Is My House a Good Investment?

November 28, 2010, By 4 comments

Is My House a Good Investment?

For most of us Americans, our biggest investment is in our house. It is ingrained in our psyches that owning real estate is the road away from serfdom. Our government heaps all kinds of incentives on us to own versus rent, believing that homeowners make better neighbors and citizens.

For us dads, our home is our castle, the family seat in which our memories are formed. The recent housing bubble and crash has many of us re-thinking these age-old sentiments. It’s time to put sentiment aside and think about real estate rationally, as we would about any other major investment. 

Think about the following when researching buying a home:

I am my own landlord. Owning your home produces income in the form of not paying someone else rent. For example, let’s say I look at buying a $240,000 house that could be rented for $2,000 per month. A good rule of thumb is that 40% of rent goes to maintenance expenses, property taxes, etc. That leaves $1,200 per month or $14,400 per year of cash flow. Divide $14,400 by $240,000 and I get a yield (known as a “cap rate”) of 6%.

I own an inflation hedge. From the 1890s to the mid-1990s, US residential real estate barely beat inflation before the recent run-up in prices. There have been price spikes and price drops, but in the end, US residential real estate tracks inflation. The owners of real estate benefit from inflation, while renters are hurt by it. If the market is expecting 2.5% inflation, and our cap rate is 6%, we can expect a total return of 8.5%.

I am willing to pay a “control premium.” When I own my own house, I control its destiny. I can renovate it, landscape it, or paint it how I see fit. I don’t have to worry about the landlord selling it out from under me or not renewing my lease. If I think the value of the control premium is adding an extra 20% to the price, maybe I would pay up to $288,000 for the house and accept a lower cap rate of 5%.

I have collateral. Because of government subsidies like guarantees of mortgage backed securities and the mortgage interest tax deduction, owning a home gives me the ability to borrow money at low after-tax rates for a variety of productive purposes.

I assess price risk. In places like Houston, land is plentiful and prices don’t fluctuate much. In places like Manhattan, supply is constrained and prices rise and fall in large swings. Within the same market, real estate prices in prime locations are less volatile than those for marginal locations. There are areas like Silicon Valley and Aspen that have done well, and places like Detroit and Cleveland that have not, although today’s Silicon Valley can be tomorrow’s Detroit. I weigh the risks and opportunities before investing.

If I do my homework, my home can be my castle and a profitable investment.

What do you think about home investments? Tell us below.
 

Comments (4):

Darnell C. I think we may be missing something vital in this discussion. When someone rents a home out to someone else, they are usually not taking a loss, otherwise there would be no point in doing so. This usually includes any of the expenses that you would associate with owning your own home and often times higher insurance and property tax expenses as well as potentially higher interest expenses. Considering we all have to live somewhere, I think these facts are worth mentioning. I could be wrong, but it seems comparable to asking would I rather pay someone rent for the rest of my life and after 30 years have absolutely nothing to show for it, or have a home completely paid for. I don't think it is completely accurate to say that a cap rate is inapplicable. It is different, but if you consider it as though you are paying yourself rent vs paying someone else then that sort of cap rate does still make sense. The only thing I would say is worth noting is that there are also areas in Detroit and Cleveland that have continued to do very well in the midst of their city's decline. - 05/14/2011
Anon A. Yeah, to make a statement that owning vs. renting is the right way to go, is completely false. The right answer is, is that it depends on your market. Google the NY Times Rent vs. Buy calculator. Have a look. In certain property markets (Seattle, New York, San Fransisco etc), buying makes absolutely no sense. You are poorer after 30 years if you bought (assuming you could get 4% a year return on your free cash flow if you rent). Just FYI. - 05/13/2011
John M. Even if your home is paid off, there are three things you must continue to pay; insurance, property tax, maintenance. All three go up with inflation. At a minimum they amount to $500 a month. Add a mortage on top off that, and then renting looks much more desirable. - 04/27/2011
John S. Houses, especially those bought in established middle and upper-middle class areas, are an extremely conservative investment. Owning includes costs that renters do not have to bear, such as maintainence and repairs, property taxes, insurance, etc. When you factor those in, the gain in the house's value is greatly diminished. Add to that the cost of paying interest to the bank, closing costs, and periodic improvement projects (which a future buyer may not value in the same as the current owner), and owning a house becomes less and less of a wealth building move. The cap rate in the article above is inapplicable to a person living in his own house and paying a mortgage on it. If you were to own a home outright, and rent it out, then you can talk about cap rate as an element of return. That is not the case for most homeowners. At the end of the day, if you consider everything over the long term, the house is marginally better than a savings account in financial terms. I recommend that people use the New York Times Rent versus Buy calculator, which forces the user to consider the true costs of owning a home. Of course, I don't oppose home ownership. I just think it's a matter of social prestige and of comfort, but definitely not a great investment strategy. - 12/06/2010

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