Why Real Estate Is a Risky Investment
Assets such as gold and real estate are staple investments, and purchasing a home is a common investment for individuals across the globe as it is widely considered a secure and profitable investment. (For more, see Exploring Real Estate Investments: Introduction.)
Investing in real estate, however, requires a long period of commitment and a high down payment, and is risky, even in the long run. Additionally, many investors often ignore the costs.
Below are some important points regarding the hidden costs and factors that make investing in real estate a risky, costly and not-so-profitable venture. Investors should keep all of this in mind before plunking down their hard-earned money.
A Common Perception
An average investor may observe that a two-bedroom condominium in the suburbs was available for $300,000 five years back, and now sells for $450,000. That's a cool return of 50% in five years, much better than the return of stocks, bonds or gold. The absolute profit value also appears to be high at $150,000, and the availability of financing gives an illusion of using leveraged money to make a profit.
With all of these apparent benefits, what are the challenges and hidden costs of real estate investments?
The Cost Anatomy of Property Loans
Consider the case of an individual moving to a new city for a new job. He expects to stay about five years, but can extend that period based on his career growth with his existing employer or with other employers in the same city. Under the assumption of good returns, he considers buying a home or condominium instead of renting one. (For more, see Reasons Renting Is Better Than Buying.)
Keep in mind that a person can purchase a share or a unit of an exchange-traded fund for as little as $5, but investing in real estate requires thousands of dollars. Though the majority of real estate investments are financed through loans, purchasing a home or condo worth $300,000 still requires a 20 percent ($60,000) down payment.
Individuals who contribute less than 20 percent may get a loan, but they will end up paying higher interest rates and are forced to take private mortgage insurance which increases the cost. The higher interest rates lead to higher repayment amounts, and mortgage insurance usually costs from 0.15% to 2.5% of the loan amount.
If you assume one purchases the above-mentioned property worth $300,000 by making a 20 percent down payment and borrowing the remaining $240,000 at a 3.875% interest rate for a 20-year long-term mortgage, the monthly payments come to around $1,440.
There are additional one-time costs for loan processing, which are around 4% of the loan amount ($9,600). Property-transfer taxes or registration charges vary from state to state, and taking an average of 2.5% of the property value adds $6,000 to the cost.
If you assume that the property's value increases by 1.5 times in five years to $450,000, the price will increase by about 9% on a compounding basis. Adding a yearly property tax at a rate of 1.5% of the current property value, the total tax paid in five years comes to about $30,000.
If our investor bought a condo, a monthly charge of $200 to the condominium association would total $12,000 over five years. Then you should add costs for repairs, furnishings and maintenance. A conservative estimate of $1,000 per year takes us to a total of $5,000 in five years.
Then, assume that the owner finds a buyer willing to purchase his condo for $450,000 after five years.
By that time, the investor would have paid back the bank $86,400 of the loan. Adding the $60,000 down payment, costs of loan processing ($9,600), property-transfer tax ($6,000), property tax ($30,000), condo-association charges ($12,000), and general maintenance ($5,000), the total comes to $209,000.
What Is the Net Return?
The original 20-year loan principle amount of $240,000 will come down to around $180,000 in five years, as the investor keeps making $1,440 monthly payments. The investor will pay back this outstanding $180,000 from the sale price of $450,000 received from the new buyer. The investor pays $209,000 in total costs for this property, another $180,000 to the bank for the remaining outstanding payment, and so the net he receives is $61,000.
Essentially, the investor spent $209,000 in five years and got a net profit of $61,000 for a return of 29.2%. Even though the sale price seems high, the hidden costs has taken away much of the gain.
Let’s take a longer duration. Assume the investor continues his stay in the city and holds his condominium for the full 20-year term of the loan. Every five years, the condo's value increases by 1.5 times. In 20 years, the value will reach $1.52 million, an appreciation of more than five times.
The investor will repay $345,600. Adding the $60,000, the total cost goes to $405,600.
Using similar calculations as above, we get a total property tax of $251,000, maintenance costs ($48,000), general repair and maintenance ($20,000), costs of loan processing ($9,600) and property-transfer tax ($6,000). The total is $739,600, and so the net profit over 20 years is $780,400 for a return of 106%, essentially doubling the money in 20 years.
Over the longer term, the effective returns are not that great. Even though the price appreciated by five times, the costs of interest payments, taxes and other expenses diminish the profit.
Investors should also note that the real value of money declines over time. The cost of maintenance and regular repairs increases because of inflation. If inflation is also considered, the net returns will come down further. Investors should also consider insurance, broker fees and property-transfer taxes at the time of a sale. Including these will further reduce the net returns.
There are other associated risks in real estate investments. Developments during the investment period may lead to difficulty in selling the property later. For example, a noisy new highway or a spike in crime may devalue the property. Any supernatural calamity like a hurricane or earthquake can devastate the property completely, while only a partial amount may be recovered from insurance claims. Even after a rebuild using insurance money, getting a higher price becomes difficult after occurrences of such events in the area. (For more, see: The Most Important Factors For Investing In Real Estate)
Alternatives to Property Investments
Instead of buying real property, investors should consider real estate investment trusts, real estate options, real estate-based ETFs, mutual funds and stocks as low-cost alternatives. (For more, see Simple Ways To Invest In Real Estate)
While stocks come with stock-specific risks, funds, ETFs and REITs provide diversification. For the brave hearts willing to take counterparty risk in an unregulated market, real estate options can offer higher returns without the costs or taxes. (For more, see: How To Make Money With Real Estate Options)
The Bottom Line
Real estate investments require hefty financial commitments spanning long periods of time. Assessing the value of such investments spread over long durations is a complex task. While some investors get lured by looking at nominal price increases, it is necessary to take all costs into consideration