While chatting with a friend in Colombia recently, the topic came to real estate. Due to the strength of the dollar right now in much of Latin America and especially Colombia which is discussed in Cash Chronicles Abroad: Colombia, my friend and I weighed the options of investing in real estate there.
Obviously, the direct comparison I would have to make right off the bat is comparing investing in a foreign country versus investing in the US. Investing in the US is easier simply because I already am aware of the process and familiar with the rules, laws and regulations, even if there always seems to be a new one. Investing in a foreign country presents a steep and potentially expensive, learning curve that dissuades many from even attempting to try. Luckily, I have some experience in the region but that isn’t enough, there are a number of other factors people have to weigh besides local culture, in order to invest in real estate abroad.
A good amount of the appeal of investing in real estate in a developing market combines two somewhat exclusive investment dreams for those wanting to get rich: the allure of emerging markets, with their potential for explosive growth and the perennial attraction of real estate.
If you log on to Instagram or take any course in building wealth, real estate eventually rears its head. There are people that only invest in real estate and claim it is the best and fastest way to get rich for ordinary people. Emerging markets offer another potential path to riches. Although they have stumbled in the past decade, with the aging of the rich world population and the movement towards open markets and economic freedom for much of the world, emerging markets offer one of the best hopes for world growth going forward.
The question is, does combining the two equal a good deal for an investor in a rich country, in this case the US?
What Return Can You Expect?
If we are looking forward, the easiest way to put a number to helping predict a return from real estate is to look backwards. Below is a chart of the Case-Shiller index of real estate in the US since 1987.
Source: Federal Reserve
The index takes a range of prices of home resales from 20 cities in US. In the 32 years shown here, this index increased from 63.99 to 206.72. That growth works out an average price appreciation of 3.7% per year over the period.
As always, real estate is local. It’s easy to make a bad investment locally as well as anywhere else. I assume here that the investor does her homework and makes a reasonable investment in a larger US city and ends up seeing an average return. For these purposes we can say we would expect that return to be about 3.7%.
What about in emerging markets? The IMF keeps a global real estate index for such purposes since the year 2000. From 2000 to 2014, the index moved from 100 to about 170. This 70% return averages out to about 3.8% annually.
Source: IMF Blog
This is not an exact science, the chart above is based off of 30 emerging economies and their GDP weighted equally on the blue line. It’s not a perfect measure but again, provides us with a relative average for a market segment over a period of time.
If we also disregard the fact that we are comparing more data points in the US versus fewer in emerging markets, it’s still a pretty strange result. You would think emerging markets would see much higher growth given that the typical growth story there is a burgeoning middle class which would likely be lookin for a quality housing stock. What accounts for the difference?
Property Rights
There are a few things that came to mind when thinking about how they differ. Remember during the financial crisis in the US, when a lot of former boom neighborhoods became dangerous places you didn’t want to buy in? As the economy came back from recession, those places were slowly inhabited once again and many of them even saw a renewed boom.
Places like the neighborhoods that became dangerous during the crisis exist overseas as well, there just happen to be more of them. We are relatively spoiled in the US I’m the sense that many of us can live close to a large city in a relatively secure home and not have to deal with petty crime on most days.
That’s not to say that there aren’t areas in emerging economies that are safe and you can leave vacant for some time, but you will likely have to pay for that convenience. Whether you are present in the country matters as well, there is no guarantee that locals won’t plot on your nice vacant place and even rent it out to others themselves.
This would then lead you to seek the local legal system. If you want to go to the courts, it won’t always function as transparently as the US justice system either. If someone knows the judge or pays off the right people, you could quickly find yourself on the wrong side of a verdict on your own place.
These are pretty broad generalizations and there are still plenty of great places to invest in emerging countries, you just have to be careful to be familiar with local laws, customs and aware of scams and schemes that many locals cooked up. Having to be this vigilant and aware, rather than rely on transparent laws, dissuade most people in the first place.
Loan to Value
One of the hallmarks of an advanced economy is a sophisticated banking sector as well as social services to assist those in need. These come into a strange convergence in many advanced economies, where usually due to reasons of lobbying, past crises or both, the government has a strong hand in the mortgage market.
This is the case in the US more than anywhere. The current norms for a home loan are quite distinct compared to many other countries. Fannie Mae and Freddie Mac are government sponsored entities that essentially prop up and lay the ground rules for the entire mortgage market. These companies were formed during the depression to help keep the mortgage market from falling victim to banks imploding.
Prior to the Great Depression, most home loans were “balloon” payment loans where you paid interest for example, for a 10 year period on a $10,000 loan for a home valued at $20,000 (or 50% loan to value when dividing the loan amount by the home value). At the end of the 10 year term when the loan was due, you would just refinance the loan into a new one and keep moving along.
When banks failed during the depression though, homeowners found themselves unable to refinance their loans and ended up defaulting on the entire balance of the mortgage. To solve this problem, the government came up with the idea of setting the standards nationally for home loans. Freddie Mac and Fannie Mae would serve as intermediaries and buy loans from banks that met standards set by the government: 80% loan to value, good credit of the borrower and 30 year terms with a little piece of the loan repaid along with interest every month. That last part would allow a borrower to pay off the loan balance over the life of the loan so at the end of the 30 year term, the loan was completely paid off.
This was a unique solution to a gripping problem of the time. It set the standard for the US market: mainly 30 year terms, 80% loan to value and rates that were influenced by the government. Other advanced economies offered government insurance or a different type of support structure either after war or economic collapses in their own countries.
Emerging markets however, do not have this same history. The banking sector may still be sophisticated, but may only bank a small portion of the population i.e. those that are middle class or rich, which may only be a minority of the entire population.
In these cases, the maximum loan to value is usually determined by the banking market and may look much like the US mortgage market pre-depression era: smaller loan to value ratios (like that 50% mentioned above), higher interest rates (not backed by the government so more risk) and shorter terms (more like 10 years).
Compared to the US then, the portion of the home that you own, or that 20% of the home value in the US when you first get a home loan, is now highly leveraged. Leveraging means that you borrow to buy an asset and if the asset grows in value, the leverage enhances your return.
To show the power of leverage, let’s forget the similar growth rates in the US and emerging markets I mentioned previously, and say emerging market homes grow at 6% annually while the US just grows at 3.7%. On the face of it, the emerging market sector is better, throw in leverage though, and it changes the math. Below is the calculation of the levered return with a 3.7% growth rate levered 80% and a 6% growth rate levered at 50%:
- Emerging Market Return = 6%/0.5 = 12%
- US Return = 3.8%/0.2 = 19%
The 0.5 and the 0.2 being the factors that represent the portion of the home owned by the buyer.
So as you can see here, despite the lower overall return, the leveraged return in the US ends up being higher.
Conclusion
All this being said, I haven’t even accounted for currency risk and political risk, all of which tend to be higher in emerging markets from the perspective of a rich world investor. This is probably the reason you seem to see more people getting rich from real estate in the US compared to other places. It’s a unique characteristic of the government support of the mortgage market here and the big secret that all those Instagram pages and get rich courses forget to mention. It’s a confluence of unique factors that exist in the US as to why real estate makes you rich (in America).
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