I'm gonna talk about the decision to become a home owner,
and I wanna break it down into two questions.
The first question is: Should you invest in real estate?
And the second question is:
Should you invest in real estate as a home owner?
In this talk I'm gonna focus on the first question
and then I'll go to the next question on the next talk.
So should you invest in real estate?
So you're gonna imagine yourself buying shares in apartment buildings
as a way of investing in real estate.
And lets say you are buying something that costs $100,000
and the annual rent that you'll get as a rental income is $3,000.
So that means that the ratio of the rent to the price...
...is equal to 0.03.
If you invert that and you did the price-to-rent ratio,
P over r, which is like a price-earnings ratio for a stock,
it's about 33.
Which is actually a very high ratio as we'll see shortly.
But let's leave it at 3%.
So, is that better than putting money into the bank?
So, let's say that we can put money in the bank and get 5%.
So, 5% is our interest rate.
Okay, we have 5% interest rate, so let's call that 0.05
to give it the same dimension as the rent-price ratio.
All right, now, next suppose that the inflation rate,
the annual appreciation rate of the house...
So the appreciation rate is 3% per year.
So what that means is,
if we were to borrow or take out of the bank
$100,000 to buy this rental property,
at the end of one year we would have $3,000 in rent,
another 3%, or $3,000 in capital gains,
and then minus $5,000 in interest.
So we have $1,000, okay?
I apologize for those of you who already know this very basic stuff.
What it boils down to is,
if you compare the rent-price ratio...
...vs the real interest rate...
...real interest rate, which is...
I'll call the inflation rate, the rate of appreciation, "pi,"
and the nominal interest rate "i".
When the rent-price ratio is greater
than the real interest rate,
then you should buy real estate.
It's better than leaving the money in the bank.
And when it's less,
you should put your money in the bank
and not buy real estate.
Okay? So that's, it's very basic financial calculation.
It does need to be modified in the real world.
An important issue is property taxes.
Property taxes might be, let's say 1.5%.
So there's $1,500 that you have to subtract from the rent.
So, if... sorry, let me write it more neatly...
So if you have that in property taxes...
...then the net rent, net of the property taxes
is just the $3,000 minus $1,500...
...we're only $1,500.
So that's one real world complication.
Another real world complication is depreciation.
The property is gonna physically depreciate,
which means you're gonna have to put money in to maintain it,
also, over long periods of time,
features of the property will become obsolete,
and you'd need to put money into it for that reason.
So, let's stick with the simple
rent-to-price vs the real interest rate.
And historically, real interests rates
I think in the US have been about 2% or 3%.
They vary all over the map, but let's say that it's around 2% to 3%.
The rent price ratio, interestingly enough,
historically has been I think 7% to 10%.
So, it looks like it's always a good time
to buy residential real estate,
and maybe the property taxes fit in there,
maybe the depreciation fits in there,
but on average, it's often a good time.
Now, if during the housing bubble, the price-to-rent ratio,
at least in summer, went as high as 20,
so that the rent-price ratio was around 5%,
let's say 4% to 5% at the peak of the bubble,
and even
Now, that doesn't mean you did well buying at the peak,
because what happened if you bought at the peak is that prices fell.
There is something about a normal rent-to-price ratio
that's kind of self-fulfilling.
If this is the normal ratio and the price gets above that,
so that the rent-price ratio gets below it,
then prices are gonna fall subsequently,
and so that when prices fall,
that means that the real interest rate gets to be very high.
So, again there's something self-fulfilling
about this normal rent-price ratio.
So, to get to the main point,
the choice to invest in residential real estate
vs keeping money in the bank would be a good choice
when the rent-price ratio is greater than the real interest rate.
And so that would be the main criteria
for deciding to invest in real estate.
And next time I'll talk about
whether the form of investing in real estate
ought to be buying your own home.