Many personal finance pundits write about how real estate can be a very good investment, but is that really so? Let’s delve a little bit deeper into the claims of real estate as an investment vehicle and understand it from a scientific analysis.
So, the first thing to understand about real estate. The whole idea of the real estate market revolves around one single type of event: sales. If some piece of real estate never gets sold, none of the other “derivatives” of real estate finance are applicable. And as it turns out, there is nothing that guarantees a real estate to always end up being sold. One obvious event that would cause real estate to never get sold, for example, is mass flight and emigration out of a particular geographic area. If a specific geographic area becomes unpopular and gets depopulated, chances are that most of the real estate in that area may never get sold before it looses too much of its value due to lack of maintenance and becomes unhabitable.
So, rule number one. Since nothing is guaranteed in the real estate market, all valuations must be treated in a probabilistic manner. So, with that being said, what are the probabilistic variables that increase or decrease the likelihood of an payout after a reasonable amount of time?
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Growing population in general. If the world population is growing in general, that means there will be more people looking for places to live, and ultimately it is more likely that someone will end up settling in your old place. The higher the growth rate, the better. By contrast, a slow growing or shrinking population means it is more likely that people can pick and choose among a surplus of real estate, and your place on sale could easily end up not being chosen and never end up getting sold in a reasonable amount of time.
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Popularity of a geographic area. All else equal in a slow growing, non-growing, or shrinking population, you better have your real estate in a popular area, or else it may never sell. Be forewarned of changing demographics. Some areas just become unpopular at random, regardless of their development status. Especially if that determination is made by the rich with high disposable incomes. “They don’t want to live in old houses, they would rather build and buy all new.”
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Having a house on developed land does not automatically make it more valuable. Only if it gets sold does that valuation become real, and only in the past up until the point of the sale.
So, that’s a whole mouthful of if’s, and if you only own a small amount of real estate, you should not get too eager about the investment prospects of it. BUT, if you somehow happen to own a very large amount of real estate, you can do much more interesting things from a financial standpoint. First of all, you can have clear numbers on what is the total size of the real estate market. You can know the total number of homeowners at a particular instant in time, and with a record of past sales, you can extrapolate to determine what the market size will be in the near future, in terms of number of homeowners. Or apartment owners, apartment renters, or otherwise, for that matter. You can determine the total number of sales that have occurred over a particular period of time. You can determine what percent of total ownership has been sold over that period of time.
And, ultimately, armed with those numbers and data, you can answer the final questions. How much real estate will never get sold and effectively have its value lost? The law of the land, with all sales of property, is that the last owner must be capable of absorbing the full depreciation of the final sale. Naturally, that typically means that the owner must accrue the entire necessary funds for the sale before the time of the sale. Otherwise, they might accrue a debt that they cannot repay if they fail to resell the property at or above the original price.
But, here’s the really big thing for the biggest of the big. If you can anticipate that the real estate market is shrinking in advance, you can take the path of the more complex financing scheme where you may accrue a debt at the first sale, but before the anticipated market closure on the particular property, you would have accrued enough money to pay down the balance in full. Then when you do, you realize that part of the real estate market is toast, but that’s okay, because you’ve been adequately prepared for that event in advance.
But here, the point is, in order to keep the books balanced, you must be able to do something outside of the field of real estate. That is necessary to be able to successfully financially cope with a shrinking real estate market. Essentially, this statement is entirely true: if a home never gets resold, that money effectively exits the real estate market and is transferred to other areas of the economy. Obviously, this is an over-simplified explanation of the economic phenomenon, the real thing is much more complicated, more difficult to explain, and more difficult to understand. It’s more like the moment you buy a new home, you are shortly transferring money into the real estate market to pay for its construction, but then that money quickly gets transferred out to pay for the living expenses of the workers, but if you later sell the home, the buyer quickly transfers money back into the real estate market to pay for the home, but then the money gets quickly transferred out of the real estate market when it goes back into your bank account. You get the idea. It’s all about “derivatives” that unfortunately some people have a tendency to take too far and put too much faith in.