Real estate - Basic considerations

A couple of days ago a colleague of mine proudly reported that acquiring his own property was one of his best investment decisions in life. In 2010, he paid EUR 550,000 for a rather basic terrace house in the outskirts of Munich. He financed the acquisition through EUR 125,000 of equity and the remainder through a mortgage loan at a 3.50% p.a. fixed rate. He was very proud of his investment. To me paying off a loan for the rest of my life appears not so promising. Who knows what will happen during such a long period of time!?

I have been asking myself for some time now whether my dividend income strategy is really superior to a regular real estate investment. The reasons for not having considered such an investment so far were rather practical in nature:

First of all, with 4 years of professional experience I still consider myself to be a job starter. Being flexible and not put on the chain has been very important for me in today's fast-paced work environment. Secondly, prices for real estate in German cities (and particularly in the Munich area) dramatically increased in the past years. They swiftly reacted to the ECB monetary policy of low interest rates. As a consequence, it takes more time to build up the equity required to be granted any mortgage loans. Of course it might also be possible to pursue a real estate investment without any equity at all. Whether this is a good and sustainable way forward is, however, another thing.

When I turned 30 last month, I felt that it is time to reconsider my personal situation and review my investment goals. Lets give more thought into this.

What are the pros and cons of either strategy?

1. Dividend income

+ continously growing return on investment if long-term dividend growth rate is positive

+ diversification across various sectors and geographies

+ investment amounts can be randomly split across assets

+ real estate exposure can also be achieved via investment in REITs

+ moderate risk concentration

+ hedge against inflation

- considerable tax impact (25% witholding tax (Abgeltungssteuer) on interest and dividend income)

- regulatory risk / risk of financial repression (higher taxes, extra duty)

- high variation in market value during stock market turmoil

2. Real estate

+ appreciation of property value if asset location has a positive long-term outlook

+ saving of monthly rental expenses

+ interest on loan is tax deductible if asset is rent to 3rd party

+ hedge against inflation

- no diversification across sectors and geographies

- high risk concentration

- difficult to split up the investment

- interest burden (paying interest on any loans which is not payable when renting)

- considerable tax impact (3.5% land transfer tax (Grunderwerbsteuer))

- regulatory risk / risk of financial repression (higher taxes, extra duty)

- limited mobility

I am sure I missed out some aspects of each investment strategy. Nonetheless, it seems that given my current personal circumstances a dividend income strategy has more advantages compared to a real estate investment.

However, there is one aspect which is worth to highlight: My girl-friend and I currently pay EUR 1,400 per month of rental expenses for our 3-room apartment. I consider this as money thrown out of the window. Wouldn't it be better to buy a property, really own something, and pay-off a mortgage loan instead? In my view, saving the rental expense is a real advantage of real estate even though I would have to invest all equity into such a new project at once. I could still start all over again with my dividend income strategy in parallel once this investment is made.

You might be asking 'why is he still hesitating then?' Well, main reason is the following: As I wrote in the beginning, prices in the market have exploded since 2009. I would even say that prices in Munich increased faster than my personal savings rate throughout the last years. This does not mean that I did not save enough, but rather that there was a run into real estate due to the low interest environment.

Experts believe that there is no real estate bubble in German cities, but I deem real estate prices of 30-35x of annual rental income in the Munich area as over-priced. At this price levels, I would have to finance a very large portion of the acquisition price through loans.

This is the critical point here: While the interest compounding effect in a dividend income strategy works for me, it works against me when I take on a loan.

Now, what does that mean in detail? How can I make sure that the financing is still bearable? Of course, I do not want to drown in financial indebtedness.

Lets have a closer look into this in part 2.