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Should You Invest in Residential Real Estate?

My Top Real Estate Pick for 2014

Written by Geoffrey Pike
Posted December 27, 2013

Real estate is an interesting topic these days.

We saw what was probably the biggest real estate bubble in American history just recently, when housing prices topped out somewhere in 2006 or 2007.

We then saw a major bust, the beginning of which actually preceded a bust of the entire economy.

Of course, we have to remember that real estate is a local issue. A few parts of the country didn’t see a housing boom, and some parts, such as New York City, didn’t really see a bust. In general, however, we saw a big boom followed by a big bust.

After housing prices bottomed somewhere around 2011, we have seen them climb quite significantly, though still not to the levels we saw in 2006 in most places.

Different Points of View

There are differing points of view on where real estate is headed, even by advocates of the free market.

Some people think we are in another bubble that will pop again. They point to the fact that the housing market is being propped up by low interest rates, a loose monetary policy by the Fed, and bank bailouts.

While these things are certainly true and they do prop up real estate prices, what's to say it can’t go on for a while longer?

Other people think that real estate prices will continue to go up and maybe even enter a new bubble at some point, while maintaining that it is not a bubble yet. They correctly point to Federal Reserve inflation.

When there is high inflation, investors look for hard assets. You can’t get more of a hard asset than real estate. So if you expect inflation to continue to get worse, real estate is something to seriously consider.

A Consumer Good

A lot of people refer to their own house as an investment.

I don’t think this is a good idea in most cases, because a house is a consumer good, just like a television. The difference between the two (besides the obvious) is that shelter is a basic necessity, whereas (and some people will argue with me on this point) having a television is not.

So if you are buying a house (as opposed to renting) because you need a place to live, this might be a valid reason to buy.

However, it's important to remember that buying a house to live in is not really an investment, other than the fact that you need a place to live. The only sense it could be considered an investment is that it's somewhat of a forced savings plan, as you pay down the principal balance on your mortgage each month.

If you're buying a house with luxury amenities (a pool, extra bedrooms and acreage, etc.), it's important to realize that you are buying it because you want the amenities, and not simple because it is some kind of an investment.

Now, there is nothing wrong with buying luxuries and extra space — if you can afford it. You just shouldn’t fool yourself into thinking it makes good financial sense.

Investing in Residential Real Estate

Investment real estate has a potential to be quite profitable in the long run.

Even if inflation is not as bad as we might expect, we can still likely count on some inflation. With a federal government in $17 trillion of debt and no signs of anything close to a balanced budget, I think some inflation in the future is a pretty good bet.

While I don’t consider buying a house to live in an investment, there is such a thing as investing in real estate.

Personally, I favor residential real estate. Residential real estate is easier to get in to and there's less risk. If there's another downturn in the economy, you can get wiped out quickly with commercial real estate... but there will always be a demand for places for people to live.

Cash Flow

It's important to buy an investment property in an area that is not likely to decline.

This means that you stay away from areas with high crime, bad schools, and deteriorating houses. You would not have wanted to buy a place in downtown Detroit several years ago.

That said, I don’t think you should overly concern yourself with appreciation. It happens with too many real estate investors... Appreciation is their number one goal. But I think appreciation should be icing on the cake.

As long as you are buying in an area not likely to decline, then cash flow should be your top consideration.

If you're going to take out a mortgage, you need to be sure you will have positive cash flow.

If the cash flow is negative, then you simply should not buy it, unless you know of some hidden secret on why the property is going to skyrocket in value in the near term. If you don’t know of a secret plan by Disney to buy up the property around you, then you should probably stay away if you're calculating a negative cash flow.

It's important to consider all of your expenses, including your mortgage payment, property taxes, association fees, insurance, and repairs. You should also consider that there could be times when it is not rented, and you may not collect anything for a month or two.

If you can collect rent that is generally higher than your expenses, the property is something to consider.

Your Investment Return

Let’s say you can buy a $100,000 house that will rent for $900 per month. Taxes and insurance are $200 per month, and there are association fees of another $200 per month. If you buy the house with no loan, you will net about $500 per month, assuming no repairs.

At $500 per month, you will net about $6,000 per year. This is a 6% return on your investment ($6,000 divided by $100,000).

Can you tell me where you can get a solid 6% return on your money in the market right now?

Sure, you would have made more than that in the stock market this past year, but are there any guarantees that it will continue? Are you sure that you won’t lose money in the stock market this year?

While investing in real estate is not risk-free, it is a lot closer to risk-free than the stock market today. And if you put $100,000 in a savings account or money market fund in the bank, you'll be lucky to get a return of $500 for the entire year.

I'm not saying that you have to pay cash for a house. It can be profitable to use a mortgage and there are good arguments for both. But you can assume a mortgage scenario for calculating cash flow, and you can assume a scenario of buying for cash (which is really a check) when calculating an estimate on your return.

Your Situation

Of course, investing in real estate isn’t for everyone.

There are headaches that go along with it, although you can eliminate a lot of them by hiring a management company to do most of the work.

More importantly, not everyone is in a financial position to be a real estate investor. While you can take out a loan, you do need some financial reserves. You have to expect that some things will go wrong.

You should consider that you will have to make some repairs and you should consider that it might be vacant for short periods in between tenants.

Of course, you also need money upfront to pay for a down payment, closing costs, insurance, and other fees.

Inflation and Deflation Hedge

If you decide that investing in residential real estate is right for you, it may be a great complement to your investment portfolio.

Real estate investing can work as a hedge against both inflation and deflation.

If you take out a mortgage, then it is more of an inflation hedge, as you will pay back your loan in depreciating dollars. You will benefit with increasing rents and price appreciation. While your taxes and repairs could go up in price, at least your main mortgage payment is fixed.

If you buy a place outright, then this is more of a deflation hedge. You are essentially locking in a rate of return by collecting rent and not making mortgage payments. If you have a mortgage with an interest rate of 4% and you pay it off early, you are doing the equivalent of locking in a 4% rate of return.

Even if you own a property outright with no mortgage, you can still benefit from inflation with increasing rents and price appreciation.

In conclusion, I recommend considering investing in residential real estate as diversification — again, if you are in the right position to do so and you can buy in an area that will give you positive cash flow.

You don’t have to invest solely in traditional investments, such as stocks and bonds, and real estate can offer a nice complement to your other holdings.

Until next time,

Geoffrey Pike for Wealth Daily

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