This Investment Could Lose You Money for the Next 100 Years

Last week was an interesting one for the investing community. Warren Buffett, CEO of Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) , released his annual newsletter laden with inspiring economic messages and his general thesis for what could transpire in the upcoming year.

Admittedly, I can't remember a time when Buffett hasn't been anything but an optimist, and this annual newsletter didn't deviate. Even in the face of being wrong, Buffett stands steadfast in his predictions.

Such was the case with a call he made in 2011 that housing was at or near a bottom. In Buffett's own words, "Last year, I told you that 'a housing recovery will probably begin within a year or so.' I was dead wrong." According to the Case-Shiller home price index, home prices fell another 4% in 2011.

Wrong or not, Buffett once again stood by his prediction that housing prices were bound to recover. While being interviewed by CNBC, Buffett commented that:

I would say the single-family homes are cheap now, too. If I had a way of buying a couple hundred thousand single-family homes ... I would load up on them. ... It's a very attractive asset class now.

It's very rare that Warren Buffett and I will not see eye to eye, but I'm on the complete opposite side of the camp on this one. Let me explain why.

This is not an investment
My argument begins with housing price gains over time. Most of today's investors and homebuyers have a very short-sighted view when it comes to what it means to own a home. Prior to 1997, owning a home was not an investment. I can almost hear you all screaming through the computer, "Then why is the home I bought in 1964 for $35,000 now worth $200,000 -- isn't that a nice return on investment?" The answer is "yes," but have you factored in the effect of inflation on your return? Between 1890 and 1990, the average inflation-adjusted return on your home was a paltry 0.21%. It gets even worse if you focus on the period between 1950 and 1997, when the inflation-adjusted return was just 0.08%.

Source: Robert Shiller, Irrational Exuberance.

As you can see from the chart above, only in the past decade has owning a home actually paid off as an investment for most people -- and even then you had to have sold to have turned an actual profit. With 23% of homeowners currently underwater on their mortgage, that didn't happen in most cases.

A nation of squatters
Which leads me to my next point: What are homeowners and banks going to do to get foreclosed properties off the market?

According to data from RealtyTrac, there are currently 1.354 million homes in foreclosure throughout the United States with many analysts forecasting that number to increase dramatically over the coming years. Separately, in October, LPS Mortgage Monitor noted in its study that the length of time from when a borrower begins to miss payments to when the bank actually repossesses the house has increased to a staggering 611 days! That's up from 523 days earlier in 2011 and more than double the 251 days LPS noted in 2008.

As of August 2011, there were more than 4 million homes that were either 90 days behind in their payments or were already in the foreclosure process. In short, the housing market is going to have to absorb somewhere in the neighborhood of 5 million to 6 million foreclosures over the next two years. This isn't good news for housing prices, and it's definitely not good news for a housing market already glutted with foreclosures.

Source: RealtyTrac.

RealtyTrac data released last week showed that foreclosures made up 24% of all property sales in the fourth quarter. Amazingly enough, that's down from 26% in the year-ago period. Based on the rate distressed properties have sold over the past four years (an average of 963,000 per year), it could easily take six years to return the housing market to somewhat normalized foreclosure inventory levels.

The payoff
Home prices since 2006 have fallen at an annualized rate of 9% per year, and a glut of foreclosed properties is a primary reason for the drop. Foreclosures often price well below going market values and, according to RealtyTrac, foreclosed property prices fell another 5% in the fourth quarter from one year ago.

Keep in mind that while home prices are dropping, almost precipitously, inflation data continue to show that the things we buy are becoming more expensive. Historically, deflation is rare in the U.S. and based on consumer price index data from the Bureau of Labor Statistics that go back to 1914, we have averaged inflation of 3.61% over that period. In simpler terms, the things we buy are getting more expensive and our home prices are shrinking.

Now humor my hypothetical scenario.

Let's assume, even with the economic data squarely against Mr. Buffett's prediction of a rebound, that home prices stabilize and stop going down. Let's also assume that foreclosures continue to sell at a rate around 963,000 per year and inflation plugs along around 3.6%.

Based on this data, in a best-case scenario, it would take six years for most foreclosures to clear the market and for home prices to have any chance of heading higher. If you recall, over a 100-year period from 1890 to 1990, home prices only outperformed inflation by 0.21%. Assuming inflation gets a six-year head start on housing prices while they remain stagnant, it would take about 100 years for home prices to break even when adjusted for inflation! The scenario gets even worse if home prices continue to fall.

I would hardly call an asset class that could lose you money for the next 100 years an attractive investment. In fact, I would call that perhaps one of the worst investments you could possibly make and potentially Buffett's worst call of all time.

Fool contributor Sean Williams has no material interest in any companies mentioned in this article. He is one of the many people currently underwater on their mortgage. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.

The Motley Fool owns shares of Berkshire Hathaway. Motley Fool newsletter services have recommended buying shares of Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy whose front door is always open.


Read/Post Comments (26) | Recommend This Article (30)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 05, 2012, at 6:27 PM, TMFJoeInvestor wrote:

    Worth noting that an investment in a home pays a significant daily dividend -- shelter.

  • Report this Comment On March 05, 2012, at 6:29 PM, DJDynamicNC wrote:

    Excellent, excellent analysis.

    Personally, I'm of the opinion that lower housing prices are great, given that I like affordable housing, but I can see why the glut of available single-family homes in the foreclosure market is a problem for people who want to treat home ownership like an investment.

    By contrast, rental rates continue to climb, and there will be a demand for additional rental unit construction. I expect that to pull developers into the rental property market just as this foreclosure issue pushes them out of single family homes, and that's where I think the sound investment dollar rests at this time.

  • Report this Comment On March 05, 2012, at 6:33 PM, SisyphusRocks wrote:

    Your article assumes two things implicitly, one of which is clearly wrong.

    First, it assumes that the investment (residential real estate) produces no income, and the only returns are capital gains. That is not even true for an owner-occupied home, since there is use value in the home and it replaces the rental value of a similar house at the very least. For investment properties, you can rent out the house for investment, and that yields about a 9% annual rate of return in my local market before expenses, and maybe 3-5% after (that will vary quite a bit from market to market). This is the same mistake some investors make in examining growth stocks against dividend-paying stocks without reinvested dividends, with the latter actually performing better on average over the long term because of the reinvested dividends, but usually lagging when dividends aren't included.

    Second, it assumes that you will not have a substantial price increase in the principal in the medium term. The author's argument that foreclosures will prevent that is reasonable. But with new household formation substantially higher than home construction for the past two years, there is a possibility that with cyclical economic improvement back to a 5-6% unemployment rate and 3%+ economic growth we will see a significant run up in housing prices to match the new-found scarcity in the medium term. That is basically Buffet's argument.

    While an increase in housing prices from current depressed levels in the medium term is somewhat speculative, there is no question that you have to include rental income to properly value residential real estate as an investment.

  • Report this Comment On March 05, 2012, at 6:37 PM, TMFUltraLong wrote:

    TMF Joe - Absolutely. I'm not saying don't buy a home. I'm just insinuating that buying a home as an investment has historically been a silly idea.

    DJDynamicNC - Right.. the one aspect excluded from the above analysis is the income generated from renting out the house. It's very, very difficult to find historical nationwide rental data but assuming you did rent it out then you would come out ahead.

    More or less, what I'm trying to show is that buying a house an investment is a debunked theory unless you plan to rent it out or get really really lucky and sell when emotional investors flood a market. You take your pick. =)

    TMFUltraLong

  • Report this Comment On March 06, 2012, at 8:58 PM, Mega wrote:

    Who would buy a couple hundred thousand single family homes and not rent them out?

  • Report this Comment On March 06, 2012, at 9:00 PM, Mega wrote:

    You're trying to prove Buffett wrong with an entirely inappropriate metric.

  • Report this Comment On March 06, 2012, at 9:29 PM, 1Douggie wrote:

    Developers have had to get into the rental business to make a living and most favor single family homes as they tend to attract a better class of renters. Assuming they are buying these homes at what they consider at a discount (using discount figures from bubble market highs), they on average have to sink on average $6800 before renting.

    Providing they get good paying tenants, the water heater doesn't fail, and roof doesn't leak, and basement doesn't flood, and and the tenants don't treat it like a dog house, etc., he may make money. They are hoping for an uptick in prices and with depreciation to make some money in the end. Good luck with that for I don't think we will see a bottom of in housing prices for a long while.

  • Report this Comment On March 06, 2012, at 9:35 PM, 1Douggie wrote:

    Oh, and I forgot one other major factor; taxes. Property owners are and will be saddled with larger real estate tax bills as municipalities are faced with losses of the state and federal subsidies and guess who will make up the shortfalls?

  • Report this Comment On March 06, 2012, at 9:52 PM, EnigmaDude wrote:

    Buffett said, "If I had a way of buying a couple hundred thousand single-family homes ... I would load up on them"

    Perhaps he intends to buy a home-builder like KB Homes or Pulte. That would be one way for him to load up.

  • Report this Comment On March 07, 2012, at 3:55 PM, GrumpyOldGuy wrote:

    There are several flaws in this article but I will point out two of them. One, almost no one buys a home for cash so you aren't plopping down 200K for a place to live, you are maybe plopping down 40K total so you contol 200K worth of property for 40K of your money. If your payment/upkeep is equal to the comparable rent in your area the only cost of ownership would be possible loss of house value.

    Two, let's assume taxes skyrocket. Do you think that rents will not skyrocket to cover the taxes?(Or will the landlord just eat that expense because they like you?)

    I know I said two, but :Three, do you actually not want to buy real property at historically low interest rate? Silly you.

  • Report this Comment On March 07, 2012, at 4:01 PM, TMFUltraLong wrote:

    GrumpyOldGuy,

    Actually, all-cash sales accounted for 33.2% of all home sales as of January and that's yet another reason home prices are being driven even lower. According to MSN, 74% of investors are using just cash to make their home purchases.

    History has clearly shown that owning a home is a terrible return on investment, rental income excluded. That's my point, plain and simple. I'm not saying I wouldn't buy a home with rates near historic lows... I'm just saying I'm not going to go out and buy 5 homes as an investment in my future.

    TMFUltraLong

  • Report this Comment On March 07, 2012, at 4:09 PM, DJDynamicNC wrote:

    "Developers have had to get into the rental business to make a living and most favor single family homes as they tend to attract a better class of renters"

    This sounds like a claim made from anecdotal or emotional sourcing, rather than evidence based. There are great economies to be realized by builting multi-unit apartment buildings which you are discounting, and the "better class of rentors" is an arbitrary and subjective judgment. You may prefer single-family home life, but believe me, us city folk view it as a big waste of space and energy, and don't understand why anyone would want to spend hundreds of thousands of dollars on car maintenance and operation rather than take that money and pay the downtown premium (and there is a premium) on housing for an enhanced quality of life.

    Which doesn't make us any more right than you, but be aware that that's a subjective value judgment and as such makes for suspect investment calls.

  • Report this Comment On March 07, 2012, at 4:11 PM, DJDynamicNC wrote:

    "More or less, what I'm trying to show is that buying a house an investment is a debunked theory unless you plan to rent it out or get really really lucky and sell when emotional investors flood a market. You take your pick. =)"

    Could not agree more!

  • Report this Comment On March 07, 2012, at 4:12 PM, TheoryMeltFool wrote:

    Buffet's statement is also a bit ridiculous. He has plenty of capital to purchase several thousand homes if he thinks it's a good investment. With Buffet, I've learned to watch what he does, not what he says.

  • Report this Comment On March 07, 2012, at 4:16 PM, TMFUltraLong wrote:

    TheoryMeltFool,

    Very true... Buffett is always optimistic even when his investments may not exactly reflect that optimism. Investors look up to him and, as such, he has to watch what he says almost as much as a politician these days.

    TMFUltraLong

  • Report this Comment On March 07, 2012, at 5:07 PM, sailrmac wrote:

    The article above mostly refers to the price of housing not the overall return. The arguements listed are quite solid that the price of housing in general through the US is more likely to go down than up for the next few years.

    As for total return on investment that includes not only things like rent but also mortgage payment (historically low rates), maintenance, property taxes, etc. Being serious about this and having decent excel skills, I have put together a spreadhseet that accounts for all this down to exoected net cash flows, ROI, NPV, etc. The net result is at today's prices, rents, mortgage rates, etc. in my area (Northern Nevada, may be different in your area) you have to assume a 3% average annual increase in prices and rents over the next 10 years for a 9% ROI (my hurdle rate).

    Since I think that is unlikely to happen, it doesn't make sense to buy. It's amazing what happens when you are willing to spend 5-6 hours finding out the answer for yourself.

    I commend the author for a not following the (insert here: guru/neighbor/recent history/friend/talking head), but actually, sitting down, taking more than 5 minutes and thinking about it for him or herself. Excellent article!

  • Report this Comment On March 07, 2012, at 6:08 PM, sheltonclan wrote:

    Well, my family is also currently underwater on a house that in June, 2008 (yeah, yeah, I know) we put down 35% on. So, it is particularly painful for us. Nonetheless, I disagree with the view that a home isn't a good investment. Some of the numbers in this article don't jive with what I know.

    First, I KNOW that homes have become a much bigger portion of our income. I know this because in 1961, my parents bought a home here in SoCal for $3,500 - while he was making $16,000 a year as an engineer. They argued about it for decades - he had wanted to buy a high-falutin' home for $9,000. Notice that either of them were considerably less than their annual salary - which was a common yardstick of affordability at the time.

    THEN, in 1981, my hubby & I bought our first home here. Paid $86,500 and together were making about $50,000 per year. I distinctly remember the lender saying we were "comfortably" within the guideline of purchasing a home not valued over "TWO years worth of income."

    Current avereage home price in our area is $360,000...but our salary is stuck at about $70k/annual for the family. Notice anything? If I'd stuck with the original house we bought, I would have accomplished a lot.

    FIRST of all, the mortgage would be paid and housing would be free...freeing up more to Foolishly deal with. SECOND - as the years go one, housing is costing more compared to income...so it is wise to have "been there, done that, gone the deed in hand." THIRDLY - while I understand adjusting value for inflation, housing has outpaced inflation during much of the period - thus the difference in value. In other words, you have to adjust the house in terms of income growth, NOT inflation.

    Open for rebuke, Fool away!

  • Report this Comment On March 07, 2012, at 6:44 PM, TMFUltraLong wrote:

    Sheltonclan,

    Most of my thesis is that housing does indeed outpace inflation... but by such a ridiculously small amount (0.21%) that it can take decades just for your housing price to catch up with inflation in real dollars.

    As for wages, I agree that things have gotten out of hand. The scary thing is inflation is actually outpacing wage growth right now. I'm sure that's not helping the housing situation one bit.

    Thanks for the comment.

    TMFUltraLong

  • Report this Comment On March 07, 2012, at 8:31 PM, karlm1 wrote:

    Many of Berkshire holdings are dependent on a housing recovery. As a long time Berkshire Hathaway share holder I too was surprised when I heard him say the comments on housing. Employment will recover when housing recovers and I think WB just wanted to help instill some confidence in the housing market which benefits us all.

  • Report this Comment On March 09, 2012, at 12:58 PM, rawise wrote:

    I dunno, I bought a house & am renting it out & everything seems to be working fine, for now; own it outrite. Don't really see how I could go wrong so bought another, it's also working perfectly ok. Am in the process of doing it a 3rd time...what am i missing?

  • Report this Comment On March 09, 2012, at 11:32 PM, Redabbler wrote:

    rawise,

    Below are a few things that you might consider.

    As an example, if you gave 100K for the property and the rent is say $1000/mo then that seems to me like a 12% return. So if I take it a step further and assume that you must dedicate 30% of the monthly rent for repairs, maintenance, property taxes, insurance, future vacancy, reserves for future replacements ect., then your return would be 8.4%.

    I think that rents will probably increase over time. The amount that you can raise your rents will of course be dependent on how well you take care of the property and as the author noted, property values (historically) increase over time slightly more than inflation. Whether or not the rents will rise with inflation is certainly in doubt. I suspect that rents will rise, fall or stay the same based on supply and demand of comparable rental units. I expect there is some relationship, I just do not know what it is.

    In addition to the property taxes that you will pay on your rental real estate, you will have to to pay income tax on the net income generated by the property. Rental real estate currently gets favorable tax treatment in that you can depreciate it by small increments over a certain period of time, thereby incrementally recovering your investment. That time period is not usually 100 years!

    All in all, I more agree with Mr.Buffett and think that real estate is a good investment now. Also, I think you have right:)

    Redabbler

  • Report this Comment On March 12, 2012, at 5:55 PM, PoundMutt wrote:

    VERY informative article and comments.

    Just a thought:

    Walking away from an under water mortgage IF YOU CAN AFFORD THE PAYMENTS is morally equivalent to not making payments on an auto loan because the vehicle lost a large percentage of its value as soon as it left the dealers lot!

  • Report this Comment On March 20, 2012, at 1:51 PM, shbeavers wrote:

    Where does the average CPI of 3.61% come from?

    I calculate a mean average of about 3.35% from this Bureau of Labor Statistics table: ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt.

    BTW, going back just 60 years (1942-2011) yields a 3.70% average CPI.

  • Report this Comment On March 20, 2012, at 2:00 PM, TrackUltraLong wrote:

    shbeavers,

    I used a standard compounded annual growth rate calculator from the data here: 1914 to current:

    http://inflationdata.com/inflation/consumer_price_index/hist...

    TMFUltraLong

  • Report this Comment On March 20, 2012, at 2:34 PM, shbeavers wrote:

    Excuse me - going back 70 years, not 60.

  • Report this Comment On March 23, 2012, at 11:08 AM, dwillymep wrote:

    Very interesting article. I read your follow-up as well and am looking forward to Part 3!

    As I read comments I think part of what is clouding the issue is that there is a clear difference between your FIRST home and any more beyond that.

    Your first home can be viewed quite differently, I think, and is much more likely to be considered a "good investment" than subsequent homes. This is because your first/only home offsets other "mandatory" costs (namely rent). In other words - you have to live somewhere. Most of us can't live with no housing costs (unless you shack up with parents or stay under a nice bridge?!), and offsetting those costs should be factored into the value equation for purchasing a home. So the comparison here is really not home vs. no-home, but home vs. renting. Obviously that computation and which is better varies in every market, but I think frequently owning can come out on top here (esp. at today's prices & rates). In that light, even today, owning can be a "good investment" relative to your only real alternative, which is renting. (or being a 40yr old that still lives at home - assign a dollar value to THAT, would you? ;-) )

    Second, third, etc., homes, are quite different, because your alternative is different. Your alternatives now include stocks, bonds, sitting on cash, etc., and really any other investment you can fathom. In this case - and this is the case about which I believe your article was focused - then I would tend to agree that there's a heck of a lot more to think about, as your article points out.

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