Thursday, June 23, 2011

Your home is an investment... whether you like it or not

Your home is an investment.  There.  I said it.  Call the personal finance blogging police to take me away.  Buying a house is the biggest purchase most people will ever make and it's foolish to not view it as an investment.  Sure, as an investment your home is extremely illiquid but just because something is illiquid doesn't mean that it isn't an investment, it just means that we value its return less highly.

I'm not saying you should be banking on your house appreciating significantly; there's little historical evidence for big returns.  This Case-Shiller chart puts growth of homes at 40% over 111 years.  40% sounds great but it's a .3% annualized return, significantly less than what you can get from a CD or t-bill.  Some people might be able to beat the market with houses just like others have had some success in beating the stock market, the advantage being that real estate is a less efficient market and insider trading isn't illegal.  But for most people the average returns are about what you should expect in the long run and having a single house considered as a major portion of your portfolio would leave most people woefully undiversified.  No, your home is an investment in keeping a roof over your head, keeping you warm and dry, and buying is just one way of financing that comfort. 

When you buy a house you're basically buying out your housing costs for the foreseeable future. (We're going to ignore utilities since you'll be paying them in either case)  So let's say you're renting.  Your rent is $700 a month and you're pretty happy with the place but you want to consider buying a house.  If you were a completely rational consumer you would say "hmmm, buying instead of renting basically pays for my housing costs for perpetuity.  A nest egg of $140,000 would do the same for me right now with a 6% return."  A portfolio of $140,000 at a 6% return will yield you the $700 a month you need to pay your rent.  In other words, all other things being equal (which of course they aren't), your house shouldn't cost more than $140,000 since otherwise it would be a better deal to rent.  To be totally accurate you'd also look at funding maintenance, property taxes and additional insurance costs of your house and add them to the purchase price along with the transaction cost.  So if you think these will add up to, say, $5000 a year then you should add $83,000 to your purchase price since that's what you'd need to fund those expenses at a 6% return.  So you'd compare your $140,000 nest egg for renting against the price of the perspective house plus your $83,000 maintenance and tax nest egg.

Another way to look at it, if you're getting fancy, would be to take the net present value of all your rent payments and use that as your housing payment.  The NPV of 20 years of your $700 rent payments is $104,747.  Oh no you say, we really should be considering 50 years.  Okay, that's $140,800.  Remember the further in the future it is the less valuable it is so extending your time horizon has a diminishing effect on something's NPV.  Again, you'd want to repeat this process for maintenance and taxes and add that to the purchase price of the house to be comparing apples to apples.

NPV versus a "nest egg" really should work out to about the same thing if you use the same rates for both.  It's just a different way of looking at the same thing. This is really all rent versus buy calculators do, you can just do it yourself now. Comparing your house to a "nest egg" is also valuable because it allows you to see the flexibility that renting can buy and the true cost of your current housing situation.  This can be a powerful tool for any expense in your life.  Like spending an extra $50 a month on utilities to keep your house at the perfect temperature requires a nest egg of $10,000 with a 6% return.  To some people that sounds like a great bargain to others $10,000 is totally worth setting the thermostat a little higher in the summer and lower in the winter.

The key takeaway here is that purchasing a house based solely on what you can afford is not a rational way to buy a house and in some cases it's stupid.  You don't go to the mall and say "well I think I can afford to buy a $1,000 shirt since I bring in $5,000 a month and on my credit card over 30 years that shirt will only cost me XYZ per month and I'm comfortable with that based on some rule of thumb my personal shopper told me about how much debt I can carry." Most people will compare their options and have an idea of what they should be paying for a shirt based on their other options and will buy the item they think will be cheapest in the long run. (Again, all other things being equal and of course they aren't)  You'll consider a few brands. One might be cheaper and you'll have to replace the shirt more often, but you might pay for quality and buy a higher price upfront to avoid the series of payments you'd have to make replacing the cheaper shirt. 

Okay, to be totally accurate you'd have to take into account the appreciation rate of your house in your NPV calculations and comparison to renting or other houses, but I haven't since that rate historically hasn't been particularly high or consistent and you'd have to sell the house altogether to realize it. This is a super oversimplified analysis, however it illustrates the same point that a more complex analysis would just with less obfuscation.  Your house purchase is as much as an investment as a dividend yielding stock bank rolling your rent.  Terming your house a home and explicitly not an investment is not going to help you financially.

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Is purchasing a house an investment?  Why or why not?

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  1. An unrelated question, since I can't find your contact info. You have a post on get high gmat scores. Is it possible to get scholarships based solely on gmat? I would think one of the best ways to graduate with no debt would be to get scholarships.

  2. TR - Unfortunately the scholarship opportunities for MBAs are much more limited than those for undergrads. Most top programs offer little to no merit aid and having a high GMAT score is not enough since everyone has them just to get in. Same goes with third party scholarships - a high GMAT score is a requisite to get your foot in the door, not nearly enough to land you the money. Scholarships would definitely help, but they are hard to find and harder to win.

    Maybe I need to make a contact me page if it's not obvious. My email is in About right now. Thanks for the feedback!

  3. I like the idea of investments being things which put money in your pocket (I can't remember if that's Jacob's definition or someone else...?) so in that sense, a house really doesn't qualify. Even if the house appreciates, consider it's nature as a spending magnet: you buy tools to take care of it (lawnmower, alarm systems, etc), furniture and stuff to fill it, insurance to protect it, foot ongoing bills for maintenance (furnaces and roofs and plumbers, etc), pay yearly property taxes... I'm sure there are ways to balance all of these and come out ahead, so by your terms it's merely an illiquid investment - but it seems to qualify only by technicality.

    But I think the most meaningful question is not whether the house "counts" as an investment or not, but rather whether it facilitates or undermines the goal of financial independence. As you point out, if the calculations work and you pick a property that doesn't beguile you into developing a high spending lifestyle, then awesome, do it. The trick lies in realistically assessing what home ownership will do to how you live.

    And congrats on your plan to do school debt free and in service of long term independence goals! :)

  4. I think when people say "investment" they mean it will generate a certain return over time. For me, owning a home is a critical part of my early retirement plan, as housing costs are more than half of my expenses. I don't really care what you call it. :)

  5. Depends on location, location, location, doesn't it? Getting a great deal on a duplex in Detroit or Youngstown, not so comparable to other growth areas like Raleigh-Durham or Alexandria, VA.

  6. I don't see how anyone can deny that a home is an investment. Yes it costs money to maintain and doesn't generate any income while you live in it, but not all of those costs should be attributed to the house.

    YOU need a place to live, those are your expenses. The house's return is the rent it saves you less maintenance and taxes.

    To get technical, you shouldn't be using that same hypothetical 6% return because rents are increasing and a inflation protected. Can't say the same about a nest egg of bonds generating 6%. Not a big deal, just a nit pick.

    Other than that agree 100% that purchasing decisions should be based on valuations. I think the pendulum's swung really far from "a home is always a good investment" to "it's always better to rent". - I'm just basing that on anecdotal evidence of people I talk to and blogger posts.

  7. To be fair, the Case Shiller home index is inflation-adjusted. The returns, then, are inflation plus .3% annualized, which is better than the rate on CDs and t-bills.

    I still think homes are a pretty poor investment, and a single home should never be labeled as such.