Why Real Estate Is Not a Good Investment Right Now

Is real estate a good investment right now in 2018? While not as dicey as in, say, 2008, it is fraught with substantial risk. The parts of the country with strong economies have overheated real estate markets featuring prices out of proportion with household incomes. The places where real estate prices are more reasonable tend to have softer economies and job markets, and less sanguine growth outlooks for the coming years.

Since the real estate market collapsed during the Great Recession, buyers who braved the deluge of negative headlines and purchased at the market low points have been rewarded. From the first quarter of 2009 (the nadir) to the first quarter of 2018, the median home sale price nationally has risen by nearly 60%, according to the latest U.S. Department of Housing and Urban Development statistics. In certain cities, however, the run-up has been especially substantial, including San Francisco, Phoenix, Miami and Las Vegas (both of which were wrecked in the recession). Home prices are even above their pre-recession peaks in 57 of 105 metropolitan statistical areas, including Houston (up 79%), Dallas-Fort Worth (78%) and Denver (75%), according to an April 2018 ATTOM Data Solutions U.S. Home Sales Report.  

Real estate prices are only sustainable as long as people can afford to buy homes. The law of supply and demand dictates that if buyers stop buying, prices fall in response. An easy way to determine if housing prices exceed the level that buyers can comfortably afford is to compare them to household incomes. Household finance experts recommend spending no more than three times your annual income on a home. Over the long-term, U.S. housing prices have hovered around that ratio.

However, from 2011 to 2018, home prices have grown disproportionately to household incomes in most cities that have hot markets and booming economies. In San Francisco, for example, the ratio of home prices to household incomes is 45% higher than the long-term baseline. In other words, buyers are stretching their budgets to buy homes that cost four and five times what they make each year. The story is similar in Denver, Miami and Seattle, all of which have seen housing prices ascend rapidly, even as incomes make only small advances.

Before the real estate market imploded between 2007 and 2008, median home prices exceeded median incomes by a multiple of five – one of the factors leading to the subprime mortgage meltdown. As prices approach this threshold once again (as of May 2018, it was at 4.39), buyers should exercise caution to not jump in right at another market peak.

Certain cities still offer reasonable housing prices in relation to how much residents earn. In St. Louis, for example, the price-to-income ratio hovered right around the long-term benchmark as of year-end 2017. Unfortunately, the city has evinced none of the growth and price appreciation seen elsewhere since 2011. In fact, prices have declined slightly during that time. Chicago is another city that features affordable homes, but its prices have also dipped since 2011, and the city's unemployment rate, as of August 2018, was in the upper third among the 50 largest U.S. metropolitan statistical areas.

The conundrum with the U.S. housing market is that the best-performing cities are becoming overheated and unaffordable, while the places with affordable housing don't have the greatest outlooks for the future.

The real estate bull market, which is going into its seventh year, is making housing hot again. Based on Warren Buffett's advice, however, investing in what is hot is not the way to succeed financially. The last smart real estate play was in 2011 when the masses were still trampling each other to get to the exits. Now is the time to seek out undervalued investment opportunities elsewhere.