Should You Buy a House Right Now?

Ruth Saldanha: Why we increased Apple’s fair value estimate—and awarded it a wide moat rating.

How much is it safe for you to withdraw from your portfolio in 2023?

And what’s a better investment right now, an actual house or a REIT?

This is Investing Insights.

Saldanha: Welcome to Investing Insights. I’m your host, Ruth Saldanha. Let’s get started with a look at your Morningstar headlines.

Morningstar Upgrades Apple’s Moat

Apple’s iOS ecosystem gives Morningstar greater confidence in the tech giant’s competitive advantages, and we’ve upgraded our economic moat rating for Apple from narrow to wide, indicating we expect these competitive advantages to last for at least 20 years. A company with an economic moat can earn high returns on capital for many years to come. Our confidence in Apple stems primarily from switching costs related to auxiliary products and services that make switching away from iOS more difficult over time. Morningstar also thinks Apple benefits from network effects like its iOS user and developer base and intangible assets related to hardware, software, and semiconductor design. We’re raising our estimate of what we think Apple’s stock is worth from $130 to $150 as we expect the company to earn excess returns on invested capital over a longer time horizon. That said, we do expect the upcoming quarters to be challenging for Apple both from a demand and supply perspective. We recommend that investors wait for the stock price to come down before they buy.

Procter & Gamble Reports Q2 2023 Earnings

Procter & Gamble’s second-quarter results suggest to us the company is powering through macro and competitive challenges, even though the headline numbers seem to be telling a slightly different story. The consumer goods manufacturer reported 5% organic sales growth along with a slight decline in gross and operating margins. Sales volume slumped, but higher prices helped offset it. We don’t think this means deteriorating consumption trends. Half of the volume pullback was part of P&G’s decision to ratchet down its Russian business and due to temporary retail inventory reductions, especially in China. Morningstar doesn’t plan to change our near- or long-term outlook for the business. We raised what we think shares are worth from $125 to $126. We consider the stock overvalued and suggest that investors wait for the price to come down before they buy.

Palantir Makes Strategic Missteps

Palantir’s strategic missteps have created problems. And that’s leaving Morningstar less optimistic about the software company’s long-term profitability and revenue growth. One misstep worth noting has been Palantir’s risky investments in early-stage companies—which soured in the 2022 market correction. Meanwhile, Palantir has been able to land large clients that spend millions for custom-made AI and machine-learning solutions, but this strategy of focusing on high-value organizations has stunted customer growth. Palantir’s platforms are now seen as too expensive for many large organizations, and to counter this, the company now allows customers to purchase specific modules instead of onboarding an expensive platform right at the start. Morningstar is lowering our estimate of what we think the stock is worth from $13 to $8. We view the shares as fairly valued today but see opportunities elsewhere in the fast-growing technology sector.

Saldanha: Investors love real estate, and despite the volatility and uncertainty of the housing market over the past three years, real estate remains a valuable part of an investor’s portfolio. But with rising rates and declining house prices, is owning a physical house the best investment idea right now, or are real estate investment trusts, or REITs, a better bet?

Jeremy Pagan is a NEXT research analyst for Morningstar Research Services, and he has done some work on this topic. He’s here today to tell us what he thinks. Jeremy, thank you so much for being here today.

Jeremy Pagan: Hi Ruth, thank you for inviting me.

Saldanha: What are some of the benefits of physical real estate versus REITs?

Pagan: When most people think of the financial benefits of rental properties, they think of income generation and price appreciation. However, property owners’ tax benefits are substantial. You could save thousands of dollars in taxes each year through depreciation. Better yet, you could utilize tax programs like the 1031 exchange to defer capital gains taxes if you decide to sell the property. Homeowners are not only entitled to 100% of the income capital gains and tax benefits but can also leverage home equity to buy more real estate.

Saldanha: And what are some of the benefits of REITs versus real estate?

Pagan: Right now, more than 45% of American households own REITs, nearly double the estimate from two decades ago. They can be a good fit for your investment strategy if you want higher dividends than the average stock on the S&P 500, if you want to increase the diversification of your portfolio by investing in various real estate markets and sectors, or if you want to earn profits without the commitment and responsibilities of directly owning property. Or, if you’re not interested in starting a mortgage, REITs offer lower cost to entry.

Saldanha: In both cases, what are some of the cons?

Pagan: Yeah, so on the other hand owning physical real estate can come with some headaches, like dealing with tenants if you decide not to cut your profits with a property manager. In addition to large upfront costs, homes are typically illiquid. Selling a property can take months and be costly. Rental property ownership also comes with geographical risks. Property markets are quickly to rise and fall, so picking the right time to invest and location can be anyone’s guess, making hindsight bittersweet.

Saldanha: Finally, from an investment standpoint, which do you think is the better bet right now and why?

Pagan: If you’re thinking about investing in real estate and aren’t sure if you should purchase REITs or rental property, it’s really going to depend on the type of investor you are and the strategy you’re able to execute.

Let’s say you’re a busy professional and cannot commit a lot of time into real estate, then REITs might be ideal. And if you’re still interested in physical real estate, then perhaps being a limited or silent partner, where you don’t have to make management decisions, could be right for you. Or if you are an early professional with a flexible job but perhaps low on cash, again, REITs might be the way to go, but a rental property could make sense if you already built that traditional investment egg and have savings to protect yourself if markets crumble. And perhaps you already retired and you’re simply looking for income, you want something safe and consistent, then REITs again are right for you. But if you’re an empty nester and deciding to relocate or downsize, maybe it’s a better option to keep that property as a rental, especially if you can’t sell it at the price you want.

Saldanha: Thanks so much for being here today, Jeremy.

Pagan: Thank you for inviting me.

Saldanha: Rising inflation means all our bills have increased, and if you’re retired and on a fixed income, that means you have to think carefully about your withdrawal rates. What’s a safe withdrawal rate for 2023? Morningstar Inc.’s director of content Susan Dziubinski talks to Morningstar Inc’s director of personal finance Christine Benz about this. Here’s their discussion:

Susan Dziubinski: Hi, I’m Susan Dziubinski from Morningstar. Stocks and bonds both lost money in 2022, while inflation rose dramatically. Joining me to discuss implications for safe withdrawal rates in retirement is Christine Benz. Christine is co-author of a recent research report on this topic.

Christine, nice to see you today.

Christine Benz: Hi, Susan. It’s great to see you.

Dziubinski: You and your co-authors, John Rekenthaler and Jeff Ptak, concluded that people retiring today can reasonably take a higher withdrawal percentage than they would have been able to, say, a year ago. Talk a little bit about how you arrived at that conclusion.

Benz: Right. We used what are called Monte Carlo simulations to figure out what someone could safely take out of their portfolio as a percentage in Year One of their retirement using a balanced portfolio and have a 90% success rate—so, a 90% chance of not running out of funds over that 30-year horizon. And we assumed a fixed real withdrawal system for those retirement withdrawals. So, we’re assuming that someone is taking X percentage in Year One of retirement, and then inflation-adjusting that dollar amount thereafter, and that’s kind of a convention in talking about and thinking about safe withdrawal rates.

When we used the inputs that we received from our colleagues in Morningstar Investment Management for expected stock returns, expected bond returns, expected inflation over that 30-year horizon, what we saw is a little bump up in safe withdrawal rates in 2022 versus what they were in 2021. So, when we ran this study in 2021, we came out with a fairly low number, kind of a worrisome number, a 3.3% safe withdrawal rate for that 30-year horizon starting at the beginning of 2022. Thanks to increasing bond yields as well as lower equity valuations, we came out with a 3.8% number in 2022. That’s because the team in Morningstar Investment Management expects that stock returns will be higher over the next 30 years and bond returns will also be higher.

Dziubinski: Now, inflation also rose quite a bit last year. How did that factor into your analysis?

Benz: Yeah. Super good question. Inflation is all top of mind for all of us today. But the fact is, we’re planning for a 30-year time horizon. So, there are periodic blips in inflation, but the team in Morningstar Investment Management makes an estimate of what they think inflation will be over that 30-year horizon. Their estimate that they’re using is 2.8% as of late 2022. So, over that 30-year horizon, the expectation is that inflation will be elevated a little bit for the next couple of years but then will level off to a more normal level going forward. When we ran this study in 2021, the forecast that we were using was 2.2%. So, it’s a little bit elevated but not a lot elevated. It’s nowhere near the 7% inflation level that we’ve had over the past year in the U.S.

Dziubinski: Christine, you say in the research that it’s important to note that even though safe starting withdrawal percentages are higher for retirees this year, that might not actually translate into a higher payout for most retirees. Unpack that for us.

Benz: Yeah, I think that’s such an important point, Susan. People care about their dollar withdrawals. They don’t care about the percentage. So, a higher percentage, say, 3.8% on a shriveled-up portfolio may translate into a lower payout. So, what matters at the end of the day is how much you’re able to spend in dollars and cents, not the percentage. And the fact is many retirees, many of us, have seen significant declines in our balances over the past year because stocks have declined and bonds have declined simultaneously.

Dziubinski: Christine, who is this research really for? Is it mostly for people who are just about to retire and who are thinking about what their optimal portfolio withdrawal rate might be? Or is this useful research for those who are already in retirement and tapping into their portfolios?

Benz: It’s mainly relevant for people who are on the cusp of retirement or just starting retirement, but I do think there are some takeaways in this research, especially in the broad white paper that we wrote, where we look at various time horizons and what would be safe withdrawal rates for various time horizons. We take it all the way down to 10 years, a 10-year time horizon. That would be someone who has been retired for a long time or for whatever reason thinks that they will just have a 10-year time horizon for that portfolio. What you see quite intuitively is that as the time horizon shrinks—so, if you’re an older adult, and maybe you’ve already been retired for 10 years and you think, maybe “Well, I think I’ll live another 20 years” or whatever it might be—as that time horizon shrinks, the payouts that are supported are higher. So, when we look at a 20-year time horizon, for example, you can see that with a balanced portfolio and a 90% success rate, you can actually take over 5% today. If you have a 15-year time horizon, you could take over 6%. So, definitely, it can be a check for people who are further on in their retirement. It’s not just for retirement newbies.

Dziubinski: In your paper, Christine, you and your team explore how flexible withdrawal strategies can help elevate those starting safe withdrawal amounts. Let’s dive a little bit into these flexible strategies. How are they able to do that, and what are the trade-offs with a flexible approach?

Benz: Sure. This is an element of the paper that frankly I wish had gotten more attention. Because when we look at all of the retirement research that’s been done over the past couple of decades by people like Wade Pfau or our former colleague David Blanchett, our research points to the value of being flexible in terms of your withdrawals. If you’re willing to vary them a little bit based on how your portfolio has performed, maybe even based on that time horizon, how long you’ve been retired, you can very likely take a higher withdrawal amount. So, in our paper, in our research, we tested five different dynamic withdrawal strategies ranging from really simple tweaks on the old 4% style, fixed real withdrawal guideline to things that are a little bit more radical in terms of making adjustments. What we found is that starting safe withdrawal rates increased and lifetime safe withdrawal rates—so how much you could pull from the portfolio over your whole retirement time horizon—also increased. So, my hope is that people will explore some of these dynamic strategies because I think they can be really powerful. They can translate into higher spending, higher quality of life. The trade-off, though, is more variability. That you have to be willing to put up with some changes in your paycheck from year to year. They can be modest changes, but they’re changes all the same.

And the other point I would make is that for some of the strategies—especially what’s called the guardrails strategy, which was developed by Jonathan Guyton, a financial planner, and William Klinger, a computer scientist—strategies like guardrails or an RMD, required minimum distribution type strategy, they basically get you consuming more of your portfolio throughout your retirement. Some of us might say, “Well, that’s exactly what I want. I want to enjoy the fruits of my labors.” Some people might say, “Well, for me, having a bequest, money left over at the end is a really important goal, too.” So, bear that in mind as you evaluate these flexible strategies. If you’re bequest-minded, you might want to lean more toward just the modest tweaks. Whereas if you’re very consumption-oriented, you want to really enjoy what you’ve managed to save, you might look at a guardrails type strategy, for example.

Dziubinski: And then, lastly, Christine, your research also looked at how retirees actually spend, which is specifically the tendency of retirees to spend less as they age. How does that affect the safe withdrawal amounts?

Benz: Right. This is some research that was prompted by, again, David Blanchett’s research on how retirees actually spend. And what he found in surveying retiree spending habits is that retirees do tend to spend less as they move on in their retirement. So, in the middle to later years of retirement, spending trends down. It’s higher early on in those pent up, go-go years and then trends down in the middle to later years of retirement. So, we decided to model that in. We consulted with David on how best to do that, and he suggested to simply reduce the inflation adjustment that we were giving retirees each year throughout their retirement. So, he found that, on average, spending tends to decline by about a percentage point less than the inflation rate. So, if we’re assuming a 2.8% inflation rate for the purpose of modeling, we used a 1.8% inflation rate. What we found is that that translated into a nice uptick in spending early on in retirement. So, a retiree could spend more in those early go-go years, but the trade-off, of course, is the assumption that spending is going to level down, that spending won’t necessarily increase in line with inflation. But I think it was an attempt to reflect how retirees do indeed actually spend in aggregate.

Dziubinski: Thank you for your time, Christine, today. As we know, withdrawing from a portfolio in retirement can be a very challenging and frustrating experience, and we appreciate your new insights today in light of what happened in the market last year.

Benz: Thanks, Susan.

Dziubinski: I’m Susan Dziubinski with Morningstar. Thanks for tuning in.

Saldanha: Thank you Susan and Christine! That’s all for this week’s episode. Don’t forget to subscribe to Morningstar’s YouTube channel to see new videos about market news, personal finance, and investment picks. Thanks to podcast producer Jake VanKersen, who puts this show together. I’m Ruth Saldanha, an editorial manager at Morningstar. Thank you for tuning into “Investing Insights.”

Read about topics from this episode.

Raising Apple Stock’s Fair Value Estimate to $150

P&G Announces Fiscal Year 2023 Second Quarter Results

Procter & Gamble’s Stock Looks Overheated After Effectively Weathering Headwinds in the Quarter

Cutting Palantir Stock Fair Value Estimate as Strategic Missteps Create a Plethora of Problems

Investing in REITs vs. Direct Real Estate

Retirement Income and Safe Withdrawal Rates in 2023