Archive | December, 2010

Why Your Home Is a Lousy Investment…But Is Still an Excellent Investment

14 Dec

We’ve all heard it before: renting just puts money in someone else’s pocket.  Why would you do that when you could be building equity in your own home instead?

One major argument espoused by those who encourage home buying is that your rent will continue to go up and up and up, while your major expenses (mortgage, property taxes, etc.) are largely fixed.  Of course, consider how many of these people are saying this because they have a vested interest in your homeownership:  your local mortgage company, your local Realtor, your friend who really wants you to buy the house next door to them so a new meth lab doesn’t move in to replace the one that was there before.

These same people will also emphasize that, not only do your costs not increase when you own a home, you also get the added benefit of being able to deduct your mortgage interest on your tax returns.  Does that sound contradictory?  It should.  Early on, most of your mortgage payments go to pay down your principal.  What this means is that you have less tax-deductible interest as time goes by; eventually, the tax advantages of home ownership become less and less important.  Of course, you can also deduct your property tax payments from your income taxes…but do you really want to pay taxes in order to realize the benefits of receiving a small portion of them back come April 15th?

And let’s not forget building up equity:  Realtors in particular love to remind you that real estate, on average, appreciates at a rate much faster than inflation.  What a surefire way to become a millionaire, simply by paying your own mortgage!  Well, as it turns out, there’s a major flaw in that argument too.

So is homeownership really a good deal?  Actually, despite all the misleading evidence, home ownership remains—on the average—a financially savvy move.  Let’s take a look at some of the numbers.  Yes, there is going to be some math involved (sorry).

Let’s Look at Apprecation

I’m going to start with the last issue I mentioned—inflation—first, because much of what I’m going to say will hinge on this.  If real estate truly does gain faster than inflation, eventually we hit a point where nobody can afford to buy a home, and homes stop selling.  Hmm.  Does that sound at all like the bursting bubble we’ve seen in the past couple of years?  In actuality, it is true that home prices have increased faster than inflation:  the average new home sales price increased 5.4% annually between 1963 and 2008 (per the U.S. Census Bureau), which matches the average price of existing homes sold between 1968 and 2009 (per the National Association of Realtors).  Compare that with the average rate of inflation of 4.4% per year within the same period (per the Bureau of Labor Statistics).

So real estate is clearly a hedge against inflation, right?  Well, not so fast.  Let’s keep in mind that the average home has increased dramatically in size—from about 1000 square feet in 1950 to well over 2000 square feet by 2000—at a rate of about 1% per year.  If we discount this average increase, we can see that a home of x square feet would appreciate at a rate of roughly 4.4% per year.

Does that number look familiar?   Yep, on the average, and barring any external factors (such as skyrocketing crime rates, collapse of or sudden boom in the economy), any given home should appreciate precisely at the rate of inflation.  Not such a great investment now, is it?

So Renting Is a Good Option, Then?

Hold on.  Obviously, there are going to be dramatic local differences in appreciation rates.  Between 1998 and 2008, the average sales price of a house in Detroit fell from slightly more than $70,000 to just over $20,000.  Compare that with Los Angeles County, where home values increased in value from $191,700 to $340,000 within that same period.  And of course, the times change as well; L.A. County looks like a great place to invest, unless you had decided to take the plunge in 2006 when the median price was nearly $600,000.  So you can build some serious equity, in certain areas, at certain times.

But if it’s your home, no matter how much equity you have, you still need somewhere to live.  If you cash out that equity by selling your house, you either have to 1) buy a new one or 2) rent.  If you time your sale right, you can sell at the peak of a real estate boom, then rent while you wait for the market to crash, and buy a nicer house for dirt cheap at the bottom of the market.  Obviously, opportunities to do this sort of thing don’t come often, and I don’t recommend using that as your principal investment strategy.

Where was I?  Oh yeah, renting.  Renting can be a good option; as the last real estate downturn was beginning, I was renting a house for about $2300 a month.  That was a fair amount of money to be “throwing away” to my landlord, but consider that comparable houses were depreciating at a rate of $5000 or so a month.  Once the numbers worked out better and I found a house I really enjoyed, I bought it.  Of course, I did lose some equity after that as the market slid a bit further, but that underscores one other point: the decision to buy or rent isn’t solely a financial decision.

But I digress.  Let’s crunch some numbers.

Some Financial Assumptions

Let’s say you happen to have $60,000 in cash sitting around and are deciding whether to buy a house, or rent and invest it in the stock market instead.

We will assume inflation increases at the average rate of 4.4% per year, and that a given house will appreciate at that same rate.  The stock market has increased, on average, at a rate of 9.4% per year between 1900 and 2009, so let’s assume it continues at that rate.

Just for fun, let’s also assume that you live in an area with a rather favorable property tax rate of 1.1%, which (in keeping with Prop. 13 limits) increases at a rate of 2% per year.

And let’s also assume that your comparable rental unit falls under the City of Los Angeles’ rent control ordinance, and your rent can be raised no more than 3% annually.

In the interest of simplicity, I’m going to exclude tax deductions (since those are going to be variable based on your personal tax situation), homeowners’ insurance rates (which will cost more than renters’ insurance), any HOA fees, and maintenance/upkeep costs (since, again, those will vary).  You should consider those in your personal financial plan, but let’s just keep things simple in our little imaginary world, OK?  Good.

Ownership Has Its Rewards

So you take that $60,000 and buy a $300,000 house with 20% down.  You finance the rest with a 30-year fixed-rate mortgage at 6% interest (yes, you can get lower rates now, but historically that’s pretty darn good).

After 30 years of 4.4% appreciation, your $300,000 house will be worth $1,091,700.  Hooray!  You’re a millionaire!  If you sell the house, that is.  I imagine that after 30 years, you’ll be ready to take your winnings and retire to Arizona.

Except that, after 30 years, you will have made $518,010 worth of mortgage payments and paid $131,015 in property taxes.

So what’s your profit?  If you take $1,091,700, then subtract the $518,010 in mortgage payments, $131,015 in property tax payments, and your initial $60,000 down payment, you’re ahead $382,675, which is a 638% return on investment, or about 6.66% per year increase on your initial $60,000 investment.  Not too shabby, actually.  It’s even better than putting your $60,000 in an account with a 4.4% annual yield; it does help to be able to leverage borrowed money to your advantage.

But What About Investing that $60,000?

Excellent idea!  You put your money into stocks, and you ride the market for 30 years.  With the value of your stock portfolio increasing in value 9.4% annually, you wind up with $888,528.  Subtracting your initial $60,000 investment, you just made a profit of $828,528—a far more impressive 1,380% return on your investment.

So, clearly, you would be a fool not to invest that money in the stock market.  Hello!  You’ll more than double your profits compared to building equity in your home!

Except that you still need to live somewhere.

Oh, yeah.  I forgot that part.  So, let’s say you find a nice rental that is comparable to that nice $300,000 house you were considering.  Let’s say you get a screaming deal of $1,400 per month on the place and you stay there for 30 years.  Assuming the aforementioned 3% annual rent increase, you will have paid out $799,267 in rent.

Subtracting your rental costs, you’ve made a piddly $29,261 from your original $60,000, for a net return on your investment of 48%.  Plus you have to continue to pay your rent.

What If I Already Own AND Have a Spare $60,000?

Obviously, then you can stand to make some serious bucks in the stock market.  A 1,380% return on your investment is pretty sweet.  But real estate investing can be lucrative too, if you’re willing to stick it out for the long haul and don’t mind your money being tied up in highly illiquid assets.

Let’s say you use that $60,000 as a down payment on a $300,000 house, and you rent it to someone at $1,400 per month for 30 years while they “invest” their money in the stock market, and you increase their rent 3% per year.  After 30 years, you have $382,675 in profit from simply letting the house sit, plus $799,267 in rent payments.  That’s $1,181,942, or a 1,969% return on your initial $60,000 investment, after 30 years.

Of course, I’m over-simplifying things: few places will be continuously occupied by the same tenants for several decades (though I do know of some that have been).  That’s bad in terms of clean-up, vacancy, etc., but good in terms of being able to raise the rent to current market rates when tenants move out. (In reality, single-family homes in L.A. are not subject to rent control laws.) And we all know that rental properties—and their tenants—don’t just take care of themselves, so they can require more active involvement on the owner’s part than buying and selling stocks.  And mortgage interest rates tend to be higher for investment properties than for owner-occupied properties.  And so on, and so on.  I told you I was going to keep things simple.  If you’re a serious investor, you’ll already know the ropes (and you probably aren’t even reading this blog); if you’re not an investor but are considering becoming one, hopefully you’ll know that you need to consult with your own investment counselor, tax advisor, spouse, and so on.

The Non-Monetary Benefits

I have always been of the opinion that we should not look at our home as financial investments, but rather investments in ourselves and in our communities.  However, many of the other benefits of home ownership do relate to property values as well.  Neighborhoods that are primarily owner-occupied tend to be considered more desirable than neighborhoods that are primarily tenant-occupied.  Residents’ sense of permanence very directly produces increased community involvement, pride of ownership, and all sorts of other intangible benefits that in turn lead to increased property values.

By being involved with your neighbors, you’re not only improving your own quality of life, but you’re also protecting your investment—whether you look at your home as an investment or not.