Comparative Appreciation

If a Wall Street index has an appreciation rate of 10% and real estate only 8%, Wall Street is two points better, right? Yes and no.   When economists compare stock versus real estate they typically compare the dollar capital appreciation and ignore tax advantages in the event of profit. The profit on any stock sale begins with the first dollar made, but taxes on an owner occupied home begin at $250,000. In the case of income property, only after expenses are deducted.

If the house was bought for cash with no mortgage the return on the capital dollar is a fair comparison. If the stock and the house investment were bought and liquidated at the same time, (less cost of sale) the stock could yield a better return. But real estate is seldom bought for cash. The deposit (10 to 30%) is usually leveraged with a mortgage. Here is where the magic starts.

Cash-on-Cash Returns

This is a term that all but the most sophisticated investors do not seem to understand or talk much about.

Wall Street talks about a ten or 15 percent return with a certain reverence. This is the effective return on the actual amount of money invested. Take the same definition of “the actual money invested” by an investor in real estate. Then determine the value of the amount of property that can be controlled using the power of borrowed money (a mortgage), and the actual cash invested is leverage massively. For example if $10,000 is the deposit required as the down payment to buy a $100,000 property, a 10% rise in the value delivers a 100% return on the 10% invested:

• Price of property: $100,000
• Deposit: $10,000
• 90% mortgage:  $90,000
• Property value: $100,000
• Assume 1^st year
• Appreciation 10%: $110,000
• First year return: $10,000
• Equals 100% return

The cash (return) on (the) cash (employed) equals 100%. This example is conservative. The appreciation reported by US Census for the Pacific Region for the year ending March 31^st 2005, translates into a 212.5 percent return assuming 90% loan to value loans were used. In 2008 appreciation has moderated and in many cases is reported to have gone backwards by up to 10 to 25 percent but is still ahead on 2005 valuations. Where can you get this type of return on Wall Street especially given the 33% retrenchment in 2008? Now add the security of real estate that can never go to zero value? Historic appreciation through good years and bad is averages about 5 percent.

The competition for investment dollars.

In the battle for investment dollars, Wall Street advisors are competing with real estate with both hands tied behind their back.

Wall Street was on full “bubble watch” during the real estate value run up from the late ‘90s to 2006 as they were increasingly concerned by the amount of money that had left their care and management for the security and the superior returns of real estate.

When the market started to moderate and slip backward, indexes like S&P Case/Shiller diligently reported precipitous losses by averaging samples in 20 of the most dynamic markets. This immediately raised doubt in consumers and other market interests about the viability of housing as an asset. The ratings agencies like Moodys, Fitch and S&P did not break stride and reaped huge revenues from rating the mortgaged backed security funds and the bond insurers that covered risks on these.

Having been associate publisher of Technology Investor Magazine (a NASDAQ focused magazine) we have a slightly “dark” attitude toward the Wall Street marketing machine. A savvy self-directed investor is not an ideal Wall Street customer. They ask tough questions that are not satisfied with simple answers.

For example why can S&P Case/Shiller only look at 20 markets and average homes in good neighborhoods where values have remained steady and not fallen? Then there are new build neighborhoods in remote areas that have dropped 30 to 50% as they became nearly undesirable and uneconomic destinations for the folks they were meant to house. Wise real estate investors understand this. Wall Street and their cheerleaders do not.  Most homes are considered “castles” that defy convenient and misleading commoditization. Behavior maybe, but not the housing stock that ranges from inexpensive tract home to luxury homes is perennially stable and desirable neighborhoods. To the fundamental and technical analysis of a stock, any home analysis must also add messy cultural and personal value considerations driven by a location.

INDEX CHALLENGE

The S&P 500 is a basket of five hundred companies; however 206 of the companies that were on the list in 2000 were replaced by January 1^st 2006. That means the data making up the baseline index is subject to a “best of breed” adjustment!

Take the top 500 zip codes in the United States and map appreciation. First the base line data cannot be adjusted as these exist as long as the USPS says so or near in perpetuity. We have not done this calculation but we suspect it will result in a very favorable real estate story.