What Business Are You In? A Lesson For Farmers From A New York City Real Estate Deal
Jim Prevor’s Perishable Pundit, September 27, 2011
Sometimes numbers can be very deceptive — especially if one tries to calculate comparative returns on investment on different asset classes over long periods of time. Even with the recent decline in real estate prices in many parts of the country, one still hears about people who bought property for a pittance a long time ago and now can sell for large profits.
In many cases, though, upon close examination these profits turn out to be less impressive than they seem to be, and the lesson is less about real estate than the power of compound interest.
For example The New York Times recently ran a piece by Diane Cardwell, titled Her $16,000 Town House, Now Available for Just $1.879 Million More. It details a real estate buy that has benefited from many advantageous circumstances:
When Mildred Furiya moved to a 19th-century town house on State Street in Brooklyn from a cramped walkup in Greenwich Village in 1967, a boarding house known for prostitution stood across a barren street, groups of unemployed men hung out on the corner and the Brooklyn House of Detention was a defining presence a block away. Standing in the garden — which functioned as a garbage dump for the apartment building next door — her husband, George, was almost hit in the head by a plaster Madonna statue someone had thrown from a window.
The jail, on hiatus from housing inmates, still looms over State Street, but Mrs. Furiya’s block, between Smith and Hoyt Streets, is much changed.
Sunlight filters through the trees, the unemployed men are long gone and the boarding house prostitutes have given way to middle-class and affluent families. The apartment building that once abutted Mrs. Furiya’s Italianate brownstone, which was declared a city landmark in 1973, is now a parking lot slated for nine new town houses, siblings to a row of 14 down the block that were among the first to sell for more than $2 million in Downtown Brooklyn.
And now Mrs. Furiya, 89, says the time has come for her to sell as well. Mr. Furiya died in 1994, her daughters have homes of their own, and she would like to live more simply: an apartment in the neighborhood or on the Upper East Side, perhaps, a place where she could walk around at night. She has also grown accustomed to being near the subway she rides to the classes in Sanskrit that help keep her mind agile and her outlook on life positive.
Given how values have climbed in the area, she said, “I knew I could be provided for by selling the house and how it could benefit the children.”
It is the gentrifier’s holy grail: a fixer-upper in a marginal area with potential. After the renovations, the lobbying for community improvements with like-minded neighbors, the holding on through the ups and downs, the scrappy, savvy buyer trades it in for a bigger, better place — or cashes out and retires in luxury.
It happens all the time in New York, but not usually at as high a level as at 299 State Street, in part because Mrs. Furiya held on so long.
So this is a house in a neighborhood that has dramatically improved. It was also a fixer-upper that they fixed up, and it is in a city, New York, where there are exceptional barriers to building additional housing.
Yet, although the New York Post headlined its story on the matter, Hi-ri$ing real estate, and began it as a tale of extraordinary profitability:
She’s turning brownstone into gold in Brooklyn.
An 89-year-old Brooklyn woman stands to make a startling 11,744-percent profit on a Boerum Hill brownstone she and her family paid $16,000 for in 1967.
The reality doesn’t stand up to the hype. The New York Times article does quantify the return:
She bought the house for $16,000 in 1966 with a cash gift from her father, the economist Alvin H. Hansen; her brokers, Ross Brown and Florence Ng of Citi Habitats, plan to list the house at about $1.895 million. A sale at that price would represent an increase of nearly 12,000 percent over 45 years — or an annual return of about 11 percent.
In other words the 11,744% profit is a consequence of the power of compound interest over a period of 45 years, with the return working out to about 11% per year.
Of course, the property hasn’t actually been sold and, very likely, the sales price will be less than the asking price. Plus, there is no allowance made for any investments made in the house — either through cash expenditure or sweat equity — over the past 45 years. There is also brokerage to pay to the real estate agent and the cost of carrying the property until it is sold. New York city also levies a 2.625% real property transfer tax when the amount of consideration is in excess of $500,000.
Even if we chalk off 45 years of real estate taxes and maintenance as rent — the net return is likely to drop below an annualized return of 10%.
In contrast, if one invested $16,000 into the S&P 500 and held it through the week the article was published — and if one reinvested all dividends — one would have earned an annualized return of 9.36%.
Now this was still an excellent return for Ms. Furiya, because she could enjoy living in the property. A pure investor would have the work of renting the property out and the risk of it sitting empty or being damaged by tenants.
In fact, it could have been a much better investment. She paid cash for the home. Had she put down 20% and taken out a mortgage, the return on her initial investment would have skyrocketed.
The S&P 500 return has many advantages, most notably instant liquidity, but it would have been difficult to actually realize the return of 9.36% because that includes re-invested dividends. In fact, unless the holding was in some tax-sheltered entity, a holder of such an investment would have to pay annual taxes on dividends received.
In contrast, owning a home offers immense tax advantages. Not only is interest on a mortgage generally deductible, so are real estate taxes and, often overlooked, one pays no taxes on the imputed value of the rent one doesn’t pay on living in a home one owns.
The long term value of real estate investments is, in fact, what underlies the business model of many growers. Berkshire Hathaway’s Warren Buffet loves the insurance business because if one can operate at a breakeven — if one can take in premiums equal to what one pays out in claims plus administrative expenses — one can get rich — as Buffet has — on the interest one earns on the “float” — the float being the money one has because the premiums are paid in advance of paying out the claims.
So if farmers can operate in such a way that they can cover their operating costs and real estate taxes, farmers who own land will actually make their profit on long term appreciation of their land.
Sometimes it is important to know what business one is really in.