12/14/14: Stocks or Real Estate – Which is a Better Investment?

In a recent article published by CNBC, famed economist Robert Shiller (yes, that Robert Shiller of the oft-referenced Case-Shiller index) is quoted as saying he thinks stocks are a better investment than real estate over a lifetime.

REALLY???

That’s like kicking a sleeping dog.  

So we got up off the couch and decided to do a show on this topic.

Some might say we’re shills for real estate…but we’ll find out who’s a bigger shiller here.

In the broadcast doghouse for this episode of The Real Estate Guys™ radio show:

  • Your big dog host, Robert Helms
  • His little dog co-host, Russell Gray

So we’re hanging out in our broadcast briefs perusing the news for interesting subject matter…and we see an article by CNBC headlined, “Where to put your cash? A house or a stock?”

Hmmm…that sounds interesting…

The article opens up saying that even though the stock market is at record highs, the government is pushing home ownership to build wealth…and using easy credit to help all those poor, unqualified borrowers.

The author immediately questions the premise by reminding readers of the “catastrophic housing crash of the last decade“…while completely failing to mention the accompanying catastrophic crash of the stock market…but more on that in a moment…

Then the author invokes Nobel Prize-winning economist Robert Shiller who is quoted as saying, “It would be perhaps smarter, if wealth accumulation is your goal, to rent and put money in the stock market, which has historically show much higher returns than the housing market.”

Seriously? Okay, now our hackles are up…

So we keep reading…and discover those comments were made at a Standard & Poor’s conference.  Last time we looked, S&P is mostly about stocks and Wall Street.

Of course, we do a little speaking from time to time, so we know when you’re in someone else’s house, it’s smart to say nice things. We don’t begrudge Mr. Shiller for playing to his audience.

Side note: a few days later, CNBC put out a video where Shiller says, “Go back to buying houses.”  Wow, that was fast. But we know the stock market moves quickly. 😉

Back to our current article…

So the CNBC author says, “Shiller notes that the comparison between stock returns and home value returns is rough, given that stocks pay cash dividends and housing pays ‘in kind’, in the form of housing services; that is, you get to live in the house.”

That VERY important point is quickly set aside in the next paragraph, which compares ONLY the capital gains of the broad stock market since 1890…yes EIGHTEEN NINETY…and Shiller’s own secret recipe (that’s how you win a Nobel Prize) of the “real” U.S. home price index.

There’s SO much here…we’re starting to pant.

The bottom line says Shiller according to the CNBC article…is that the net real capital gains (presumably after being adjusted for inflation) are “smaller than one might expect” (we get that a lot…)

Really? How small?

The article quotes Shiller as saying for stocks it’s about 2.03 percent per year. And houses…only a paltry 33 basis points (about 1/3 of 1%).

Confused? If buying stocks and real estate sucks so badly, why would ANYONE do it?

The perhaps obvious answer is that NOT doing it sucks WORSE.

Think about it. The dollar has lost about 98% of it’s value since the Fed was created in 1913. If you simply stacked up paper dollars, you’d be at a negative 98%. So plus 2%…or even plus 1/3% sounds pretty good by comparison.

So now that we know investing…even spending… is better than cash under the mattress, we’re back to comparing stocks and real estate.

The CNBC article points out that “A house can offer greater returns if the owner chooses to rent it out and not to live in it.” Duh. Welcome to our world.

This highlights a bigger point, which is that when you’re reading a mainstream financial media article on real estate, they almost always are talking about the house you live in.

To the CNBC author’s credit, she mentions that “Shiller adds homes should not be seen as an investment vehicle, like a stock, but as a consumption good, like a car.”

We agree. But, isn’t the entire premise of the article a comparison of the investing in stocks versus real estate? You might want to lead with that next time…

Still, this is a VERY USEFUL exercise for anyone enticed by this record high stock market...and every real estate investor being chastised by their stock investing friends. And ESPECIALLY useful for any real estate entrepreneur who’s out raising money to syndicate real estate deals.

After all, we’re all hearing about how great the stock market is doing. In fact, here’s an amazing chart from the CNBC article:

This shows how the stock market (blue) is crushing housing (red).

Aren’t you impressed?

Do you see the real estate bubble of 2003-2007 and the “catastrophic crash” in 2008? (Pay no attention to those GIGANTIC blue line ups and downs…but since you are…what does the pattern say might be next for stocks???)

The CNBC article concludes with this:

“The happy compromise [between taking the risk of leaving equity in a house whose value might drop and putting the equity to “better” use by investing in the stock market]…would be to keep less equity in your home though a long-term, low-down payment mortgage; or…through an interest only loan, and keep more cash at the ready for investing in the stock market. It’s a riskier choice, given the current volatility in home prices, but it may be the best way to build wealth.”

So NOW we’re on the floor laughing out loud…

Open your eyes. You can now look at the blue line in the chart.

Who’s calling who volatile???

First, before we go ballistic…we must say we LOVE the idea of getting idle equity out of a property to shelter it from that ever-fickle Mr. Market.

And because mortgage interest rates are SO low…you don’t have to be Warren Buffet to out-earn the cost of borrowing…especially when you consider that the interest is tax-deductible.
But stocks? We don’t think so. That chart makes us dizzy…

So we need to do some math. We figure if you’ve read this far, you must be a SERIOUS reader, so you can probably handle it.

We’ll only do enough to help you understand why there’s NO CONTEST when it comes to risk-adjusted returns in real estate versus the stock market.

Ready?  Take a cleansing breath…and…here we go…

First, let’s just say that Shiller is right and the real average annual value increase (capital gain) on housing is 33 basis points per year. We could argue, but he’s a Noble Prize winner. We’re a couple of schmoes with microphones.

What his comments and the CNBC article don’t take into consideration is financing…or better stated…leverage.

So if you were to put 20% down, you’d control five 20% parts of an asset (the property) which is 100% of it. That is, your “capital stack” is 20% cash from you (down payment) and 80% cash from the bank (the loan).

But YOU get 100% of the 33 basis points appreciation. At 5:1 leverage (you have only 20% cash in), YOUR appreciation rate on your cash is 5 x .33 or 1.65%. Nothing to run naked through the streets bragging about, but 5 times better than 33 basis points and a WHOLE lot closer to the 2.03% that Shiller says is the stock market’s history.

Now let’s stop right there.

Go back and look at the roller coaster blue line in the chart. Do you notice that the last low was lower than the prior low? Do you see that the high before this one, was higher than the high before that one? Any guesses on where the next low might be?

Now look at the red line. Looks like a smoother ride.

Would you be willing to give up 38 basis points (that’s the difference between 2.03% and 1.65%) to avoid having your stomach come out your ears?The stock market can be a wild ride

But we’re not done…

Remember that 80% loan? Well, this is a RENTAL property.

That means you have tenants who are paying enough every month to cover ALL the expenses, including the mortgage (and professional property management…because who wants to manage a property?), and a little bit more. If that’s not the case, then you shouldn’t own the property.

Assuming your loan rate is 5% fully amortized for 30 years, the very first loan payment includes a pay down of principal (that increases your net worth on your balance sheet because it reduces your liability…we call it amortized equity) is $96.12 and it goes UP each month from there.

So month 1 is the LOWEST profit rate of the entire 30 years. Make sense?

Math time!

$96.12 x 12 = $1153.44 minimum annual equity build up from amortization

$1153 on a $20,000 cash invested (remember, you only put 20% down) is a growth rate of 5.76% annualized. Add that to your 1.65% of new equity (previous calculation) and you’re up to 7.41%.

See? It’s starting to look better. And it smokes the actual return of the stock market (according to Shiller) and still doesn’t take into account tax breaks or positive cash flow from rents.

So just for fun…can you think of anything you’d rather be doing right now???…let’s add in some net operating income.

Suppose this rental property only provided a modest positive cash flow of about $70 a month net spendable after ALL expenses…including maintenance, turnover, vacancy and set-asides…plus property taxes, insurance, property management, etc.

Is that reasonable?

We think so…and here’s the math (don’t worry, it’s simple!)…

If this $100,000 property is renting for $1000 a month (our 1% rule…and there’s lots of those out there right now) and you budget 50% for all non-mortgage expenses and set-asides, you have $500 a month left for debt-service.

An $80,000 loan at 5% fully-amortized over 30 years gives you a payment of $430.

$1000 rental income less $500 for expenses = $500… less $430 for mortgage = $70.

See?

But $70 x 12 = $840

And $840 return on $20,000 down payment is a 4.7% cash on cash.

So when you put it all in your financial blender and hit puree…your 4.7% cash on cash together with your 5.76% amortized equity and your 1.65% from Shiller’s 33 basis points at 5:1 leverage, you have a total return of 8.11 %.   That sounds a LOT better than 2.03%.

Wow. Now we need a nap.

But take a listen as we take on the challenge of stocks versus real estate. We debate. You decide. Then we can all go have a pint.

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6/15/14: Ask The Guys – The Next Bubble, Green Renters and Global Warming

Real estaIt's time to answer your questions when you Ask The Guyste investing isn’t as simple as it used to be.  At least not judging by the kinds of questions we’re getting from our listeners!

Back in the old days, you just bought a piece of property and rented it out.

Sure, you needed to pick a good neighborhood and tenant, and you’d want to pay attention to interest rates so you could refinance if rates dropped.  But other than that, real estate investing was about as exciting as watching paint dry.

But over the last couple of decades, real estate investors have added things like Fed policy, global warming, mortgage derivatives and currency wars to their list of worries…just to name a few!

That’s why we’re here.

While you’re busy with your nose to the grindstone at your day job…or scouring neighborhoods looking for just the right property to place in your portfolio… The Real Estate Guys™ are traveling the world attending conferences, interviewing experts, touring markets and sitting full lotus meditating on macro factors affecting you and your real estate investing.

In the studio, a trio of posers going to the mat for you:

  • Your guru of gab, host Robert Helms
  • His half-crow co-host, Russell Gray
  • The Godfather of Real Estate, Bob Helms

As always, for this episode of Ask The Guys, we ask Walter to fly down to the mail room and rummage through the email bag for some likely candidates.  We don’t use everything Walter pulls out, which sometimes ruffles his feathers, but it’s always great to have lots to choose from.

So before we dive in to this batch, we invite YOU to add your question to the pile.  Who knows?  Maybe YOUR questions will be selected for the next episode of Ask The Guys.

Should I Accelerate the Payoff of My Loan?

When does it make sense to pay down a mortgage?What a great question!  The short answer is…it depends on your personal investment philosophy, objectives and strategy.

Here’s what we mean:  Paying down the loan is like making an investment.  You’re essentially investing your cash to save the expense of the mortgage.

So if you’re paying down a 5% mortgage, from an ROI perspective, it’s no different than buying a 5% dividend paying stock or making a 5% interest loan to someone else.  Make sense?

Of course, you’ll want to consider other factors like risk, liquidity, tax breaks, control, impact on borrowing power, etc.

Look at the total impact of the loan pay down and compare it to all your other available investment options.  If paying down the loan is the best investment available to advance your goals and fits your investment philosophy, then do it.

We’re guessing you’ll usually find a better investment.

What Metric Can I Use to Know if I Should Keep a Residence as a Rental?

Another great question!  You guys are so smart.

The big two metrics are cash-on-cash and internal or total return.

Cash-on-cash is about how much cash flow you get back each year divided into the amount of cash you put in.

So if you have $10,000 a year coming back to you on $100,000 invested, you have a 10% cash-on-cash return.  Cash-on-cash can be BEFORE tax or AFTER tax.  And it’s usually a good idea to look at both.

Total return takes into account amortization (equity build up from the pay down of the loan) and appreciation (the increase in the value of property over the price your paid).

Of course, you don’t get this until you sell, so these are paper gains (unrealized) until the property is liquidated.  It’s like when the stocks you have in your 401(k) go up in price, but you haven’t sold yet.

In both cases, you simply need to calculate the return on the property you have versus other properties you might buy.  If the current property is better, keep it.  If there’s a better investment, do that.

Of course, you need to take into consideration things like market trend, current interest rates (assuming financing is involved), transactional costs, and the hassle factor…just to name a few.

Will Tenants Pay More for Energy Efficient Properties?

Will tenant's pay more for energy efficient homes?We’re guessing some will.  But we’re also guessing that most won’t.  However, there aren’t any empirical studies that we’re aware of.

So we think that the best thing to do is talk to property managers and leasing agents in the particular market you’re interested in.  Are they getting inquiries for energy efficient properties?  Are any properties in the area energy efficient, and if so, are they commanding extra rent?

Will Global Warming Put Entire Real Estate Markets Underwater?

Wow.  This is a hot topic over which there’s been many heated debates.  Some claim the global warming is a very real threat.  Others say the argument is all wet.

The inconvenient truth is…we’re not qualified to have an opinion.

With that said, the Godfather has heard a lot of claims about both man-made and natural disasters threatening mankind’s economy, well-being and real estate.  In his seven decades of investing experience, nothing much ever came of it.

It;s not that the threats weren’t credible or very scary.  They were!

In the 60’s people were fearful of nuclear war.  Any major U.S.city, especially New York (financial center), Washington DC (government), Detroit (manufacturing…back when we still made things), and other major cities were considered to be on the short list of targets.

And how safe did Florida seem with the threat of nuclear weapons in Cuba?  We’re not sure how long it took real estate prices to rebound in Hiroshima, but we’re guessing it took awhile.

In the 70’s, it was projected the world’s oil reserves would be completely depleted by the year 2000.  A national speed limit of 55 mph was created. Laws were passed mandating fuel efficiency (we sure miss those American muscle cars.  And not only did gas prices skyrocket (we’re sure this didn’t have anything to do with shutting the gold window), but gas supply was rationed.

If the world ran out of oil, the prospects for real estate in Texas and other oil producing regions sure didn’t look good.Is the world running out of time?  Or is there plenty of life and opportunity left for you to invest for the long term?

In the 80’s, AIDS was thought to be on it’s way to a modern day bubonic plague capable of wiping out tens of millions of people…especially in major metros like San Francisco, Los Angeles and New York.  Imagine the impact on real estate prices if there were suddenly tens of millions fewer home owners and renters.

In the 90’s, the world feared the looming click over of the time clocks to the year 2000 would mean the catastrophic failure of the computer systems which ran key communication, transportation, financial and utilities infrastructure.  Think about the impact on rental income and real estate values if entire cities didn’t have power or utilities for weeks or months.

We could go on (and on and on)…but you get the idea.

We’re not making light of any of these threats.  We aren’t smart enough to know how close to the edge mankind really came.

But Simon Black made a great point on his powerful presentation on the 2014 Investor Summit at Sea.  Simon reminded us that in spite of all the problems the world has faced, both real and imagined, that somehow…some way…mankind has figured it out.

So all we can say is that if global warming is real (and we aren’t saying it is or isn’t), if there’s anything mankind can do about it, we’ll do it.

But if you think that the threat is so real and irreversible that it threatens specific geographic regions of the world, then you should adjust your personal investment strategy to avoid those areas.

There are people right now who believe the U.S. dollar is in trouble.  In response, they avoid bonds and bank accounts in favor of real estate and precious metals.  Other people feel the opposite and keep collecting dollars in the bank as quickly as they can.  Only time will tell…

Is Real Estate in a Bubble and is Another Crash Coming?

We don’t know and probably.

The answer to this could fill a book, so we’ll try to keep this short and sweet.

Real estate prices are rising, but wages and employment are not.  However, population is growing and new home construction is inadequate to meet the need.  So while supply is shrinking relative to demand, capacity to pay (incomes and interest rates) aren’t improving.

On top of this, up and down cycles are part and parcel of an economy…because economic activity is a reflection of human psychology.  So when things are good, people become irrationally exuberant and flood the hot investment with too much money.

Then, when everyone has bought all they can (the market is overbought), investors begin to sell to realize their profits.  This slows the upward pressure…or goes as far as to cause prices to fall (what pundits call a “correction”)…and people (being people) hit the panic button and begin to rush to the exits causing an OVER correction.

This “business cycle” of turbulent ups and downs repeats over and and over.

Monetary planners attempt to moderate this turbulence by increasing and decreasing demand.  How? By hindering or empowering capacity to pay via interest rate manipulations (and…perhaps…allegedly…direct market manipulations).

In other words, when interest rates are low, it’s easier to borrow to spend and invest.  When they’re high, it’s harder so less spending and investing happens.

But in spite of best efforts and good intentions, the result of these manipulations is an exaggeration of the natural ebb and flow of the business cycle.  Like a panicked driver fishtailing on an icy road, each attempt to moderate the movement actually exacerbates it.

We think these cycles and manipulations are inevitable.  And attempting to time them to the precise top and bottom is a fool’s game.

Better, we think, to accept them as normal and structure your deals to weather extremes.  In ideal conditions, you might not do as well as a more aggressive investor.  But when things get slippery, you’ll stay in control.  Just like that prudent driver on an icy road is less likely to lose control than the guy who’s only planning on sunny skies and ideal road conditions.

The bottom line is that a real estate bubble is mostly painful for flippers, short term speculators, and over-leveraged holders whose cash flow is too thin to weather a storm.  We know from experience.

Hope for the best.  Plan for reality.  And be patient because in real estate, time not only heals all wounds, but rewards the patient.

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The Real Estate Guys™ radio show and podcast provides real estate investing news, education, training and resources that help real estate investors succeed.