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Real Return on RE is ZERO!!!!!!!!!

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Real Return on RE is ZERO!!!!!!!!!

Last updated: July 2 2010
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  • Real Return on RE is ZERO!!!!!!!!!

    This is the MSN Money article - and I completely agree to it...How many of you ?

    Why rent? To get richer
    Houses don't appreciate any faster than the level of inflation over the long term, so forget about buying a home and put your savings into stocks.
    By SmartMoney
    I have something un-American to confess: I rent an apartment despite having enough money to buy a house. I plan to keep renting for as long as I can. I'm not just holding out for better prices. Renting will make me richer.
    I normally write about stocks for SmartMoney.com, but the boss asked me to explain to readers my reason for renting. Here goes: Businesses are great investments while houses are poor ones, so I'd rather rent the latter and own the former.
    Stocks versus houses: Returns
    Shares of businesses return 7% a year over long periods. I'm subtracting for inflation, gradual price increases for everything from a can of beer to an ear exam. (After-inflation, or "real," returns are the only ones that matter. The point of increasing wealth is to increase buying power, not numbers on an account statement.)
    Shares have been remarkably consistent over the past two centuries in their 7% real returns. In Jeremy Siegel's book "Stocks for the Long Run," he finds that real returns averaged 7% over nearly seven decades ending in 1870, then 6.6% through 1925 and then 6.9% through 2004.
    The average real return for houses over long periods might surprise you: It's zero.
    Shares return 7% a year after inflation because that's how fast companies tend to increase their profits. Houses have their own version of profits: rents. Tenant-occupied houses generate actual rents, while owner-occupied houses generate ones that are implied but no less real: the rents their owners don't have to pay each year.
    House prices and rents have been closely linked throughout history, with both increasing at the rate of inflation, or about 3% a year since 1900. A house, after all, is an ordinary good. It can't think up ways to drive profits like a company's managers can. Absent artificial boosts to demand, house prices will increase over long periods at the rate of inflation, for a real return of zero.

    More from MSN and SmartMoney
    Robert Shiller, a Yale economist and the author of "Irrational Exuberance," which predicted the stock-price collapse in 2000, has recently turned his eye to house prices. Between 1890 and 2004, he says, real house returns would've been zero if not for two brief periods: one immediately after World War II and another since about 2000. (More on them in a moment.) Even if we include these periods, houses returned just 0.4% a year, he says.
    The average pundit, planner, lender or broker making the case for ownership doesn't look at returns since 1890. Sometimes they reduce the matter to maxims about "building equity" and "paying yourself" instead of "throwing money down the drain." If they do look at returns, they focus on recent ones. Those tell a different story.
    Between World War II and 2000, house prices beat inflation by about 2 percentage points a year. (Stocks during that time beat inflation by their usual 7 percentage points a year.) Since 2000, houses have outpaced inflation by 6 percentage points a year. (Stocks have merely matched inflation.)
    Stocks versus houses: Valuations
    But though stock returns have come from increased earnings, house returns have come from ballooning valuations, not increased rents. The ratio of share prices to company earnings (the price-earnings ratio) has remained relatively steady. It's about 16 today, close to both its 1940 value of 17 and to its 130-year average of about 15. Not so the ratio of house prices to rents. In 1940, the median single-family house price was $2,938, according to the U.S. Census Bureau, while the median rent was $27 a month, including utilities. That means the ratio of prices to annual rents was 9. By 2000, the ratio had swelled to 17. In 2005, it hit 20. We can adjust for the size of dwellings, but it doesn't make much difference. The ratio of single-family house prices to three-bedroom apartments is 19. In SmartMoney's hometown of Manhattan, where more detailed data is available, the ratio of condo prices per square foot to apartment rents per square foot is 22.

    Two main events have caused house valuations to inflate since World War II. First, the government subsidized housing by relaxing borrowing standards. Before the creation of the Federal Housing Authority (FHA) in 1934, homebuyers who borrowed typically put up 40% of the purchase price in cash for a five- to 15-year loan.
    By insuring mortgages, the FHA permitted terms of up to 20 years and down payments of just 20%. It later expanded the repayment periods to 30 years and reduced down payments to 5%. Today, down payments for FHA loans are as low as 3%. Aggressive lenders offer loans with no down payments or even negative ones so that homebuyers can borrow the full purchase price plus closing costs. Some require little documentation of income, assets or ability to pay.
    That means more Americans can win loans for homes, and they can win them for far more expensive homes than their incomes had previously allowed. Two-thirds of American households own homes today, up from 44% in 1940, even though the percentage of Americans living alone has tripled during that time. The ratio of house values to incomes has risen 260% in just under four decades.
    A second event helped boost house demand in recent years. Share prices plunged in 2000. The Federal Reserve, fearing that the decline in stock wealth would cause consumers to stop spending, reduced the federal-funds rate, the core interest rate that determines the cost of everything from credit cards to mortgages, to 1% by summer 2003 from 6.5% at the start of 2001. Since most of the cost of financing a house over 30 years is interest, monthly house payments shrank and demand for houses soared. In some markets a string of big yearly increases in house prices led to panic buying.

    Stocks versus houses: Conclusion
    For house returns over the next 20 years to match those over the past 20, the government and private lenders would have to "up the ante" by relaxing borrowing standards further. Given the recent attention paid to swelling foreclosures, that seems unlikely. I suspect real returns will turn negative over most of the next two decades, but that house prices won't necessarily dip. Since 1963, they've done so in only two years versus 18 for stocks.

    That's because homeowners mostly just stick it out rather than sell during soft markets. But if house prices remain flat, they produce negative real returns due to the creep of inflation. According to calculations made by The Economist in summer 2005, house prices would have to stay flat for 12 years with annual inflation at 2.5% for the ratio of prices to rents to fall from its 2005 perch to merely its 1975-to-2000 average.
    So to sum up why I rent: Shares right now cost 16 times earnings and over long periods return 7% a year after inflation. Houses right now cost 19 times their "earnings" and over long periods return zero after inflation. And they look likely to return less than that for a while.
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  • #2

    #2

    Re : Real Return on RE is ZERO!!!!!!!!!

    Questions and objections
    In what follows I've tried to anticipate and address questions and objections:
    "You can't live in your stocks" or "Renters throw money down the drain."
    Rent is the cost of owning shares with money you would otherwise spend on a house. Houses have ownership costs, too: taxes, insurance and maintenance. Rent costs about 5% of house prices each year if we apply the price-rent ratio of 19. House incidentals often cost around 2%.
    If you have $300,000 and a choice between spending it on a house or shares, you'll pay $6,000 a year in incidentals if you buy the house or about $15,000 a year ($1,250 a month) in rent if you buy the shares. But the shares will return $21,000 a year after inflation while the house will return zero. (My numbers work out even better than these. I pay a smidgen less than $1,250 a month for rent, while house prices in my neighborhood are far higher than $300,000.)
    Note that houses and shares have transaction costs, too. Homebuyers pay around 1% in closing costs when they buy and 6% in broker commissions when they sell. Share buyers pay $10 trading commissions, which are negligible for buy-and-hold investors.

    "Homebuyers get tax breaks."
    So do share buyers, but both are a bad deal. The interest on loans for houses (mortgages) and shares (margin balances) is tax-deductible. But the rates are almost always too high. A big house loan presently costs 6.1% interest, while a big stock loan costs about 9%. For the returns, we can forget about inflation because it helps debtors while hurting investors, making it a wash for those who borrow to invest. Still, nominal returns of 3% for houses and 10% for stocks aren't high enough to justify those rates. The tax breaks aren't really breaks at all. Moreover, a majority of homeowners don't claim them. Their incomes are low enough to make the standard deduction a better deal.
    "What about the pride of homeownership?"
    It's not for me. I define ownership as no longer having to pay for something and being able to do as I please with it. I own my coffee maker. Homeowners must pay taxes each year even when their mortgage payments are done. In certain markets they can't even make changes to the houses they've paid for without seeking the approval of others. Personally, I feel the pride of ownership for shares of businesses, and I'm proud to occupy a nice place while leaving the burden and poor returns and maintenance to someone else.
    "You seem to knock government housing subsidies, but they've helped many Americans afford homes."
    My inner sot agrees. My other inner sot worries that the government has effectively raised prices to the point where the middle class can't afford houses or buries itself in debt to own them. My inner capitalist is too busy watching shares to care about house prices. My inner conspiracy theorist notes that while politicians tout the social benefits of homeownership, none mentions its tax benefits to the government. I pay no taxes on the overall value of my stock portfolio, just on my cashed-in gains and collected dividends. But Americans pay taxes on the full $11 trillion worth of housing they own plus the $10 trillion worth of it they're still paying off.

    "Houses are bigger than apartments."
    True, and both can be rented. A third of renters live in single-family houses. I prefer an apartment for now. I like not having to fill it with stuff. I like using a fifth of the energy of the average American. I like being 20 minutes from work and not having owned a car in 10 years. I like not stressing over whether to get the marble countertops or the imported tiles or the 52-inch flat screen. I'm not especially frugal; I spend a teacher's salary each year on restaurants and travel. But I guess I'm too busy or lazy right now to bother with a big house and its innards.

    "Are you saying I should sell my big house and rent an apartment instead?"
    No, unless you have more space than you need and moving wouldn't be disruptive to your family, and you want to cash in on recent housing gains, make more money over the next couple of decades, use less energy while simplifying your life, and you don't mind seeming odd to friends. In which case, yes. But really, I'm not trying to win anyone over. Strong demand for houses keeps my rent cheap.

    "Renting is for poor people."
    True. But it's for rich people, too. The average renter makes about $34,000 a year, but while the percentage of renters declines after incomes exceed $20,000 and rents exceed $600 a month, it jumps again once incomes top $150,000 and rents top $1,200 a month. In other words, poor people rent modest apartments for lack of choice. Middle-income people buy houses. High-income people, presumably with a dose of financial savvy, often rent nice apartments instead of buying.

    "You say houses return zero. But I've made a fortune on my house in recent years."
    I'm referring to inflation-adjusted returns over long periods, absent external boosts to demand. You're referring to gross returns over a short time period that combined lax borrowing standards and ultra-low interest rates. Over the next 20 years I believe houses will return zero or slightly less after inflation, and that stocks will return 7%.

    "So you're never going to buy a house? What about raising a family?"
    I might buy one eventually, but the longer I can put it off the more I'll get out of the shares I'll have to sell to afford it. I'm 34 now with a fiancée and a fish. I'm going to try to rent for at least 10 more years. If I have kids I'll probably move into a big apartment or a house once they reach running-around age. I'll rent, most likely.
    This article was reported and written by Jack Hough for SmartMoney.

    Comment

    • #3

      #3

      Re : Real Return on RE is ZERO!!!!!!!!!

      Originally posted by pcpune View Post
      Questions and objections
      In what follows I've tried to anticipate and address questions and objections:
      "You can't live in your stocks" or "Renters throw money down the drain."
      Rent is the cost of owning shares with money you would otherwise spend on a house. Houses have ownership costs, too: taxes, insurance and maintenance. Rent costs about 5% of house prices each year if we apply the price-rent ratio of 19. House incidentals often cost around 2%.
      If you have $300,000 and a choice between spending it on a house or shares, you'll pay $6,000 a year in incidentals if you buy the house or about $15,000 a year ($1,250 a month) in rent if you buy the shares. But the shares will return $21,000 a year after inflation while the house will return zero. (My numbers work out even better than these. I pay a smidgen less than $1,250 a month for rent, while house prices in my neighborhood are far higher than $300,000.)
      Note that houses and shares have transaction costs, too. Homebuyers pay around 1% in closing costs when they buy and 6% in broker commissions when they sell. Share buyers pay $10 trading commissions, which are negligible for buy-and-hold investors.

      "Homebuyers get tax breaks."
      So do share buyers, but both are a bad deal. The interest on loans for houses (mortgages) and shares (margin balances) is tax-deductible. But the rates are almost always too high. A big house loan presently costs 6.1% interest, while a big stock loan costs about 9%. For the returns, we can forget about inflation because it helps debtors while hurting investors, making it a wash for those who borrow to invest. Still, nominal returns of 3% for houses and 10% for stocks aren't high enough to justify those rates. The tax breaks aren't really breaks at all. Moreover, a majority of homeowners don't claim them. Their incomes are low enough to make the standard deduction a better deal.
      "What about the pride of homeownership?"
      It's not for me. I define ownership as no longer having to pay for something and being able to do as I please with it. I own my coffee maker. Homeowners must pay taxes each year even when their mortgage payments are done. In certain markets they can't even make changes to the houses they've paid for without seeking the approval of others. Personally, I feel the pride of ownership for shares of businesses, and I'm proud to occupy a nice place while leaving the burden and poor returns and maintenance to someone else.
      "You seem to knock government housing subsidies, but they've helped many Americans afford homes."
      My inner sot agrees. My other inner sot worries that the government has effectively raised prices to the point where the middle class can't afford houses or buries itself in debt to own them. My inner capitalist is too busy watching shares to care about house prices. My inner conspiracy theorist notes that while politicians tout the social benefits of homeownership, none mentions its tax benefits to the government. I pay no taxes on the overall value of my stock portfolio, just on my cashed-in gains and collected dividends. But Americans pay taxes on the full $11 trillion worth of housing they own plus the $10 trillion worth of it they're still paying off.

      "Houses are bigger than apartments."
      True, and both can be rented. A third of renters live in single-family houses. I prefer an apartment for now. I like not having to fill it with stuff. I like using a fifth of the energy of the average American. I like being 20 minutes from work and not having owned a car in 10 years. I like not stressing over whether to get the marble countertops or the imported tiles or the 52-inch flat screen. I'm not especially frugal; I spend a teacher's salary each year on restaurants and travel. But I guess I'm too busy or lazy right now to bother with a big house and its innards.

      "Are you saying I should sell my big house and rent an apartment instead?"
      No, unless you have more space than you need and moving wouldn't be disruptive to your family, and you want to cash in on recent housing gains, make more money over the next couple of decades, use less energy while simplifying your life, and you don't mind seeming odd to friends. In which case, yes. But really, I'm not trying to win anyone over. Strong demand for houses keeps my rent cheap.

      "Renting is for poor people."
      True. But it's for rich people, too. The average renter makes about $34,000 a year, but while the percentage of renters declines after incomes exceed $20,000 and rents exceed $600 a month, it jumps again once incomes top $150,000 and rents top $1,200 a month. In other words, poor people rent modest apartments for lack of choice. Middle-income people buy houses. High-income people, presumably with a dose of financial savvy, often rent nice apartments instead of buying.

      "You say houses return zero. But I've made a fortune on my house in recent years."
      I'm referring to inflation-adjusted returns over long periods, absent external boosts to demand. You're referring to gross returns over a short time period that combined lax borrowing standards and ultra-low interest rates. Over the next 20 years I believe houses will return zero or slightly less after inflation, and that stocks will return 7%.

      "So you're never going to buy a house? What about raising a family?"
      I might buy one eventually, but the longer I can put it off the more I'll get out of the shares I'll have to sell to afford it. I'm 34 now with a fiancée and a fish. I'm going to try to rent for at least 10 more years. If I have kids I'll probably move into a big apartment or a house once they reach running-around age. I'll rent, most likely.
      This article was reported and written by Jack Hough for SmartMoney.
      Although i agree to what u r trying to say, equating American Scenario to Indian Stock Market/RE is a fundamental error..tht too u r quoting a Smart Money Guy, wo how can you expect a neutral view?? u ll find thousands of such articles when u google, but how many of them actually stand the research and substance is questionable!! If u really want to derive some conclusion out of any kind of study, i suggest go to Gartner and other research websites!! not sure if they carry Pune specific Study

      personally i am big time into Stock Market, but putting my savings into Stock Market will be worse than booking a house in Pimple Saudagar for 4500 psf There needs to be a balanced allocation of portfolio and if someone is taking care of it, they don't need to worry too much about fluctuations in Stock / RE market!!
      Last edited June 21 2010, 04:42 PM.

      Comment

      • #4

        #4

        Re : Real Return on RE is ZERO!!!!!!!!!

        In our scenario it is not completelytrue. We had a cycle and it ran from 2003-8. This cycle has eloped and a new cycle will emerge after a while (don't know when ). So if you can ride on this so called cyle you can earn almost twice as much.
        Well stocks give more than 10-15 % PA in our country. so money has also doubled in this case too.

        Comment

        • #5

          #5

          Re : Real Return on RE is ZERO!!!!!!!!!

          I agree with what pcpune has said but only on investment terms.
          Man, how can one compare a house for self use with investments?? By this logic one should not buy a luxury car but invest that money, get +ve returns on it & travel by public transport as it would be virtually free.

          House for self use is a LIABILITY & NOT INVESTMENT. Personally, I would always buy a house/s (why isn't many houses called hice like mice ) for self use, you can't calculate everything in terms of money. There are somethings in life meant for pleasure (hey, nothing that sort of thing) & you can't bring in money here.

          As said before house ownership is great, until & unless you ruin your life paying for it!! For me, it is rent as long as valuations are not logical, the moment you get good deal, jump in.
          If you are happy, you are successful.

          Comment

          • #6

            #6

            Re : Real Return on RE is ZERO!!!!!!!!!

            Originally posted by chinmay686 View Post
            Although i agree to what u r trying to say, equating American Scenario to Indian Stock Market/RE is a fundamental error..tht too u r quoting a Smart Money Guy, wo how can you expect a neutral view?? u ll find thousands of such articles when u google, but how many of them actually stand the research and substance is questionable!! If u really want to derive some conclusion out of any kind of study, i suggest go to Gartner and other research websites!! not sure if they carry Pune specific Study

            personally i am big time into Stock Market, but putting my savings into Stock Market will be worse than booking a house in Pimple Saudagar for 4500 psf There needs to be a balanced allocation of portfolio and if someone is taking care of it, they don't need to worry too much about fluctuations in Stock / RE market!!
            I disagree, I am as well BIG into stocks (Dads been since 30 years) infact bulk of my savings go into Mutual Funds and into Stock Market. The problem with RE is - you cannot SIP it ...and the investment does not grow - even in India the long term average is 5-7%, while for stocks it is over 12-15%. In RE, one bad move and you are stuck with it for your life....

            In stocks & MFs, you can build your wealth slowly but steadily - and there is no need to TIME the market,...in RE --- you definately need to.

            Comment

            • #7

              #7

              Re : Real Return on RE is ZERO!!!!!!!!!

              Originally posted by saggii View Post
              In our scenario it is not completelytrue. We had a cycle and it ran from 2003-8. This cycle has eloped and a new cycle will emerge after a while (don't know when ). So if you can ride on this so called cyle you can earn almost twice as much.
              Well stocks give more than 10-15 % PA in our country. so money has also doubled in this case too.
              As I said earlier, the returns in RE are 5-7% in India...for stocks it is well over 12-15% in long term..hence inflation adjusted ..it is still 7% for stocks and 0% for RE in India as well.

              You are correct - one needs to ride the boom and bust cycles in RE and one needs to time to the market...However, for stocks - JUST SIP it....

              Comment

              • #8

                #8

                Re : Real Return on RE is ZERO!!!!!!!!!

                Originally posted by realacres View Post
                I agree with what pcpune has said but only on investment terms.
                Man, how can one compare a house for self use with investments?? By this logic one should not buy a luxury car but invest that money, get +ve returns on it & travel by public transport as it would be virtually free.

                House for self use is a LIABILITY & NOT INVESTMENT. Personally, I would always buy a house/s (why isn't many houses called hice like mice ) for self use, you can't calculate everything in terms of money. There are somethings in life meant for pleasure (hey, nothing that sort of thing) & you can't bring in money here.

                As said before house ownership is great, until & unless you ruin your life paying for it!! For me, it is rent as long as valuations are not logical, the moment you get good deal, jump in.
                That is very true, but even this is what the author is saying...He is just calculating the PE of RE and for him 19 is expensive -- that is cost of owning is 19 times annual rent...

                Mathematically, at 10% inflation and 10% interest rate, and at PE of 20, you need to really grow at 20% each year for the next 20 years to break even --- THIS IS VERY IMPROBABLE...

                In India, the annual rent:sale is way ahead - 1:30, even 1:40 in Pune...Now that is considered to be a very expensive PE...and this is the reason he is content with stocks available at PE of 15,maybe 10...

                So...once the RE reaches that levels...I say even 1:20 -- which is where I will surely jump in to buy in Punee..

                Also, another point I like is - he is delaying the purchase to say when he is 40-45 - this is the age most of our fathers use to buy or own...the average age has gone down today to 27-30...

                However, I believe 35-45 is the right age to make a purchase - this way you should be able to pay atleast 50-70% of the property value with your savings - THEN take a 5-10 year kind of a loan and still keep investing in Mutual Funds and Insurance.Hence, at retirement you will have a good corpus + a house + insurance + PF....

                Comment

                • #9

                  #9

                  Re : Real Return on RE is ZERO!!!!!!!!!

                  hmm interesting post,
                  would be great to put actual purchase figures from our personal purchases versus rates of inflation in that period, India specific & see what actual real returns are.

                  For e.g.
                  I bought a flat 1075/- psf in 2004, today, asking price is 4200/-.
                  Can I get a work around on real returns please !!

                  Comment

                  • #10

                    #10

                    Re : Real Return on RE is ZERO!!!!!!!!!

                    Easy Money, Not in this world my friend.

                    Originally posted by ferozkarim View Post
                    hmm interesting post,
                    would be great to put actual purchase figures from our personal purchases versus rates of inflation in that period, India specific & see what actual real returns are.

                    For e.g.
                    I bought a flat 1075/- psf in 2004, today, asking price is 4200/-.
                    Can I get a work around on real returns please !!

                    Any purchase done during 2004/2005 have similar returns. Nothing special or specific to your investment. Do you have any example of purchase done early 2008/2007 end?


                    I am sure this was the asking price even in 2008. right so say you got appreciation in 4 yrs from 1075 to 4200, so 3100/sq feet. so for 1200 sq feet 2BHK, you made 1200 * 3125 = 37.5L cool. How much salary did you make from 2004 to 2007 end? 4 yrs? If your salary is 10L /yr average you made salary of 40L.

                    Few questions to you. You should ask yourself and try to answer them yourself. It will help you only.

                    So do you think you should work? go to office? Just buy flat in Pune and you make money right?

                    Average Pune salary may be ~5L/yr (rough guess), why should people work? when they make more buying a single 2BHK?

                    Prices rose and rent did not. This indicates a price bubble. Prepare for its burst instead of investing now.

                    Comment

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