Woohoo. Ok, I'm gonna try to reply here. Probably only interesting to your or I. I figured out some of the confusion is coming from our context. I was soley discussing an owner occupied dwelling. So I'll clarify here (see below).
Quote from pitz:
The fallacy lies in looking at it from the point of view of 'paying down the mortgage'. That's not the issue. Leverage only works if the total return on an asset is greater than the cost of the financing.
The current yield on typical real estate is less than 5%. Inflation is 3%. 30-year money costs 6.5%.
Rents will grow at the rate of inflation in the long run, and no faster, on average. Thus, the ROA for 'typical real estate' using the parameters given is 8%. The spread earned between the cost of borrowing, and the return on assets acquired through borrowing is, at best, 1.5%.
To achieve a return of 10%/annum, which is the long-run unlevered return of the stock market, you would have to lever your money up by 6.7X.
But wait! Its fairly unlikely that you're going to find a 6.5% interest rate to finance an asset that's been levered up 6.7X. So you have a little bit of a problem even maintaining the same ROE that you would get from an unlevered investment in the stock market, through real estate.
But it happens all the time. You buy a house (to occupy) with 3% plus closing costs, and you're levered at about 17 to 1. And they give you the owner occupied rates of 6.5% fixed. Right now, you can get about 5:1 on investment property, but you can do "no money down" deals and theoretically have infinite returns. I once walked away from a closing with money in my pocket, but that makes me sound like Carleton Sheets and those days are over for now.
Quote from pitz:
What 6%? My calculations are based on *total* return, which is the rent (net of expenses) paid to the owner of the real estate asset + a component for inflation of the underlying building itself.
But leverage always has a cost (and 10X leverage has a much higher cost than lower amounts of leverage).
The 6% was intended to represent the opportunity cost. My statement was confusing and poorly written. Moving on, the interest rate spread for different amounts of leverage is very small. If you leverage at 17 to 1 by putting down a 3% down payment, you may pay only a 1/4 of a percent more than if you put down 20% and you're leveraged at 5:1. It is interesting that if you seek leverage, there is little disincentive not to lever huge.
Quote from pitz:
Yes, but that $900k note is costing you at least $65k/year to service. Yes, your tenants will give you some cashflow to pay for it (~$40k), but at the end of the day, you only have $15k/year left over as 'return' on your $100k investment.
Here I was talking about owner occupied. Agreed that this would be not so hot returns for rental properties, but owner occupieds can lever much more, like 17:1. Cash needs to flow better for an investment property.
Quote from pitz:
Crash of 1929 aside, borrowing $50k to fund a $150k stock portfolio would not have posed any risk to your portfolio in the long term. But there have been plenty of instances of 10% declines in RE prices in markets throughout the world.
Borowing $50K to fund a $150K stock portfolio is more dangerous than leveraging 17:1 for a typical home purchase IMHO. Stocks move backward 33% all the time, but home prices seldom do...at least in the long-run.
You only realize a price decline in real estate if you sell. If you're owner occupied, there is no reason to take a loss unless you move, get divorced, etc. Yeah, there is risk involved. But with rental property, when prices decline, the demand for rental housing most often gets better. Again, no reason to sell. Also, bear in mind, there are no margin calls in real estate, but you can get a margin call if you leverage high.
Quote from pitz:
Shiller makes a fairly good case that RE is 50% overvalued based on historic relationships between incomes and rents; if reversion to mean took place on your 10X leveraged RE investment, you would be in the hole by $400k. At worst, with the stock portfolio, it can go to zero, and no worse.
Correlating incomes and rents doesn't make sense to me, because if incomes go up, rents can actually go down because more people buy homes so landlords compete for the remaining tenants. The reality is that rents have been depressed for years because it was so easy to get a loan and buy a house. Now that worm has turned, and people are less inclined (or able) to buy a house we're seeing it in rising rents. This is actually making rental properties more attractive and I've noticed that the smaller houses more typically befitting rental property are actually rising in my neck of the woods based on landlord demand.
I'm not saying that housing prices can't fall 50%, but I think that these ratios will close based on movement of other variables. Like wages going up, or rents going up. Or perhaps even rising rents creating more demand for purchases.
Quote from pitz:
If, under the conditions you describe, I can lock in a return for my landlord that is far beneath the long-run average of the stock market, and offload all of the risk associated with owning a home, then I absolutely would take you up on your offer.
When I do the math on the scenario of renting a $100k place at $4000/year, 3% inflation, for 30 years, the present-value, discounted at 10% of that obligation is $49,699.
I'd have to look at exact figures, since the ranges you give are fairly wide, but when I run the numbers using a 6% up-front payment, and a 20% premium, I get a present-value calculation of $50,953. (plus free rent for the rest of my days...)
So its pretty much a wash, and definitely not a magic means to transfer a lot of wealth from me to you, or vice versa.
You realize that my "offer" was the net effect of buying a house? You make a downpayment, and lock into a payment for 30 years. You can sell the house at any time and take back the downpayment, plus the leveraged returns on that investment.
When you buy a house, you can leverage your downpayment at 17:1 to 10:1 depending on right tolerance and reasonably expect returns at the inflation rate on the asset, which is a great ROI. You don't have to worry about margin calls, and the money you borrow for the levered portion is at about 6.5% which is a screaming deal. You generally can sell when you want to, unless something happens in your life that would likely require you to sell your other investments at a bad time too (job loss, divorce).
If you're a landlord, right now, you can't lever your money as well as you used to be able to. 5:1 is more typical now days, and this may mean a final yield of only 15% to 20%. However, you do get an enormous tax benefit associated with purchasing rental properties, and you can increase your cash flow every year which eventually more than offsets the payment. You can manage the risks with diligence, and sell when you want to.
SM
