What Real Estate Can Teach Us About Investing

Valuations Matter!

I’m going through my stack of Journal for Financial Planning magazines and I came across a very interesting article, “To Rent or Buy? A 30-Year Perspective” which you can find here.

What is interesting is how many similarities real estate has to financial investing.

The authors studied 6 different cities going back to 1984 to determine which course of action, buy or rent, had left the highest ending net worth. The cities were Kansas City, San Francisco, Chicago, Miami, Minneapolis and Stamford, CT.

What they found was those who bought in San Francisco in 1984 made out like bandits. Those who bought in Stamford or Chicago though would have been much better off renting.

Now, I do take issue with some of their research.

First, they compare a 4 bedroom apartment for rent to a 3 bedroom home for owning. A 4 bed apartment has roughly the same squared footage as a 3 bed home, which is why they make the comparison. I think this is a mistake. In my opinion, the utility of a 3 bedroom apartment is more congruent with that of a 3 bedroom home. No one is looking for a place to live based on the square footage of the place BEFORE they look at the number of bedrooms.

If they were to have looked at 3 bedroom rentals vs. 3 bedroom houses to buy this would have greatly improved the rental results in their study.

Secondly, they assume when there is savings from renting in terms of a monthly payment, those who rent would invest that savings diligently over 30 years. Yeah, I don’t think so.

This is similar to the fallacy of the “buy term and invest the difference” theory. Term is SO much cheaper than cash value life insurance you’d be well ahead after 30 years if you bought term and invested the savings than if you bought a whole or universal life policy.

In my experience, very, very few people actually “invest the difference.” There is always an immediate need to consume that money. In that case, where one is not actually “investing the difference” whole life insurance, similar to owning a home, can be a type of forced savings. It’s not the most effective way to build net worth but it works better than spending all one’s cash.

But even with these issues, the article still has a lot of wonderful takeaways. The most important in my mind is this:

“(T)he best renting scenario, Stamford, Connecticut, with net ending wealth of $462,629, and the best buying scenario, San Francisco, with net ending wealth of $1,456,296 (assuming a federal tax rate of 15 percent, a 50 percent equity/50 percent debt investment portfolio, and a 30-year holding period).”

So, if you would have rented in Stamford, CT you would be nearly $500,000 richer in your overall net worth. But if you would have bought in San Francisco, you’d be nearly $1.5 MILLION richer in your overall net worth!

That’s crazy, huh? Of course, hindsight is a wonderful thing. The study does look at many different time frames too. In 1991 San Francisco was the only of the 6 cities that made sense to own instead of rent if you were in the 15% tax bracket.

If you were in the 28% tax bracket, Miami was the only place you’d have preferred to rent in 1991.

They go on to look at a bunch of different time frames too. What they found that over 30 years owning increased your net worth over renting in Kansas City, San Francisco and Minneapolis for those in the 15% bracket. You’d have been better off renting in Chicago, Miami and Stamford.

Why is that?

And here is the kicker, the fundamental take away for ALL investors in ANYTHING….

“The main factors seemed to be initial rental costs and housing values, and the trajectory of housing and rent prices during the holding period….In 1984, the median price of a three-bedroom home in Stamford was $175,387, while the median price in San Francisco was a relatively inexpensive $114,547. Over the next 30 years, however, median three-bedroom home values in San Francisco increased by 393 percent to slightly more than $450,000. The median three-bedroom home value in Stamford increased to $520,000, but because of the higher initial starting point the rate of increase was lower at 296 percent.”

Let me emphasize the key thing here…”but because of the higher initial starting point the rate of increase was lower”

Valuations Matter! As I said at the start of this email.

The higher the price you pay for something today, the less potential for appreciation it has in the future, be it real estate, stocks, bonds or even baseball cards.

This is why the main factor in ANY investment that outperforms will always be valuations, i.e.. buy LOW and sell high. Buying low typically means when things look grim. San Francisco in 1984 was still a beautiful city but things looked grim.

Everywhere else in the US gays were denied rights. They found recourse in San Francisco. But AIDS was devastating the community. People weren’t quite aware of AIDS yet, and thus were nervous about it. So combine fear of AIDS and the fact that gays were an outcast, San Francisco didn’t have the same draw as a nice, “safe”, suburban town like Stamford.

Don’t forget, back then too, New York City was a cesspool of crime. People maybe worked in the city but they got the heck out of dodge come the 5 pm bell. For a wonderful description of NYC life back then read Tom Wolfe’s “Bonfire of the Vanities”.

So, where did people live who worked in NYC? They escaped to the suburbs, driving prices up in places such as Stamford.

Fast forward to the 90s, Giuliani cleans up NYC and suddenly it’s safe for wealthy hipsters to move in. Valuations take off.

While there wasn’t a Republican, crime-battler for mayor in San Francisco, acceptance of gays increasing and fear of AIDS collapsing, PLUS the tech industry taking off like a rocket, the beauty of San Francisco drew many a wealthy hipster too, all competing for a limited number of housing supply.

In hindsight, seems obvious, right? But few had the guts to actually invest in properties in these cheaper communities. After all, what if???

For those who did, though, they made out. Big time. Rewards go to the risk takers. But for every San Francisco there is another beaten down town that hasn’t risen from the ashes. Rochester, NY? Danvile, VA? In 30 years will these be today’s San Francisco or New York?

The thing for investing in the “stock market” is that the risk is ALWAYS there. A company that seems to be down and out has three ways to go. Bankrupt, continue to struggle along, or take off.

How do you know which it will be? You can’t. You can make presumptions but those are speculative of course. You can’t be sure. Which is what makes value investing, be it in real estate or equities, scary. What if you’re wrong???

Hard not to go with the “safe” of Stamford, CT. But to do so is a risk too. You could be $462,629 poorer. But if you go with the “risky” of San Francisco, you may be $1,456,296 richer, or broke.

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