One of my readers sent me this article last week, it was titled: Americans Think Owning a Home is Better For Them Than it is. As you guys know, I’m a huge proponent of using real estate to build wealth. Whether it’s your primary residence or a rental property, real estate should always be treated like an investment because it is. I was actually just on a podcast a few weeks ago talking about how real estate has had a huge impact on my net worth and how my rental property is now providing me a nice secondary source of income.
So naturally when I read the title of the article I was pretty sure I was going to disagree with it’s premise. If you’re too lazy (or don’t have the time) to read the article, it basically detailed how real estate isn’t as great as an investment as everyone thinks it is. Here’s a quote from the article:
Over the past century, housing prices have grown at a compound annual rate of just 0.3 percent once one adjusts for inflation, according to my calculations using Shiller’s historical housing data. Over the same period, the Standard & Poor’s 500-stock index has had comparable annual returns of about 6.5 percent.
Those facts are true but the author failed to consider a lot in her article (I didn’t think much of her article to be honest). The real problem is that most people don’t consider their primary residence as an investment. If they did, 90% of the homes in California (where I live) would not be selling for the prices they’re selling for, they’re almost all bad investments right now.
Unlike the stock market, the real estate market is very inefficient. If you’re a good/smart real estate investor you can find a great deal and make a lot of money in many different ways. But as a homebuyer you need to consider the exact same things you would when buying stocks and bonds. Things like earnings potential and duration matter with homes just as much as with stocks and bonds.
Triple Threat of Home Ownership
My main problem with the article is that it only considers the capital appreciation (the amount your home goes up every year) portion of owning a home. There is also the tax savings (mortgage interest and property tax deduction) and the biggest one of them all: the money you save vs. renting. Nobody has to buy stocks but you do need a place to live, unless you plan on slumming it with your parents forever. This article is pretty much 100% flawed since it doesn’t take that into account.
Here’s a real life example of just how much home ownership can benefit you:
I bought my condo in 2009 for 280k. At the time I could have rented the exact same place for ~$1,700 a month (or more). My mortgage was $900 ($350 went to principal)/month, tax savings was around $150/month, prop taxes was $300/month, HOA was $400/mo. So you have $900+$300+$400-$350-$150 = $1100. So my true cost for this place was $1100/mo. I was saving $500/mo (let’s assume my monthly expenses were $100/mo($600-$100 = $500)) vs. renting.
I had to put $56,000 down to buy my condo and I made $500/mo. for the 3 years I lived there. $6,000/$56,000 = 10.17%. So I made 10.17% per year for 3 years straight while I was living there.
You also have to remember that your capital appreciation is based off leveraged money. So if I put 20% down on a 280k house and the value of the house goes up 20%, now it’s worth $336k(conservative estimate), I just made a 100% return on my investment in only 3 years. So that would be 33.3% APR per year on the capital appreciation side.
So basically I invested $56k 3 years ago and I now have $130k(43.13% return per year) and I also had two roommates during that time which I didn’t account for in this analysis
So Where Does it all Go Wrong?
People run into trouble when they start buying homes that are significantly more expensive than renting. This price to rent ratio tends to be the worst in high cost of living (HCOL) areas like California, New York, etc. In these HCOL areas, on average it’s probably a better deal to rent than it is to buy but people don’t want to feel like they’re throwing money away. But if you’re buying a home that’s a bad investment that’s exactly what you’re doing.
If you’re looking for a rule of thumb, my advice is to compare the cost of a mortgage+property tax+insurance+HOA to the price you pay for rent. Conservatively estimate that your tax savings and principal addition will be canceled out by expenses(there are lots of expenses that most new homeowners fail to consider). If the numbers are equal, than it’s obviously a better deal to rent. I probably wouldn’t even consider buying until I knew I’d be getting an 8-10% return on my money. Here’s an example of what I mean:
If it costs me $2,000 a month to rent a 2 bedroom apartment in California and I can also buy the same property for $300,000, that means I have to invest(in a downpayment) $60,000. If my total costs per month as a homeowner are $1,700 that means I’m saving $300/month vs. renting. 12 months x $300 = $3,600. $3,600/$60,000 = 7% return on my investment. Not a good deal in my book, I’d rather rent.
Here’s a cool buy vs rent calculator from the NYT that you can use in your own analysis. I think owning a home can still be a great investment and for me it’s worked out better than I ever could have imagined. But you need to treat it just like an investment, if it’s not a good deal, don’t be afraid to say no and wait for something better.
Readers, what do you think about buying a home vs. renting? Do you agree with my premise that you should treat buying a home like an investment?
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-Harry @ PF Pro