I got into a friendly argument with another financial writer recently. I said houses count as investments. He said houses didn’t count.
We chatted about this a bit. And after discussing, we agreed to disagree.
You don’t care about that, of course. Except I think our points of disagreement suggest actionable insights for people buying homes and wanting to get the best financial outcome possible.
See if you agree.
Why Houses Should Count as Investments
To start, let me explain why some people (me included) count houses as investments.
Consider this situation. You rent me a single-family home for $1,000 a month, or $12,000 a year.
Say the home’s value equals $200,000. Further say that you incur $4,000 a year in “landlord “-type operating expenses for taxes, insurance and repairs. To keep this simple, assume the property carries no mortgage.
In this example, you as landlord earn $8,000 a year in rental income. The rental income equals the $12,000 in rent minus the $4,000 in expenses.
Further, you can calculate the return on your investment as 4 percent. You just divide the $8,000 of net rental income by the $200,000 home value.
And all of this looks exactly like an investment, right? Right.
Let’s move on to a question…
What happens if I receive a $200,000 windfall, plan to use the money to purchase my own home, and you graciously allow me to buy your house? (This means my kids can stay at the same school. And you’re the sort of person who thinks about stuff like that.)
In this case, if I buy your rental, I think I also get a 4 percent return on investment. Just like you did.
If I buy, I stop paying you $12,000 in annual rent and instead pay $4,000 in property expenses.
That “trade-off” nets me $8,000 in savings.
The $8,000 of net savings represents a 4 percent return on the $200,000 home purchase price.
No, wait, I can guess what some folks say at this point. Some folks will say this example is too simple. Some folks will say once you lather on the complexities of real life, a house loses its investment quality.
But I don’t agree. Rather, I think the complexities of “real life” just complicate the arithmetic.
The Complication of a Mortgage
Think about a complication like a mortgage, for example…
Say I buy your $200,000 house using a $20,000 down payment and a $180,000, 5 percent mortgage. To keep the math simple, say the mortgage charges 5 percent interest but requires no payments toward the principal.
In this case, the financial impact of buying changes. I still save $12,000 a year in rent and pay $4,000 a year in property expenses. But I have a new expense: $9,000 of mortgage interest.
And now my family in effect loses $1,000 a year on the housing investment according to this math:
|Less: Property tax expenses:||$4,000|
|Less: Mortgage interest:||$9,000|
|Equals net cash outflow:||-$1,000|
Losing $1000 on a $20,000 investment (the down payment) means a -5 percent return (so minus 5 percent annually).
Obviously, that’s not good. Is this sort of house purchase really still an investment? Good question. Maybe not… but maybe so.
One also needs to think about all the other complicating factors that impact the investment. Like inflation, for example.
Inflation Impacts First Year Return But Not Cash Flows
So, what about the effect of inflation? Let’s continue with the example where I use a $20,000 down payment and a $180,000 mortgage to buy the $200,000 house I rent from you.
Remember that looking just at my cash flows, I lose $1,000 the first year on my $20,000 “down payment” investment.
But say the property appreciates by 2 percent that first year because of inflation.
In this case, though I do pay out $1,000 in cash the first year, the property value increases by 2 percent, or $4,000.
In effect, then, I haven’t lost $1,000. I’ve actually made $3,000 due to the combination of the $4,000 of property appreciation and the -$1,000 of cash outflow.
That $3,000 of profit equates to roughly a 15% return on the $20,000 investment: $3,000 divided by $20,000 equals .15 or 15%.
And now maybe the house does look like a good investment. Maybe.
Note: Most of the time, studies show, people in most countries apparently do earn pretty decent returns on housing.
And One Other Point About Return Calculations
So now one other clarification…
When you or I do our return calculations we need to count all of the economic benefits. And all of the economic costs.
For example, you and I want to consider any tax benefits of property tax and mortgage interest deductions.
Further, we need to recognize economic costs like selling expenses if we’ll pay these to realize the investment’s appreciation as a benefit (surely we will right?).
Typically, we also want to look at the full period of ownership. If you or I own for ten years, we want to look at the ownership benefits and costs for ten years.
Finally, we may need to include softer economic benefits and costs. Like access to higher-wage jobs. Or needing to pay for private schools for kids.
By the way, these additional inputs to the return formulas don’t mean that housing is or isn’t an investment. Or a good or a bad investment.
Rather, these additional inputs just complicate our return calculations.
Note: If you build an Excel spreadsheet that looks at the imaginary situation just described where I buy your $200,000 rental property, and you assume ten years of ownership, 2 percent annual inflation and a 6 percent sales commission, the annual rate of return equals about 8.2 percent. That rate of return is a nominal internal rate of return…
And now, finally, I want to talk about why some folks, as practical matter, don’t see houses as investments. Because even if I don’t agree with these people, their discomfort with the “houses are investments” argument provides actionable insights.
Factor #1: Using “Houses as Investments” Argument to Justify Spending
So a first practical issue…
Some people probably use the “houses as investments” rationale to buy a bigger house. Or to justify spending scads on improvements.
Which is a giant problem…
If you rework the math, the extra expenses of owning a bigger home may eat up the cost savings I described just a few sentences ago.
I can’t, for example, financially justify buying an $800,000 McMansion because then I won’t have to rent your $200,000 rambler.
Further, say I do buy the house you’ve been renting to me. And say on paper, that means I should enjoy $8,000 of annual net rent savings. If I then spend $40,000 to renovate the kitchen and the bathrooms? Hey, big problem, right?
And so, I guess, one of the things you and I need to not do? We can’t use the “houses as investments” argument to spend the net rent savings that home ownership can provide. Do that, and we’ve potentially screwed up the investment return.
Factor #2: Riskiness of Rent Savings and Resale Values
Another problem, potentially, of the “houses as investments” position?
The folks who don’t believe houses are investments point to the riskiness of the rent savings and appreciation an owner hopes to enjoy.
This criticism of the “houses as investments” philosophy might also be re-framed as concern about buying a risky asset.
I agree the riskiness is a concern.
This same risk, by the way, shows up in many of the big decisions adults make: spending money on education, marrying someone, timing retirement, and so forth.
And so the possible actionable insight? People shouldn’t rely on the historical goodness of housing investments to compensate for poor or foolhardy decisions.
You and I want to make smart picks. Something affordable. Something we’ve carefully inspected. Hopefully someplace that works for us and our families for years if not decades.
A Final Comment
Which leads to a last comment. And it’s redundant. Are houses investments? Or more importantly good investments? Well, they can be. Maybe they often even should be for most folks.
But we all need to be careful in our decisions.
Related Articles You Might Find Useful
We’ve blogged a bit about what the recent “Rate of Return of Everything” study means for people considering home ownership and real estate investment. If you’re wrestling with real estate decisions, you might find these posts about that research, Lessons from the Rate of Return of Everything Study and Rate of Return of Everything Line Charts useful.
We summarize the new mortgage interest deduction rules in another post.
Finally, if you want to use Microsoft Excel to precisely calculate the rate of return on a housing investment, you may find these posts useful: Small Business Investment Returns Astronomical and Small Business Net Present Value Analysis.