Thursday, May 1, 2008

The Housing Myth - Busted!

Housing blues
A house is an asset, the best and first investment you should make. That is what I had heard and believed when I was getting ready to buy my first house. With the housing bubble bursting – is the contention that buying a house is the best investment really true?

Housing is classified as a necessity but it comes with its own set of peculiarities and financial implications. Some thoughts on owning, renting or flipping a house.

Leveraged Appreciation
You put up 0-20% of the cost of the house and borrow the rest. The property appreciates over time and when you sell – you get to keep the appreciation (usually tax free). Sounds good – right? In theory yes – but reality is different. Housing has seen reasonable appreciation in stable markets but the overall concept is oversold.

Appreciation is usually rather tame (2-5% annually) and is offset by inflation, loan interest, taxes, insurance and maintenance costs. Although compared to depreciating assets (car) , a house is usually on the appreciation trajectory. But as the current market painfully highlights – price appreciation is not a guarantee thereby buying a house solely for appreciation may not be financially prudent.

Home Equity
Every payment you make against your mortgage (except for interest only loans or other such exceptions) includes some principal. This principal buys back the house from the lender and in turn builds equity. Is this an investment strategy?

In my view – it is more a saving strategy. Every month you are putting some money into your house which is available to you as home equity. Is this money growing or compounding? Not really – thereby I don’t qualify this as an investment strategy.

Rent Vs Buy
You can avoid the market gyrations by renting but then you miss out on the automatic saving (equity) and possible appreciation. This is a highly debatable topic but based on my experience – renting and owning are comparable options. You lean towards one or the other contingent on assumptions you make. If you assume 10% annual house appreciation – buying is preferred. If you assume high interest rates and taxes – maybe renting is a better option.

Run the numbers and see what works for you. Renting can be beneficial if you truly are paying less per month than a mortgage payment and investing the difference. Contingent on your investment rate of return, mortgage interest, rent fluctuations etc – you may come out ahead with renting. Rent versus buy is a wash if you analyze comparable properties and account for expenses associated with owning a property.

So is buying a house an investment? On this one I agree with Robert Kiyosaki – a house is not an investment or an asset. You need one (ideally) so you have a roof over your head. To accomplish that objective you can rent or buy but the key is affordability. There will be price fluctuations but unless you are in a volatile market like California or Nevada – the impact on your bottom line should be benign.

If you buy real estate as an investor – then you need to do your due diligence to understand the market, the business, the valuation and potential. And if you are a real estate speculator then you have to ask yourself – am I feeling lucky today?

(Graph courtesy WSJ)


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2 comments:

Praveen Puri said...

I think what people miss in the debate about whether to rent or own your primary residence is that you should compare identical properties.

Usually people think of buying a 3 or 4 bedroom house but renting a condo, townhouse, or apartment.

If you rent a 3 or 4 bedroom house for 5 years or more, I think you will almost always be better off if you had bought it.

Notwithstanding the recent headlines about exotic mortgages and declining prices, most house rents tend to be equal to or higher than their mortgage payments.

Most of the mortgage payment (in the form of interest and property taxes) is tax deductible, but not the rent.

There is almost always some appreciation after 5 years.

Even if that appreciation does not completely cover the mortgage interest and property taxes, it will reduce the total amount spent on the house over the 5 years.

The combination of appreciation and tax benefits will almost always mean that you would come ahead owning rather than renting your home.

Can you more than make up for this combination by renting, and investing what would have been the down payment?

It's possible, but not guaranteed. Also, you are losing the natural diversification from owing your own home.

Mark Runta said...

Praveen:

If one is interested in real estate as an investment - REITs are a good option. Four pillars recently had a post on REITs investing.

Thanks for your thoughts.

- Mark