Returns on apartment rentals

A friend of mine, who lives in Washington DC, actually asked me a similar question today. To calculate the returns, you need to take into account net rental income -i.e, gross rental income and then deduct utilities, repairs, property taxes, and so on-. Then divide this net income by the actual price you paid for the house. Assume that house prices, over the long term, go in line with inflation, that's a realistic assumption (see Shiller).

By the way, the advice I gave to my friend was that she shouldn't buy the apartment. It is quite expensive, 500K (it is in the Foggy Bottom area of DC, just two blocks from the Watergate building). The market rental price for such an apartment is $2,200 - $2,300/month, to which she has to deduct about $1,100 of expenses. The net rental income is $1,100 - $1,200/month, or about $14,000 a year. This implies a real rate of return of just 2.8 percent, which is pretty low, in particular when we consider that the DC area market is clearly overvalued and there is a high risk of a downward price adjustment (which has already started to happen during the last months).

Yes, $2,200 rent on a $500k apartment sounds very unappealing. Sounds about as bad stocks right now (in terms of earnings per dollar invested)

I will research local prices a little. I will talk to some friends who are in related businesses, as well. What I like about this is a lot of tax writeoff possibilities and a relatively steady income.

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It may help if you compare the return of this investment with other potential investments -such as stocks- as well as the interest rate you would pay if you had to get a loan to buy the building (about 6.2 percent at end-2006). This means that you would pay a real rate of around 4 percent (expected inflation is around 2 percent a year). You would need to charge a rent of 4 percent of the value of the home plus expenses just to balance your investment. My feeling is that such rent is too high, given current market conditions (another sign that the housing market is overvalued).

This paper by Shiller -written 9 months ago- provides some insight about long-term trends in the housing market (prices and rents):

Just a minor point. The average P/E of the U.S. stock market right now is 18, while the average P/E implied in my friend's (potential) investment is 100 / 2.8 = 36. So if she buys the house (I don't think that she will buy it, she is a pretty smart lady with two PhD degrees) she will buy an asset which is much more expensive than stocks. In fact, most analysts don't think that the U.S. market is overvalued at all right now.

Tax is only one aspect of it. If the fundamental investment isn't sound, all the deductions in the world don't help. And keep in mind, as you take depreciation, your basis drops. So in 10 or so years, if the property is up 50%, and you've depreciated half, you have 2/3 of the sale price to pay tax on. I speak from experience that in real estate *stuff* can and does happen. You run a spreadsheet, find that even with x% for repairs the property runs cash positive. Then the tennant (whom you ran a credit check on) stops paying. Three months later, the judge gives him three months to vacate. See the movie "Pacific Heights" before buying any rental property. On the other hand, an eight unit apartment building in the right area can work. You're not counting on one tenant to pay. In a multi-unit situation, where six of eight occupied units are break even, you have the chance to get through a bad tennant or two, and treat every vacancy as a chance to put some sweat equity in with some fixing. Just my thoughts. JOE

Oh yawn.

There are two types of income from stocks: dividends and captial gains. You've got recurring and one time. There is no guarantee that earnings will show up in dividends or share price. Those 100 million dollar CEO compensation packages and corporate jets have to come from somewhere you know. Dividends and long term capital gains are tax advantaged (15% bracket). Short term capital gains isn't tax advanted.

There are two types of incomes from real estate: rent and capital gains. Rent isn't tax advantaged, but is often offset by the depreciation allowance. Long term capital gains is much like stocks (15%). I am currently living in my former rental to get the $250K owner occupied capital gains deductions. Unfortunately you can't live in your Microsoft stock.

There is also the matter of leverage. Prudent stock market investing is typically done with a leverage of one (no margin used). Prudent real estate investing is done with a leverage of 2, 5 or even 10 (infinite is possible, some properties will cash flow with 100% financing). A 5% rise in the price of housing with leverage of 5 is a ROI of 25% on your down payment.

There are more complications than that. Comparing P/E to P/NOI is apples to oranges.

The basic fact is that long-term average returns of stocks are much higher than those of real estate. Stocks yield an average of 7 percent in real terms over the long term (dividends and capital gains), with some types of stocks -small caps, value stocks- yielding as much as 12 percent on average.On the other hand, real estate/houses do not show any significant long term real price appreciation, i.e., zero capital gain over the long term, and the rental income -similar to the dividends paid by stocks- is around 3 percent of the house price. If you compound an investment earning 7 percent a year, you need only 10 years to double your initial investment, wheeas a 3 percent return means that you need 23 years to achieve the same result.

Of course, the caveat of stock market investments is that their returns are more volatile over the short term. But then again, given the degree of overvaluation of most local housing markets in the U.S., investing right now in real estate doesn't seem pretty safe either.

Jose Bailen wrote: On the other hand, real estate/houses do not show

An excellent example of the claims about real estate return made by stock investors.

No appreciation on real estate? Leverage times nothing is nothing? Right?

Let's look at the Office of Federal Housing Enterprise Oversight (OFHEO):

Note that a house worth 100 points in 1980 is worth 406 points in 2004. Round that off to 24 years. This is a return of 6%, not the "3% inflation rate". This rate is lower than what California has seen recently as it looks at conforming loans and California has appreciated well beyond that recently. A 3% return would be 203 points Further more with leverage of 5 this is a return of around 30% on down payment (the actual math is a bit messy). So let's say the rent just covers the inflation rate (a modest assumption), you are way ahead average stock return.

So in general real estate appreciates above the inflation rate. What about the specific? Let's take my experience. Investing a million dollars in California real estate in June 2000. (Any guesses how I got a million bucks during the dot com craze?) It appreciated about 15% a year for the next three years invested in real estate. Oh and returned

3% or so additional in rent when CDs where returning 1% or 2%. The S&P 500 was about 1450 in June 2000. Three years later it was about 900, a loss of about 13% a year. How much pain can an investor be expected to suffer before selling? Oh, but there were those great 2% or 3% dividends. That would have turned my million dollars into about $655,000. Summary: Real Estate worth about 1,450,000, S&P 500 worth about $655,000. I guess I missed out on that great opportunity by not "buying a well diversified stock portfolio". This example has GREAT personal meaning to me. It's just a story to you.

As an engineer it is obvious that high technology has heavily subsized the reported inflation rates. Gigabyte disk drives, megabyte memory chips and most any electronics keeps sinking in price. I'll bet a PS3 has just about the highest depreciation rate of any common (somewhat durable) consumer item. Cars simply couldn't meet emissions standards without high tech electronics, at any price. Housing, gold and oil keeps going up. There is differential inflation. Housing "inflation" is much higher than electronics inflation (deflation actually). This obviously affects real estate investment. If electronic equipment rose in price by the standard inflation rate, the inflation rate would be much higher.

Stocks are a great investment for employees who want a "paper investment" with no work. The simplicity of stock investing has great appeal to me. Stocks simply don't return 3 to 4 times as much as real estate for the people who have the time and inclination to manage it.

What I find interesting is that data seems identical to that which I referenced in another post, yet my source called it 'median home value', which did not adjust for size, and during that time, house grew at

1.5/yr on average. (of course not a given home, but median size due to new construction). And this time period did see high inflation, 4.5% on average. The math works out to zero appreciation. JOE

There's no denying real estate was a great investment from 1997 to

2005. From looking at the data, it appears to be the biggest housing boom ever. But since we can't get into our time machines and head back to 1997 to buy real estate, all we can do is prepare for what may happen by examining past trends. And past trends have shown that housing before 97 has typically appreciated at about the rate of inflation after evening out the peaks and valleys. (Your example period of 1980-2004 included 7 of the 8 boom years and yet was still only ~2% higher than inflation during the period.)

My own pers> Note that a house worth 100 points in 1980 is worth 406 points in 2004.

Isn't there an option of investing in commercial real estate? I've read from several sources that it can have returns of 10%, although those books were written pre-2000. (On the other hand, I don't see the evidence of that in current REIT prices, although they have run up at more than 10% in the last 10 years - see my recent post on what appears to be overvalued REIT prices.)

(disclaimer: I don't claim to know anything substantial about the real estate market - residential or commercial)

These are the long-term trends:

The fact that prices have gone up by so much it's actually an indicator of a bubble and that prices will likely decline in the near future. It's the same with stocks: the fact that the prices went up in the late

1990s so much -the average P/E reached a historical level- only made the fall much more likely, as it happened en the early 2000s.

I personally invested in commercial real estate -in Spain, 5 yrs ago- and the return has been great (I've more than doubled my initial investment). But I don't think that these returns are permanent (planning to sell real estate and buy more stocks here). Real estate was a good investment -in the U.S. and in many European countries- 5-7 yrs ago, when the interest rates were low and the stock market was overvalued and going down. But not right now, if anything, now real estate is overvalued by most measures, including price/rent ratios.

Thanks. I looked a little bit at my local real estate listings and apartment listings. Admittedly did not do a very fine job at statistics gathering. One bedroom apartments in a certain area of multifamily buildings are listed for about $125,000. I figure that if I negotiate patiently, and pay cash, I could buy one for $115,000 or so, especially given current "housing slump".

Rent on such an apartment is approximately $720 per month.

On a year to year basis, this means 7.5% return. With sensible tax related maneuvers, it might be bumped a little bit into 8% area. Assuming modest 2% per year appreciation (we are in a housing slump, so prices are less than at the peak), it goes to about 10 cents on the dollar invested, per year. This does not figure in property taxes, upkeep expenses, bad tenant expenses, etc etc. All in all, definitely not a rocket investment, though it is much better than having cash in a CD account.

As for stocks being an alternative, they are of course an alternative, but not a huge bargain either. Most of my money that is invested in stocks (which is about half of my savings) is invested in one stock only, that's done okay over the years. Unfortunately, it is not cheap now and I would not be adding to it.

Stocks have done very well in the past, but that does not say much about how they will do in the future.

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Joe, thanks, I will try to see if I can find that movie anywhere. Yes, nothing more unpleasant than dealing with crappy irresponsible people.

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We need to compare apples with apples, and add rent to appreciation of homes. I just ran some numbers and think that real returns could be about 7-8% on homes.

Well, right now we are in a somewhat of a housing slump, which makes investing in housing look more attractive.

Another caveat is that just because something has done well in the past, means only that and has no such implication for the future.

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