(Un)Real Estate – part 1 of 2

Quite some time ago, I received an interesting email from an ‘insider’ in the real estate finance industry.  His mail is in line with my views on real estate as an investment, but with some disagreements.  I have largely reproduced it here with only some edits to be relevant to the present scenario.  If you are already financially independent from investment properties, this may not apply to you, but vast majority of homeowners and real estate mogul-wannabes face many pitfalls in this route.  Considering the provocative content, I am not disclosing the author’s name until I receive specific permission to publicly disclose it.  There are 15 hard-hitting points on this note so I split the post into two parts.  It is important for all of us to read and think over.  Take it away, Mr. Insider!

Wonder if a house will be a profitable investment?

Real estate related businesses would say yes, but I disagree, because they don’t make money if buyers do not buy. These businesses have a large financial interest in misleading the public about the foolishness of buying a house now. Buyers’ agents get nothing if there is no sale, so they want their clients to buy no matter how bad the deal is, the exact opposite of the buyer’s best interest.   

Agents make billions of dollars each year in commissions from buyers.  Agents claim the seller pays the commission, but always fail to mention that the seller gets that money from the buyer, especially in flat to up markets where eager buyers are available.  There are good buyer’s agents who really believe they are helping the buyer, but they are often in denial about their conflict of interests.

  • Mortgage brokers take a percentage of the loan, so they want buyers to take out the biggest loan possible.
  • Banks get origination fees but sell most mortgages, so they do not care about the potential bankruptcy of borrowers, and will lend far beyond what buyers can afford. Banks sell most loans to Fannie Mae or Freddie Mac. The conversion of low-quality housing debt into “high” quality Fannie Mae debt with the implicit backing of the federal government is the main support for the housing bubble. Even for the “jumbo” loans that banks cannot sell to Fannie Mae and Freddie Mac, they have a motive to lend beyond what buyers can afford. Banks designate interest as “income” whether they receive it or not. As long as borrowers do not actually default, additional interest owed is counted as bank income, and banks can claim higher “earnings”. This is why banks love both a growing real estate market and higher interest rates. Of course, the party ends when those borrowers cannot even make the principal payments.
  • Appraisers are hired by mortgage brokers and banks, so they are going to give the appraisals that brokers and banks want to see, not the truth.
  • Newspapers earn money from advertising placed by realtors, so papers are pressured to publish the realtors’ unrealistic forecasts. Worse, realtors have a near-monopoly on sale price information, and newspaper reporters never ask realtors hard questions like “how do we know you’re not lying about those prices?” The result is an endless stream of stories saying it’s a good time to buy, as if there were some news in hearing salesmen say that you should give them your money. To be optimistic about this market takes a real estate “professional”. Everyone else speaks the truth too clearly.
  • Owners themselves do not want to believe they are going to lose huge amounts of money. What are their arguments?
  1. “Renting is just throwing money away.” FALSE, renting is now much cheaper per month than owning. If you don’t rent, you either:

* Have a mortgage, in which case you are throwing away money on interest, tax, insurance, maintenance (OR)

* Own outright, in which case you are throwing away the extra income you could get by converting your house to cash, investing in capital markets, and renting a place to live.  This extra income could be 50% to 200% beyond rent costs, and for many is enough to retire right now.

Either way, owners LOSE much more money every month than renters. Currently, yearly rents in the Bay Area are about 2% of the cost of buying an equivalent house. This means a house is returning about 2%, and it is a bad investment.  Even investing in a boring local utility giving you safe 3-4% dividends is better.  In effect, landlords are loaning the purchase price of a house to their tenants at a 2% interest rate.

This is a fantastic deal for renters. When it is possible to borrow a million dollar house for 2% yearly rent at the same time a loan of a million dollars in cash costs say, 4% interest, plus 1% property tax, plus 1-2% maintenance, something is clearly broken. I would think every rational businessman would take the extreme discount renters are enjoying.

  1. “There are great tax advantages to owning.” FALSE. The tax advantage is not significant compared to the large monthly loss from owning. For example, it is far cheaper to rent in the San Francisco Bay Area than it is to own that same house, even with the deductibility of mortgage interest figured in. It is possible to rent a good house for $2400/month. That same house may, in many inflated markets, cost about $1 million (2.9% rental yield).

Buying Related Costs Example:  Property Tax: $486 ($729 per month at 1.25% before deduction, $486 lost after deduction.). Interest: $2,333 ($1750 per month at 3% interest before deduction, ~$2000 lost after deduction.)  Other Costs: $450 (Insurance, maintenance, long commute, etc.)  Principal opportunity cost on 20% equity in diversified stock market index: $933 (8% yearly loss on $140K, 20% of $700,000. Reality will be much worse.).  Monthly Outflow: $3600 (for 3% interest rates).

This is a very conservative estimate of the loss from owning per month. If you include a realistic decline in house prices, in some frothy markets, you’ll see that owning right now is a very poor choice. House value losses will stop eventually, but it could take 5 or 10 years to bottom out.  Remember that buyers do not deduct interest from income tax; they deduct interest from taxable income. Interest is paid in real pre-tax dollars that buyers suffered to earn. That money is really entirely gone, even if the buyer didn’t pay income tax on those dollars before spending them on mortgage interest. Of course the creeping AMT will eliminate the mortgage interest deduction soon anyway.  

Get into the guts of tax benefits.

Buyers do not get interest back at tax time. If a buyer gets an income tax refund, that’s just because he overpaid his taxes, giving the government an interest-free loan. The rest of us are grateful.  If you don’t own a house but want to live in one, your choice is to rent a house or rent money to buy a house. To rent money is to take out a loan. A mortgage is a money-rental agreement. House renters take no risk at all, but money-renting owners take on the huge risk of falling house prices, as well as all the costs of repairs, insurance, property taxes, etc.

If you can rent a house for 2% of its price, but have to pay 4% to borrow the equivalent amount of money, it is much cheaper to rent the house than to rent the money.  Then there’s earthquake insurance. It’s really expensive, so most people just skip it and risk everything on the chance that no earthquake will happen.

  1. “A rental house provides good income.” NOT OFTEN.  Rental houses provide very poor income in pricey markets  and certainly cannot cover mortgage payments. In the best case, a $1,000,000 house can be rented out to net $25,000 per year after expenses like property tax and repairs.  The return is therefore 2.5% with no liquidity and a huge risk of loss. If the owner were to sell that rental house for a million dollars, he could get about 6% market return with risk diversification, no work, by buying a broad index fund. And the money would be liquid and portable. That said, there are many parts of the US where it does make sense to buy because mortgage payments are less than rents in those areas. They are generally rural areas away from the coasts, and have not seen the same bubble that the coasts have.
  2. “Future regulation changes to allow 40 and 50 year mortgages will fix everything.” FALSE.  The 40 and 50 year mortgages will probably not be paid back, since a large number of borrowers may die before 40 or 50 years are up.  This makes these loans a bad idea from the lender’s point of view.  It also doesn’t make sense from the borrower’s point of view, since almost of their payment will go to interest for most of the life of the loan. This makes it almost the same as renting – except that it’s 2 or 3 times more expensive! [TFR edit:  Actually, in Switzerland, the mortgage interest rate is 1% or less, and mortgages can be carried till you die, so the asset and the liability both pass on to the heirs!]
  3. “OK, owning is a loss in monthly cash flow, but appreciation will make up for it.” FALSE. Appreciation is negative if you buy at the wrong time. Prices barely match up with inflation, which just adds insult to the monthly injury of crushing mortgage payments.
  4. “House prices never fall.” We pretty much know this is FALSE. The 2008-09 Great Recession proved it in recent times.  Even before, San Francisco house prices dropped 11 percent between 1990 and 1994.  Buyers in SF in 1990 did not break even in dollar amounts until about 1998. So those buyers effectively loaned their money to the sellers for 8 years at no interest, losing all the while to inflation. With inflation, 1990 buyers truly broke even only about the year 2000, ten years after buying.Los Angeles’ average house plummeted 21 percent from 1991 to 1995, and of course there have been many similar crashes all around the US. The worst may have been after the oil bust in the 1980’s, when Colorado condos lost 90% of the value they had at their peak.
  5. “House prices don’t fall to zero like stock prices, so it’s safer to invest in real estate.” MISLEADING. It’s true that house prices do not fall to zero, but your equity in a house can easily fall to zero, and then way past zero into the red. Even a fall of only 5% completely wipes out everyone who has only 10% equity in their house because realtors and other costs of sale will take away 5%. This means that house price crashes are actually worse than stock crashes. Most people have most of their money in their house, and that money is highly leveraged.

Stay tuned for part 2 of 2…

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8 comments on “(Un)Real Estate – part 1 of 2”

  1. By The Money Commando Reply

    I’m actually not worked up at all. I’m just confused (and a little annoyed) by the author’s cherry picking of facts in some cases and total disregard for facts in other cases.

    To be clear, I absolutely agree about leverage. And I’m definitely not saying that real estate is always a great investment, or that it’s necessarily better than the stock market.

    However, the author of the article doesn’t mention any positive aspects of real estate. He mentions that leverage can hurt you…but doesn’t mention that it can help. After all – if you could buy the S&P with 10% down and have NO chance of a margin call for 30 years, wouldn’t you jump on that investment? I would. Over any 30-year period the market has averaged a minimum of over 7.5% (http://www.businessinsider.com/30-year-sp-500-returns-impressive-2016-5).

    Imagine being able to amplify that return 2x or 3x or 5x…

    The thing that annoyed me about the article was that it comes across as a hit piece against real estate. It’s misleading, cites no facts/research, and makes ridiculous statements like “Of course the creeping AMT will eliminate the mortgage interest deduction soon anyway” that are demonstrably false and reflect such a misunderstanding of the tax code that it’s hard to take the rest of the points seriously.

    Again, I just don’t understand the author’s point.
    The Money Commando recently posted…How to calculate if you should pay off your mortgage earlyMy Profile

  2. By The Money Commando Reply

    I’m having a really hard time understanding the basis behind this article. First, there are no facts given to back up the assertions. For example, in “fact” #2 the author states that you can rent a good house in the Bay Area for $2,400. I’d be VERY interested in seeing the author back that claim up with some actual listings. The author is then showing after-tax deductions but never states what the assumed tax rate is or how that tax rate was calculated.

    The author states that owning a house is throwing away money because that money could be making money in the market. The author says “If you can rent a house for 2% of its price, but have to pay 4% to borrow the equivalent amount of money, it is much cheaper to rent the house than to rent the money.” Yes, that’s true, but that’s not counting appreciation of the underlying asset. If

    In “fact” #5, the author says that sometimes the value of houses decreases, and that’s absolutely true. Of course, sometimes the value of stock investments decreases. It would make more sense to make an argument based on long-term trends. For example – why not look at the average rolling 10-year increase in a stock index vs. house prices?

    It took me about 5 minutes to grab some info on US housing prices (https://fred.stlouisfed.org/series/USSTHPI). In 1975 the index was 59.77. In 2017 it was 388.60. Using my handy financial calculator I see that works out to be 4.56%/year. If you’re leveraged (and according to my very brief research online (http://www.thehomestory.com/cash-only-home-sales-declining-but-still-one-third-of-transactions/) about 66% of purchases are financed) then your return on investment would be higher. If you put 20% down then you’d get 5x return on any appreciation, meaning an average of 4.56% appreciation per year results in 22.79% return per year.

    In “fact” #3 the author switches from considering the case where the real estate purchase is financed (as he analyzed in “fact” #1) to purchasing the house with cash.

    Throughout the article the author considers only high-cost areas, like the Bay Area. In high cost areas more of your investment return is appreciation. In low-cost areas a higher percentage of your return is cash-flow. By looking at a high-cost area and then discounting appreciation the author is being intellectually dishonest.

    Finally, many of the arguments are straw men. Does anybody actually believe that “house prices never fall” or “Future regulation changes to allow 40 and 50 year mortgages will fix everything”?

    I can make the same type of ridiculous arguments against investing in the stock market:

    1. “Stock values always go up”
    FALSE – What if you’d invested in Enron? You’d be bankrupt.

    2. “You will be able to live in the same rental unit for the rest of your life”
    FALSE – if the owner wants to live in the rental unit you’ll be kicked out and living on the street.

    3. “Future regulations in the stock market will fix everything”
    FALSE – even after Sarbanes-Oxley there are still stock market investments that lose money

    As somebody who has both stock and real-estate investment I find these types of bombastic, over-the-top hit pieces to be extremely annoying.

    • By TFRadmin Reply

      Boy TMC! The author’s mail certainly seems to have worked you up. I understand and agree with some of your arguments, and as I mentioned in my introductory paragraph in the post, I also have some disagreements with the content – especially a few straw man arguments. I agree that housing is all local – Bay Area is a different animal than Indiana or North Carolina. Yet, factors like leverage work both ways and on that, I entirely agree with the author. The idea of earning leveraged return with just 3-4% appreciation is attractive but that only works over decades like you cited. For holding periods of 10 years or less, the same leverage (say 90%, with just 10% down) could cream you if the sale price was just 5-10% lower than your purchase price of the house. No stock market investment can be held at 10% down like a housing asset can. As Warren Buffett said, the only way a smart person can get screwed in the markets is by using leverage. While I agree his mail cites some extreme examples to make his case, he also makes some valid points and coming from an ‘insider’ who has worked in senior levels in real estate finance, I want to give him some leeway to do that.

      And stay tuned for Part 2 next week – keep your ammo ready 🙂

  3. By lesscode Reply

    All true. The worst financial decision we ever made was buying a house that we didn’t need, in 2005. I remember at the time that realtors would show us multi-million dollar McMansions which were well out of our price range, while promising that they could “get us into that house” with a sweet (interest-only) mortgage deal because the banks were salivating to get as many mortgages as possible crammed into securitized products. We sprung for a modestly sized and priced property and still ended up taking a bath — but we dodged a bullet and could have ended up much worse.

    While it was nice to have some extra space and freedoms, it really wasn’t worth the premium costs of continuing ownership (not least because of ridiculously high property taxes in the tri-state area). Last year we finally were able to sell (for a small loss) after local prices recovered back to pre-2005 levels. Now renting again and not looking back. There are obviously ways to use real estate as an investment, but your primary residence is generally not one of them.
    lesscode recently posted…Docker Support in Visual Studio 2017My Profile

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