction costs and by the effects of inflation. And that's just the beginning. After you account for maintenence, association costs, utilities, new furniture, stuff for the house, financing costs, property tax, insurance, loss of return on down payment, etc., the value of that investment is FAR lower than most people think. Most people just take the selling price and deduct the purchase price, and figure they've made hundreds of thousands of dollars. But if you really want to know what you've "made" on a house, you need also to deduct EVERY DOLLAR you spent on the house over the period you owned it. And most people are either unwilling or unable to make that calculation. They want to feel good about themselves and just ignore the real cost of owning a home. Fine by me. If it makes you feel good about your lot in life by owning your own home, do it. But don't try to convince me (and the other people who know what it really costs to own a home) that home "ownership" is a great investment. It's not. It's an average investment, at best, and anyone who thinks it much better than that is kidding himself.

And as an aside............Most people save very little for retirement, apart from the equity they have accumulated in their homes. At the same time, the VAST majority of people are ridiculously ill-prepared to live comfortably when they retire......shocking!!... (I thought owning a home was such a wonderful, magical investment????)

2008 Jul 14 04:09 PM

[mallarde:]

ScottC, there is the generous tax benefits the government gives you. And houses give you the chance to leverage yourself out the whazoo. And our population continues to go way up.

So in some ways, it is a unique investment. Maybe just not a good one now.

2008 Jul 14 04:32 PM

[vicmart:]

When figuring out the "true cost" of ownership vs renting, the majority of renters also have to buy furniture and other furnishings. I do agree with Scottc33 that to derive the true value of your "investment", owners have to keep track of all costs--sobering!

2008 Jul 14 05:24 PM

[ScottC33:]

It's a HORRIBLE investment now. It's an average investment most other times. It's a very good investment at very few times in history (2001-2004) being the most notable.

And please don't get me started on the mortgage interest deduction. It's overrated as a substantive benefit. For those who pay very little mortgage interest in a given year, the deduction is of almost no benefit because those people would get it anyway through tthe standard income tax deduction.

For those with higher household incomes, deductions gets phased out beginning at a certain household income level ($150K or so -- don't quote me on the number -- more of an issue in California). All things considered, the deduction doesn't come anywhere close to offsetting the huge financial negatives of home "ownership."

Home ownership makes people feel good about themselves, and that's a very powerful draw. The NAR and the governnment spend millions every year trying to convince people that they need to own their own homes. And people listen. By and large, people are proud of their lots in life when they "own," and renters are less satisfied. That's well documented, but those emotions have little or nothing to do with finances.

If the entire housing industry stopped marketing to people about how important home ownership is, the percentage of people owning their homes would drop significantly because people simply wouldn't care as much about the perceived value of homeownship.

Buying a house is a far more emotional decision than a financial one. The financial benefits, assuming any occur, are an incidental by-product of that emotional decision to buy. Trying to convince oneself that homeownsership is an amazing financial investment is sheer ignorance. But, as they say, ignorance is bliss, so maybe I'm the one who's in the dark.

2008 Jul 14 05:31 PM

[Rew_77:]

I constantly watch the talk about the pros and cons of homeownership online. I have to say your comments have probably been the most thorough and well articulated I've seen so far.

To those saying that homeownership is a bad investment and essentially "not worth it" is your argument essentially that: the mortgage plus additional costs of insurance, taxes, and maintenance make the equity, tax sheltering, and sales appreciation on the home less valuable then having cheaper monthly rent? Essentially the money I keep in pocket every month from renting is more valuable then the equity I build in a home I purchase? Wouldn't I have to be doing some investing of that money I have left over to equal the benefit I am gaining from buying the home?

The tricker question I guess, if the above works out to be true (rent vs buy calculators), is "Will I be able to stay in the home long enough to offset the costs of purchasing and is the amount extra I am spending on the home worth it to me for improved quality of life." Obviously no one can answer that for anyone else.

Thanks again for the discussion and comments.

2008 Jul 14 07:06 PM

[sfnative_1967:]

Attention ScottC33 and the rest of the renters against homeownership: Most of you are really missing many important points of purchasing a home. Whenever you're buying your first home, of course it's expensive, but it's also a LONG-TERM investment. Otherwise, everybody would be doing it and no one would be renting. When you do your calculations of what you would net by subtracting the purchase price from the selling price, you neglected to take into consideration the fact that you are benefitting by living in that home over a period of time as well as getting a substantial tax break on the interest and taxes you'll pay that cannot get by renting. The alternative to paying a mortgage would be to be paying rent, so I'm not quite sure how renting can be such a better deal unless you live under rent control and have lived in that same residence for at least 10 years. Another benefit homeowners enjoy that renters do not is the ability to customize their own living space without fear of losing a deposit (on a rental) or being evicted.
<p>
And speaking of evictions, this is another fear that well situated homeowners get to live without. I know too many disgruntled renters who have been pushed out of their homes for one reason or another only to pay a higher rent on the next place they live in. Unfortunately, that is a vicious cycle because they can never seem to get ahead and homeownership becomes impossible dream. Then there's the ability to leverage - a beautiful thing that the anti-homeownership renting population refuses to comprehend. How many other types of investments allow you to borrow 80-90-100% to purchase an asset that provides shelter. Let's face it, homeowners who have held onto their property for decades, not years, are better positioned to become far wealthier than their renting counterparts.
<p>
After renting for over 16 years in San Francisco (obviously one the most expensive cities in the country), I purchased my first home in 2005 at the age of 37 and have no intention of selling it anytime soon. Yes, I put 10% down and got into a 10-year interest-only loan with an option to pay down principal. So, while paying the interest over 10 years, I can sock away the money I'd be putting towards principal in other investments. When the time comes where I need to refinance and I can't get a decent rate, then I'll use the money to pay down the principal (hopefully all of it) and/or buy down the rate. With the housing market and banks struggling, under-qualified borrowers losing their homes that they had no business purchasing in the first place and rents rapidly climbing, I see no better time than now to become a first-time home buyer if one is ready and willing.
<p>
The list goes on and on, but the bottom line is, if you financially and mentally prepare by saving your money and doing your homework, a home purchase can pay big dividends over time. Like author and speaker David Bach says, "it's not about timing the market, but TIME IN THE MARKET". The key is to buy as early in life as possible and stay put if you can for as long as you can and eventually paying a long-term fixed rate mortgage can become cheaper than paying market rate rent. There are just too many bitter renters out there saying "shouda, coulda, woulda" (bought their own home back in the day), but never did. Will you be one of them? Only time will tell!

2008 Jul 16 12:25 PM

[Joey Marino:]

Great read. I agree on some things. I believe there is no better investment on earth, than the earth itself.
JoeyMarino.com

2008 Nov 29 02:32 AM