Just because something costs a lot doesn’t mean it is an investment. An investment is something that pays you money.
For most families the largest purchase they make will be their house. It is crucial to understand how to consider real estate holdings in every aspect of wealth management, from asset allocation to retirement planning.
An investment is something that pays you money. Therefore the house you and your family live in is not an investment. Neither is the vacation home you rent occasionally. Nor that piece of land next to your house you bought to preserve your view. It is human nature to justify a purchase by calling it an “investment,” but if it doesn’t pay you money, it shouldn’t be treated as an investment in financial planning.
Historically, equities appreciate at a rate of about 6.5% above inflation. If inflation has historically been 4.5%, equities average about 11%. Equities include stocks, stock mutual funds and stock exchange-traded funds (ETFs). Your portfolio should be invested mostly in equity investments to appreciate at a rate greater than inflation.
Fixed income is more stable, but averages interest payments of 3% over inflation. If inflation averages 4.5%, fixed-income investments average 7.5%. Fixed income includes bonds, bond mutual funds and bond ETFs.
Real estate as an investment falls somewhere between stocks and bonds. On average commercial real estate produces a real return of about 4.9% over inflation. If inflation averages 4.5%, commercial real estate averages 9.4%.
Commercial real estate as property with no income does not appreciate at the rate of inflation. It actually depreciates against inflation by about 1% a year. Fortunately, it should produce 5.9% in profit to overcome this depreciation and produce a real return of about 4.9% over inflation.
Handling commercial real estate privately requires more work. If your commercial real estate isn’t generating a lot more income than it costs to maintain it–including depreciation–it isn’t pulling its weight. Only if it can produce significant income and grow at a real return of 4.9% over inflation will a $100,000 investment in real estate grow to $331,000 after 25 years.
Similar equations can be used for residential real estate. On average it produces slightly less income, giving a real return of 4.1% and growing to have a buying power of $273,000. Obviously all real estate is subject to the increasing desirability of the area where it is located. Some excellent school districts have experienced appreciation significantly greater than inflation. But many rural communities have barely kept up.
These historical averages provide benchmarks as a way to judge the investment worthiness of a particular piece of property. If you own a $300,000 rental home, you should expect to average at least $3,000 each year in repairs and upkeep. One year it might be lower only to have major bills the next. Your benchmark is a real return of 4.1%. After repairs and all other expenses, you should have a profit of $12,300, or 4.1% of your investment. That means you have to have a profit of at least $15,300 (5.1%) or more for your investment to pay you the appropriate amount.
Real estate that pays you appropriately can be considered an investment for the purposes of wealth management. But you need to run it like an investment and track your return after all of your expenses.
This analysis helps explain why property that you do not rent is not an investment. Every $100,000 of equity put into property that lies fallow costs you $1,000 in expenses just to keep up with inflation. And although keeping up with inflation is good, without the 4.1% income there is no way your $100,000 investment will grow to have the increased purchasing power of $273,000.
In financial planning, therefore, we consider fallow property as simply keeping up with inflation and holding its purchasing power. In reality it deteriorates about 1% a year, but we assume your costs of upkeep are factored into your standard of living expenses. Whenever you decide to sell fallow property that money can be invested either in bonds earning 3% more than inflation or stocks earning 6.5% more than inflation.
A family’s home, however, is not even worth that much. Some couples sell a large expensive home, purchase a smaller house and invest the difference. Many believe they will, but when the time comes, their downsized house is so much nicer that little is left over to invest.
Additionally, for many couples the value in their home is used as equity toward an assisted living arrangement. The larger their home, the more expensive the retirement community they buy into. For these and other reasons, we usually do not assume that the equity in a family’s home will be available during retirement.
To reiterate, just because something costs a lot doesn’t mean it is an investment. Investments should appreciate at a rate that grows faster than inflation and gains purchasing power. And spending your money on noninvestments can jeopardize a plan to reach your goals of financial freedom. Investments should work for you, paying you money that you can spend or reinvest elsewhere.
Photo by Megan Marotta