Interest in real estate investing around Los Angeles has reach a curiously high level recently. This is not a new phenomenon, but it seems to be getting feverish. It is not without good reason. Real estate investments carry certain benefits that are hard to match, but in the end, is the juice worth the squeeze? We compare investing in real estate in Los Angeles and the stock market.
This peaked my interest recently as I sometimes browse Meetup and/or Eventbrite for upcoming events I may want to attend. If you are not aware, these sites allow you to market your event and collect RSVPs and even sell tickets. I’m always interested in the types of events that are happening. It provides a barometer for what types of investment related events are resonating with investors.
When I search the word “Invest” on either of these sites, the results show a lot of interest in real estate. There are at least eight real estate investing events for every one event focused on investing/personal finance. For example, on the first page of Eventbrite, there were 17 real estate events, two on investing or personal finance, and one cannabis event. There are a number of benefits to investing in real estate, but is the general public getting a little too excited over this?
Los Angeles Housing Market
Part of this has to do with the economics involved in real estate. In a normal real estate transaction there is 6% being paid to agents. On top of that, you have escrow companies, title companies, and even mortgage companies that stand to make money on a transaction. Additionally, you have contractors, roofers, plumbers, and others who stand to make money if a property needs repairs or is going to be flipped.
According to Zillow, the median home value in Los Angeles is currently $694,200. This suggests that the broker commissions on a single sale of a median priced home is more than $41,000. Since 2012, the median property value in Los Angeles has increased by more than 70%, roughly 9.25% per year. With returns that good, and large marketing budgets funded by big commissions, it is no wonder why you see so many real estate events targeting investors.
The big question is, has all this interest in owning real estate as an investment fueled another housing bubble. As a homeowner, I certainly hope not, but hope is not a strategy. Let’s take a look at some data to guide our perspective.
In order to purchase a $694,000 home, a typical buyer would need to put 20% down, or $138,800, and finance the rest through a traditional 30-year fixed rate mortgage. Assuming a 4.25% mortgage rate, the payment would be $3,015.37 before home owner’s insurance and property taxes.
In 2017, the median household income in Los Angeles County was $64,912, according to the US Census. Monthly it comes to $5,409 before paying taxes, making it very hard to cover a $3,000 mortgage payment. Based on this simple analysis of the housing market, you would say that the median family can’t afford a median priced home.
The government recommendsthat households spend no more than 29% of their monthly income on housing. Using 29% as a guide, the median household should spend no more than $1,568 on a mortgage.
Before you start thinking we’re on the cusp of the next housing bubble, understand that median household income considers all households. Not just those who own homes. In fact, only 48% of households within Los Angeles County are homeowners. Those who are homeowners, likely earn more than the median household income and therefore care in a better position to buy a home.
Additionally, we don’t have risky lending practices that were pervasive during the early 2000’s. Back then, you could purchase a home with no money down, and without even documenting your income. If you could fog a mirror, someone would give you a loan. Today, lending standards are much more stringent and require detailed documentation of a borrower’s income and assets.
Historical Returns for Real Estate and Stock Market
There has been a long-standing debate on the wealth creation potential of real estate vs. the stock market. To be fair, comparing the two are like apples and oranges. They are two very different types of investments, and both have experienced major booms and busts over the last 30 years. Currently, both are at or near all-time highs, so it is safe to say both are booming.
Investing in real estate has a number of benefits that are not available to investors in the stock market. The tax code allows a homeowner to deduct mortgage interest from their taxable income. It also allows investors to sell a property and purchase another without paying taxes on the gains, via a 1031 exchange.
Another big benefit is leverage, but this can be a blessing and a curse. Typically, a homeowner or investor will put 20% down, and finance the other 80% through a mortgage. That’s 5x leverage. So, if the value of a property increases by 4%, it’s actually a 20% increase on your initial investment, the down payment. Of course, you have to factor in a slew of other expenses including interest on the mortgage, property taxes, maintenance on the home, etc.
Investing in the stock market has a different set of pros and cons. It doesn’t offer the same amount of leverage, but the stock market has produced better long-term returns than Los Angeles home values. The chart below shows the growth of the stock market and Los Angeles home price index since 1987. Home prices have appreciated 476% over that time, while the stock market is up 2,161%.
On an annualized bases, Los Angeles home values have appreciated at an annual rate of 5.62%, while the stock market rose at an annualized rate of 10.24%.
Los Angeles home values declined 41.5% during the 2008 financial crisis, but actually rose during the recession of 2001. Stocks on the other hand, fell 51% during 2008, and 40% between 2000 and 2002.
Another interesting fact is that Los Angeles home values did not appreciate for the ten years between 1990 and 2000. Similarly, the stock market was flat for the ten years between 2000 and 2010. Periods of poor performance in real estate and the stock market can be attributed to recessions. Our Business Cycle Indicator is designed to warn before a recession occurs.
Apples and Oranges Comparison
Keep in mind, this is comparing a stock market index vs. a home price index. It’s apples and oranges, and you can’t invest directly in either. However, the comparison does provide some context into how both investments have done long-term. Importantly, it doesn’t consider rental income, interest expenses, property taxes, leverage, management fees, or property maintenance that all play a role in real estate returns. On the stock market side, it doesn’t consider management fees, potential buys and sells, transaction costs, etc.
One other benefit of real estate as a long-term store of wealth is that it isn’t liquid. While liquidity is often seen as a risk, in some cases it can be a benefit. Most stock market investors struggle to match the returns of an index. Part of the reason is accessibility and emotion. At any point, an investor can check the value of their portfolio on their phone and choose to buy or sell at a negligible cost. The ample liquidity often leads to poor investing decisions that are driven by emotion. Imagine if every time you made a trade in the stock market you were charged the same amount as a real estate transaction, or 6%.
Real estate can be a great investment. However, before you dive in, it is important to calculate each of the variables mentioned above. The stock market has historically outperformed Los Angeles home prices by nearly 5% per year. If an investment property can generate 5% or more in income, net of taxes and all expenses, then it could be seen as a good alternative to stocks.
Real estate and the stock market have been great investments, but both are at all-time highs. Los Angeles real estate has become a very popular investment over the last five years. Importantly, a well-rounded investment portfolio will likely have both stocks and real estate. Make sure that your investments, whether they be real estate or assets in financial markets, are aligned with your long-term goals.
Learn more about our planning process.