Is Real Estate Really an Investment?

Part III 

The Beauty of Leverage and “The American Dream” 

Their Effects on Investment Real Estate Return 

In the final segment of the investigation to determine whether the S&P 500 Index or purchasing real estate is a better investment, we will examine and quantify how leverage and The America Dream benefit real estate investment returns.

In the case of equity investment in a group of stocks or mutual funds in the S&P 500 Index, the return percentage is based on and investment/return ratio of one to one.  This means that if a person invests $500,000 in a stock portfolio gain and loss will be measured against this investment total.  For example, if after year one the stock investor’s portfolio total is $550,000 the investor gained (pre-tax) about $50,000 (ignoring broker/trading fee’s).  This percentage return is measured as the gain divided by the investment (i.e. $50,000/$500,000) which is equal to ten (10%) percent.  In order to gain $50,000 the investor needed to risk $500,000 which is a one to one investment to return ratio.  There is no leverage available in this style of investment and the owner’s entire cash position is at risk.

In the case of investment real estate, leverage works to the benefit of the owner to allow the owner to realize the same gain with less exposure.  For example, if the selling price of a second home was $500,000, the owner in most cases would typically place a down payment of twenty (20%) percent equal to $100,000, and the rest would be financed via a mortgage vehicle.  If after year one, the property appreciated ten (10%) percent to $550,000, and was sold, the owner would realize a gain of about $50,000 (ignoring broker/closing fees), which is the same as the stock investment above. 

The critical distinction is that the real estate investor was able to gain $50,000 on his cash outlay of $100,000 versus the stock investment of $500,000.  This means that instead of a ten (10%) return like the stock investment, the real estate owner’s percentage gain on his investment (downpayment) is 50% or 500% percent higher than the stock gain…even though it is the same money gained. 

The reason this is true due to the beauty of leverage.  Although both investments produced the same monetary gain, the real estate gain was achieved by 1/5^th of the actual cash amount exposed and at risk.  Leverage enables real estate owners to realize appreciation gains on the sales price of the property, with only 20% actual invested exposure versus the 100% exposure of the S&P 500 Index stock portfolio.  Because of leverage real estate owners are in a position to realize larger gains with less risk exposure over the long term.

The American Dream

Demographics & The Desire to Own and Benefit from Real Estate  

For decades many have considered home ownership to be the true American Dream.  People need a reasonable place to live, raise their families, and call home.  To have the opportunity to actually own a home and call it theirs is something that most aspire to achieve.  Over time, the percentage of home owners in the United States has grown consistently.  Continued rises in population and low interest rates have spurred insatiable demand for real estate ownership.  People have been achieving their dream and owning homes at growing and record levels. 

Some of this growth was unfortunately helped along by unsustainable creative financing, undisciplined lending standards which caused some people that weren’t financially ready to own the types of homes they were able to afford in the short term with the creative financing (i.e. subprime), as well as others like speculators, to suffer the consequences of a market correction. 

All markets correct and they need to.  No market goes straight up.  All markets go up and they go down and the real estate market is no different.  As shown by the chart in Part I, over time the real estate market has peaked, corrected, bottomed and then made new highs.  And it will again. 

In the long term, the demographics and the desire to own the best real estate possible have not changed. In 2008, we live in a time of continued global population expansion, an aging baby-boomer generation, and increased Non-US investment into global real estate.  People desire and will continue to desire second/investment homes in the finest places in the world for life experiences, income, tax incentives and long term value. 

Conclusion

Is the S&P 500 Index or Real Estate the Better Investment?

In summary, due to ultra-negative market sentiment currently surrounding real estate, it was proper to return to the basics, examine historical facts, and compare whether the S&P 500 Index or real estate is the better long term investment.  For many reasons demonstrated in detail in this exercise it is clear that the better investment for one’s hard earned financial resources is real estate, preferably the finest real estate in the most exclusive locations possible. 

Real estate is the better investment for the following reasons:

1.)     Return Consistency:  As detailed in Part 1, the S&P 500 Index over the past fifty years has averaged a return of 10.99% versus 6.67% annual average for real estate.  However, the S&P Index’s gain has been very sporadic and often +/- 20% of the average return.  If your money isn’t in the right place on the right days, the gain could be reduced or missed entirely.  Real estate investment returns, although on the surface appear less, are much more consistent and achievable.

2.)     Tax Advantages: Owning real estate has numerous tax benefits.  Many components of ownership can be taken as income tax deductions, which can lower the “taxable” income of the homeowner and the amount needed to be paid to the government annually.  This advantage is not present with gains in the S&P Index where gains are taxes at least as income.

3.)      Leverage: As detailed in Part III, real estate investors can produce higher percentage returns with less exposure due to leverage.  Leverage is not available in most equity portfolios invested in the S&P Index, where the investment/return ratio is one to one.

4.)      Demographics:  Over the longer term, the desire to own real estate has proven to be insatiable.  Favorable demographics that include an ever increasing population, an aging baby-boomer generation, and increased Non-US investment in global real estate.  These trends will continue and will drive the demand side of the curve for decades to come.

Is Real Estate Really an Investment?

Part II

How income tax deductions benefit real estate investment return

Although we are not tax law professionals and recommend that all questions concerning income tax deductions are best referred to an experienced tax expert; it is important to understand the mechanics of real estate income tax deductions and how they affect the comparison between which investment return is better: the S&P 500 Index or real estate.  Additionally, how each investment may benefit your specific financial position.

In many countries, including the United States, one is able to deduct the cost of numerous second home ownership necessities.  In basic terms, taking a tax deduction against your income means that you are able to subtract the amount of paid mortgage interest from your income, which reduces your “taxable” income, and more importantly the amount that you may owe to the government annually.  Depending on the method of ownership, in most instances, the following components are considered deductable: mortgage interest, property taxes, maintenance/repairs, expenses, and depreciation.  However, monies received through any rentals are considered income and need to be claimed as such.  The ability to claim these components as income tax deductions can lessen your financial responsibility to the government.  The best way to illustrate the benefits of tax deductions is through a short example.

Investment Home Price: $300,000

Down payment: $60,000 (20%)

Mortgage Amount: $240,000

Interest Rate: 6%; 30 year fixed rate mortgage 

Monthly Estimated Carry Cost:

Mortgage: $1440/mth (Principal and Interest)

Taxes: $400/mth (Estimated)

Insurance: $75/mth (Estimated)

Total: $1,915/mth

Possible Tax Deductions:

$14,400 (1^st Year Mortgage Interest) = $240,000 * 6%

$ 4,800 (Estimated Property Taxes)

$ 3,000 (Estimated Maintenance/Repairs)  (i.e. Painting/Carpet/Landscape/Other)

$ 3,000 (Estimated Expenses) (i.e. Advertising, Utilities, Insurance, Phone, Mileage)

$ 8,727 (Estimated Depreciation) (Depreciated over 27.5 years) (i.e. $240,000/27.5 = $8,727/yr)

Total Deductions: $33,927 * 33% (tax bracket) = $11,295 of Possible Income Tax Savings.  This number could be more of less depending on each owner’s tax bracket.

Estimated Rental Income = $2,500/mth = $30,000 Income added to owners income

The above example shows that the owner in this situation paid about $22,980 to carry the investment property for one year.  It was rented to an interested party at $2,500 per month which totaled an annual rental income of $30,000.  In addition, the owner took $33,927 in income tax deductions.  Depending on country/state laws and how tax experts prepared the filing, the owner is in a great financial position because (s)he spent $22,980 in real dollars to receive $30,000 income and is able to deduct expenses of almost $34,000 which is an advantage to the owner all the way around.  Depending on how the gains and deductions are taken, this situation could result in a double digit (11.7%) cash return on down payment (i.e. ($30k-$22,980)/$60k = 11.7%) or the above discussed $11,295 tax income savings which is an 18.83% return on the $60k downpayment.  Either way, the taxable income position of the owner has been advantaged significantly.

The purpose of the above example is to show that, unlike the S&P 500 Index in which all gains are taxed as income, the return on real estate is more than just an absolute 6.67% average annual gain. (Based upon the average selling price of houses over the last fifty (50) years).  The ability to realize the benefits of income tax deductions on real estate ownership is critical to recognize and include when considering the real return on a real estate investment. 

Please read Part III: Is Real Estate Really an Investment in which we examine the benefits of demographics and "The American Dream" on real estate return, summarize the entire research project, and make a final determination of which investment, (real esate or the S&P 500 Index), is better for long term investment return.

Toll Brothers Releases 2Q2008 Market Status

A Sign of Real Estate Market Progress?

On May 13, 2008 Toll Brothers, the nation’s leading luxury home builder, reported second quarter 2008 and six month totals for home building revenues, contracts, and backlog for the period ended April 30^th 2008.  The results were preliminary and unaudited and will be certified with the actual 2Q2008 earnings release scheduled for June 3^rd 2008.

It isn’t news that the numbers were terrible.  There are more than a couple reasons that Toll Brothers could blame for their poor performance.  What is important is Toll Brothers outlook for the sector and market overall.  The financial performance of Toll Brothers is an excellent indicator of the overall health of the primary residential real estate market because of their size and scale of operations.  Toll is currently building developments in many parts of the country including some of the most beleaguered zip codes. 

Jim Cramer, famed host of the TV show Mad Money on CNBC, aired an interview with Robert Toll, CEO of Toll Brothers the week of 5/13/08.  In this interview Robert Toll gave a candid summary report card of how Toll developments are doing across the board in the United States.  He commented how traffic is down and if it were a school report card it would be one, “in which you would talk to you child upstairs for a couple of hours, and then come down and have a stiff drink.  Most developments would receive a grade of F, F+, F- .”  These comments come as no surprise as the media has been very clear and consistent in highlighting all of the real estate market negativity. 

Robert Toll went on to make one very important statement; He commented that one area actually has seemed to turn a bit.  To the surprise of many people, Toll commented that in Naples, Florida they have actually been able to RAISE PRICES!   Toll stated, “One year ago in Naples, Florida we (Toll Brothers) were unable to give a house away, no matter what the price.  People were walking away from their deals and forgoing their deposits because they didn’t want the homes.  Although we (Toll) kept their deposits we were left with tons of finished inventory and unsold houses.  Since that time, most if not all of the inventory has been worked off and we have now raised prices commensurate with demand.” (CNBC, 2008)

The reason this is an interesting event is because Naples, Florida was one of the first and hardest hit locations in the country during this recent real estate market downturn.  The blood was in the streets and it appeared that even if you gave the homes away, nobody wanted them.   It seems as though this now may be changing, at least in this one particular location.  Does price increases in Naples, Florida indicate the bottom of the entire real estate market, and from here all will go up as desired?  Probably not, but what it does show is progress and a light at the end of the tunnel. 

We felt it important to share Mr. Toll’s sentiment with you as it is easy to lose sight of progress amidst piles and piles of daily negativity.  As a real estate investor it is critical to gauge negativity levels in investment marketplaces as many people have had more long term success buying quality real estate assets at the time when nobody else wants them.  Making money “following the herd” and mimicking what everyone else is doing is often harder than taking strategic, long term positions in historically strong markets which will eventually re-surface.  We urge you to look for small signs of progress in negative markets because one day the negativity will stop and reverse.  We don’t want our clients to be among those trying to “time” the market and getting caught off guard, unprepared, and back in the undesirable position of trying to make money chasing an up market once again.  For more information or questions please visit us at http://www.legacyresortconsulting.com

Real Estate: The Forgotten Asset

It seems lately, every article and interview features reports and numbers demonstrating declining existing home values, declining new home sales, declining investment property prices, abandoned projects and doom & gloom for the real estate sector with no turn in site.

The continued beating delivered by the iron hand of a severe credit crisis, a “subprime” mortgage meltdown, as well as  a new batch of CDO’s, SIV’s and mortgage backed securities seem to blow up a different financial institution every day…..Bear Stern’s style.   

The real estate market sentiment for both primary homes as well as investment properties have gotten so negative that it feels like our houses lose value every moment.  The more deeply affected market segments are portrayed as abandoned waste lands in which nobody wants to own a home, even if it was given to them.  The current situation seems grim, and makes one wonder if anyone in the United States will consider owning a piece of real estate ever again.

For in the end, perspective and reason trump panic and irrationality, especially when related to finance.  Nobody ever made money by panicking!

Part 1: The S&P 500 Index vs. Real Estate

Which is the better investment?

The S&P 500 Index is widely considered by investment professionals to be a true indication of equity (stock) market performance because it contains 500 stocks of companies that are suppose to best represent the current architecture of the US economy.  The S&P 500 Index is often considered the benchmark against which alternative investments, as well as, the performance of investment professionals are measured.

According to Moody’s and Morningstar over the past fifty (50) years, since approximately 1958, the S&P 500 Index has yielded an average annual return of 10.99%.  This is a healthy return that has been delivered in a very erratic fashion.  Sixty-four (64%) of the time the return was at least 10% higher or lower than the average annual return.  This means that roughly two out of every three years, the annual return was about 0% OR 20%.  Markets that trade erratically in this fashion can be very exciting and opportunistic for trained professionals and “market-makers” on Wall Street, but scary for the average investor.  If one was not fortunate enough to have their money invested for the good years…or really the good days within the year, the majority of these opportunities could have been missed, depleting the investments ability to produce a reasonable return for the accepted risk.

On the other hand, please see the below chart that shows average housing prices from (1964 – 2005) according to public data supplied by the Census Bureau.  Note: Raw data numbers for 2006 and 2007 were not included in the following because only estimates were available at the time of publishing.  The chart shows the average house price in 1964 of $20,500 rising to a staggering $297,000 in 2005.  Over the measured forty-three (43) year time period the accumulated return is about 287% which is an average annual return of 6.67%.  Not too bad for doing nothing but living in your house for awhile (and paying the mortgage and taxes of course).    

 At first glance it appears that the 10.99% average annual return of the S&P 500 Index is a much better place to invest one’s hard earned money than the 6.67% annual average real estate return.  However, although slower to grow over time, real estate growth was much less erratic and had far fewer instances of inconsistent and/or negative growth.  This means that the home owner would have the opportunity over a long period of time to realize and experience the gain versus the gain that may have been missed in the equity markets if not perfectly timed.

The average annual gain from the S&P 500 Index versus the average real estate gain is lessened and rationalized more when the phenomenon of leverage, tax benefits, and tangibility are examined and applied.  In part two and part 3 of this series we will introduce and examine these critical elements and their impact on the average rates of return. 

Until these critical elements are broken down and factored into the average real estate return numbers, it remains unclear at this time which is a better investment option. 

Please  read Part 2 of The S&P Index versus Real Estate; Which is the Better Investment,  in which we will continue this analysis, and break down the property return advantages with respect to leverage, taxes, and tangible assets to see how it affects rate of  real estate investment return.      

Welcome to Legacy Resort Consulting, your “one-stop-shop” for new construction resort real estate.  Please check back over the coming weeks for insights into Investment Real Estate. Topics such as the following and many more will be analyzed and discussed.

Is Real Estate really an investment?

What components are critical to the success of a real estate development?

What regions and countries are the most popular places to own real estate and why?

Thank you for investing the time out of your day to contact us. 

Why do I search endlessly for the “right” real estate investment without knowing if I’ve found the one that best suits my needs?

Why do I have to make dozens of phone calls to request information on project after project, when in the end they really aren’t what I am looking for?

Why has the onus of research and discovery been put on my shoulders in the first place?

Making an informed decision takes much time and due diligence.

Is this development right for me? Being told every opportunity is perfect for your needs by sales people is frustrating. Do they truly understand your goals?

Be nimble. Too much information, too many projects, and likely few opportunities are perfect for you. Recognize your opportunities and go after them, before they are sold out!

Legacy Resort Consulting (LRC) has changed the paradigm of how new construction resort real estate is sold. We will eliminate your frustration, and work tirelessly to find your perfect real estate opportunity.

Our licensed consultants are dedicated to helping you evaluate and purchase your paradise based on your needs, your goals and your desires. LRC represents the finest investment real estate in and around the United States, in all ownership forms including full residence, condo/hotel, and fractional. LRC bridges the gap between resort developments and those that want to own them.