The Reality of Real Estate Investing

There are people who have made successful careers - even fortunes - out of real estate investing. However, when you hear breathless pitches for get-rich-quick schemes based on "flipping" houses, the best words of advice are "buyer beware."

Looking at historical real estate price data and 30-year fixed mortgage rate data, the numbers show that making money in real estate over the past quarter century has been a tough game, and one in which the odds were stacked against investors. If you are to tackle this challenge, you need to consider some points which may improve your odds of success.

Returns on home prices

The S&P/Case-Shiller Home Price Indices include a 10-city composite that goes back to the beginning of 1987. Based on that composite, if you had invested at the beginning of the period and held on through the most recently-available data, you would have earned a total return of 187 percent. That may sound all right, but it works out to just 4 percent a year compounded annually.

Worse, these returns are far from steady. Based on an investment made at the start of each year from 1987 on, returns after one year ranged anywhere from a high of 18.69 percent to a low of -19.44 percent. What is really challenging though, is trying to earn enough to beat the cost of borrowing money. That's where mortgage rates come in.

The mortgage rate hurdle

Unless you have a pool of investment capital at your disposal, mortgage rates form a natural hurdle to making money in real estate. Assuming you have to borrow to make your investment, you not only need to make money on the house, but you have to make more than the mortgage rate you are paying.

This hurdle varies in degree of difficulty over time. Based on Federal Reserve data, since 1987 30-year fixed mortgage rates at the start of the year have ranged from a high of 11.26 percent to a low of 3.35 percent. One way to look at your odds of making money in real estate is to look at how often housing prices have beaten 30-year fixed mortgage rates.

Over a series of 26 one-year holding periods, housing prices beat 30-year fixed mortgage rates just 42 percent of the time. The odds get even worse with longer-term holding periods. Over five-year holding periods, housing prices beat 30-year fixed mortgage rates just 36 percent of the time, and over ten-year periods housing prices cleared the mortgage hurdle just 29 percent of the time.

Investment considerations

How can you improve these odds? Here are five things to consider when making a real estate investment:

  1. Mortgage rates. Low mortgage rates certainly help, both by lowering the mortgage hurdle and by supporting home prices. When 30-year fixed mortgage rates were above 7 percent, one-year home price returns cleared the mortgage rate hurdle just 31 percent of the time. When 30-year fixed mortgage rates were at 7 percent or below, one-year home price returns cleared the mortgage hurdle 54 percent of the time. Besides the fact that this makes real estate a more attractive investment when mortgage rates are low, you should keep in mind to be alert for opportunities to refinance a mortgage once you have bought a property, because this could lower the hurdle for a positive investment return.
  2. Home prices. Investing when prices have already risen sharply, as at the peak of the last housing boom, stacks the odds against you. Pick your spots opportunistically, either when the market as a whole is down, or when you find particular properties selling at an unusual discount for the area.
  3. Cash flow. Mortgage payments, taxes, maintenance, and improvements all represent costs you will have to sink into a property, while the timing of getting money out of a property is uncertain. Even if you could make money in the long run, you have to make sure you have enough cash flow to meet expenses before the investment pays off.
  4. The value of your time. Being willing to put your own effort into fixing up a house is a good way to add value to your investment, but when you figure out your return on investment, you have to ask yourself whether you've been adequately compensated for your time, or whether you've essentially been contributing free labor to the project.
  5. Investment alternatives. The idea of "flipping" houses is to quickly make a profit buying and selling properties, but the reality is that the market is much more uncertain than that. If you are interested in real estate investing, consider alternatives such as income properties, which will give you a stream of cash flow even if you can't quickly re-sell the property, or real estate investment trusts, which allow you to invest in a more diversified group of properties.

The numbers are sobering, but they do not mean it is impossible to make money in real estate. They do, however, indicate that your skepticism should be on full alert when somebody implies that real estate investing is a sure thing.

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