Sunday, September 25, 2005

Investing in Real Estate

I've been trying to figure out how to start talking about Real Estate without losing any audience I might have. I will start out by talking about the reasons to believe that the returns are higher and more reliable than other investments. As I go, I'm going to have to note various topics that I'll address later. I expect you to be sceptical, because I was too, at first. But the promised gains were good enough that it was worth setting the scepticism aside long enough to look at the evidence. The evidence was good enough that Janet and I have been taking classes and reading books for the last year and a half, and have been buying real estate over the last six months. We now have tenants in Phoenix, and our property there has increased in value by about the amount that it cost us to purchase it.

Real Estate Returns

Real Estate investors expect returns of 12% per year, minimum, not counting serious calamities, and not accounting for (often expected) supernormal returns due to rapid appreciation. Unlike stock market investments, you can investigate the recent performance of an investment, and then expect to reach that metric reliably. Some of the reasons that real estate returns are reliable are (compare these to stocks market investments or running your own business)

  • you can get insurance to cover property losses;
  • you can look up rental rates and vacancy rates before you buy
  • tenant don't like to move; most of the time they just keep paying the rent
  • the bank initially owns 80%; they verify that the property is worth the price

One of the main reasons that real estate returns exceed other investments are that individual investors are in competition with businesses and institutional money (REITs, for example) for properties, which sets the returns, but individuals can get bank loans with 10 or 20 percent down, which multiplies your expected returns by five or ten. In addition, the government insists that you account for your property as if it's losing value every year, and gives you a tax deduction for the depreciation even though the value is usually increasing.

The bottom line is that it's not hard to find investment properties for which the rental income will be within a hundred dollars plus or minus of covering all your expenses, including the mortgage. So you gain equity even before you take appreciation into account. And appreciation is pretty reliable--there are few areas where annual appreciation changes much from year to year. The worst historical cases that I know of were times when housing prices dropped 10 or 20 percent. And it's much more common that appreciation rates change by only a little bit in any locality from year to year.

Much more commonly (though not at all common), homeowners get upset about a crash of their local market because appreciation drops from double digits to single digits, or goes slightly negative. But if you are an investor, you can liquidate, accept a minor loss on top of the gain you've earned over some number of years, and reinvest somewhere where appreciation continues. Or just wait it out while the renters continue to fund your equity and the market recovers. The renters who funded the run-up still need a place to live, so prices and investment income don't fall by much.

Here is a list of some topics that I ignored in order to get started.

  • Bubble Babble, and why it doesn't bother investors
  • Bay Area real estate (buy your own home if you can, but don't invest here)
  • "Risky" loans (manage your mortgage; if equity increases faster than debt, you're ahead)
  • Resources for learning more about Real Estate
  • Resources for investigating properties and markets

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