Real Estate as an Investment

If 2008 taught us anything, it’s that real estate doesn’t always go up. Many people seem to prefer investing in real estate, rather than stocks and bonds. One of the reasons they would have given before 2008 is that real estate doesn’t go down. Further reasons include the face that real estate is tangible (you can touch it), you can insure the value, so it won’t go to zero, and real estate is familiar, since most people live in a house or property of some sort. So let’s see how real estate investment works.

Residential real estate seems to be a speculative investment. Rent generally doesn’t cover the cost of the mortgage payments as well as maintenance. Therefore, making money in real estate requires an increase in market value. Historically, real estate prices have increased in line with inflation. Some properties have increased faster, as demand increases, for example desirable neighbourhoods in large cities. Normally, to benefit from the increase in value, people who buy real estate use a mortgage to leverage the growth. A house that increases in value by 10% over five years wouldn’t provide an acceptable return to most investors. But with a mortgage at 75% loan-to-value, the return on equity would be 40% (or 7.5% per year)

House prices tend to move inversely to interest rates, precisely because almost all purchasers use a mortgage. As mortgage interest rates drop, a larger and larger mortgage will produce the same payment (including interest). For example, at 8%, $1000 might be the monthly payment on $130,000, whereas at 4% the same $1000 might be the monthly payment on $260,000. As people are able to qualify for a larger mortgage, demand for houses increases, pushing the prices up.

In the early 1980s, interest rates peaked around 15%. Over the course of the following decade, as interest rates fell, house prices increased. During the 1990s, house prices continued to rise, but at a slower rate. In 1999 and 2000, interest rates rose as the tech bubble formed. In the aftermath of the market crash and 9/11 interest rates were brought close to zero. From 2001 to 2006, during a period of low interest rates, real estate prices rose quickly. But it couldn’t last and when interest rates started to rise and the economy started to shed jobs, house prices tumbled.

Canada didn’t experience the same volatility as the United States because there are two major difference to real estate investment in Canada versus the United States. First, mortgage interest in the U.S. is tax deductible. This means that many people will buy the biggest house they can afford, in order to benefit from the tax deduction of the interest each year. This works fine as long as their income doesn’t drop or, worse, stop during a period of unemployment. Second, in the U.S., realised capital gains can be deferred on real estate as long as it is reinvested in other real estate. This causes turnover of real estate to be lower in Canada, in order to avoid tax leakage.

Real estate can be a good investment. It may provide a hedge against inflation, given that, over the logn-term, prices rise about in line with the cost of other goods and services. Mortgage payments are usually structured in such a way that each payment includes some repayment of principal. This is a form of forced savings, causing the owner to save more and spend less. This explains why interest-only mortgage payments are aggressive. Finally, we all need somewhere to live. As long as your home provide real lifestyle benefits (such as access to family, friends and community resources, such as schools), it may be more valuable than only the financial growth.

Real estate can be a good investment, but it is not a sure thing. The value tends to move inversely to interest rates, so the best strategy would be to buy when affordability is low and there is little competition. The investor would need to be able to afford high interest rates and benefit from interest rates falling, increasing demand for, and prices of, housing.

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