The layman's theory of real estate goes something like this: The Pilgrims arrived. They started using land. More Europeans came. The demand for land was so high that Native Americans were pushed out to make room for the newly arriving settlers. More land can't be built, so demand and prices will always rise, making real estate a great investment. Unfortunately, the formula isn't quite that simple. Here we take a look at real estate prices, and the long-held theory that they will rise indefinitely.
TUTORIAL: Exploring Real Estate Investments

Historical Real Estate Prices, Bubbles and Beyond
Prior to the well-publicized burst of the housing bubble and the resulting real estate crash that began in earnest in 2007, historical housing price data from the National Association of Realtors (NAR) seemed to support the theory of endlessly rising prices. The chart below tracks median home prices from 1968 to 2004 and shows an average yearly increase of 6.4%, without a single decline during the 36-year period.

Figure 1: Medium home prices from 1968 to 2004
Source: National Association of Realtors

What the Data Doesn't Show
Unfortunately for homeowners, 2004 was the last year of healthy growth numbers before the market flattened. By 2006, NAR data showed just a 1% increase. After that, the markets experienced an unprecedented decline. Nationally, prices fell in 2007. They fell again in 2008 and yet again in 2009. By mid-2010, housing prices had fallen back to 2004 levels in a stagnant market. What had for decades seemed like a one-way ticket to growing profits had fallen by more than 30% in just a few years, according to Standard and Poor's data. (Why Housing Market Bubbles Pop provides additional insight into declining real estate prices.)

Even before the numbers began to go the wrong way, the sales price trends data provided an incomplete picture. The National Association of Home Builders reports that the average home size in America was 983 square feet in 1950, 1,500 square feet in 1970, and 2,349 square feet in 2004. This trend continued in the first half of the 2000s, after which it began to decline somewhat. (For more information on home sizes, take a look at McMansion: A Closer Look At The Big House Trend.)

With the size of homes getting bigger and inflation adding to the cost of building materials, it is only logical that home prices would rise. But what happens if inflation is factored out of the picture? The result is something completely unexpected. Even before the real estate crash of the late 2000s, home prices fell frequently and significantly. (When the housing market is down, selling your home becomes a daunting task. Learn the top recession home-selling tips in Closing A Real Estate Deal In A Down Market.)

In Fact, World War I, the Great Depression, World War II, the 1970s and the 1980s, all saw periods of significant price decline. Lesser declines have occurred on a regular basis at other points as well. (To see a great illustration of this, check out this graph produced by the New York Times in 2006.)

National Numbers, Regional Trends and Your Neighborhood
Even the national trend numbers tell only part of the picture. Housing price trends can vary widely from geographic region to geographic region. A boom in California can mask a bust in Detroit. Even within the same city, numbers can vary widely. Areas that are experiencing new growth or gentrification can show significant price appreciation while areas across town can be in decline.

When looking at the national and regional statistics, be sure to account for the reality of the market in your local area. Rising prices at the national level may not help you if your city, state or neighborhood is in decline.

Another important point to consider when looking at real estate as an investment is that your "investment" won't ever pay off unless you sell it. So even if your primary residence has doubled in value since you bought it, from a practical standpoint, it probably just means that your real estate taxes have gone up. All of the gain that you have experienced is merely a gain on paper until you sell the property.

If you chose to sell and hope to purchase another home in the same area, remember that the prices of other homes have risen too. To truly book a gain from your sale, you will likely need to move to smaller home in the same area or move out of the area and find a less expensive place to live.

While it is possible to tap the equity in your home by taking out a loan against it, using your house as an ATM has proved to be a foolish strategy in the past. Not only does the interest you pay eat into your profit, but the loan payment takes away from your financial stability. If real estate prices decline, you could find yourself in the unenviable position of owing more on the loan than the house is worth. (For more insight, see Home Equity Loans: The Costs.)

So, Is Real Estate a Bad Investment?
By now you may be thinking that there is no value in purchasing a home in the hope that it will gain in value over time. While it is true that you are unlikely to see any profits that you can spend if you plan to live in the same house all of your life, if you go into the purchase with an exit strategy, there is a much better chance of seeing a cash profit.

First, consider the reason you're a buying a home. If the answer is "to live in it" then you should stop thinking about profits and losses. If the answer is "to make money" then you need to enter the transaction with an exit strategy. Keeping in mind the purchase price of the property, you should have a sell price in mind. When your price point is reached, you would sell the property just as you would a stock that has appreciated. This may not be a practical approach for your primary residence, depending on your lifestyle, but it is exactly what many real estate investors do when they purchase properties, renovate them and sell them. Just remember that prices don't always move up. In 2010, some parts of the market were down 40% from their peaks. In the past, Japan has seen housing prices fall even more. That doesn't mean that those prices won't bounce back into profitable territory, but keep in mind that in some cases it could take a very long time.

The Bottom Line
With history as a guide, most would-be homeowners would do well to buy a place they actually hope to inhabit, pay off the mortgage quickly, live there until retirement, and then downsize and move to a less expensive home. It's not a sure bet, but this strategy does increase the likelihood of making a profit.

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