Why real estate is still a good investment

Now that the housing bubble has crashed, a growing number of academics, journalists, and financial gurus are trying to reassess the value of real estate as a long-term investment class.

There is a growing -- and much needed -- consensus that much of the conventional wisdom about real estate as a "great investment" is over-hyped and oversold by the National Association of Realtors who also happen to be a powerful lobbying group, dictating our national housing policy.

The Wall Street Journal's Cheapskate columnist looks at housing and reaches a good conclusion (subscription required), explaining that the real financial return of homeownership comes from not having to pay rent: "That's why you should buy as much home as you need -- but no more. A bigger home than you need isn't an investment -- it's an extravagance, the equivalent of renting a bigger apartment than you need. You may choose to do so, but that doesn't make it a smart move financially."

Unfortunately though, Cheapskate also makes a key math error in calculating the return on his housing investments over the years: "When I constructed a very basic cash-flow model for our home-buying history-selling price minus purchase price, renovations and repairs -- it showed a roughly 3.5% annualized return on investment, from 1991 through the summer of last year."

The problem is that this return on investment calculation doesn't take into account the fact that if Cheapskate and wife are like the vast majority of real estate buyers, they didn't pay cash for their properties -- they took out mortgages. So calculating the return on an investment size that they couldn't have come up with for anything other than real estate isn't really fair either.

Forbes makes a similar logical miscue in its look at How Much Real Estate Should You Own?: "Strip out inflation (and the fact that homes are much bigger than they used to be) and you find that home prices have scarcely budged over the past 120 years, according to Yale economist Robert Shiller."

These arguments are good in the sense that it backs up the notion that a primary residence is not a good investment -- But most financial sophisticates already knew that and even if they didn't, Robert Kiyosaki has been hammering away at this point in his Rich Dad, Poor Dad books for the past decade. Sure, real estate agents were telling people that buying a 5,000 square foot McMansion was a better investment than a smaller home and a larger savings account but seriously: Haven't most people always known that real estate agents are full of crap?

But investment real estate -- i.e. rental properties and shares in publicly-traded real estate investment trusts -- still makes a lot of sense: It allows ordinary investors to borrow large sums of money at low interest rates and, when purchased well, tenants can pay the interest and all the operating expenses: while amortizing the mortgage and possibly even generating cash flow. On a 30-year fixed rate mortgage with 20% down, a rental property that doesn't appreciate at all will generate a 400% return just from equity build-up. That's an annualized cash on cash return of 5.51%, compounded (calculate it yourself here) assuming that property values are the same in 30 years as they are now -- and given that housing values usually keep pace with inflation, you end up with returns that are pretty good. And remember: In the later years especially, you'll have strong cash flow too because rents will rise while your mortgage payment stays the same. Better still, borrowing money at today's low interest rates and plowing it into hard assets seems like a pretty good inflation hedge.

Real estate is on the whipping post right now -- and with good reason. But it's important to remember that the overconsumption of luxury properties purchased with funny money over the past few years should not render old-fashioned real estate investing for the long-term -- with 20% down -- a thing of the past. It's been making people rich for a long time, and it will continue to do so.
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