With the stock market volatility making many sick to their stomach, investment real estate continues to hold steady. Real assets, as opposed to paper assets, are more stable in volatile markets for several reasons. Liquidity, scarcity, and tax benefits are three major factors that create a stable real estate market.
First, liquidity of an asset is an important stabilizing factor. In the equity markets, stocks can be bought and sold in minutes. This ease of liquidity lends itself to investor mood swings. And, it lends itself to the volatility of the latest unemployment report or other government index report.
Real estate, on the other hand, other than owning it in the form of a real estate mutual fund, is not very liquid. To sell real estate, the seller has to have some patience. Even once a buyer is found, the buyer generally has some due diligence time to look over the property in order to make a final decision to purchase. Everything about the process, from surveys, inspections, and appraisals, is a slow methodical process. This slow process stabilizes the effects of short term bad economic news.
You might question the wisdom of buying real estate when you contemplate the recent housing market. However, the housing market is quite different than the investment real estate market. Housing has been subject to forces that inflate value. First, housing value is generally based on comparable sales. And, a decision to purchase a house is determined by the “value” of the school system, the amenities of the neighborhood, the curb appeal, and other abstract factors.
While these and other decision making factors can be important, they are open to interpretation and opinion. Hence, home buying can be an emotional process.
Investment real estate, on the other hand, is seldom an emotional decision. While the value can be affected by some of those abstract factors, the major determinates are the income and expenses from the property. The net income determines the value to an investor. If the income doesn’t warrant the asking price, then the investor moves on to another investment.
Additionally, the mortgage market in the past has created lots of programs to help sell houses. Longer terms to pay off the note, which is known as amortization, have lowered monthly costs; which in turn, has created an upward affect on home values. Investment real estate typically has shorter amortization periods. A shorter amortization period keeps the value of the real estate in check, since the shorter period creates a higher monthly payment and less monthly income.
Secondly, the scarcity of real estate is a stabilizing factor. Since there is a finite amount of land, there is little downward pressure on the value. Stocks, on the other hand, are paper assets and their value can be affected by the supply that is created. The supply of investment real estate is usually controlled by outside influences, such as zoning, typography, availability of sewer and utilities, and financing. Not only is the land a defined parameter, but also permissions to create more of a particular real estate product can be a hindering factor; thus, creating a scarcity for certain types of real estate.
Thirdly, real estate can be depreciated while it appreciates in value. Under current tax law, improvements upon the land can be depreciated off of your federal tax liabilities. So, even though your investment continues to appreciate in value, the government allows you to deduct a percentage of its value each year. This one-two punch is of tremendous value to an investor and affords a unique benefit that stocks don’t.
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