The focus of this blog is on real estate investing. Today’s post is more about buying your own home so slightly off topic if we only think about investing. As the housing market in both the US and the UK is dominated by owner occupied home owners an investor needs to see the market through the eyes of the typical buyer to truly understand the market dynamics. Even if the typical buyer does not get the numbers right you need to understand how they think and what the public press is telling them. Lets dive in.
There is a great article on the Wall Street Journal website discussing what it really costs to own your own home in the US. Few people understand the lifetime cost involved with owing a home. Most of us find it easier to just think of the purchase price vs. the sale price. We also have more control over our home when we are the owner so a bias towards wanting to buy. Few people are major savers so buying also seems a way to ‘save’ for the future.
The big message from the article is: “It’s risky and bad planning to have too much of your net worth in your principal residence. No prudent stock-market player would put 60% or 70% of a portfolio in just one stock, but millions will hold that much or more of their total net worth in just one house.” This raised a few questions. If concentrating one’s net worth in one home is bad then would owning more than one house make a great difference? Second, should one rent and invest in something other than one’s home?
Tip: A distinction that many real estate investors make is they live in a home but they invest in houses. The ‘home’ can be rented or purchased. A house is not a home so not something to be emotionally attached to when buying or selling. Investors focus on the numbers as the numbers tell the story. A home is a ‘liability’ in that you need to produce an income to support it. Rich Dad Poor Dad by Robert T. Kiyosaki highlights this. A house in an investment property where someone else gets to go to work to pay the mortgage (the tenant).
The rental side of the question is not covered in the article so I have provided some information for how you can produce the equivalent rental numbers at the end of this post.
The link to the WSJ.com article is:
Why Your Home Isn’t the Investment You Think It Is
by David Crook
March 12, 2007
If you have a WSJ.com membership you can go to the link and read the article. If you do not have a membership try the link anyway and see if you are offered a 14 day trial membership.
The article includes a sidebar where David provides some helpful tips.
Home Sweet Home: Here are five things you can do to better manage your number one asset
My summary of the 5 points.
1. Think differently – It is a home and not an investment.
2. Pay early, pay often – You can pay off the mortgage early.
3. Share the burden – Buy a multi-family and collect rent. I did something similar by having 2 roommates in a 3 bedroom home. This was my first home. I ended paying the same to be the owner as I did to be a renter based on the monthly cash-flow.
4. Watch the renovating – Many home improvements cost more than they will bring in terms of an increase in the property’s value. You might enjoy the improvement but it is not the best choice financially. Do not justify the improvements by thinking you will get the money back when you sell.
5. Do not move so often – Moving comes with real costs that are not recovered. I would not be as concerned as the article about starting a new loan if you follow #2.
A few graphics from the article.
The lifetime costs for getting a loan to buy a home (mortgage loan or trust deed loan) vs. paying all cash.
Note: No adjustment was made for any tax deductions associated with the home loan interest being paid each year. There is also no discussion of the opportunity costs if you can borrow at a lower rate than you can earn on alternative investments (if you have the cash you can still borrow and invest the cash at a higher rate of return).
So, rent vs. buy?
The graphics above and the article cover the issues related to buying. What about renting?
It is pretty easy to get a benchmark for the current market rents. You just need to look in the paper and other sources where landlords list property for rent in your area. Then you have to factor in possible rent rises over 30 years.
Historically rents reflect both the local demand and the wage levels. Assuming no major shift in the rental sector supply or demand rent levels will tend to rise at a rate similar to wages. If wages in 30 years are expected to be higher then you can assume rents will be higher. If someone thinks their job will receive annual salary increases inline with inflation then assuming rents will rise in a similar fashion is reasonable. History has worked this way in the past and there is little reason to think rents will not perform the same way in the future.
A shift in demand or a shift in the supply of rental housing is possible. When interest rates were at a 40 year low and sub-prime mortgages at 100% LTV were easy to qualify for many tenants were able to switch to being owners. Rents in many communities dropped as the pool of tenants was reduced but the supply of rental units did not fall as fast. There was some conversion of rental units to owner occupied property but not inline with demand in many communities. At this point the sub-prime market correction should help drive up rental demand as fewer people will be able to buy without a down payment. Some apartments converted to condos for sale will return as rentals. There is an oversupply of condos in some markets.
Back to the math.
Pick today’s rental levels for a home, adjust for an annual increase that is aligned with inflation expectations, sum for 30 years and you should have a good approximation for what renting will cost over 30 years. Compare this with the ownership model being presented in the WSJ.com chart above to see which choice makes more sense. Do try to adjust a bit if the ‘typical single family home’ used in the chart is not right for your rental benchmark. The calculations do not have to be perfect to still provide a useful sense of direction.
What is more important than all the math?
The true bottom line is more about lifestyle and personal matters than it is about economics. Job changes, marriage, children, divorce, death, medical or credit problems are all reasons why people rent or why they buy. Those events happen independent of what the math suggests we should do. People want control over their home. They want to redecorate without asking a landlord for permission. They have a nesting instinct and feel socially more established if they are owners.
There are also cultural biases and biases based on living in a city center vs. living in a more suburban area. The US and UK have high rates of home ownership (67% and 70% respectively) while in other countries renting is much more the norm. Renting is common in city centers so people do not expect to be an owner in many major cities. Or the city center owners are families who need less space (young families or empty-nesters where the children have flown the coop). What is available to buy is smaller or designed for mostly for adults. Adults who value the social aspects of city life compared to the desires of a growing family who want green space in which the children can play (a ‘backyard’ in the US or a ‘garden’ in the UK).
Investing in real estate as a way to fund your retirement?
Here is a twist which is a bit off topic. If buying a home is not a good way to save for retirement how about adding a rental property (owing 2 properties). One you live in and the second you rent while holding it as an investment. This is not a second home that you use part time; no personal use. A true rental property where the tenant helps to pay off the mortgage over time. You can sell the rental when you need the cash for retirement. Or you can continue to own the property while receiving the monthly income after the tenant pays off the debt. If your lifestyle implies that one rental property will not fund your desired retirement you can buy more rentals. You have a choice that is largely not available at work; buying a bigger company sponsored pension is rather difficult at best.
I have a 10 years to retirement model that I will write up and share in a later post. Remind me to do so if I forget.