Ask DWM: Should We Invest in Real Estate?

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Great question.

 

Let’s start with some basic concepts.  Real estate is an illiquid investment. You can’t buy or sell it in a day or two like liquid investments. It is somewhat uncorrelated to the stock market returns- which is good.  While it is smart to consider adding real estate as a portion of your overall investment portfolio, you don’t want to have too much in illiquid investments. We suggest a rule of thumb is that real estate, excluding your house, should be at the very most 40% of your overall investment portfolio.  So, if your investment portfolio (both liquid and illiquid) is $1 million, real estate should at most be $400k.

Location. Location. Location. Appreciation in value over time is key. This will impact the ultimate sales price when you sell your investment property and the rental income amounts while you hold it. Historically, US real estate has increased, on average, about 3% per year, similar to inflation. However, location can produce tremendous differences. Charleston real estate has done very well in the last ten years, though some areas of the Lowcountry haven’t done so well. Chicago’s market overall has been flat for the last ten years, yet there are areas that have done very well and areas in the suburbs that have lost significant value.  Investing in a piece of real estate is not like buying shares in an S&P 500 index, where your investment will rise as the market will rise. Rather it is a singular investment in one piece of property, subject to both the general market risks and the specific risks of the property.

Would you be prepared to self-manage the investment property? Do you have the skills, time and patience to handle phone calls or texts, perhaps in the middle of night, from an upset tenant?   If you decide to have someone else do the property management, it won’t be cheap- likely 10% of your rental income.

Let’s look at the key metric- your likely return on investment. We start by calculating the “net operating income” (“NOI”), which is the cash flow of the property, assuming there is no financing, and compare this to the purchase price.  For example, let’s say you think you can buy a property for $500,000 that will rent for $3,000 per month. You need to include an amount for estimated vacancies/rental commissions- let’s use 8%. So, the hypothetical annual net rent would be $33,120. Now, let’s look at expenses- taxes might be ½% to 1% or more of the property value. There may be homeowner association fees and/or repair costs. And, there will be insurance-perhaps an amount equal to the real estate taxes. Just for simplicity, let’s say all of those expenses combined are 1 ½% of the value of the property. Based on a $500,000 property, expenses might be $7,500, assuming you do the property management yourself. Therefore, in this example, NOI would be $25,620 ($33,120-$7,500) or 5% of the investment.

The hypothetical total return on the investment is NOI + expected appreciation. Let’s say this property would be sold in 6 years for $650,000. Assuming you sell it using a broker, there would be a 6% commission. So, net proceeds of $610,000. This would represent a 3.5% annual appreciation on the property. Therefore, your total expected return in this example would be 8.5% (5% net operating income + 3.5% appreciation).

We haven’t talked yet about financing and taxes. If you get a loan at less than your NOI (5% in our example), your total return will increase slightly as you are benefitting from leveraging. If the rate is higher than NOI, the total return would be a little less. Depreciation is a non-cash expense that can reduce the taxable income on the property during your ownership. Any depreciation taken has to be “recaptured” (given back) when you sell the property. Depending on your personal circumstances, you may be able to take losses on rental property and you may be eligible for a 20% Qualified Business Income Deduction. Financing and taxes are generally not the key determining factors in deciding to buy the property, but may have some impact on the total return.

We generally suggest a minimum threshold for expected total return on real estate investments to be 9% or more. If a balanced liquid investment portfolio is expected, over a long-term, to have a total return of 5-7% net of fees, a real estate investment should be at least 3% more. Real estate investments are illiquid, riskier (due to lack of diversification) and, if you self-manage, will require time, skill and patience.

Under the right circumstances, investment real estate can be a nice addition for a portion of your investment portfolio. At DWM, we are very familiar with real estate. We understand the pluses and minuses for a portion of your investment assets. In 50 years of marriage, Elise and I have purchased and sold over 40 properties, some of which were our home and some were investment properties. Real estate investment has helped increase our income and net worth.

If you think you might like to invest in real estate, or, if you already own real estate and wonder if you should be adding more or subtracting some or all of it, give us a call. Once you’ve assembled all the facts (cost, income, expense, appreciation), we’re happy to help you review the NOI and total return and discuss how investment real estate fits into your overall investment strategy. We don’t do property valuations and we certainly can’t guarantee your future results, yet we’re happy to provide competent, independent and valuable input as you determine whether or not you should invest in real estate.

 

 

 

 

 

U.S. Housing Market: Not Hot Everywhere

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Zillow just reported that the U.S. Housing Market is up 49% overall since 2012. That’s roughly 6% per year in that time period-though, to be fair, 2012 was when the housing market hit bottom after the 2008-2009 financial crisis. The U.S. Housing Market is huge- $33 trillion (“T”). It’s larger than the value of all U.S. stocks and is about equal to the Gross Domestic Products (GDPs) of the U.S. ($19T), China ($12T) and Canada ($2T). Commercial real estate, including retail, hotels, office buildings, apartment buildings and industrial is about $6T.

The U.S. housing market has had some big winners and some big losers in the last 7 years. Almost 1/3 of the gain of $11T since 2012 has occurred in California. Four of the country’s 10 most valuable markets are in California; LA (5% increase in value in 2018), San Francisco (9.6% increase), San Jose (10% increase) and San Diego (3% increase). New York Metro itself has $3T of housing. The Washington, D.C. metro housing is worth $900 billion. DC itself has more housing value than 40 states, including Colorado, Arizona, Ohio and Oregon.

Unfortunately, housing in some areas hasn’t done so well. Illinois has many state-specific issues which makes it one of the worst housing markets areas. In fact, among the nation’s top 100 metro areas, Chicago is expected to be the weakest housing market of them all in 2019. With mortgage interest rates possibly causing a likely national homes sales slowdown of 2% in the U.S. in 2019, Chicago metro, including Naperville and Elgin, is expected to have an 8% decline in home sales this year. Taxes are a big problem in Illinois. Illinois homeowners are subject to the highest overall tax burden in the country, including the second highest property taxes in the U.S. Since 1996, Illinois property taxes have grown 43% faster than home values and 76% faster than home values in Cook County (Chicago). Worse yet, less than 50% of the tax increases have gone to pay for services. Most of the increase has gone for teacher and other governmental pensions and debt service on bonds.

In 2017, Illinois raised income taxes- the largest permanent state hike in history. Add in a sluggish state economy and outbound migration and the Illinois housing market is hurting. Even so, the Illinois Association of Realtors expects the median value of houses in IL to rise in 2019 by 4%, to roughly $196,000 for the state and $241,000 for Chicago.

The Lowcountry in SC is faring much better. Charleston Metro is now home to 700,000 people. Ongoing job growth means continued housing demand. The median home value in Charleston is now about $320,000 and Charleston home values went up 8% in 2018. The forecast for 2019 is 3% growth. Buyers outnumber sellers. A typical home in Charleston receives only one offer. However, homes sell for only 3% less of the listing price on average with 73 days on the market.

Charleston has many reasons for its housing growth:

  • A booming job market with an unemployment rate under 3% and one of the least unionized states in the nation
  • Wages are low
  • South Carolina’s overall tax burden is among the lowest, particularly for retirees.
  • Huge Tourism industry including being the most sought after wedding destination in the country
  • Home Appreciation is strong- 31% over the last 10 years

Overall, the U.S. Housing market is strong for now. Many winners, but some losers. Mortgage rates, after jumping to 5% and more on 30 year mortgages just a few months ago, are now down in the low 4% range. If they stay there, 2019 could be a pretty good year again for the U.S. Housing Market. But, with many areas coming off a strong run overall the last several years, a cool-down on housing prices wouldn’t be surprising. We’ll continue to watch how the events unfold and keep our clients and readers informed as conditions warrant.