Why aren’t people buying homes these days? Ask all the experts and, well, you’ll get a different opinion from each of them. Are homes unaffordable? Do Millenials need so much flexibility in where they live that owning makes no sense? Are we building the next real estate bubble? Are there better investments than real estate? Is it too hard or expensive to maintain a home? Is the real estate market about to crash?
In the ongoing debate of “Rent Versus Own” I’ve heard all of these concerns when this topic comes up. I can’t address them all, and it’s only my opinion anyway, but as most of you know I’m better with numbers than opinions. (More accurately, perhaps, my math is generally accurate, and my opinions better kept to myself.)
So let’s talk about return on investment of owning real estate, compared to other investment classes, such as stock, bonds, gold, bitcoin, fast horses and lottery tickets. They key to the high returns on real estate is leverage.
You will pay all cash for almost all investments that you make in your lifetime. There can be exceptions if you use margins to invest in equities or bonds, but most of us mere mortals can’t do that, and even if we could we would be able to finance only a small portion of the investment.
Real estate, on the other hand, can be highly leveraged. Even more mortals can get in with as little as 20% of the investment, financing 80%, but 100% financing is available too. (Not always wise, but available.) Leveraging can multiply your ROI several fold. This is best illustrated with an example.
Let’s say we have $50,000 to invest. On the one hand, we can deposit it into a safe money market account at 3.000% (I’m being optimistic). Alternatively, we could buy a $250,000 home with 20% down, and finance the balance. We’ll assume that it will cost us $2,500 in closing costs to purchase the home, and that the home will appreciate at 3% per year, the same as the return on the money market.
If you look at the analysis to the left, you’ll see that after 7 years our money market account at 3% has yielded us, well, 3%. Our home, on the other hand, yields an impressive return on investment of 10.78%. What? How does that happen?
It’s simple. You are earning 3% growth on the money you’ve invested in your home, plus 3% on the money the bank has invested.
It’s true this is over-simplified for the purpose of illustration. For instance, we’ve ignored the payments that you have to make each month on your mortgage. On the other hand, you would have to pay rent if you didn’t own, and we ignored the tax benefits of owning real estate and the equity growth you would get from paying your principal balance down.
We also ignored sale costs, but then you will pay taxes on the income from your money market fund, and no taxes at all (in the U.S.) on the money you earn on the home, ever, if you make less than $250,000 net profit (as a single person) on any single transaction. (See your accountant – your mileage may vary)
Finally, a quick survey of money market funds tells us that our 3% return on a money market fund is very optimistic (most pay less than 1% today, and even long-term CDs pay only 2.00% to 2.25%). Real estate, on the other hand, has been appreciating the last few years at double-digit pace. It will not continue at that pace, but the general consensus is that it will continue to appreciate, and outpace inflation. (See my post from 9/23/2012)
So, the bottom line is that the ROI on the non-leveraged example is probably over-stated, while the real estate ROI is under-stated.
ROI is not the only concern, of course. Money market funds are highly liquid; real estate is decidedly not. The transaction costs of real estate are high, so you must hold it for several years to make the magic of leveraging work. And, let’s not forget that sometimes real estate depreciates, rather than appreciates. When that happens, leverage works in reverse, quickly wiping out your investment.
You’ve read it before here – owning real estate is not for everyone. (This is from a life-long real estate junkie.) However, those who argue that real estate does not appreciate significantly are missing a rather significant element of the equation, don’t you think?
Casey Fleming, Author The Loan Guide: How to Get the Best Possible Mortgage
(Available on Amazon)
Mortgage Advisor, C2 Financial Corp.
(408) 348-3442 / email@example.com
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