This is my first article for Seeking Alpha and I gave it a lot of thought whether it is a good idea to write a debut article that is on a controversial topic and then share it with an audience that I greatly respect and admire. After a recent article titled, "Is A House Really A Good 'Investment'?" by my very capable fellow author at SA, "Cullen Roche" on July 19th, 2013, I really thought that it is time to chime in and make an attempt to enlighten people's minds via logic and with real numbers rather than vague advice as to whether a house is a good investment or not. Just to make it clear, I do not have any negative view about his article and as a matter of fact, I shall demonstrate below using a real world scenario how owning a house could turn out to be not such a good investment, it all depends how you look at it since home investment should be weighed differently than, say stock market investing. I believe that author touched the surface of a very important subject, which begs further detailed clarification. I have been (and am) a Real Estate Investor as well as Investment Manager having years of experience with Stock investing, so I sincerely believe that I can bring some value to the learned audience on this forum. Again I want to emphasize that I am not promoting my opinion on this controversial subject but attempting to inject some thought process into people's minds via fact based arguments.
Caveat: I would encourage readers to take a big picture view with focus on long time horizon (20 years for this article) and I am not going to mull over minor expenses (such as "garbage collection") that are typically common to leasing or owning.
In order to make my point, I will use an imaginary character by the name of "Joe," who has a steady job and currently has $300,000 in savings. Joe has rented all his life and is now ready to make a transition and become a homeowner. Since Joe is not a very emotional person, he would like to weigh pros and cons of renting vs. buying. Joe will only buy a house if it is also a good investment, otherwise he is happy to rent for the rest of his life. Joe has done some research and is slightly confused on this subject of whether home is a good investment. He has heard arguments on both sides but would like to see some real numbers before he could make a decision. So let's do some number crunching for Joe for renting and owning and take a walk 20 years down the road with him under both scenarios and come back to the present to see how Joe fared with both of these choices. (I once thought to name this article "Back to the present" but feared to somehow run into copyright infringement issues)
Assumptions are a necessary evil for this article so please bear with me. I know various markets are different across country but I will try to be as fair as possible keeping all America in mind. (Apologies to Wall Street gurus for not keeping Manhattan real estate market in mind, although hoping you'll take away something from this article)
Let's arbitrarily assume that the market where Joe presently lives, gives him these TWO options:
1. Rent a nice size apartment or even a home for $2,000 per month
2. Buy a house for $300,000
Let's see where Joe is going to end up in 20 years with renting and owning. Let's start with renting scenario first.
Math in this scenario could be pretty straight forward; just add the rent for 20 years and you are all set. But in a real world let's assume that landlord will increase his rent at 3% per annum. I think this is very fair to say considering many markets across the country. Please ignore such expenses that are incurred in both rental and home ownership, i.e. utilities, garbage. Please see table below for total rent increases per year and total out of pocket rent cost for Joe at the end of 20 years.
Joe's Rent Amount Per year Rent increase at 3% Per year
Total rent expense for Joe in 20 years with 3% increase per annum
This will allow Joe to freely invest his $300,000 in stock market. (Ignore the fact if he would have further savings from his job etc). Let's assume that Joe is a smart investor and he is very capable of earning 10% on his money. (I think someone who truly thinks himself worthy of giving up a house for stock market, better be capable of returning 10% per year; 5% was too low in my mind and 20% or more will align your ranks with Warren Buffett, so let's stick with 10%) That's how Joe's investment of $300,000 will fare in 20 years at 10% compounded annually, please see table below; Joe's $300,000 has now grown into a healthy $1,834,772.71
$300,000 compounded annually at 10% per Annum for 20 years
Joe's $300K in Investment in 20 years with 10% annual compounding
But we are not finished yet since we would like to arrive at Joe's "Net Worth." So at the end of 20 years, Joe would have paid $644,888.99 in total rents but would have made $1,834,772.71 in profits from his original $300,000 investment.
Net worth of Joe at the end of 20 years: $1,834,772.71 - $644,888.99 = $1,189,883.72 (About $1.2 Million dollars).
Buying a House:
Now we are going to work some numbers for Joe if he were to buy a house. Remember Joe has $300,000 in savings today. He plans to put down 25% on his house, a sum of $75,000, which will leave Joe with $225,000 for his stock market adventures. To be fair we will use the same numbers that were used in rent analysis, i.e. Joe is capable of earning 10% in stock market year after year. Also assume that the house he is going to purchase will appreciate at 4% per annum for the next 20 years.
Please also consider the following assumptions:
- Joe purchased at 5.5% interest rate (his mortgage rate on $225,000 loan). Based on this, his monthly mortgage payment for a 30 year term is: $1277.53
- Joe pays $2,400 per year for house maintenance costs
- Arbitrarily assume, taxes are $416.67 per month ($5000 per year)
- Arbitrarily assume, Insurance is $120 per month ($1440)
Total Monthly Payment: Principle & Interest + Taxes + Insurance = $1277.53 + 416.67 + 120 = $1814.20
Thus, Joe will be paying $1814.20 every month in PITI (principle, interest, taxes, insurance) for the coming 20 years.
Total out of pocket expense at the end of 20 years (for simplicity, assume no tax/insurance increase) = $1814.20 X 12 x 20 = $435,407.20
Add in the maintenance expenses throughout these years, i.e. $2400 per year X 20 years = $48,000
Total Out of Pocket Cost for Joe at the end of 20 years = $435,407.20 + $48,000 = $483,407.20
The house appreciation looks as follows in 20 years:
Joe's Home value in 20 years (at 4% per annum appreciation Rate)
Fair Market Value of Joe's house in 20 years
So house is worth $632,054.75 at the end of 20 years.
Sale of the House:
Now Joe is going to sell this House after 20 years. Here are some factual numbers based on $300,000 purchase of home with 5.5% interest rate with 30-year term:
· After 20 years (240 months) on a 30-year loan, using Amortization Tables (which you can easily do yourself via excel spreadsheet), the Principle balance on Joe's initial loan ($225,000) now stands at $116,977.76
· The total interest (from Amortization Tables) that Joe has paid to date is $199,861.34 (after 20 years)
We will assume that he can sell his house at fair market value, which is now at $632,054.75 (See Above table). Following two are the major expenses associated with Home Sale:
· Remaining Principal Balance: $116,977.76
· 6% Real Estate Commission (on $632,054.75): $37,923.28
So the total Proceeds to Joe (again ignoring some closing cost expenses that Joe has to incur etc) are as follows:
Joe's Net Worth = Sale Price - Total Out of Pockets Cost for Owning home - remaining Principle balance - Commissions
= $632,054.75 - $483,407.20 - $116,977.76 - $37,923.28 = ($6,253.49)
Wow! This is troubling, isn't it? Are you telling me that Joe is going to lose money on his house, which, as a matter of fact, more than doubled in the course of 20 years?
But wait a Minute!
What about $225,000 (left over after $75K down payment on $300K home) that Joe invested in stock market for a 10% return year after year? Here are the numbers:
$225,000 compounded annually at 10% per Annum for 20 years
Joe's stock returns in 20 years at 10% per annum
So combining above sum with a Loss on house, we arrive at:
Joe's Net total would be: $1,376,079.54 - ($6,253.49) = $1,369,826.05
Thanks to the stock market investment, which keeps Joe out of Red.
I see some raised Eyebrows:
Now I can see some of you raise your eyebrows questioning me why I subtracted $483,407.20 (Joe's mortgage payments throughout these years) from his net total in the end because "But he has to live somewhere." Well this is a valid point and exactly what makes this argument difficult, "Is house a good investment?" Don't forget that we are "strictly" considering our house an investment and you must take into account all income and expenses in an investment (hoping income to be greater than expenses). This is exactly why owning a house is not exactly apples-apples comparison with Stock Investing and is a great source of confusion for many people, who constantly try to get their heads around this issue. If you buy Coke stock today, Coke's management will not allow you to live in their warehouses, will they? But when you spend the same money on a house, you are allowed to live there hence foregoing living expenses. But when you are doing your profit/loss calculations, should you not account for these living expenses?
By a similar token, this argument should be valid in renting scenario. Please scroll above and notice that when I calculated Joe's profit/loss from his stock ventures, I did subtract all rents paid in 20 years from his net worth. Thus, if you did not have any objection then, you should not have an objection now.
Now to be fair to both schools of thought, I will give you computations down the road where I will not include these rents or mortgage payments in the computation of Joe's net worth in 20 years. So please read on.
Applying "But you have to live somewhere" logic:
So for those of you who are true believers that since Joe had to live somewhere, therefore his living expenses should be excluded from his profit/loss computations. So here I forgo these two expenses from my calculations:
· Joe's rent expense for the 20 years
· Joe's PITI payments for 20 years
I am not going to do computations line by line this time but give you end numbers as below:
· Not subtracting monthly Rents for 20 years, Joe will net following amount from stock market gains: $1,834,772.71
· Not subtracting monthly mortgage payments for 20 years, Joe will net this amount from house sale plus stock market gains: $1,846,979.76
Aren't both numbers from renting and owning surprisingly close to each other? Furthermore, owning a house wins renting by a small margin: $12,207.05
Now some of you might be quick to jump at a conclusion that a house is a better investment but it is important to note is that home investment above does not win from profits derived from house sale itself (which is only $477,153.71) but rather from Stock market gains on Joe's $225,000 initial investment. (Now at $1,376,079.54 after 20 years)
What about Tax Benefits from home ownership:
We all know Uncle Sam gives us a tax deduction for owning a home. However, it is not straight forward to arrive at an accurate number due to two reasons:
1. The amount of deduction would depend on the tax bracket Joe is in
2. Amount of interest you pay per month is going to change over the course of 20 years. When you first buy the house, you are paying almost all interest and very minimal principal balance (for example during 1st month of ownership, Joe's very 1st monthly mortgage payment ($1,277.53) pays $1,031.25 in interest and only $246.28 towards principal. However, after 20 years, Joe's 240th mortgage payment pays $539.53 in interest and $737.99 towards principal). So his tax deduction on paid interest is going to be far less in 20 years than now not to mention that Joe might be in a totally different tax bracket.
So we have to arrive at a reasonable number for all these years. I think $10,000 per year in interest is a fair average over the course of 20 years. Thus if Joe is in the 30% tax bracket, he would receive roughly $3,000 back every year. Multiply this by 20 years and you arrive at $60,000. Adding this back into house gain ($477,153.71 + $60,000) and we come up with total gain of $537,153.71.
Although this $537,153.71 is a profit on house, nevertheless, this number remains minor as compared to investment gain of $1,376,079.54 from stock market proving that gain from house itself is relatively small than that from stock market investing. However, don't forget that Joe's actual cash outlay at the time of purchase was only $75,000, thus you are looking at leveraged gain on house, which more than doubled in value over 20 years. So relatively smaller sum of $75,000 has actually enjoyed leveraged gains over the entire house value (starting at $300,000 and ending at $632,054.75)
Some of you might already be wondering on which side am I really on; "Is buying a house good investment or not?" To make things clear for my readers, just look at it this way; suppose you put down $75,000 down to buy a $300,000 house and do not have $225,000 to invest in Stocks as Joe did, (and I do not think most people have this type of spare change anyway), you still come out positive in the end as shown above. So if you apply "You have to live somewhere" logic and using above numbers from house profits, Joe made $537,153.71 on his $75,000 initial down payment at the end of 20 years. This turns out to be an annual compounded return of 10.34%. Isn't this greater than Joe's return on his other $225,000 investment in stock market (10%)?
I suggest that you read the above article a few times before reaching any conclusions and posting comments. It might be helpful to follow the exact same format above and do your own scenario based number crunching and see if owning a house turns out to be a good investment for you.
In the end, if you ask me if I would own a home; absolutely! Would I ever make money on it in future? I hope so; but what I am certain about is that I would have many memories with my family in this home for years to come and nobody can place any value on that.
World's greatest investor (Warren Buffett) owns the same house today that he purchased in 1958 for $31,500. Boy does he love this investment or what?