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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I don’t really think of my place as an investment, but it is definitely cheaper than renting. My monthly cost when I first bought was about the same as renting, but I bought a two bedroom 1200 sqft condo and was renting an 800 sqft 1 bedroom apartment. Renting a comparable place would have cost about $2,400/month. I didn’t pay any closing costs when I bought or when I refinanced either.
I’ve actually been keeping a running spreadsheet of renting vs buying and tracking how much my old apartment is now renting for. I saved about $4,000 in 2012, just under $10,000 in 2013, and I’m on track to save just over $10,000 this year. That’s even with the cost of my various home improvement projects. I’m on track to break even with the costs to sell the place, assuming no appreciation, by early next year.
I also do really like my place! 😀
If you kept a running spreadsheet then it sounds like you do think of your place as an investment 🙂 Either way, do you think you would have bought it if the tables were flipped? I don’t think so and that’s why you are in the minority, which is usually a good thing when it comes to finances.
I think you bought around the same time as me so you’ve probably also seen a 20-30% capital appreciation. Do you factor in tax savings too in your calculations? That should be 2-300 a month too.
Well I see it as a renting vs buying calculation and going with whichever is cheapest. Maybe you call that investment, but I don’t. To me, an investment would be buying real estate for the appreciation. I wouldn’t have bought if renting was cheaper. I think I’ve only seen about 15% appreciation in the last two years. Still decent though! I do factor tax savings in my math. That was only about $125/month at the most though and it is going down the lower my mortgage balance is. I know you think I’m crazy for that, but I really want to make sure the mortgage is paid off before I get married to separate premarital assets more easily. I’m okay with things being shared post marriage, but not before. If I was married, I probably wouldn’t have been paying off my mortgage so aggressively.
Haha I think we’re on the same page. I usually look at RE investments from a cash flow and appreciation POV. So in this case, the buy vs rent spread would be the cash flow.
Oh yea I remember that fun argument we had about tax savings when you totally proved me wrong haha! There’s definitely nothing wrong with paying off a mortgage early. Keep it up and that does make sense about the marital stuff, I’m going through some of that right now 🙂
After paying off our mortgage, the tax savings are gone, but so are the payments. Now we just have property taxes and maintenance costs to worry about. And the property taxes are deductible, so that’s nice. We also continue to invest the equivalent of our accelerated mortgage payment every month in our brokerage account.
Nice work Bryce, your property taxes are higher than the standard deduction? Those must be some pretty high taxes 🙂 but I bet it feels pretty good to not have that monthly mortgage payment anymore.
Don’t forget that when you buy a place you lock in the amount you pay on your mortgage. The taxes, utilities, and repair go up, but they are only ~half the total cost. Rent, on the other hand, will continue to go up in the long term in almost all cases. So, if you stay put you will almost certainly come out ahead.
However, the cost of buying a home is expensive because real estate agents, mortgage brokers, and mortgage lenders make a lot of money at the transaction. So, if you move frequently (how frequently is hard to define, but many say <5 years) then you will almost certainly lose out in buying.
The two most important question in the buy vs. rent equation are not 'cash-on-cash ROI' and 'rent vs. actual cost'. They are 'how long will you live there?' and, 'can you purchase a house without risking financial issues like bankrupcy?'
That is a good point Brett, real estate is a good hedge against inflation. And as people who’ve owned their home for 30 years know, prop. taxes do not increase at the same pace as inflation 🙂 I’d say 5 years is a good general rule of thumb, though I might lean towards 10 since you indirectly pay 5-6% the first time and directly pay 5-6% the second time.
But I’d have to disagree with you big time since I think rent vs. buy spread and potential capital appreciation are why you should be buying a home. Who cares if you’re only going to live in a place for 2-3 years if you can rent it out afterwards and make $500/month? A lot of the bad that you mention can be avoided by owning a home that can be rented out for a profit if things in your situation go south.
I think we are basically talking about the same thing. If you ask the question how long you are going to stay put and the answer is a long time then your rent vs. buy spread and capital appreciation look better and better as the rent rises faster than the variable portion of your purchase. You are talking about the underlying variables, I’m talking about the pragmatic question one might choose to ask oneself. It really is a question of time because if you buy and sell every six months you will never beat taking six month leases because the inefficiency in the market you mention in your article. If your buying for 30 years even a home in California can be a good investment.
However, I don’t think that $500/month profit from renting your home is much of a safety net if you are talking about things going south. If you loose your job and need, say, 3 months to find a new one you would be well served to have cash reserves on hand rather than $500/month and no place to live. The $500 won’t cover rent anywhere so the move out (to where?) and rent your place at a profit isn’t really a safety net.