How Does Real Estate Stack Up to Other Investments?

What characteristics do people look for in a good investment?

Start with positive cash flow, low expense ratios, low transaction fees, and proven returns on a historical basis. Using these criteria, does the average house match up with other investment options?

If you buy a house, how much money goes into your pockets every year? How much goes out? Most often, a house produces negative cash flow.

Think about it. The mortgage payments, maintenance, and taxes add up to a lot of money heading out … and none coming in.

This is not necessarily true for real estate as an asset class. Purchase a parking lot, apartment block, or strip mall, and you very well may find that the rents are higher than the cost of ownership.

But in terms of investment vehicles with low expense ratios and transaction fees, taking out a huge home loan to buy a place leaves something to be desired.

The expense ratio is the cost of owning an investment as a percentage of its value over the course of a year. Many financial experts search for mutual funds with expense ratios of less than 1 percent.

How does this compare to housing? Costs vary significantly by location, but for urban areas, annual property tax bills are typically between 1-2 percent of the current property value.

Maintenance costs can add another 1 percent of the property value. If your down payment is less than 20 percent, you will usually have to pay private mortgage insurance. Add property insurance, and the annual expense ratio associated with homeownership can be 3 percent or more.

The big hit, however, arrives when you sell a property.

Real estate agents will collect 6 percent of the selling price, while, lawyers, inspectors, title companies, and banks will collect additional fees.

These fees appear as though they will remain stubbornly fixed for years to come. If you flip properties as though you are actively trading stocks, the only folks getting rich will be your real estate agent and mortgage broker.

Meanwhile, transaction fees for stocks and mutual funds have plummeted in recent decades, to the point of falling below $10 per trade at several discount brokers.

Over the 50 years of data compiled, Pfizer and Altria returned 16.0 percent and 19.8 percent respectively. For any time period longer than the past few years, residential housing prices fall far behind these returns.

So should you take out a home mortgage loan or wait?

Perhaps the best measure of whether you should take out a mortgage and what housing-market appreciation really amounts to is the S&P National Home Price Index.

This index represents actual appreciation of the same house over time, whereas a portion of overall home price increases occurs because new houses are generally much larger than old houses and people frequently spend substantial money upgrading and expanding their houses.

Looking at the index, from 1987-2006, we see that the overall appreciation in the U.S. was only 5.6 percent. Even cities showing huge gains in the final years of the housing bubble - including San Diego, Las Vegas, and Washington, D.C. - showed gains slightly above only 7 percent for the 19-year period.

If we adjust these returns for inflation, we end up with real returns on housing in a range of 3-5 percent. Subtract an annual expense ratio of 2 percent, and the return gets pretty thin.

This index is relatively new, and the data ends at the top of the final eight years of the biggest boom in U.S. history. There were periods of rising prices and periods of falling prices, but not a continuous march upward with spectacular returns.

A house is a great place to live. But those who think renting is “throwing money away” should consider that home mortgage interest, maintenance, taxes, and insurance are also “thrown away.”

Having a place to live costs money no matter what you do, and conducting a real evaluation of your local housing market should let you know which one is actually a better value.

Before you start plugging overly optimistic numbers into the rent-buy mortgage calculator, remember that real estate’s past performance may not be indicative of future returns.

SOURCE: Motley Fool