Monday, March 14, 2011

Home as an Investment - Sample Calculation

 Is your home really an " investment"  or just a place to live?  Let's crank some numbers and find out.

The following is a little thought experiment I did, to crank some numbers on the overall profit of home ownership.

Is your home an "investment" in the sense that it is something you will make a lot of money on?  Chances are, over the long haul, you will get back more in resale price for a home than you pay for it.  But that does not necessarily mean you are making money on the deal.

As I noted in You Can Never Really Own Real Estate, the concept of "owning" Real Estate is somewhat flawed.  At best, when you buy a property, you become steward of it, on behalf of the State, and you may realize some income from it over time.  But all it does, really, is take most of the stream of expense payments that a landlord would pay, and hand them over to you.  There might be a slight savings to you, in that a landlord's profit is no longer there.  But on the other hand, landlords typically don't make a lot of profit on properties - most of the money you pay in rent goes to taxes, mortgage, maintenance, and utilities.  A landlord is lucky to be making a 10% profit, if that.

The other part of the profit to you is that you might make some capital gains on the property over time, which your landlord would otherwise collect, and to you, those capital gains are tax-free.

Whoa, tax-free?  Why is that?  Well, I think in large part because the IRS recognizes that for your personal residence, any "gain" you get basically reflects the rate of inflation, over time, in a normal market.  Thus, it would be cruel and unfair to tax a homeowner on his "profit" on the sale of his house, when the increased value of the home is little more than the rate of inflation, perhaps less.  And the tax code has long recognized this exception (the rules were tweaked recently to make it even more lucrative, but it is still largely the same for most middle-class Americans).

And maybe that tells you something, too, about Capital Gains tax in general - and the arguments that some have, that it should be abolished.  If you tax someone on a long-term capital gain of 5%, and the rate of inflation is 5% over the same time period, have they really made money, or just broken even?  And if they broke even, if you tax that, do they not actually lose money?  It is an interesting thought, but subject for another posting.

Anyway, as I noted in an earlier posting, the "Rich Dad" dude, who became rich by telling us all how to be rich (like all good Gurus do) says that your personal residence is not an "investment".  This may be over-stating the case, I think, but it does make a good point.  The home you live in really is not as great an investment as you think.

Note that this is NOT to say you should not buy a home, or not pay down and pay off your mortgage.  Please don't take the wrong normative cues away from this illustration, or engage in lazy thinking to self-justify poor economic choices.  Rather, the idea here is to explore reality a bit and understand the real costs and benefits of home ownership, beyond the mantras and slogans tossed about by Real Estate Agents.

To begin with, we will assume a typical home in America, and make some pretty broad, but I think accurate assumptions on price, terms, taxes, and insurance, based on the homes I have owned and other properties I have seen or owned by others.  I don't think these assumptions are too wild or over-stated:

Here are the stats on our "typical" home:

Home Price:  $200,000

10% Down Payment: $20,000

Mortgage Amount: $180,000

Interest Rate: 4.5%

Monthly Principle & Interest: $990.03

Total Interest Paid, 30 Years: $148,332

Future Value of Down Payment, @7.5% interest, 30 years:  $175,099

Property Taxes, estimated, first year: $1000.00

Property Taxes, all 30 years, estimated, with inflation: $50,000

Homeowner's Insurance, estimated, first year: $800

Homeowner's Insurance, all 30 years, estimated, with inflation:  $35,000

Maintenance and Repairs, estimated, annual: $2000

Maintenance and Repairs, estimated, all 30 years, with inflation: $100,000

Utilities, per year, estimated:  $2400

Utilities, all 30 years, estimated, with inflation:  $110,000
Note, of course, that Interest Rate makes a big difference over time, and today, we have very low interest rates (advertised as low as 3.9%, but realistically, without points, higher than that).  You can imagine how higher rates such as the 7.5% that was the norm not too long ago, affect the analysis.

Note also that this illustrates, neatly, how interest rates and other expenses affect the overall cost of a home, the monthly payment, and thus the underlying home price.  If rates skyrocket, prices go down.  If rates go down, prices can go up.

Most of the cost assumptions I am basing on properties I have owned or own.  As I noted in an earlier post, a new roof, air conditioner, appliances, paint, siding, flooring, etc. can add up to thousands and thousands of dollars over time.  $2000 a year in maintenance (1% of the purchase price of the home) is probably under-estimating real costs, and doesn't factor on regular maintenance, like lawn mowing, gutter cleaning, small repairs, etc.

Over 30 years, a home will need at least one roof, two or three HVAC units, two or three hot water heaters, two or three sets of appliances (stove, refrigerator, washer, dryer, dishwasher, etc.) and likely will need a bathroom remodel.  And this is just assuming basic repair, not blowing out the home to "improve" it.  $2000 a year for all of that, is, if anything, cheap.

And of course, many will be quick to point out that a typical homeowner moves every 5-10 years, and doesn't stay in the same home for 30 years.  This may be true, but in most cases, the homeowner merely moves to yet another home, effectively transferring the equity from one home to another, and starting the whole process over again, adding in the 10% transaction fees (or more) plus the re-amortization over a new 30-year period.

In other words, if you jump from home to home over time, the process gets staggeringly more expensive than the illustration shown here.  This is a very cheap example!

So, taking these bald assumptions, what is the overall "cost" of owning the home over 30 years?  Here is the total I come up with:


Home Price:  $200,000

Total Interest Paid, 30 Years: $148,332

Property Taxes, all 30 years, estimated, with inflation: $50,000
Homeowner's Insurance, all 30 years, estimated, with inflation:  $35,000

Maintenance and Repairs, estimated, all 30 years, with inflation: $100,000

Utilities, all 30 years, estimated, with inflation:  $110,000

Opportunity Cost of Down Payment, invested, @7.5% interest, 30 years:  $155,099
Total Cost of Home, including Opportunity Cost: $798,431

As you can see, over time, the cost of a $200,000 home is about four times the purchase price.

The "opportunity cost" factor is a bit difficult to calculate.  If you put down $20,000 on a home, there is a cost in that money not being invested over 30 years, which would be worth about $175,099 after 30 years at a modest 7.5% interest rate.  I subtracted the $20,000 from this amount, to represent the lost potential interest from that investment cash.

(Note:  Opportunity cost arguments really have no place in personal finances, as I have noted before.  But here, a $20,000 down payment is indeed a real amount of money tied up in the home.   Car salesmen like to use "opportunity cost" arguments to get you to lease a luxury car - which is not an opportunity forgone, but merely spending more money.  Here, Opportunity Cost may apply.  Mere consumer purchases are just spending money, and they don't apply).

Of course, it is possible to put less down on a property, but if you do so, your interest rate will be higher, so I think that is sort of a wash.  Plus, you have to buy Private Mortgage Insurance (PMI) if your down payment is less than 10%, in most cases.  And frankly, banks are shying away from these nothing-down deals these days.  So they are hard to come by.

So, what will the home be worth in 30 years?  More than $200,000, that's for sure.  Using a compound interest calculator, we can project future home prices for different appreciation rates:

Future Value of Home, 30 years, 2.5% annual appreciation:  $419,513.52

Future Value of Home, 30 years, 3.0% annual appreciation:  $485,452.49

Future Value of Home, 30 years, 4.0% annual appreciation:  $648,679.50

Future Value of Home, 30 years, 5.0% annual appreciation:  $864,388.48

As you can see, unless the home appreciates more than 4%, there really is no payback at all, over time - no big "profit" to be had.  You pay out, over 30 years, about the same amount you'd pay in rent - perhaps more - and the net result is, you break even.

But what could we expect as an annual rate of appreciation for a home in the US today?  In the last 10 years, it was nearly 10% per year.  In the next 10, I doubt it will be much more than 2-3% for most markets.  Predicting the future is hard to do.  We can look at past results, but that is no guarantee of future results.

Average rate of appreciation on a home in the United States from 1963 to 2008 was 5.4%.  Sounds great, until you realize that statistic ends in 2008, and does not includes the severe drops between 2009 and 2010.   Even this fellow, who touts a home as an "investment" is a little skeptical of those numbers.

This blogsite analyzes these numbers a little further, and breaks them down by decade.  If you don't count the madness of the 2000 decade, the overall rate drops considerably.  Note also how home prices shot up after WWII, not only due to the baby boomer generation, but, I think, due to the availability of 30-year mortgage financing and the home depreciation tax deduction.

The upshot is, I think expecting 5%+ rate of return on your home might be a bit optimistic.

What I am taking away from this, so far, is that when you buy a home, you buy a place to live, period.  The amount you spend on the home is about equal to the cost of renting it.  And as I noted in earlier posts relating to the Real Estate Bubble, there are people who will pay MORE to own a home than it costs to rent it, which is, of course, insane.

Many of these folks will defend such practices by saying, "Well, with the mortgage interest deduction, you come out ahead!"  Or they argue, "Well, with the Capital Gains you can make on a home, you can come out way ahead!"

Let's examine both arguments.

As noted above, the Total Interest Paid, 30 Years is $148,332.  Even assuming you are in a 33% tax bracket (unlikely in this scenario, for a $200,000 house) the most tax savings you will receive, over time, is $48,949.56.  And actually, the savings are less, as the mortgage interest deduction is less and less every year, until you finally reach a point, in the last 10 years of the mortgage, that the interest deduction is less than your standard deduction.

And actually, if you think about it, when viewing the home mortgage interest deduction, the "value" of it should always be subtracted from the standard deduction, as the real savings are what you would get back in taxes, above and beyond your standard deduction.  And since few of us are in the 33%+ brackets (or above it by much) the actual value of the home mortgage interest deduction will be less - far less - than the $48,949.56 listed above.  And when you think about it, fifty grand is a pretty paltry amount to consider in a transaction that tops, overall, nearly three-quarters of a million dollars.

So, yes, the home mortgage interest deduction helps, particularly the first few years, but overall, it doesn't help much overall.  And if you are in the 25% bracket, it is helping very little.

As for the capital gains, as our illustration shows, unless you can show a consistent appreciation of 4.5% or greater, you end up breaking even.   Even at 5%, your net sales price might be $864,388.48, based on cash costs, over the years, of  $643,332, or a "gain" of $221,056.48  This represents an overall "gain" of 34%, of course, but over 30 years, that works out to a pretty small rate of return.

How small?  Since the money paid in is over time, it is hard to tell without complex calculations, what the rate of return is.  However, the $642,332 works out to about $21,444.40 a year in payments into this deal, which at a paltry 2% rate of return (about the rate of inflation!) would yield about $887,357.28

So, in other words, you throw all this money at a house, over the years, and get back....your money.  You break even, at best.  And this is based on assumptions that the market doesn't tank when you want to sell, that the Teacher's Union doesn't force your property taxes up to $10,000 a year, that you don't decide to add granite counter-tops and over-improve the home, etc.

So does this mean you should not buy a home?  Please, don't do that.  I hate it when people keep looking for extremist solutions to simple problems - that everything is either one way or another.  That you should eat all fiber and no fat, or all fat and no fiber, when in fact the balanced diet is the way to go.

No, what it does mean is that buying "the most home you can afford" - which the Real Estate Agents chant as a mantra, is not a good idea.  Buying a tacky mini-mansion on the basis that the "resale value" will be greater and thus you should buy it - even though it would stress you financially - makes no sense at all.  At best, you'd get back your money, adjusted for inflation.  Unless the market goes berserk again, of course, but that doesn't seem ready to happen.

Buy the house you want, that looks as though it will meet your present and future needs.  And buy one that will be affordable, over time.  And rather than invest in "more home" you might want to invest in other things - diversify your portfolio to include other investments, such as stocks, bonds, and yes, perhaps even investment real estate.

And that is where the "Rich Dad" guy might be coming from.  As I learned, owning investment Real Estate, all the above numbers were about right.  The only difference was, my tenants paid for the cost of all the bills, and I reaped the reward of the final payoff.  So instead of a paltry 2% rate of return on my investment, I received an effective 1000% rate of return, perhaps more (when you put down 20% on a home, and then sell it a few years later for 2x the purchase price, the gain, calculated based on the down payment, is pretty fantastic).

But to do so, you have to have a property that is self-funding - that costs less to own and maintain than the income received in rent.  AND you have to be an effective and efficient landlord.  People who don't get this - or didn't get this back in the 2000's - ended up losing it all in short order.

So, I'll chalk this one up as "Rich Dad is right" - your home is not really a great "investment" over time.  But then again, a stopped clock is right twice a day.  Doesn't mean you should use that clock as your primary timepiece, right?