Sunday, March 13, 2011

Why Your Home is Not an Investment

One of the things the "Rich Dad"  guy says is that your home is not an investment.  And you know, even a stopped clock is right twice a day!

In the ads for the "Rich Dad Seminars" they blare all sorts of unconventional advice to get your attention and to get you to attend the "free" seminar, which as we discovered, is a come-on to get you to sign up for paid "training" that can cost hundreds, if not thousands, of dollars.

One of these bits of unconventional advice is that "your home is not an investment" - which shocks many people, as they have been told their entire lives that "your home is likely your largest investment".

But you know, the "Rich Dad" is right on this one.  You can go to his "free seminar" and pay $499 to find out why.

Or, we can cut to the chase, and I'll give you the 411 here for free.

While to many people, their home is a major "investment" it is probably a better idea not to treat it that way.  Real investment real estate actually makes money for you, while a home actually is nothing more than an expense.

"But," you say, "I will make lots of money on my home, over time, as it appreciates in value!"

Yes, that is what the Real Estate Agent who sold it to you said, but it largely isn't true.  During the insane years of 2001-2008, Real Estate jumped in value by double-digits nearly every year.  And a lot of people made a lot of money.  And a lot more lost a lot more.  And that, in a nutshell, is the danger in thinking of a commodity like your home as an "investment".  It is about as silly as thinking your box of Corn Flakes in your kitchen is an "investment" that will appreciate in value, just because the price of food is going up.

In a normal market, which is what we are in now (or approaching, anyway), Real Estate will appreciate about 2-3% per year.  This is not a great rate of return, of course, and one you can easily beat in long-term T-bills or even long-term CDs at the bank.  And of course, the stock market will trounce it, even with all the crashes and Black Fridays.

So the idea that your home will "pay off big" is flawed, particularly if you are looking at the next decade in the Real Estate market.  Prices will remain fairly flat for the next 2-5 years and then appreciate slowly, in many markets.

Now, granted, there are always some markets where prices will be solid, or increase, based on local demand, such as Washington DC, New York, and San Francisco.  But even in those places, prices do fluctuate in both directions, as people discovered in 1989, and again, 20 years later in 2009.

But even then, add up all the costs of buying a simple home - including the purchase price, the staggering interest payments, the property taxes, homeowners insurance, repairs, utilities, maintenance, etc. and then subtract your home mortgage interest deduction.  After 10, 20, or even 30 years, chances are, what you paid in to buy and maintain the home will be more than what the home is worth.

"But," you say, "what about the big tax deduction?" 

Yes, you get a nice tax deduction for your mortgage interest - which is the government's way of skewing the market.  And as any economist will tell you, this does not really serve to "make it cheaper" to own a home, but just raises prices higher, as any economic stimulus does.

Thus, for example, in a market where the average middle-class person can afford $1000 a month for a home, the price of the home can be calculated with exact certainty based on the property taxes, the insurance cost, the interest rate available, and the mortgage interest deduction.  People buy on monthly payment, not on overall cost, and as a result, the cost, in terms of real dollars, reflects only the "affordability" based on monthly cash flow.

Raise property taxes to $6,000 a year, and the home price will plummet.  Lower the interest rate to 2.9% and the price will go up.  Eliminate the mortgage interest deduction, and well, a lot of people will end up out on the street.

So, don't confuse a deduction with real wealth.  At best, it merely alters prices.

"But," you say, "Paying  rent is just throwing money away!"

And here, you might have a small augment that makes sense - provided that a number of other things are true.  For example, suppose you rent an apartment that costs $1,000 per month in rent.  You look at a home with an effective mortgage payment of $1,000 a month, after taking into account property taxes, insurance, and the home mortgage interest deduction.  For the same amount as renting, you could own your home.

And since you are paying down a mortgage over time, you are increasing your equity in the home, and also making a 2-3% rate of return on the overall value.  In fact, if you put down only $10,000 on the home, you could argue that the "rate of return" on that investment is far higher. (But for an investment property, this rate of return could be yet higher!).

And yes, such a scenario can make a lot of sense, as you have to pay for housing anyway, and if owning cost the same (or less) that buying one, then, yes, it makes sense to do so.  But even then, you are hardly "making a killing" on your home as an "investment" over time.  This is not to say it is a bad idea, just that it isn't like a license to print money.

Why?  Because there are a lot of other issues you aren't thinking about when buying a home.

Repair costs can negate "profits" from home ownership over time.

One thing people don't think about when buying a home is the cost of repairs over time.  As I have noted in my Weibull Curve posting, things like roofs, appliances, windows, sewer lines, air conditioners, siding, etc. all have a design life of about 15 years, perhaps less.  Eventually, a whole building has to be torn down and rebuilt - houses have a design life.

So, if you live in a house for 15-30 years, you can expect to put on at least one new roof, a furnace, hot water heater, washer, dryer, entire kitchen, bathroom, siding, windows, driveway, gutters - you name it.  And some of these things you may do more than once.  And things like foundation re-parging and the like, well, they get messy and expensive.

And we are not talking small amounts of money here.  HVAC systems can cost $5,000 to $15,000 depending on the size of your house and the complexity of the system and how much needs to be replaced.  This is one reason I shy away from "look at me" showplace fancy HVAC systems like hydronic heating.  Fun to play with, great to show off, an expensive nightmare to repair when old.

A new roof can similarly run $5,000 to $15,000 depending on the size of your house and the complexity of the roof.  Appliances are all over the map as well, from a $299 apartment stove to a $5,000 "gourmet" model.

And as you can see, the more house you buy (the fancier a house) the higher these repair costs will be.  Many a mini-mansion owner will be distressed to discover, 15 years down the road, exactly how cheaply his "look-at-me" house was made, when it all starts to fall apart in an expensive manner.

Note also, that in addition to repair costs, you also have maintenance costs - mowing all that lawn, cleaning gutters, etc.  These are things that are done for you in an apartment, and the first time you go shopping for lawn mowers, you will understand that the cost of home ownership goes beyond monthly mortgage payment.

So it pays, in the long term, to buy an appropriately-sized home for your needs.

Many people buy more house thinking it is an investment.

And therein lies the problem that can negate any "savings" and knock-down your investment.  Many folks, particularly during the crazy years, thought (mistakenly) that if a home was  good investment, that buying a huge home was an even better one.

But as illustrated above, the repair and maintenance costs can skyrocket for larger homes, not to mention the utility bills (which for some apartments, are included in the rent!)  As a result, you can end up "house poor" by throwing all your available money into mortgage payments, on the hope that the house will "pay off big" in the end.  And of course, in 2008, this rosy scenario turned into a black nightmare for many, as their home values plummeted, and all that money went down the drain in a hurry.

Your home is an expense, not an investment.  Treat it that way.  Just as buying more car than you need makes no sense, buying a bigger house on the premise it will "appreciate in value" makes no sense.  You are better off living in a smaller home and buying an investment Real Estate property, if you really want to make money in Real Estate!

Living in a $500,000 house you can barely afford makes no sense at all, compared to living in an affordable $250,000 house and owning two $125,000 rental properties.  Between the rental income, deductions, and the lovely depreciation deduction (that converts ordinary income into capital gains) you will make a lot more money over time, as well as be more diversified.

It is hard to "cash out" of a home as you always need a place to live.

One problem during the crazy years was that for most people, selling their home did not seem like a realistic option.  I heard from more than one person, in South Florida, "Gee, my house is now worth an astounding $600,000!  I only paid $150,000 for it a few years ago!  I'd sell it, but where would I live?  All the comparable homes are $600,000!"

And that is the conundrum for the home owner.  Unlike an investment property, it is hard to "cash out" on such a deal, as you still need a place to live.  And if you have a family, you can't uproot them to go live in an apartment (or could you?) just to make $350,000 in capital gains, tax-free.

Well, actually, in retrospect, half the State of Florida is wishing now that they did this, instead of "sitting tight" during the boom.  And the reason they did this was simple:  Everyone thought that their house was now this huge asset and would be worth more and more over time.  And of course, many folks (if not most) took out home equity loans and "spent" all that phantom gain on new cars, boats, and restaurant meals (paying off credit cards) and ended up "upside down" in their homes, which are now being foreclosed upon.

(Of course, if you ask them, that is not the way it happened.  They are the victims here, of those mean, nasty old banks, who lent them the money and now, unreasonably, expect it to be paid back).

You'll always need a place to live, so it is hard to "cash out" of a home, until you are 75 years old and moving into the home.  And that is yet another reason a home is not really an "investment".

And this is one reason why many financial "experts" don't count your personal residence when determining whether you are a Millionaire or a millionaire.    The money tied up in your house may not be spendable, unless you choose to downsize significantly.

So why does "Rich Dad" advertise that your home is not an investment?

From what I can make out from the websites and critiques of his advice, he is pointing out all of the above.  In terms of making money from Real Estate, a $200,000 rental property, properly purchase (with a positive cash flow) is a much better deal than buying a home that costs $200,000 more than your existing one.  The rental property not only appreciates in value, if property rented out, it will pay for itself.

And for me, this technique worked out, rather well.  Rather than use my available credit rating to buy a "look at me" mini-mansion (which I could have easily done) I used that available credit to buy investment properties, rented them out for a positive cash flow, and then "cashed out" before the market went to Hell.  Since they were investment properties, I could cash out, and still have a place to live.  Granted, I was socked with a hefty capital gains tax bill, but all things considered, I did far better than those who "hung on" and thought they would make yet more.

So, you can go to one of his "free seminars" and learn all of this (or part of it) and pay $499 to get the details. Or get it all for free, here.

NOTE that I am not suggesting, promoting, or hyping investment Real Estate for the average Joe and Josephine out there.

Buying and maintaining investment Real Estate is a tricky business, and you can lose your shirt, if you are not careful.  It is also a lot of hard work, and you have to be well grounded in REALITY to engage in it.  Being a Landlord is not some fun power trip, but rather a whole another level of stress in your life.

Many of these "seminar" people still hype Real Estate as a sound investment for the average Joe.  Just remember that the people selling the seminars and books are making money selling seminars and books and not Real Estate!

I knew a fellow once, who thought he would "make it big" in Real Estate, and then set out to just buy, willy-nilly, whatever property came along, using questionable financial techniques and instruments.  He never even bothered to rent the properties, as he felt the "gains" were so huge, he would make out like a bandit.  Needless to say, I don't have to tell you how that worked out for him.  It is 2011, not 2007.

Buying Real Estate is something that you should take seriously, whether it is an investment property or your personal residence.  It pays to stop listening to all the "happy talk" out there and think about this proposition realisitcally.  A house is, after all, just a house....