You Don't Own Real Estate. Real Estate Owns You.

By Logan Flatt, CFA

    Many Americans believe that real estate can do no wrong as an asset class upon which they can build wealth. I disagree. Building wealth through real estate depends on your ability to distinguish among the three types of real estate ownership – investment, speculative, and personal. If you don’t know the differences, you may soon discover that you don’t own real estate, real estate owns you.

Investment Real Estate Puts More Cash in Your Pocket Than It Takes Out

    Investment real estate refers to the ownership and operation of income-producing real estate whereby the income generated by the property – usually, rent payments from tenants – more than covers all the costs of owning and operating the property. If the income is high enough to cover all the costs of ownership and operation plus leave cash left over for the property owner, the property is said to be cash flow positive. If the income fails to cover all the costs of ownership and operation, the property is said to be cash flow negative, whereby the property owner must dig into his or her pockets to come up with the cash to pay for the remaining, uncovered costs.

    A bona fide real estate investment puts more cash in your pocket than it takes out, on a repeatable, consistent basis. As such, a cash flow negative investment property is really not much of an investment at all. If you continue to hold on to a cash flow negative investment property out of pride or any other emotional attachment to the property, you are not maintaining an investment; you are maintaining a hobby. A rational real estate investor would put a stop to the repeated, consistent cash drain ASAP. In many cases, it is simply best to swallow your pride and sell a cash flow negative investment property. That way, you can let a new owner cope with the income shortfall each month while you put your sale proceeds to work in a cash flow positive investment property you can find elsewhere.

Speculative Real Estate Is a Bet Against the Odds

    When buying real estate at or near the prevailing market price, many people firmly believe they will make a profit upon the future sale of their real estate. Unfortunately, there is wishful thinking and there is reality. Wishful thinking plays a prominent, defining role in speculative real estate. A new property owner may hope to sell his property at a higher market price in the future, but in reality, he has no idea what the future market price will be. Nobody does – all future market prices are unknown to everyone. That is, until the future arrives.

    In the face of such uncertainty at the time of purchase, all the new property owner  can know is that there are three outcomes for a future market price: significantly lower than, similar to, or significantly higher than the current market price. In other words, unable to know at the time of purchase what future market prices will be, the new property owner has only 1 in 3 outcomes where he can sell his property at a future market price significantly higher than the current market price. If each outcome is equally likely, the new property owner's odds of selling his property at a highly inflated market price are low.

    Unfortunately, the odds of making a profit on a property purchased at the prevailing market price are made even worse by the high transaction costs of buying and selling real estate. Even if a new owner sells his property at the similar future market price, he still loses money thanks to brokers’ commissions, legal fees, and other closing costs incurred to sell the property. He also loses money selling the property at a significantly higher future market price if that future market price is not quite high enough to cover the high transaction costs. Clearly, the odds of making a profit are against those who buy real estate at the prevailing market price and hope to sell later at a higher market price. Such is the nature of speculation and the wishful thinking that leads to it.

Personal Real Estate is Simply a Purchase, Not an Investment

    Personal real estate is real estate you buy primarily because you believe you and your family will enjoy living there. Making money, if at all possible, is secondary. In fact, it is hard to make money with personal real estate. To make it your home, you must take cash out of your pocket each month to finance it, insure it, maintain it, fix it, furnish it, and pay property taxes on it. Unlike investment real estate, your home generates no income to offset these out-of-pocket expenses. So, while you likely derive much pleasure from owning your home, you lose money on it every month. Don’t fool yourself – your home is not an investment. It is simply a purchase.

    Nevertheless, despite draining you of cash every month, owning personal real estate generally beats renting a house, condo, or apartment for an extended period of time. Owning personal real estate gives you at least two options that renting does not. These options provide you with real value.

    First, unlike renting, ownership of personal real estate gives you the option to keep more of your income out of the hands of career federal politicians in Washington, D.C. Current U.S. federal tax laws allow you the opportunity to deduct mortgage interest and local property taxes from your taxable income. This helps reduce your U.S. federal income taxes. So, when you own personal real estate, more of your outgoing cash ends up helping your surrounding community, its schools, and its hospitals instead of largely going to waste in Washington, D.C. This is especially true if the investors in your mortgage are also local and in your community; such investors are more likely to reinvest your interest payments locally as well.

    Second, if you ever have to move due to a job change or relocation, personal real estate ownership gives you the option to hold on to your personal real estate and rent it to tenants after you move out. Exercising this option gives you the opportunity to turn your personal real estate into investment real estate. Of course, exercising this option might not make sense given your personal interests or financial situation at the time of your move, but it is an option you would not have had if you were simply renting the roof over your head. When moving out of a rental unit, despite all the monthly payments you made to your landlord, you walk away with no ownership in any real estate asset whatsoever. The advantage goes to personal real estate ownership.

You Don't Really Own Real Estate If It Can Be Taken Away From You

    The differences among investment, speculative, and personal real estate ownership are clear. However, you don’t really own real estate. You only think you own it. Even if you have paid off your mortgage in full, a county, city, or local public school district can still take your property away from you. Just stop paying the tax bills these governments send you each year and you will quickly discover who really owns your real estate.

    Paying property taxes is all you need to do to keep your real estate out of government hands, right? Sorry, but no. You could pay property tax bills in full year in, year out for decades and still lose your property to eminent domain, whereby a government expropriates your real estate to use it for what it claims to be society’s “greater good” – your personal property rights be damned.

    Clearly, while many Americans believe that real estate can do no wrong as a way to build wealth, it sure is hard to build wealth with real estate when, in so many different ways, you don’t own real estate, real estate owns you.

Copyright 2007 PowerWealth.com. All rights reserved.

Comments

[Barrett Niehus]

Great article, but I would still argue that you can better leverage a reliable return in real estate than you could in the stock market. For a given real estate deal, the investor can structure the financing in many different ways to minimize risk. Other than margin structures, this flexibility does not exist in the stock market.

-4MySales

[Logan Flatt, CFA]

Mr. Niehus,

Thank you for your comment.

I am unclear as to your comparison of real estate with stocks. I did not mention or make a case for equities in the article.

The risk of real estate is not so much in its financing as it is in its operations, particularly in the face of market forces and unpredictable externalities. For example, unexpected vacancies, cash-draining tenant lawsuits, inflationary variable costs (e.g., energy, water, etc.), and downward pressure on market rents from similar, competing properties in the area can have significant, negative effects on cash flows. This is true irrespective of whatever fancy financing arrangements one might have engineered at the time of purchase.

In other words, the risk isn't so much in the attributes of the finance payment you structured as it is in not having enough property-generated cash on hand when a payment comes due.

Sincerely,

Logan.

[Sacramento Real Estate]

Logan, I found this article to be right-on in terms of the overall definitions of Real Estate. Your article leans more to the negative aspects of little or no return on a personal residence. Of course this can be the case if one uses their residence as an ATM machine and/or selected a mortgage that was not conducive to their circumstances or bought high and sold low. But, as we all know...there are plenty of us who did not use our home as an ATM machine, lived and stored equity in order to purchase again with that equity.

Very thoroughly thought out article. I especially liked the part where you spoke about the "investor who maintains a hobby."

- Gena Riede

[FSBO Louisville]

Very well written article, Logan! You have some very interesting points about investing in a personal home. I agree with Gina, I also liked the "investor who maintains a hobby." Thanks again!

[Super Saver]

Logan,

Nice article. I've come to the conclusion that real estate investing done well is really a "job." It's a lot of work and the returns should always be positive cash flow, before taxes. Otherwise, I'd be working for nothing:-)

Here via the CoPF

[Joan]

LOL. My sister has been telling me this since she's into all that financial stuff. You should tell Tommy this so that will be one less thing he thinks I'm weird about!

[Millionaire Mommy Next Door]

Logan, well written article. I completely agree with most of what you've said here. However, I don't completely understand the two options you cite as providing "real value":

You wrote, "when you own personal real estate, more of your outgoing cash ends up helping your surrounding community"

My thoughts: While you MIGHT reduce your Fed tax (many homeowners don't pay more on deductable mortgage interest than their standard deduction allows anyway), you could also argue that by paying rent to a local landlord, you are keeping your $ in the local economy. Most mortgages are NOT held locally. Additionally, if owning a home costs more out of pocket than renting, homeowners have less money to spend locally.

You wrote, "if you ever have to move due to a job change or relocation, personal real estate ownership gives you the option to hold on to your personal real estate and rent it to tenants after you move out. Exercising this option gives you the opportunity to turn your personal real estate into investment real estate."

My thoughts: Many relocating homeowners are finding themselves NEEDING to do this, because they owe more for their home than they can get for it by selling. Turning a personal residence into a rental investment SOMETIMES works out, but usually the property is not ideally suited for this purpose. Besides, I think it's much better to relocate, then buy investment property locally so you can keep an eye on your investment. In my opinion, purchasing investment property is better done "on purpose" -- not by default.

Thanks for visiting my blog and participating in the rent vs buy discussion!

[Logan Flatt, CFA]

Mommy Dearest:

Thank you for your thought-provoking thoughts!

Most people I know are able to take a larger than standard deduction on their Federal income taxes by deducting mortgage interest PLUS property taxes. Moreover, getting over the standard deduction allows one to deduct still more items that would not have been otherwise possible to deduct. Every incremental deduction helps (until you hit some cap). Avoiding the standard deduction through home ownership saves me plenty on Federal income taxes each year and allows more of my dollars to remain out of the hands of the U.S. Congress. I like that.

AN ASIDE: If I were made king, I would decree one single income tax rate and no deductions at all so that all this becomes a clear and undistorted issue created by over 10,000 pages of Federal income tax law. Come to think of it, if I were made king, I would decree that there be no Federal income tax at all. Starving the Federal government of income is a great way to keep it in check and under the control of the people, instead of the other way round like we have it today.

I would not argue that paying rent to a local landlord keeps one's dollars in the local economy because I believe that, while it may very well be true, it is a specious argument to make. Yes, the money is kept local with the local landlord, but that's not the priority here -- building the wealth of one's own household takes priority over building the wealth of one's landlord's household. And, both take priority over building the wealth of the Federal government, which by Constitutional design is supposed to be severely limited and the majority of government wealth placed in the hands of the individual States. For someone trying to get ahead financially, his or her household economy should be the one economy that takes the highest priority at all times. To favor the local landlord or a government entity is to counter such a maxim central to building wealth for one's own family.

While most mortgages may not be held locally, one can always freely choose to patronize a local, privately-owned bank or other lender who intends to hold the loan locally and pocket the interest payments. We have plenty of these from which to choose here in Texas.

Yes, in a given month or year renting might beat out owning when the out-of-pocket costs of renting are lower. It happens frequently for many people. However, please note my statement that owning personal real estate generally beats renting a house, condo, or apartment "for an extended period of time." I can only think of a rent control situation where renting for an extended period of time at artificially low, government-mandated rates might add to one's wealth at a faster rate than owning (that is, IF one wisely invests the difference saved from not paying higher market prices). Such an economic distortion occurs due to government intervention into the free commerce of real estate. Outside of this distortion, owning a marketable home generally beats renting for decades on end, over and over again.

I can find no faults with your thoughts regarding relocation. I agree 100% with your comment on managing investment property from afar. Better to keep your investment properties under your own eyes. My point is just that personal real estate ownership gives you the option to retain a part of the economic value you put into the monthly payments you made for possibly years and years.

With ownership you are are buying legal claims against a real estate asset that you can put on your household balance sheet. If you have to move, you can retain those legal claims and rent the property out or you can sell your legal claims against the asset. If you choose to sell, you can get compensated by a buyer of those legal claims and the value (now in the form of cash) remains on your balance sheet (as long as you are not 'under water' as you identify). It is hard to say the same for rental payments: you retain no legal claim to any asset as a result of having paid them. That's because with renting you are only buying time under a roof. Once that time is up, all value is gone and you have legal claims to nothing. You also have to move out from under the roof, or have the Sheriff's department move you out for you. That is, unless you sign yet another contract to buy 12 more months of claim-free time.

Mommy, thank YOU for visiting PowerWealth.com and adding great value to the discussion!

Logan.

[RaviKarandeekar]

hello Logan! thanks for the post. I agree with you completely. What you say is an universal truth. It is not only applicable in your US housing market but even in booming Indian real estate market. I want my readers to read you so i am blogging your Digg. Thanks!

[Portland Real Estate]

Very true. Basically were looking after the property for the bank.