Energy related real estate markets---Boom or bust?
February 21, 2015
Is Real Estate Still a Good Investment Despite Higher Interest Rates?
February 24, 2019
I am frequently asked if real estate is still a good investment with today’s higher interest rates and my answer is always yes. It might sound crazy, but interest rates have had little effect on real estate
returns. This is because cash flow is only one component of real estate ROI and many people are measuring returns all wrong.
Although the financial crisis and housing crash made it very easy for investors to get in to real estate and get great returns, the extraordinary low interest rates in the 10-year period following the Great Recession of 2008 was an anomaly that did not reflect the average rate over the last 30 years. The truth is, we got spoiled. We’ve had a great run of extraordinary low rates and anyone under the age of 30 probably doesn’t realize that these low rates were not the norm. Does that mean the ride is over and real estate is no loner a good investment? Not at all. It just means that we’re returning to more normalization and although rates have risen in the last year, the fact is, they are still well below the average for the last 30 years as the chart below shows.
Putting Interest Rates in Perspective
It’s important to put interest rates in proper perspective and understand the long-term trend of the 30-year fixed rate. The low rates that we have experienced in the last decade are an anomaly and are artificially low. In spite of the current higher mortgage rates, they are still at all-time lows.
As you can see, prior to the crash of 2008, rates never dipped below 7% until August 1993 and didn’t break 6% until December 2003. Rates of under 5% were unheard of until April 2010. Does this mean that real estate wasn’t a good investment prior to 2008? Of course not. It’s clear that the low rates that we’ve experienced for the last 10 years have not been the norm and were brought on by the Great Recession of 2008.
So, what does a return to more normalized rates mean for real estate investors? Well, let’s keep things in perspective and remember that investors have made fortunes in real estate long before the financial crisis that brought on incredibly low interest rates and an abundance of cheap houses. In fact, over the last two centuries, about 90 percent of the world's millionaires have been created by investing in real estate. So, investors have been creating wealth through real estate for generations. In fact, over a century ago, Teddy Roosevelt said:
“Every person who invests in well-selected real estate in a growing section of a prosperous community adopts the surest and safest method of becoming independent, for real estate is the basis of wealth”
The main take-away from this is that fortunes have been made in real estate long before anyone could imagine that we would have sub 5% interest rates and will continue to do so in spite of a relatively small increase in rates. Today’s rates are still close to historic lows making this still a great time to buy real estate.
What’s Caused the Recent Increase in Rates?
There’s a widespread misconception that the Federal Funds rate drives mortgage rates and therefore, today’s higher mortgage rates are due to the Federal Reserve’s eight consecutive quarterly increases since December 2016. Surely these rate hikes must have some effect on mortgage rates don’t they? The reality is that changes in the Federal Funds rate have no effect on mortgage rates. The federal funds rate is a short-term rate that does not affect long term interest rates.
Instead, the 30-year fixed mortgage rate is closely tied to the 30-year Treasury Note as shown in the chart to the right. This is because both the Treasury Note and mortgages are competing investments in the money markets and both rates are driven by long term inflation expectations. As the economy improved and inflation began steadily rising in Q4 2016 and peaking in June of 2018, the 10-year Treasury Note soon followed. Mortgage rates have paralleled the treasury note during this time.
Not only do mortgage rates not follow the Federal Funds rate, they often move in the opposite direction. Increases in the Fed Rate are a signal to the markets that the Feds are exerting monetary policy to control inflation. This is viewed positively in the markets and instills confidence that the inflation rate will be kept in check. That shows in the recent trends of the 30 Year Treasury and mortgage rates. As inflation has come down from a peak of 2.9% in July of 2018 to 1.6% in January 2019, the Treasury Note has paralleled that, followed by mortgage rates, with the 30-year fixed dropping to the lowest level in nearly a year in January 2019.
The good news in all of this is that if inflation continues to decline, mortgage rates may follow.
Why Most People Are Measuring Real Estate ROI Wrong
People question whether real estate is still a good investment do so because they are measuring real estate returns incorrectly. The most common metric used for evaluating rental properties is the cash on cash return. In simple terms, cash on cash return is the net rental income after all expenses and mortgage payment as a percentage of the cash invested to acquire the property.
The problem with this measurement is that it considers only cash flow in the return when cash flow is just one component. In fact, on average, cash flow accounts for less than 30% of total returns as shown in the chart to the right. and ignores the fact that real estate returns are comprised of both income and equity. Cash on cash return looks only at the income statement (rental income) and ignores the balance sheet (equity).
A more accurate measure of total return is Gross Equity Income. Gross Equity Income measures the total return derived from rental income and equity gain. It does not however, include depreciation which is another significant advantage of real estate ownership.
4 Sources of Real Estate Returns
Rental income is the most obvious source of return and the only one accounted for in the cash-on-cash measurement. It is the cash flow after all operating expenses and mortgage payment and what is reflected on your tax return.
One of the great aspects of real estate is that your tenant pays off your mortgage for you thus creating equity. Imagine if there was a way to buy stock on the margin and have someone else pay for the shares. In the early years of a mortgage, most of the payment is going to interest. However, principal reduction can be accelerated by applying all the cash flow to the principal each month. By doing so, it’s possible to pay the mortgage down in half the time and own the property outright, saving tens of thousands of dollars in interest. Principal reduction is a significant source of wealth and one that is a mathematically sure thing.
Although appreciation isn’t a certainty and local markets appreciate at very different rates, home prices increased an average of 3.4% since 1968 according to the National Association of Realtors. Since real estate can be bought through leverage, real estate offers appreciation returns on steroids. That’s because the appreciation rate is on the value of the entire asset, not on the capital invested. For instance, 3% appreciation on a $100K property generates a $3000 return. However, that is the return on asset not the return on investment. The true return on investment on a $20,000 down payment is a whopping 15% not 3%.
Depreciation is a tax benefit unique to real estate. The IRS allows owners to take a tax deduction based on the perceived devaluation of a property over a 27.5 year period. Depreciation is an accounting expense which can be deducted from rental income to reduce profit and, ultimately, your taxable income. Let’s look at an example of an investment property with a total assessed value of $125,000 which is comprised of $25,000 for the land and $100,000 for the building. IRS regulations would allow you to depreciate the building over 27.5 years creating a $3,636/year deduction ($100,000/27.5). This deduction is taken against net income. Although savvy investors generally factor the replacement of capital expenditures for the replacement of big-ticket items such as roofs, HVAC systems etc. they often fail to consider the offsetting depreciation tax benefit to offset these expenses.
Infinite Returns Through Real Estate
Once you’ve recouped your initial cash investment through these sources of income and equity, your returns become infinite and can happen very quickly. The chart below shows the cash flow and equity return over 3 years on a typical property priced at $120,000 and a $24,000 down payment. In this example, the total capital investment of $24,000 is more than recouped in just 3 years.
Stocks vs Real Estate---Which is Better?
Analysts often argue that the S&P 500’s long term trend of 9.8% return outperforms real estate with home price increases of 3.4%. There’s one major flaw with this. This type of analysis is oversimplified and is an apples to oranges comparison. It compares the increase in stock values with the appreciation of home values. It completely ignores the equity gain due to mortgage paydown and appreciation and the tax benefits of depreciation. When all sources of returns are factored in, real estate can easily return over 30% making it still an excellent investment despite today’s higher interest rates.
Another important advantage of real estate that shouldn’t be overlooked is that it provides a permanent passive income. 3 out of 5 retirees outlive their retirement savings. Unlike stocks, real estate provides a continuous income stream without touching your assets.