Is real estate still capable of being a real wealth builder? Why real estate can’t provide the same financial wealth as in the past. Part I

Posted on April 15, 2010 by Bill Faiferlick

A number of my clients have prompted this month’s blog because the decades’ old assumptions we’ve applied to owning real estate as a highly appreciable investment are being altered and re-written as I write this. In this new economy there are monumental changes occurring. Real estate no longer appears to be the safe and lucrative investment it once was.

I own real estate. I’m speaking from someone who since 1977 owned more than forty properties and started selling them off in 2005 because of what I saw coming in late 2007 or 2008. In this economy, having a few million dollars cash with more than half funded from tax savings isn’t only prudent it’s smart money management. This is especially significant when there’s the benefit of a 100% return funded with immediate tax savings.

You may want to reconsider whether heavy reliance on a large real estate portfolio as yourprimary wealth building vehicle is as financially advantageous as in the past. When you factor in expenses, minimal growth, and modest appreciation, I believe most people will find themselves on the end of a losing proposition from a wealth building perspective when it comes at the expense of insufficient savings and liquid investments.

When are “bargains” not really bargains?

I can’t argue with owing real estate but in this economy great bargains may be more akin to having an albatross around your neck especially in the coastal and metropolitan areas. Theappreciable benefits of owing real estate will continue to become considerably less attractive in the US as current values are really new reset points. Those who’ve continued to snatch up perceived “great real estate bargains” determined by past over inflated values may unintentionally jeopardize a large part of their financial futures.

We have been led to believe that real estate values always increase over time, though this is no longer necessarily true.

Who could have imagined that a once vibrant city of over 2 million people would be reduced to half of that population sixty years later? In the 1950s, Detroit was part of the bustling manufacturing heartland of America. But with today’s economic decline, miles and mile of previously occupied businesses and homes have become worthless. Yes, practically worthless real estate! The current plan is to raze more than 10,000 homes and businesses and convert139 square miles into farmland. Structures that once had value no longer have value. Detroit will not be the first city to raze buildings and convert them back to farmland either. It’s incomprehensible in our minds.

A doctor friend in her early sixties firmly believed in owning real estate for her retirement and she relentlessly pursued her goal of purchasing and owning 10 rental properties. Some of the properties at the time were foreclosure properties. She believed she was getting a bargain that was until the market correction. Those properties have now declined further in value and she is underwater on all the properties and has no equity and nothing to show for her capital investment or expenses she incurred over the years. Her net worth is a sizeable minus number. She could have used her capital and hard earned income in more reliable, conservative investments with financial guarantees. Had she have done that, she would easily be sitting on a $1 million in cash today. Instead she’ll realistically be working as long as she’s capable. This is not the dream she had envisioned for herself.

Before we can appreciate what lies ahead it’s important to understand a bit about the past. For the 30-year period from 1970 through 1999, existing house prices stayed roughly within the range of $125,000 to $162,500 with an average during this period of $142,100. Certain areas far exceeded these values obviously as this is a national average. The United States median price was $177,900 as of the third quarter of 2009 after the bubble burst. For a chart of historical real estate trends, click here.

Home prices depending on location have dropped to what many thought were unimaginable levels. In my opinion, the current prices are the new benchmark not some fabulous opportunity to buy cheap property. The massive run up in values between 2000 through 2007 was an aberration from historical values. Buyers today shouldn’t expect any major run-ups in real estate values. Historical trends are re-emerging. Real estate is not a commodity that is always easily liquidated and like our parents and grandparents, housing should be viewed more as a roof over our heads and less as a leveraged get rich type investment unless it’s viewed more as a speculative investment. In that scenario, if there is an increase in value, then it is a bonus and not the cornerstone of a solid financial wealth plan.

The underlying reason for the decline of real estate appreciation to more historical levels has to do with real wages and aggressive lending practices. Real wages over the last 40 years have declined resulting in a loss of purchasing power. Click here to see a chart from the Labor Research Association. Basic necessities such as housing unless we play games with mortgage qualification criteria require reliable, good paying jobs with rising incomes. The US has lost 8 million jobs in the last decade (not a net gain) and the private business sector is under attack from increasing taxes being imposed by multiple levels of government and continues to contract. Unless mortgages are extended to 40 or 50 year amortizations, lacking a real long term growth in real wages who can afford to purchase real estate with constantly rising prices? People simply lack the financial means which starts with job stability followed by increasing wages. Therefore, there’s every reason to expect we will once again see real estate return to more historic rates of about 1-3 percent annually.

In spite of the rhetoric from Washington, DC about an improving economy, another shoe is about to or already has started to drop. I’ve warned colleagues and friends for more than a year now about some of the hidden lurking dangers that were about to unravel on the commercial real estate mortgage side and how this will indirectly affect most of us again. Since last fall and continuing over the next three years or so, commercial real estate loans are coming up for renewal.

Commercial borrowers need to renegotiate new loan agreements with their banks. Since many commercial real estate loans values were established during a rising real estate environment in 2000 through 2006, they’ve not escaped the overall decline in real estate. In fact, the values of thousands of outstanding loans or notes far exceed the actual value of the property. Many commercial properties lack sufficient income because of rising vacancies to cover even the principal and interest payments. In Seattle, the Columbia Center which is one of the largest commercial buildings west of the Mississippi with 76 floors and 1.5 million square feet is expected to be between 33 to 40 percent vacant when Amazon.com leaves and relocates later this year. The owners are currently in default on their $480 million debt. The tower’s current assessed value is $380 million. For the record, it was purchased in 2007 for $621 million.

Banks will again feel the effects of this next bust. Consequently, commercial lending with high loan values against declining market values means there is a new wave of defaults and foreclosures. This will result in the write-down or loss of billions of dollars for the foreseeable future. The bigger concern is what the trickle effect will be from the devaluation or overvaluation of commercial real estate.

Lower commercial values will result in downward pressure and continued decline of rents.  Many regions have already felt a 20% decline or more. As vacancies rise, job loss effects ripple through from those who worked in the vacated office spaces. Businesses which used to fill these floors have been lost and the people who relied on those jobs are gone.

This loss further amplifies the loss of traditionally good or higher paying jobs. The trickle effect means people can’t afford higher rents or higher home values. The difference with this cycle is that there is no next national wave of high paying employment over the horizon. High paying jobs are not being replaced easily and in many cases are being relocated abroad to less expensive jurisdictions. It’s reasonable to assume it will probably take a decade before private enterprises are able to make a real dent in the vacancy rates given the changing profile of companies and years after that before real wages will have an opportunity to increase since there is an increasingly growing pool of available workers willing to work for lower wages at all income levels.

There was a story in the local paper this past week about a man in the San Diego area who had been a successful business executive who travelled frequently. All his belongings are in storage. His house was foreclosed on. He has a leased vehicle. He has managed to budget his food expenses to $5/day and is currently using his air miles for accommodation and gets the 4thnight free. Unfortunately, his scenario is replicated in different variations across the country. People who appeared financially stable and prosperous are losing everything. In this new economy, cash is and will continue to be king.

If you’re still an unbeliever, consider that in the greater Seattle metropolitan area as of March 2010, the commercial vacancy rare according to the local Chamber of Commerce is between 20-30 percent. That translates into more than one quarter of every building being vacant. California and Arizona aren’t fairing any better.

Another  reason, I believe this is not a temporary downturn but rather an actual resetting of local pricing and values is that the population behind the boomers – Generation X those born between 1964 and 1984 – only account for approximately 46 million people compared to the boomers who account for 80 million or almost a quarter of the US population. This group of 26 to 46 year olds is faced with debt typical to this age group but unlike the past, they have the added burden and constraints from high unemployment, real wage growth decline, rising health care costs for themselves and their families, raising children, increasing taxation, unstable or decreasing home values, and the drastic fluctuations in the stock market devaluing their investments and retirement nest-eggs. Recent reports of real wages over the last 40 years show that real wages have declined since 1964 diminishing this cohort’s purchasing power. These individuals and families cannot afford higher home prices, nor can they necessarily expect to have a higher standard of living than their parents. Huge government deficits will further negatively impact their weakened financial scenario and will add to further eroding of their purchasing power.

Compounding this problem is the spending habits of the aging (eighty million baby boomers) who are not focused on wealth acquisition. They are focused on maintaining their life-style as much as possible and tend to be more frugal. They are not at this stage of their life major consumers of consumer oriented goods, but rather their focus is on general consumables and health care. Unfortunately, statistics show that most retirees have less than $300,000 in assets including their home at retirement. Boomers will not fuel the economy as they have for the last sixty plus years. Consider that when approximately 23 percent of any population withdraws from active participation in the economy, there are more than rippling effects. It’s an unprecedented economic change. I expect the effects will be more like a tsunami wave because of economic structural considerations.

Speculating on real estate over the last 10 years has by all accounts been a successful investment model. However, things have changed and I believe based on the trends and data have irreversibly changed.

  1. Demographically, 70 to 80 million baby boomers are not in their high earning years. They are retiring. The cohort following on the heels of the boomers is comprised of about 46 million people.
  2. High paying, reliable jobs today are scarcer than ever and there are no signs of a reversal of this 40 year trend.
  3. Real estate will once again follow more historical norms in real dollar valuations of 1 to 3 percent increases.
  4. High quick appreciation is a specter of the past.
  5. The government is under immense pressure to raise revenue.  Don’t be surprised when capital gains taxes rise much higher in the coming years because the government needs money and there’s already an open attack on anyone who earns a reasonable income and has assets.
  6. Local and state governments are under increasing pressure to cover budget deficits and in many counties and towns assessments are increasing as are property taxes despite decreasing real estate values.
  7. Over the next decade, deductions will continue to be clawed away at. Tax benefits associated with owning real estate can be wiped off the balance sheet and owners will have no recourse.
  8. The cost of ownership without high appreciation and decreasing tax incentives means carrying costs continue to outpace appreciation which will reduce the profitability of holding large positions in real estate.
  9. Taxes which strip wealth are expected to continue to rise even further.

My next posting will discuss how the government has provided you with an opportunity to accelerate your wealth building efforts through 100% matching tax deductible contributions into an ERISA pension plan intended for business owners and professionals. The new deductions range from $80,000 to $250,000 per participant, the benefits of finally being able to control your tax liabilities is at last at hand not even taking into consideration the advantages of taking that money off the table for your future financial independence and wealth building.