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 1/5th 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.