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Real estate is thought to be the best long-term investment. Is it?

In past blogs, we have already explained why investing in real estate is not worth it compared to equities. However, prices of flats and houses have been regularly hitting new highs since then, and even last year's survey by Slovenská sporiteľňa showed that more Slovaks still prefer real estate to securities. That's why we bring you an updated comparison, in which we answer whether real estate is still (not) worth it.

Ján Tonka | Our results | 27. January 2022

Slovaks + real estate = big love

The main reason behind the popularity of real estate is the historically good experience of Slovaks with this type of investment. Most people got their housing through privatization, which turned tenants into owners with a mere stroke of a pen. The amount for which it was possible to buy flats into personal ownership is ridiculous compared to today's prices.

Hence, if today almost everyone owns the roof above their head, and the returns range from tens to hundreds of thousands of euros, the popularity of real estate does not come as a big surprise. Even the majority of young people, who already had to take out a mortgage, are now significantly "in the black".

To a large extent, the media have also contributed to the popularity of real estate. Recent years have brought many articles about the astounding growth in flat and house prices. Was it possible to miss the news computing by how many tens of thousands of euros more expensive flats in Nitra became after Jaguar Land Rover arrived? But the call on whether something is the best investment should not be made based on the past few good years.

Let's take a rational look at investment properties (i.e. those intended for renting, not occupying) and see how they stand up to Finax Intelligent Investing.

Parameters of a good investment

1. Return

The most important criterion and the main reason for investing/buying a property.

Over the last almost 19 years, apartment prices in Bratislava have grown at a rate of 7.13% per year, which is certainly not a bad result. If we look at the growth of apartment and house prices across Slovakia, we arrive at an average annual return of 6.95%.

However, it would be too bold to count on a similar rate of appreciation in the future. Most of the overall gains are due to the exceptionally high price growth between 2002 and 2008, which was greatly helped by Slovakia's joining of the European Union in 2004. In contrast, over the past 12 years, Slovak property prices have risen only slightly.

The best long-term dataset was collected by American professor Robert Shiller, who analyzed the development of real estate prices in the USA since 1890. And the result? Over the last 128 years, prices have risen by just 0.43% annually after adjusting for inflation. So much for property yields in developed markets.

But let's be a little optimistic, Slovakia still has plenty of room for catching up within the EU. So let's assume faster price growth. If we can expect long-term annual inflation at around 2% in the Eurozone, real estate in Slovakia could grow by an average of 3-4% per year.

With a long-term investment in the Finax 100/0 portfolio, you can expect an annual appreciation of 8.78% p.a. (historical return from 1987 to September 2021).

2. Risk

Each investment bears a certain amount of risk. Without taking it, achieving return would not be possible. What matters is how you protect yourself by spreading the risk.

When buying an investment property, it is impossible to manage risk effectively, as you are typically buying perhaps one or a few apartments. That makes you entirely dependent on the choice of the specific location (state, city, district, street, floor, neighbors). What seems like a good location today can deteriorate very quickly due to new construction. If a parking garage grows under your windows, you'll probably have a harder time finding tenants. And good luck with selling...

Note: All data related to the historical development of Finax portfolios are modeled and were created based on backtesting of the data. We described the method of historical performance modeling in the article: How do we model the historical development of Finax portfolios. Past performance is no guarantee of future returns, and your investment may result in a loss as well. Inform yourself about the risks you are taking when investing.

Finax portfolio vs. residential properties | Finax.eu

What’s more, the COVID-19 pandemic has exposed other risks associated with investment properties. Owners focused on short-term rentals have not been pleased by the faint traffic on the Airbnb platform due to tourism restrictions and fear of traveling.

The influx of these vacant apartments into the long-term rental market, coupled with weaker demand, has significantly reduced rents. In Bratislava, for example, rent amounts of two-bedroom apartments have fallen by 15-20% on average. Thus, many owners faced problems renting their properties at the price they originally relied on.

When investing in index funds, your investment is diversified among thousands of the largest and most successful companies from around the world, enabling you to sleep easy. You can achieve the average stock market return (about 9% per year) even if not all companies do equally well.

3. Liquidity

Liquidity is the ability to quickly turn an investment into cash.

Real estate is generally one of the least liquid assets. If you need to sell a property, it may take several weeks or months, depending on the current market situation. A quick sale will usually mean a (significantly) lower sale price.

An investment in index funds can be easily encashed within a few days. Simply place an order to sell or withdraw money from your portfolio and money will land in your account after the stock exchange settles the sale of your securities.

4. Being (un)demanding on time

Opening an investment account takes a few minutes. After transferring cash or setting up a standing order, you can have your money invested within a few days. That's it for you. For the next 10, 20, 30 years, you don't have to do anything.

Buying and managing an investment property is considerably more complicated. If you decide to entrust the whole process in the hands of professionals, prepare a few thousand euros for the real estate agent's commission. But that's not all. If you seek to avoid the management as well (renting, arranging minor repairs, etc.), it will cost you about 10% of the annual rent.

If you want to arrange everything on your own, expect performing market research, selecting a specific property, securing financing, land registry, insurance, finding tenants, preparing contracts, etc.

The job’s not finished even after successfully buying and renting a property. You will continually have to deal with tenant outages, major renovations, and minor repairs, filing tax returns, house meetings... These are hours that could otherwise be devoted to yourself, work, or family.

5. Taxes

None of us probably wants to pay more than is necessary on taxes.

Income from an investment in index funds, if held for more than 1 year, is exempt from income tax for Slovak tax resident. You don't even pay levies, so all the profit stays with you.

In the case of real estate, you should expect a 5-year time test according to Slovak Income Tax Act. If you sell the property sooner than 5 years after acquiring it, you can say goodbye to a third of your profit. The state will claim 19% in income tax and you will pay another 14% to the health insurance company.

Index funds vs. real estate without a mortgage

Using a simplified example, let's compare how much an investment property can earn you compared to index funds.

Assumptions:

  • Purchase of a 2-bedroom apartment with parking space in a new building in Bratislava for 180 thousand euros.
  • You spend extra 20 thousand euros on furnishing and equipment for the apartment. Hence, you invest 200 thousand euros in total.
  • You rent out the apartment for 700 euros per month (including utilities and parking space). The rent will increase every year by inflation, i.e. 2% p.a.
  • Let's assume a fairly optimistic scenario - monthly management and utility costs of 170 euros and total additional annual expenses equal to the monthly rent (e.g. tenant outages, minor repairs/renovation costs, taxes, etc.).
  • Assume long-term annual house price growth of 3.5% and average Finax 100/0 appreciation of 9% p.a.

Equity index funds vs. investment property without a mortgage | Finax.eu

If you invest 200 thousand today into buying and furnishing a property to rent it out, you will end up having less than a third of the wealth you could build with an index fund investment in 30 years. The foregone profit will amount to more than 1 900 000 euros. Not to mention the loss of time and effort.

Index funds vs. real estate with a mortgage

A much more common case than buying an investment property without bank financing is purchasing it using a mortgage loan. The idea that the tenant will make the monthly mortgage payments for the owner and the investor will be left with a paid-off apartment 30 years later is nice, but in reality, it is not so clear-cut and profitable. It is also important to remember that you significantly increase your risk by involving debt.

The bank won't care that the tenant hasn't paid rent and you’re unable to evict them. The mortgage payment is secured with the entire property. As a result, you could easily watch your projected monthly profit turn into a loss that has to be covered out of your income.

By contrast, an investment into index funds "doesn’t ask to be fed". Whatever the situation in the financial markets, you won’t be required to deposit extra money. Your risk is therefore significantly lower with index funds.

The current period of low interest rates will also not last forever. If you can take out a mortgage at 0.9% p.a. today and you do not expect rising interest rates in your calculations, you are in for an unpleasant surprise. With inflation on the rise, the European Central Bank will likely start to raise interest rates within 2 to 3 years, which will be reflected in higher mortgage payments.

Should you still not be sufficiently dissuaded from investing in real estate, let's move on to the numbers.

Assumptions:

  • Purchase of a 2-bedroom apartment with parking space in a new building in Bratislava for 180 thousand euros. You borrow 80% of the purchase price from the bank, the remaining 20%, i.e. 36 thousand euros, will be added from your savings.
  • You spend extra 20 thousand euros on furnishing and equipment for the apartment. Hence, you invest 56 thousand euros in total.
  • You rent out the apartment for 700 euros per month (including utilities and parking space). The rent will increase every year by inflation, i.e. 2% p.a.
  • Let's assume a fairly optimistic scenario - monthly management and utility costs of 170 euros and total additional annual expenses equal to the monthly rent (e.g. tenant outages, minor repairs/renovation costs, taxes, etc.).
  • Assume long-term annual house price growth of 3.5% and average Finax 100/0 appreciation of 9% p.a.

Equity index funds vs. investment property with a mortgage | Finax.eu

If you have a few tens of thousands of euros at your disposal today and are considering buying an investment property with a mortgage, think carefully. Index funds can earn you more even in this case and with considerably fewer worries.

After 30 years, you will have earned less on an investment property than you would have by investing through Finax. Additionally, the purchased property would take a much larger chunk of your time than index funds. As the saying goes, time is money. And in today's hectic times, it is even more truthful.

And the winner is…

Finding a good investment is easy today. Index funds offer a solution for everyone, regardless of knowledge, experience, and financial capacity. Everyone must find their own answer to the question of what the best investment is. The only one who will profit off real estate in all scenarios is the real estate agent, not the investor.

Warren Buffett, the most successful investor and one of the richest people in the world, also looks at real estate through this lens. His investment conglomerate, Berkshire Hathaway, owns the second-largest brokerage firm in the US, employing nearly 50,000 real estate agents.

The way to make money in the real estate sphere is through the intermediation of buying and selling it, not by owning it. By the way, do you know what Warren Buffett recommends as the best long-term investment for ordinary people? Index funds.

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Real estate is thought to be the best long-term investment. Is it?
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Ján Tonka
Ján Tonka
Head of Training
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