Real estate as an investment for most people means home ownership. For the great majority it represents their largest asset and largest source of debt. Let me share a couple thoughts that may help you avoid common mistakes.
You will invariably hear rules #1-#3 in real estate as location, location, location… This is not entirely true. Be careful since deception is not uncommon as we have seen in recent past!
Your home is not an investment; it is an expense. Investments have returns, your home only has expenses such as taxes, heating/cooling expenses, water bills, etc. As long as you live in your home, it has zero return. The money you invest in your home is frozen and earns nothing. If you consider the appreciation of your home as your main investment strategy, then you ought to instead focus on two other topics — how to increase the income from your job or business and how to decrease your living expenses so you can save more and invest in other assets.
I am not trying to discourage home ownership. There are numerous advantages to home ownership such as better communities, schools, etc. You should own your home if you wish as long as you can afford it — just do not consider it an investment. Quite a number of people bought houses in the past five years without having the means to weather a real estate storm such as the current one.
Various factors contribute to the misunderstanding that our homes are investments. First, home ownership generally requires a mortgage with a set monthly payment consisting of interest and principal. This principal would have been spent in most cases if the bank was not there to collect it. The mortgage enforces a form of savings discipline which is further encouraged by government tax deductions and other minor benefits. Even if the real estate and currency markets remain flat over time, these principal payments add up to result in sizable savings — especially if the home is held long enough. Again, this factor might make your home a sound purchase (certainly better than your car) with low risk and possible long-term benefits. I am certain you can do better than rely on a mortgage to save. Second, home ownership is perceived as an investment because of constant inflation. You can borrow $100 today and by the time you pay it back (even including all of the interest payments), it might be worth $10 if government acts with sufficient recklessness. Third, home ownership brings leverage and any appreciation seems like an incredible percentage of return but remember so does depreciation during falling house prices.
You should only invest in real estate in one case — to diversify. I am probably being a bit too strict for a number of reasons:
- Diversification implies you have lots of cash already invested in other assets (CDs, stocks, bonds, gold, etc.) and need to invest in yet another asset class, real estate, for higher long-term return.
- By its nature, diversification requires that you not invest all of your cash in real estate, which is a much safer mode of operation.
- When you borrow (get a mortgage), you will consider the earnings potential of the real estate alone, rather than all your other sources of income as in the case of buying your home.
- You will not get emotionally attached to the property as people get attached to their homes because it will simply represent another investment.
- You will be free to sell without worrying about uprooting your family, driven strictly by investment strategy and without any emotional family bias.
There is one danger here: do not under any circumstances speculate in real estate. I would go as far as saying do not ever speculate in any asset. Your chances in speculation are not that different from gambling at the casino.
When used appropriately real estate can be a good source of return with lower risk but the opposite is also very true, you can lose thousands of dollars in a short time.
The Harvard Management Company is one of the best money managers in the world. It invests Harvard’s endowment in almost a dozen asset classes. If real estate was the ultimate money maker, why own the other assets at all? Their asset mix changes annually but gradually. I hope you will be careful with real estate and will avoid the misfortune in the form of foreclosures that many around the United States are experiencing today.