29 January 2008

Buying a home as an investment

  • Jan 29, 2008

Buying a home as an investment

It’s supposed to be the American Dream.
Instead of throwing away money on rent every month, you can buy your own home, giving you not only a place to live rent free, but a sound financial investment at the same time.

One small problem: the number’s don’t add up.
(Check my numbers: http://www.bankrate.com/brm/mortgage-calculator http://www.dinkytown.net/java/CompoundSavings.html http://www.hsfcuonline.org/cw2.1/calcs/Appreciation/calc_appreciation.asp )

First and foremost, there is the idea that a home is an investment due to appreciation.
The logical flaw in that idea is simple, and doesn’t depend on appreciation or rental rates.

Say you buy a house at a certain price, and the value goes up 500%. What can you do with that "value"?

If you want to live in your house, the best you can do with it is use it as collateral for a loan.
Great... now you can go much deeper in debt all at once than you ever could before.

If you sell the house, now you need to live somewhere else.
If your house just went up 500%, that means every house in your neighborhood just went up 500%.
What ever you made in profit by selling, it will cost you just as much to buy something else of equal quality.
Minus what you lose to agents, banks, and taxes for the transaction.

So in order to ever make use of appreciation, you must either move to a much worse neighborhood, move to a much smaller home, or move to a less desirable location.
So: IF you have kids who will be moving out of the home in 10 years, or you plan to retire somewhere cheaper like Arizona or Florida, only then might a house which you live in be considered an investment.
(Buying a house to rent out to others is another story, since you can sell it anytime)

If you want to stay in your home, you can never cash out, and any appreciation is useless.

But at least you are saving on rent... right?

A hypothetical, more-or-less average, scenario:
You buy a new home for, lets say $400,000 (below the average for the Bay Area of 500-600, but higher than national average of around 200).
Agents, brokers, lenders, typically add in 2-3% in total closing costs, another $10,000 (for simplicity, lets say you have that much in down payment)
On a 30 year loan, add $463,000 in interest at 6% (lower than typical, but slightly higher than where it is right now)

You’ll pay around $2,400 a month, of which more than half is interest paid to the bank.

Add in home owner’s insurance - $800-$1000 per year
Property taxes, (1% in CA) - $4000 per year
(a detached home may or may not have HOA fees, we’ll assume this one doesn’t)

Factoring insurance and taxes, plus water and garbage (usually included in rentals) monthly payments are the equivalent of $2867

After 30 years you have paid a grand total of $1,042,120

Renting a 2 or 3 bdrm in the Bay Area runs anywhere from $1,500 to $2,500 a month - or $540,000 to $900,000 over the course of 30 years.

Now you have paid off the loan, and your mortgage payments go to zero. But you have paid around $322,000 more than you would have in a 2000/month rental. You are still paying insurance and taxes etc; about $470 per month - for a net savings of $1530 monthly over paying rent. At this rate it would take another 17 years (on top of the 30 which have already gone by), just to break even.

And all of this is without even factoring being responsible for maintenance and repairs.

Although you may well not be able to sell at this point (since you have to live somewhere) lets say you are in a situation where you can and want to move to a cheaper home, and cash out your equity.

The average national appreciation rate is 5.5% right now. While CA is much higher than average at 9%, metropolitan areas (such as the Bay Area) are actually lower, at around only 3%.
At 3%, a 400,000 home will be worth $970,900 in 30 years - less than the total you paid by $50,100 (not counting water, garbage, HOA fees, or maintenance)
At 4% it will be worth $1,297,360
At 5% it will be worth $1,728,775 - but remember, as the current "crises" reminds us, there are no guarantees on appreciation rates.

You seemingly came out $266,000 ahead at 4% (assuming you can sell your house and move to something smaller or in a less desirable location)
But what if instead you invested the $8000 down, along with the $800 monthly surplus?
With a guaranteed (insured) long-term CD, you can get up to 5% - which would be $446,000 more than you put into it after 30 years.

If you were luckier, your area’s housing demand went up a lot, and you had a higher appreciation rate, say 6%, you are up $1,266,000 over what you paid
But investing down payment and the difference between rent and mortgage in low risk a mutual fund at 10%, you are up $1,651,700 over what you put into it.
And you can cash out that 1.6mil without moving to a less desirable home.

So, why is it that even though real estate tends to appreciate, you still earn less than a simple CD, or even lose money in the long run? Simple.
The banks and lenders will always charge more in interest on loans than they pay out in interest on savings, no matter what the prevailing rates are at the time. Almost no one can afford to buy a house in cash. The banks, developers, realtors, and everyone else is in the game to make money. If you could make more by investing in the house, they would just buy the house themselves, rent it out, and then keep the profits. But the house is not worth as much as the interest payments that the buyer is willing to make.
The idea of never-ending appreciation is built on the idea that the population keeps growing, and the new people all need somewhere to live, therefore demand rises. Its essentially a pyramid scheme - nothing new of value is being created, home prices tend to go up only because demand tends to go up.

So, if you can so easily end up neutral, or even losing money, by buying a home instead of renting (again, this does not necessarily apply to investment property which you rent out to others, as the rent pays part or all of the mortgage, and you can sell at any time) then why is it so common for people to think that buying a home is a sound investment?

My theory is this myth has been very deliberately started and perpetuated by the real estate and financial industries, the banks, developers, real estate agents, and everyone else who make billions a year off of people buying homes.
They did a pretty good job.
It has become the American Dream.

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