There's a saying that real estate is the "IDEAL" investment. Some think of it as a guru saying that it's the best investment out there, when really, IDEAL is an acronym for:
We all know that real estate generates income when you rent it out to long term renters or as a short term rental on $ABNB
. We all know that real estate values rise overtime, which is where the appreciation comes from. We all know that people build equity on the real estate they own overtime, and in the future, homeowners would take out a HELOC (Home Equity Line of Credit) to purchase big ticket items like newer washing machines, a fancier car, or even another home. But how does leverage and depreciation make real estate the IDEAL investment?
Depreciation provides a tax write-off on the income you generate from your property. According to Coach Carson
, "[d]epreciation occurs because the U.S. government requires real estate investors to spread out most of the cost of real estate purchases over 27.5 years (for residential buildings)." In other words, depreciation is a built-in tax benefit within the tax code. In previous memos, I've written about how the changes in the tax code on depreciation incentivized manufacturing businesses to offshore their manufacturing overseas and led the US to become a more service-centric economy. That memo will be insightful with understanding depreciation better.
Then there's leverage. Some will say that the main benefit of this is to scale your real estate business and acquire more properties and others will talk about how it lowers the barriers to real estate investment. One of the biggest benefits of leverage is that it magnifies returns. Instead of putting all the capital upfront for the investment, you can take on debt and reap the same returns, but because you put less money upfront, your returns look much higher. Some will point out that the interest paid on the mortgage used to acquire property can be written off
of your own income tax returns.
Equity, leverage and income are the three characteristics that are built into real estate. Appreciation and depreciation vary depending on market conditions. However, the tax benefits that come with depreciation can disappear with a change to the tax code.
One of the main reasons why home affordability is a major issue is that investors are the ones buying up the homes in hopes of being able to rent them out for income. The blame is equal for both mom & pop investors and for institutional investors. By removing the investors from the real estate market, nearly 20%
of the demand would disappear. Since that 20% are the ones that can afford to outbid on properties and fuel bubbles in local markets, removing that 20% will also mean more reasonable competition among households for properties and less bubbles being formed.
Investors flush with capital shouldn't be chasing real estate. They should instead be funding businesses, infrastructure, research, and other things that contribute to improving people's standard of living and the nation's GDP. By allocating more capital to more productive assets, the nation would become more productive and prosperous as a whole. Labor mobility as a whole would be higher as housing across the country becomes cheaper and the infrastructure that investors have funded would make it easier for people to move to areas of opportunity.
There are arguments for why we should encourage investors to allocate more capital to real estate. One study found that institutional investors have contributed to increases in local construction employment
. One example of this is the joint venture partnership between $JPM
recently. Another example of this is the change in strategy at $DHI
where management is choosing to build homes to sell to investors looking to rent them out for income in response to the declining demand for new homes from consumers. If consumers aren't looking to buy homes, homebuilders need an incentive to keep building homes, and investors are the ones giving homebuilders that incentive.
There are arguments that blame excess bureaucracy by the government for why housing costs continue to outpace wages, but I won't go deep into them here. Instead, I will conclude by saying that by changing the tax code to disincentivize investors from continuing to gobble up homes, that this would make for a meaningful start in pushing housing prices to more affordable levels. The tax code is an underrated influence in the behaviors of investors and businesses. The effect that they have on their behaviors goes farther than the effect of subsidies. We've seen this with manufacturing and California real estate
. I hope that the removal of tax benefits from depreciation will inspire investors to fund more startups and buy less homes.