The real estate market continues to recover in 2016 thanks to record low interest rates and a strengthening US economy. In some places such as San Francisco and New York City, the recovery has turned into a frenzy where rents are surging and multi-bidding situations are now the norm. As a prodigious wealth builder, it’s important to assess your local real estate environment.
I’m down in the Sunday open house trenches to get a first hand view of what’s going on. I talk to Realtors about their property listing durations, understand why the sellers are selling, and get opinions on the market. You can never fully trust a Realtor because to them, it’s “always a good time to buy or sell property.” By going to open houses yourself, you can at least observe the amount of foot traffic and listen to the enthusiasm or lack thereof.
It should be obvious I’m an advocate of homeownership by now for the following reasons:
1) You have to live somewhere.
2) The homeownership stock is better quality than the rental stock to live.
3) Most people can’t save for poop, so paying down principle is better than poop.
4) Tax shield on income, which is especially helpful for those in higher brackets.
5) The long term trend is always up so long as there is limited land and population growth.
6) You can potentially make a lot of money over time.
7) More control over your lifestyle e.g. never have to move, remodel as you will.
8) Build real assets that can be passed along to your children.
9) Inflation hedge as your mortgage becomes cheaper in real dollars.
10) Inflation play as your asset inflates.
11) The first $250,000 in profits is tax free for singles, $500,000 for couples.
There’s nothing wrong with renting if you don’t have the money, don’t know what to do with your life, have a lot of debt, or are not sure whether you want to live in one place for more than five years. The mobility of being a renter is wonderful, so is the lack of responsibility for property taxes and maintenance. Just know the return on rent is always -100% every month. At least with homeownership, you have a chance of making some money.
This post isn’t about the merits of homeownership. This post discusses how to think about your current living situation and whether it gels with your investment outlook. Remember, the name of the game is passive income, increasing assets, and creating financial freedom.
A RENTER IS NEGATIVE REAL ESTATE
A renter benefits when home prices and rents go down, which is why I say renters are “short” real estate. If rents and home prices go up, renters get “short squeezed” as they have to pay more of their disposable income on rent, a downpayment, and a mortgage. The concept is the same with the stock market. If you short Apple stock at $520, it means you believe you can buy back the stock at a lower price and pocket the different. If Apple rebounds to $600, you may have to buy back the stock at $600 and lose $80 a share.
With inflation, population growth, QE3, QE4, QE Infinity, and limited land, the natural trajectory is “up and to the right” for rent and housing prices. Housing costs are a key component of inflation and something we must all pay in some way or another. A renter is a price taker, just like a car driver is a price taker of gasoline. As a renter, you may actually not want rents to drop because that signifies a weakening economy.
If you are still renting 40 years from now, you won’t have a place to live rent-free in retirement, nor will you have an accumulated asset you can pass down or draw from. Like gasoline and tuition, the rent you pay now will undoubtedly be much higher when you become a senor citizen. Don’t believe me? Just ask your parents or grandparents what they were paying in rent during their working days.
A ONE PROPERTY HOMEOWNER IS NEUTRAL REAL ESTATE
When it comes to investing, everything is relative. Given you have to live somewhere, if you live in your home, you are neutral on real estate. If the market goes up, your house value goes up, but it doesn’t matter because you aren’t selling. You can take out a home equity line of credit to buy a Porsche 911 Turbo instead of a Honda Accord, but that’s not very wise.
Let’s say your $500,000 home appreciates by 20% to $600,000 over 10 years. You put 20% down ($100,000) and now your equity is worth $200,000 for a 100% increase. Awesome! But the house you want to upgrade to now costs $1 million from $800,000, because it too has gone up! The only thing that allows you to purchase more house is not your own home equity, but your savings and investments.
On the other hand, if you want to downsize from a $1 million dollar house to a $600,000 house, you have benefitted more financially if you are OK with the downgrade. You made $200,000 ($800,000 to $1 million) and only have to put $120,000 down on a $600,000 house. You therefore bank the $80,000 and pay a smaller $480,000 mortgage if you are fine with simpler living. As a homeowner, you are in a neutral positive situation.
On the flip side, if your $500,000 home loses 20% of its value to $400,000, you’re not really affected either because you aren’t moving anywhere unless you can’t afford the payments. Interestingly, that $1 million dollar house you’ve been eyeing may have also lost 20% of its value down to $800,000. You no longer have to put $200,000 down and take out a $800,000 if you want to move up. You can now put $160,000 down and assume a $640,000 mortgage instead! In a declining market, those who have the financial means to “upgrade” are the ones who benefit.
As a one property homeowner, you’re like a small boat who happily floats along the rolling waves. Unless you are easily susceptible to sea sickness, the movements don’t really matter.
A MULTI-PROPERTY OWNER IS BULLISH ON REAL ESTATE
The only way to really benefit from a real estate recovery is to buy more than one property. When the markets are hot, you can raise the rent or sell the property to realize a gain. If you only own one property that you live in, you can’t do much at all except for downsize.
Why do you think there are countless examples of real estate magnets like Li Ka Shing, Sam Zell, and Donald Trump? They made their money (and lost some as well) through buying multiple properties on debt. Many have also gone bust buying at the wrong time, being over levered, and not holding on long enough. Over the long run, property has proven to be a consistent wealth builder for so many.
To recap, the point of this post is to get you thinking about how your outlook on housing and the economy fits with your current living situation. If you are very negative on housing, then owning multiple properties doesn’t make sense. If you believe there will be a multi-year housing market recovery like I do, renting doesn’t make sense because you’ll get squeezed. Rental yields are much higher than mortgage rates, which makes for an instant positive carry while you wait for capital appreciation.
Make sure your living situation is congruent with your real estate investor beliefs. Live the way you believe and everything will fall into place over time.
RECOMMENDATIONS TO BUILD WEALTH
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Updated for 2016 and beyond.