I hear a lot of people casually throw out the phrase “a home isn't an investment” or “a home is a terrible investment,” usually citing the fact that the value of a home only increases at a very low rate over the long term, anywhere from 1% nominal to 1% real (after-inflation). In actuality, homes generally depreciate and the land the home sits on generally appreciates. Don't believe me? What happens to 80 or 100-year-old homes? They get bulldozed and the value of the home instantly goes to zero. That's called depreciation.
Others argue that a home is more a consumption item than an investment. That argument holds a little more water, although a home has one fundamental difference from the boat in the driveway – you actually need a roof over your head. Once you have decided to consume a certain amount of home, it is best to think of it as an investment. Buying a home isn't always a wise move (residency comes to mind), but you should definitely evaluate the decision from an investment perspective.
A House is Like Any Other Investment
Like any other investment, it has expenses (transaction costs, repairs, maintenance, property taxes, insurance, HOA fees etc), it has capital gains (appreciation), and dividends (free rent.) If it has an accompanying mortgage, leverage can multiply returns and amortization of the loan adds to your investment return. A good rent vs buy calculator takes all this into account when helping you decide what to do.
I've had people argue with me that “free rent” doesn't count toward your return. That's silly. A simple example demonstrates why. Move out of the house and rent it out. What's changed? You still have the same expenses, the same amortization, and the same appreciation. Now someone pays you rent. Saved rent is your dividend. From an investment perspective, the only difference between living in your house and renting it out to a tenant is that once you move out you get to claim depreciation on your taxes and you lose the principal residence capital gain exemption.
Over the long run, renting generally costs more than buying. If it didn't, landlords would all be hemorrhaging money. This is easily demonstrated by looking at how things change over the years.
An Example of Renting vs Buying
You have $125K and want to live in a $500K house that rents for $3000 a month. You have to decide whether to rent or buy.
Year 1
The buyer pays $100K as a downpayment on his 15 year 3% mortgage. He pays $25K in transactional costs. He pays $1K in insurance. $3K in taxes, and $5K in maintenance and repairs. He pays $12K in interest. He saves $36K in rent. The property appreciates $15K (3%). He pays down the mortgage $21K. He gets a deduction on his taxes of $5K for the interest and taxes.
The renter invests his $125K and makes 5% after taxes on it ($6250). He pays $36K in rent.
At the end of the year, the buyer has $79K. ($100K downpayment + $21K in amortization + $5K in tax breaks + $15K in appreciation – $21K in principal payments – $12K in interest payments – $1K in insurance payments – $3K in taxes – $25K in transaction costs.) The renter has $95,250 ($125K not spent on buying +$6250 in investment gains – $36K in rent.) The buyer is way behind, especially if he wants to sell that year. That would run him about $51K, in which case he comes even further behind the renter. Obviously, it rarely makes sense to buy for a one year period. What happens the next year?
Year 2+
The buyer pays $1K in insurance, $3K in taxes, $5K in maintenance, $12K in interest and $21K in principal. He gets $21K in amortization, $15K in appreciation, $5K in tax breaks. His total for the year is -1K. The renter pays $37K in rent and his $131,250 gains another $6563. His total for the year is -30K.
The buyer has already made up his shortfall from year one, unless of course, he wants to sell, in which case he'd still be way behind. Within a couple more years, the buyer's appreciation, amortization, tax benefits, and saved rent has outpaced the round-trip transaction costs as well as the investment returns of the renter.
The deal becomes even better over the years as the home is gradually paid off (dropping interest costs) while comparable rent increases (although to be fair some of the buyer's expenses also increase, but this is a much smaller sum than comparable rent).
Pitfalls for Homebuyers
So what can go wrong to hose the buyer? There are a few things.
- Expenses could become much higher than planned. New roofs and landscaping don't come cheap and property taxes can go up.
- The home might not appreciate. In fact, it could even depreciate. Buying instead of renting can still work out even without significant appreciation, but it takes much, much longer.
The buyer may not be able to completely deduct the interest and tax payments.
- Saved rent might not be worth much if comparable rent is very inexpensive. Consider a “rent control” city like San Francisco. A home worth $2 Million might rent for only $2-3K. Without significant appreciation, that isn't going to work out well for a buyer, pretty much ever.
So is buying a home an investment? It has expenses, capital gains, dividends, and a positive expected return over the long run if bought at a reasonable price in relation to comparable rent. That qualifies in my book.
What do you think? In what ways is your home an investment, and in what ways is it a consumption item? Comment below!
I would very much like to invest in real estate but I don’t want to be burdened with the additional headaches of an additional home, people and their problems.
Also, due to the nature of my job I could potentially be required to move and I certainly don’t want to be a long distance landlord.
I have the capital to spend, I simply want to diversify beyond Prosper/401k/ROTH/HSA accounts without the headaches?
Outside of REIT’s I wonder if there is something comparable to invest in with the same tax and potential appreciation benefits?
Any ideas?
You might like this post: https://www.whitecoatinvestor.com/4-ways-to-add-real-estate-to-your-portfolio/
I think a home can be an investment for those who actually do it the right way (and plenty who luck out), but is a liability more often than not. Most people don’t run all the numbers like that. They move somewhere and think “I’m going to buy a home because that is what I’m supposed to do.” Generally that is okay if you are going to stick around, but that attitude also leads to residents wanting to buy a home and tons of military folks buying houses at places were there is little chance of follow on orders in the same location. Plus they tend to stretch and buy too much making themselves house poor. For those people it is mostly a liability. Hopefully after reading this article they will be more inclined to evaluate it as an investment rather than go just off emotion.
I’m don’t agree with a home being rent free. Sure if you move out and rent it then someone pays you, but you still need a place to live. You now need to buy another place or rent a place yourself. You may spend more or less than the rent you collect, but it isn’t like you have all that rent coming in to cover your house expenses and you are just chilling on the street. Even when your house is paid off you still have taxes and maintenance that you wouldn’t have as a renter so your “effective rent” can drop dramatically, but it is still there. Stop paying those and see how long you can live in your house.
The biggest takeaway that I agree with is that home buying is not for short timers. The math just doesn’t work for people who are in it for a few years, unless it was during the real estate boom when appreciation.
I’m a fan of having your mortgage paid off prior to retirement. It’s a good way to lock in lower fixed expenses. You still have taxes and maintenance costs, but that tends to be much less than renting a comparable size home. Lower fixed expenses during retirement leads to less stress about market fluctuations, i.e. a better sense of financial security.
I see a home as a consumption (want) expense for the portion that goes beyond your needs to survive. It’s an investment (need) expense for the portion that sets you up to live at much further reduced living expenses down the line. The appreciation side is moot until you sell or do a reverse mortgage.
My wife and I bought a home near her med school using my VA home loan. The house is located in commuting distance of two major Navy bases, so when we purchased our home we kept BAH rates in mind just in case we decided to rent the house out to an E-5 or above after we move. Because my house cost $145K and could rent for about $1,200, I can afford to leave it in the hands of a property manager and still pay the mortgage, taxes, and insurance. Buying a home works for us because we bought a $145K house even though we could have technically afforded something twice as expensive. Our monthly payments as owners, plus our improvements and unforeseen costs of ownership (termite treatment, emergency tree branch removal, etc) are still cheaper than what we would pay for an apartment downtown near the school.
We probably will buy a house in residency, but that’s because the specialties my wife is considering will have us in an income tax free state for four or five years. That seems like a good amount of time to let appreciation take the edge off selling costs, and since we will again be in a military town we will look at buying a place that is affordable on typical BAH payments.
That sounds like my rental property. I calculate your cap rate at 5.5%. Not fantastic, but not terrible. I think matching E5 BAH was a good idea. I didn’t do it purposely, but that’s about what mine rents to an E5 for too.
The cap rate might not be amazing, but I figure if I can get a good military family to stick around for 3-4 years at a time and essentially pay the expenses of keeping the home I can wait until the market appreciates enough to be worth selling at a decent profit. If the rent is just enough to pay the mortgage, property management fees, and recurring maintenance I’m still building equity.
The E-5 number came mainly from my desire to avoid having the place trashed by 18 year old sailors who just got married to move out of military housing. If the renters are E-5 or above, they have at least made it to a competitively promoted rank in the military and hopefully have a little more life experience and maturity.
and the taxes…and the insurance…and the flood insurance…and the repairs…and the upgrades etc. Sorry, I just spent $3K today putting all new windows into my rental property.
I bought a home to live in with the hopes it wouldn’t lose money. I certainly didn’t buy a home with the same type of scrutiny for potential gain like I would with an investment.
I bought somewhere close to work that I liked. I got the best deal I could at the time.
I enjoy the home, I’m paying it off fairly aggressively… but after 8 years if the Zillow value is even remotely accurate, it’s still worth about what I paid for it or if anything less despite the fact that I’ve put hours of my time and tens of thousands of dollars of repairs and upkeep into it.
I like the home and I like living in it, but it certainly hasn’t been a positive investment for me.. and I’m fine with that.
I like you bought a home to live in. If it gains value (it has) than great. If it loses value I will be disappointed, but I still have a house over my head.
Oh and Zillow values are not accurate at all unless the community you live it is very very similar is size/value. An example: My home if on the market would sell for around $120-130 a square foot. However the Zillow value is around $75 a square foot. Zillow bases your price on the price of homes selling around you without taking into account size and amenities. So if you live a community that allows for homes as small as 2200 square feet and as large as 3600 square feet you get widely different values.
Well when I say don’t think of your house as an investment I really mean don’t buy more house than you need with the expectation that it will go up in value rapidly. I agree with the analysis in this post, but you have to add the value of having living space that might not be available to rent at any price. You can customize your house to your likes, you can have pets without worry about the landlord. Owning can also impede your moving for a new job or other reason. I would like to retire to FL, but have a house that probably won’t sell for a considerable time. I don’t want two residences so I am somewhat stuck.
Most people will buy a house that is bigger than what they would rent. Actually many people judge the price of their house based on what they could afford. Not the best thing to do, but it is what the media, banks, and real estate agents pander, making a house actually a very poor investment because it decreases that families ability to put money away into tax deferred accounts. I know way too many people who have followed this exact path.
Which is why I agree with the “consumable” argument. Taking everything into account, especially taxes, and maintenance. The home is a consumable expense that will in the long run decrease your fixed payments (mortgage payed off) with some asset protection as realistically, unless you got lucky and bought a house in an up and coming neighborhood, I doubt you made any money on your house once you take into account taxes, maintenance, as well as upkeep such as the yard.
I have had several people tell me how they bought a house at price x and now about to sell it at some much higher price. I do some basic math and realize it only went up by inflation. Yeah, great investment!
All interesting conversation, but home is a money pit.
Agreed. Fore sure we’ve spent more on maintaining our old house than how much it’s appreciated and principal we’ve paid down. But you have to pay to live irregardless and our quality of life is better than if we rented.
Pretty good calculator I have been using for years that gives you the break even ownership period given your assumptions:
http://www.nytimes.com/interactive/business/buy-rent-calculator.html?_r=0
Obviously, playing around with the rent increase and home price increase rate is the easiest way to make it say whatever you want it to say, so I would avoid touching that.
Military but retiring here. We’re in the only home I could find that I would buy (acreage! but already built) and family would accept (no trailers, how prejudiced), at top of market. We added another 35% of purchase price with pool roof floors paved driveway other redos. Now I have home/place I want at, with market contraction, maybe 160% sale value (few houses on street for sale for years or foreclosed on). Mortgage paid off so our rent in retirement is insurance and taxes and upkeep. If we ever want to move the loss on the house will be factored in to how much we really value moving money wise. So definitely not an investment- just a lifestyle expense not available as a rental, and if we stay 20 years we might only have paid what rent would cost us… Just wish the only house we could find were better built- will be hard to sell or pass on to kids when my best advice is level and rebuild properly.
In this example of a $500k house, where do you come up with $1,000 insurance and $3,000 in taxes? My home is valued at that and I pay over $3k in insurance and over $7k in taxes. Paying 3K in taxes on a 500k house is a millage rate of .6. Usually rates are 1.6 to 2. I know it depends on where you live, but your example seems low.
Sorry it seems low. I just took it off my budget. Seemed reasonable enough. You might want to consider moving to another state.
Another unique aspect of a home as an investment, not present in other investments (eg stocks), is the psychological stress of dealing with tenants. Growing up, watched my parents manage their rental properties, if one is unlucky enough to rent to nightmare tenants, communication becomes bitter exchanges, sometimes incurring legal fees. We’ve taken tenants to court for property damage, had to evict tenants who didn’t make rent (even though they had good credit scores & background checks before choosing them), and having to manage the managers who would undoubtedly found something wrong with the house every month that needed to be fixed. The psychological component alone was enough for me to vow never to buy a home as an investment. Given that, I did buy a home for my own living because I liked doing what I want on my own property & home. Also, I am good at handy work around the house, so routine maintenance cost is moot, except for major repairs.
I am a 2nd yr EM resident, married to a school teacher, no kids (none planned for the near future). Will be finishing residency with approx 300k in combined debt. The majority of interest is locked at at 6.8%. We are planning on moving to a town (in the southeast) we may or may not end up staying in long term, depending on how we like it and how my job works out. (No contract signed but tentative 160-170/hr). Plan will be to stay at least 3 years unless we absolutely hate it. My plan was is to rent and hammer away at loans with the goal of having them payed off in 3-4 years. However, all of the rent vs buy calculators all show a benefit of buying after approx 3-4 years. Am I hurting myself long term by my not buying? I know there are a lot of factors that need to be weighed in. I can’t seem to get past the extra hassle/expense/debt of home ownership combined with the fact that if we did buy it would likely not be a house we would stay in long term (>10yrs). Sorry if this is rambling but I guess my basic question is would it financially hurt me (and if so how much?) to focus on paying off loans and renting during that time.
Why not rent for a year and see if things are working out? Might want to refinance those loans too.
Clint, those rent/buy calculators are limited. They may not adequately capture your risks. There’s the risk that you change jobs, for whatever reason, before you own for 4-5 yrs. There’s the risk that you have a major repair needed on your house, thereby eliminating those potential gains. There’s the risk that your housing market declines. The calculators may also not capture the potential benefits of paying off student loans (emotional relief, elimination of compounding interest, etc)for someone with as much educational debt as we have. When I took a job out of residency in 2012, I rented a $600/month duplex (admittedly not safely available in all cities) and paid off $150k in a year on my salary and signing bonus as an internist. Sure, I have no equity in a house and missed potential returns had I invested that money, but I’m now debt-free and saving a sizable down-payment. Living frugally and focusing on debt for a time is simple, uncomplicated, and motivating. Sometimes it means ignoring a few bucks that could potentially be made by other, more risky, methods (buying a house, e.g.).
A home is an investment but not a very good one IMO as such things are conventionally thought of. I’d say it’s more of a “necessary consumption” (you have to live somewhere) that has long-term benefits (financial and mental) over renting in most cases.
Residential real estate (RRE) appreciates 3-4%/yr on average. In other words, it appreciates typically 0-2% above inflation. Not much of an investment considering stocks average about 7% in real terms.
RRE is an illiquid asset has very high transaction costs. Between realtor commissions, moving expenses, and closing costs, expect to pay 8-10% in buy/sell 2-part deal. Imagine paying $1000 in commissions to buy and sell $10,000 worth of shares in an index fund.
RRE has very high carrying costs. These include utilities, insurance, property taxes, HOA dues, maintenance, repairs, etc and average about 3% of market value per year. If you’re careful you might be able to pare this down to 2.5% or so. Would you buy a mutual fund or ETF that had an annual expense ratio of 2.5-3.0%?
So the capital appreciation aspect of RRE is pretty much nil. It goes up in value on average only slightly more than what you spend on it every year. After inflation, it’s likely a negative number. The only real “investment” component of RRE are the dividends (in the form of “free rent”) and yes I agree this is a clear positive.
All in all, I’d say owning your own home (over long-term renting) is easily the better option but I think sometimes people trick themselves into believing the capital appreciation is much greater than it is. All the more reason not to make yourself “house poor” as you see lots of doctors do.
I would also add hidden costs to the pitfalls of home ownership. The two biggest ones are property taxes and homeowner association dues. Thus, there are A LOT of variables that go into the decision to purchase a home, and it’s important that you run the numbers. For us, renting is by far the better decision. We wrote about it recently and shared an Excel spreadsheet that allows you to input your actual assumptions into and see how the numbers work out.
https://www.smartmoneyandtravel.com/rent-not-buy/
The way to tell an investment from a consumption item is quite simple. An investment sends you checks, a consumption item you send checks to own it. There are significant hidden items not addressed. Taxes and upkeep are only some. My house was bought for $650,000. Taxes are $11,400, insurance as I’m in Florida is $7000+, should I sell closing costs would be about 5-7%. The tax savings went away with the recent tax law changes. After nearly 20 years of ownership that’s nearly $200,000 plus upkeep. I could not sell it today for $800,000. I’m not counting roof repairs, paint jobs, new appliances and airconditioning replacement just to name a few large items.
The Dow was about 7000 in 1999. Now it’s 27,000 and there were about 2% divided yield annually with 20 years of compounding that’s almost a 50% increase in the initial investment over the time period. That’s the alternative use of capital which one would need to decrease by the rent paid.