Here's Why Your Home Isn't a Good Investment and Won't Help You Retire Rich

Source: 401(k) 2013.

Some Americans believe that buying their own house is the best and smartest investment they'll ever make.

There are several valid reasons buying a home is better then renting. There is no landlord telling you what pets you can have or how many guests you can have at any given time, and buying a home gives you the freedom to improve or add to the property as you see fit. In other words, buying a home is the best way to make your living situation truly yours.

But buying as an investment or as the cornerstone of your long-range financial plan should not be one of your primary motivators. If your home doubles in value over the next few years, then great! Consider it a bonus. There are several reasons you shouldn't look at your home as an investment, especially in today's economy.

An inefficient investment
The main reason not to buy a bigger or fancier home simply because "it's an investment" is that there are much better ways to put your extra dollars to work. Real estate has generally appreciated around 4% to 5% per year on average, and this can be higher or lower depending on your specific location. Depending on what statistic you look at, home prices have historically appreciated at 3.4% to 5.4% annually over the past 20 years.

Compare this with an average annual return of 9.1% for an S&P index fund, 7.2% for the average mutual fund, and 7.16% for the ultra-safe 30-year Treasury, although it pays less these days, around 3.65%.

As you'll see, if you're hoping your home will generate these types of returns, you may be mistaken. Simply put, the risks are not worth the rewards.

Don't forget about mortgages
Your mortgage will cause you to pay much more for your home than the agreed-upon price, which also will eat away at your returns. Let's say you buy a $300,000 home and put 20% down, so you finance the remaining $240,000 at 4.5% (about today's rate for a 30-year mortgage). If your home appreciates at 5% annually, by the time your mortgage is paid off, it should be worth around $1,296,583. 

However, because you are paying interest on your mortgage, when you add up all of the payments, you're really "paying" a total of $497,794 for the house. This implies a total return of $798,809 after 30 years, or just 3.2% per year on an annualized basis. Better than paying rent for 30 years, but not quite what I expect my "investments" to return.

Poor risk/reward ratio
When you consider the risks involved with owning a home, it doesn't really look like a prudent long-term investment. In fact, the risks associated with owning a home are quite comparable to the level of risk associated with investing in an index fund, but without the upside benefit. From top to bottom, the S&P lost 58% of its value before bottoming out in March 2009. It has since recovered to a level that is 13% above its pre-crisis peak.

In contrast, the U.S. real estate market fell about 35% from its peak and is currently well below its pre-crisis peak.  Some U.S. states, such as Florida, lost more than 50% from the peak and have not yet recovered.

There are good investments in real estate, but your home isn't one of them
If you really want to "invest" in real estate, the only worthwhile way to do it is to buy an actual investment/rental property. These can be very lucrative if done correctly. In theory, an investment property should be a house (or apartment building, commercial space, etc.) that you buy and someone else pays for over time. 

In contrast to our example above, let's say you buy a $300,000 duplex and put $60,000 down. In a conservative case, we'll assume you collect just enough rent to cover the mortgage, and your other expenses associated with owning the property. Assuming even just 4% appreciation, after 30 years, the property would be worth about $973,000. You only put up $60,000 out of your own pocket, making your total return over 30 years $913,000, or 9.8% on an annualized basis. Much better than the return from owning your own home!

To sum it up, there are several ways of putting your investment dollars to work that simply make more sense than buying your own home. I'm not saying you shouldn't buy a house to live in, it just doesn't make sense for "investment" to be the reason to spend more on a house in the hopes of producing long-term gains.

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  • Report this Comment On January 04, 2014, at 1:03 PM, cinemind wrote:

    Respectfully, Matthew, the numbers you're using don't reflect the real world. For instance, I'm actually buying an investment property in a major American city right now. Let's take a look at my numbers.

    It's actualy a duplex (two 1 bedroom apartments). Rent will net me over 10% per year, based on my down payment of around to $90k. I'm counting appreciation at a conservative 2% -- my estimate of inflation. You also have to count the portion of principle that the tenants are paying on my behalf, which is conservatively 1/5 of my total PITI at the outset of a 30 year loan term. That comes out to about 3% (against my $90k downpayment). If we were being thorough, we'd add in depreciation.

    Granted, this isn't pure passive investing -- you have to do a little work. But 15% is a pretty good return! (To be fair, let's subtract around 3% for upkeep -- so maybe the actual number is around 12%.)

    Keep in mind that my mortgage is fixed, and rents tend to rise with inflation. This means that the 10% I'm collecting every year will increase with the rate of inflation over time. So in year two, I can raise the rent to achieve about a 10% x 1.02 return. Project that number forward 29 years: 18.11%. In year 30, the mortgage is gone, so my annual cash return jumps to around 37%. Real estate is nothing if not a bullish play inflation.

    Now, don't get me wrong, I'm also an active trader (options, mainly), so I see the value in many different types of investing. In fact, I made my down payment off of trading options. But it's simply not true that real estate is a bad investment. Real investors need both securities/derivatives and real estate their portfolios.

  • Report this Comment On January 04, 2014, at 2:04 PM, duuude1 wrote:

    Hey cinemind, can I ask you what your assumptions are on maintenance costs per year, and how costs for your time (the equivalent salary that you "pay" yourself for your time managing the property - or if you outsource this how much do you pay a property manager) - these should also be substracted from your returns - and I think those returns probably come closer to 5% - not far from what Matthew suggested as typical returns. And in fairness, you should also substract the returns that your up-front cash could have made in the S&P500 - that's the lost-opportunity cost of the cash. Also, just to be conservative, you might want to figure out how long it takes to re-coup each month of vacancy. In other words, let's say you end up with a bad tenant and have to evict, and it takes a month to find a new tenant - never happens right - but just to be conservative you should model that in as well. With all the effort and headaches involved, unless you really enjoy that kind of work (I sure would not), is being a landlord really the path to riches?

  • Report this Comment On January 04, 2014, at 2:11 PM, cinemind wrote:

    In the case where you own your own home (which I also do), you have to account for savings relative to renting. In my city, the cost of financing a home on a monthly basis is about the same as renting a comparable property -- if you were to finance at 100% of the home value. If someone can get a home with 5 or 10% down (FHA loan), they're effectively making a highly-leveraged, bullish bet on long term inflation. On a $300k home with 10% down, they're exposing themselves to $300k worth of risk -- effectively, it's a if they opened a $300k position with only $30,000. That's 10x leverage. This means that if their house appreciates 2% next year, they're up 20% on their $30,000. To wit: if the home goes up 2%, it's worth $306,000. That unrealized $6000 profit is 20% of your $30,000 downpayment.

    Matthew -- I know you're going say that you're still paying for the house over all those years, negating the effects of leverage. But the reality is that you're going to have a monthly housing expense regardless of what you do in your life. In terms of certainties, it is: death, taxes, housing expense. The monthly PITI one pays has no opportunity cost -- it's not part of our equation in figuring out what a homeowner's ROI is. They are going to be paying that money in either rent or PITI -- there's no scenario under which someone could choose to not pay both a) rent AND b) PITI, and then invest the savings in an ETF.

    Maybe the easiest way to describe this is that the owner of a $300k home and his neighbor next door who rents will both pay at least $500k in housing expense over 30 years. (Let's just disregard for a moment the fact that the renter's cost will actually be much higher due to inflation.) The owner receives about $6000 worth of appreciation per year, which compounds. Remember, that's about 20% per year. The renter pays the same amount to his landlord that the owner does to his mortgage company -- but the owner receives the equivalent of an immediately-reinvested 20% dividend. Whose situation would you rather be in?

    More broadly speaking, we can say that everyone participates in the housing market. You can either be long or short it, but no one can avoid having a position in it. (Flat position = homeless.) Owners are inflation bulls, renters are inflation shorts -- and it's a zero sum game. Which side of that bet do you want to be on?

  • Report this Comment On January 04, 2014, at 2:36 PM, cinemind wrote:

    @duuuude

    You don't subtract that SP returns from the investment property returns; you compare them and then decide which is better.

    This isn't my first investment property. I know my market and about what I can expect in terms of upkeep. I took off 3% for upkeep, which is about $4000/year. That's very aggressive, if anything it will be much less. At $4000/year, I could replace all the appliances and the roof every 4 years, just to give you an idea.

    Annual cash return: 10% - 3% = 7%

    Appreciation: 2%

    Principle payments: 3%

    So about 7% cash, 5% illiquid gains.

    Bad tenants are taken care of with preemptive screening, but you might still get one -- just like you might experience a 50% drawdown the SP. There are risks to any profitable undertaking. (Although I will point out that the number of 30% drawdowns in the housing market in the last century: 2. In the SP 500: too many to count.)

    Listen, as an investor, you're either going to spend hours reading blogs like this, trying to find some undiscovered alpha, or you're going to call a plumber every once and awhile and screen tenants. It depends on what type of work you prefer. Me, I like both; moreover, having both gives me diversification.

    For the record, landlord-ing is way less work than trading.

  • Report this Comment On January 04, 2014, at 2:55 PM, duuude1 wrote:

    Hey cinemind, duuude, sounds like you're doing what you enjoy anyways - priceless.

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