First, a tip of the hat to Darwin for finding this gem on VisualEconomics; I’m not sure how he finds these things, but his Twitter is loaded with great material—follow him! Now that I’ve paid my dues, let’s dive into the idea of historical home price trends, and how individuals can buy their live-in home as if they were an investor.
This graph, courtesy of Visual Economics, shows that the normalized price of real estate shows no gains when adjusted for inflation:
In short, had you purchased the average home at any time in history, your home wouldn’t have appreciated a single dime in real terms, but why? That’s what I want to know…why hasn’t real estate appreciated in real terms?
To get to the bottom of this question, we have to understand the data. The chart uses only data from the United States, which is very important. All things considered, the United States is very much under-populated.
Let’s throw in an additional chart showing population density:
Mmmhmm, lookie there. There are only a few places where the total population exceeds one-million people. Americans are still suburbanites—we like our space, and as an aside, we apparently still enjoy the burden of mowing our lawns.
So why is density important?
With each major city is a major chunk of surrounding land which few make use of.
When the price of a home trends higher in the United States, the cost to build a home rarely follows the same trend—if homes already in existence were to surge by 25% tomorrow, people wouldn’t go out and buy homes at a 25% premium. Instead, they’d go buy land, and build their own home, or at least pay a company to do it for them.
Also, when home values go up, the relative opportunity costs of buying a home 10 miles away from work instead of 2 miles away from work become very small.
Would you spend an extra $25,000 to buy a 40-year old home close to the city center with noise, traffic congestion, smog, etc when you can buy a home in the ‘burbs, brand new with the best appliances, insulation, design, and modern interior at a discount to the 40-year old home? Absolutely not. I’ll deal with the 20 minute commute if I get a newer, better quality home, in a quieter area at a cheaper price.
Just for fun, the median and average price of a home for the last six months:
Sep 2010 $228,000 $270,800
Oct 2010 $204,200 $254,400
Nov 2010 $219,600 $281,700
Dec 2010 $236,800 $290,800
Jan 2011 $234,800 $265,300
Feb 2011 $202,100 $246,000
Let’s think like a real estate investor, but when I say real estate investor, I’m not talking about the guy down the street who owns a few homes in the same city in which he resides. That’s not my idea of real estate investor, as a lot of these people encounter serious systemic risk; that is, risk that cannot be hedged away.
This systemic risk results from banking 1) your livelihood and 2) a bulk of your assets on the economics of one city. How can you hedge that? Recently, my town lost a major manufacturer to Warez, Mexico. How do you account for a loss of a major employer in a small real estate portfolio? Buy 10% ownership in some family-owned restaurant in Mexico? Pfft. It’s just not doable.
So, in terms of discussing real estate investors, I’m talking about people who have property in several states, and who have portfolios in the tens of millions of dollars. These kinds of people are more likely to understand risk-management and standard deviations of risk. Thanks to the internet, I’ve had the privilege of speaking to more than a few of them. I never pass up a free education from anyone, so I’ve done my best to pick their brains about what makes a property attractive.
What real estate investors say:
- Buy significantly under the cost of replacement – Buying under your replacement cost means that when home prices rise, you’re not going to be burned when homebuilders come into the market with new homes at a price discounted to yours. This is the most important element because if you can’t buy cheaper than the cost to replace, there is no upside for you if there is land outside city limits, which, by the way, is probably cheaper in terms of property taxation.
- Buy where there are natural impediments to growth – Waterways, mountains, or anything that gets in the way helps real estate investors in a big way. Waterways, for example, require that travelers bottleneck onto a bridge, increasing travel times and diluting the value of living in the suburbs. Also, lakes have a tendency to decrease the available real estate around the city. Look at Chicago, for example, which could grow in a radius that would look a little like a rotated Pacman. As a final benefit, these geographic impediments are likely to be boons for the local economy, especially waterways that are important ports for the transportation of goods throughout the country. Liquid jobs!
- Think “brand name” – Big cities normally just don’t fall apart overnight. Sure, Detroit isn’t doing too well, but this is also in the mix of buying property in areas that are not dependent on a single industry, company, etc. Generally, brand name cities have reached a size that makes them monopolies for talent within a 100 mile radius, in that the best business people and business ideas ultimately flow into city limits.
- Qualitative factors matter – School districts, income sources, and the makeup of the average family should never be cast aside. School districts help buoy homes in some areas, but how much control do you really have over district lines? Income sources are important too, because without being too judgmental there is a very big difference between “working-class slums” and “welfare slums.” Those who don’t write a check each month to a lender or a landlord probably don’t see much value in keeping up a home. Also, high homeownership rates in a certain area show that people are willing enough to own their home for the next 15-30 years, so they’re also significantly more likely to protect their home values in keeping their homes looking nice.
Most people are obviously not well-fit to buy a home in their area for purposes of appreciation. However, remember that #1 is the most important factor, and one thing that a lot of people do have control over. If you can buy 20% under the cost of replacement, you’re talking 20% upside before it makes sense for homebuilders to start building in the ‘burbs again. Cha-ching!
This list is one of the many reasons I go back and forth on owning a home for myself in the future. Part of me says screw it, buy a home. My inner idiot says, “hey, let’s get started in real estate investing!” and the intelligent part of me says, “build up a REIT portfolio before getting started to dilute systemic risk to a localized portfolio.” Finally, the entrepreneur in me says, “hey, let’s start a residential REIT with rates at all-time lows, and take it public to make a killing on a pure, non-levered residential real estate pure-play!”
Nothing has changed here, I’m still conflicted. Must…do…more…research!
Readers, tell me what you think: Does it make sense to buy a home under the guise of profitability? Or in this era when geography doesn’t much matter, does it make more sense to rent from someone else for ultimate flexibility?