New York Mayor David Dinkins was once urged by his advisors to buy some property in Manhattan. Despite claims that the proposed deal presented an “extraordinary opportunity” for the city, Dinkins declined. “If they’re selling elephants two for a quarter, that’s a great bargain,” he explained. “But only if you have a quarter—and only if you need elephants.”
Stocks are down. Real estate is down even more. With the recent stock market swoon, residential real estate looks inviting: low interest rates, bargain prices. But do you need this elephant?
Assuming you already have a primary residence, there are two reasons to “invest” in a second home. The first reason is that you want a second property (seriously). Many people buy a vacation or rental property; looking at an ocean view or a mountain vista is much more satisfying than looking at a stock certificate. Other people plan to eventually retire to another location. For these types of buyers, real estate may not match the returns of the stock market, but it sure is nice to sit on the deck. In addition, it is potentially an appreciating asset (unlike an expensive car) and provides diversification when owned along with stocks.
The second reason to purchase real estate is to save on estate and inheritance taxes. In our April 2011 newsletter (“The State of Estate Taxes”), we discussed Maryland’s low estate tax exemption of $1 million. Due to this low exemption, some retirees move from Maryland to states with no estate tax or a higher estate tax exemption. If you can afford it, now is a great time to purchase that retirement home for your future change in residency. For a discussion of which states provide income, property, and sales tax breaks, see “Considering Taxes in Retirement Location‘” in our July 2011 newsletter.
Stock Market vs. Real Estate
What about residential real estate as a true investment? Generally, stocks outperform real estate. Over long periods, the stock market returns about 10% annually, while real estate returns 3%.
But pick your period, and the picture can change dramatically. In the 1990s, the stock market clobbered real estate. From 2000 through 2007, real estate clobbered the stock market. Sounds like market timing doesn’t it?
However, the 10% vs. 3% argument leaves out real estate’s biggest advantage: leverage, or the ability to borrow money (mortgage) to make the investment. If you have $100,000 to invest, you can invest it in the stock market. Alternately, you can purchase a $500,000 home ($100,000 cash down payment and a $400,000 mortgage). At the end of one year of historical gains, your real estate investment would be worth $115,000 ($100,000 + ($500,000 x 3%)), and your stock market would be worth $110,000 ($100,000 + 10%). That’s the argument made by those late-night infomercial guys who urge you to invest in real estate.
But the leverage argument leaves out one of real estate’s biggest disadvantages: transaction and holding costs. Owning real estate generates purchasing and selling expenses (taxes, fees, and commissions), mortgage interest, property taxes, insurance, maintenance, and repair bills.
When it comes to investments, there is usually less risk and higher returns with stocks. We like stock investing because it’s inexpensive (most trades cost less than $20) and easy to diversify, and easier to turn into cash. By the way, stocks don’t wake you up in the middle of the night with a leaky toilet.
When we want to invest in real estate, we sometimes use Real Estate Investment Trusts (REITs). We have used REITs for many years to help diversify our clients’ portfolios. REITs are similar to stocks in that they are easily traded and relatively inexpensive investments. In other words, they are liquid assets, but they give you access to real estate, when the outlook for real estate returns is positive.
So, do you want to own a real estate elephant? If you buy a vacation, rental, or retirement home, it should be because you’re going to use it in some way. If you want to invest in real estate but not be an owner, then let’s talk about REITs. Contact me at 410-461-3900 firstname.lastname@example.org.