I’ve had this post queued up for three months debating whether to post it or not because I know it will ruffle a lot of feathers. Then I read this great article confirming many of my thoughts and I figured I should just throw this one out there for everyone to kick around….
Recent discussion here regarding real, real returns (returns net of inflation, taxes and fees) and the flawed BLS calculation on Owner’s Equivalent Rent sparked a good discussion about the benefits of buying a home. And it got me thinking about how most people seem to think owning a house is a great “investment”. Now, I have an obvious issue with this misuse of the term “investment” (especially as it pertains to the way portfolio managers and retail “investors” use it), but it also got me thinking about housing price returns on a larger scale. That is, on a real, real return basic. Thornburg Investments says houses return a barely positive return on a real, real return basis, but as they note, all of the fees are not actually included in this calculation. So let’s take a closer look here at this asset class that so many seem to believe is a good “investment”.
Before we start, it might help to think of a house as two distinctly different pieces. First, there is the land that you own. Second, there is the actual house itself. The land is what I would call an “investment” since it’s highly probable that the land itself will appreciate in value over time. The house itself, however, is a depreciating asset that is guaranteed to fall apart just like your car will. If it has any intangible “investment” components those are subjective and not necessarily financial (though I guess they could be, for instance, if you work from home).
Anyhow, if you’re familiar with Robert Shiller’s work you have likely seen figure 1 below showing real house prices since 1890. Since 1890, housing in the USA has averaged a 3.2% annualized return. It’s been slightly better since 1960 at 4.2%, a bit better than that since 1970 (4.8%) and more in-line with the historical average since 1980 (3.8%). That might not sound so bad were it not for inflation. Inflation has historically averaged about 3.2% as well. Hence the chart below which shows housing prices close to the 100 level throughout their history. Said differently, real estate doesn’t generate a return at all when you back out inflation.
But anyone who works in the financial services business knows that there are always costs attached to purchasing various financial assets. Most of these fees are recurring of some sort and can range from the reasonable (like ETF’s or discount brokerage fees) to the absurd (most hedge fund fees or annuities). Real estate is not immune to the fees and the costs arise in ways that are even better disguised than a bulge bracket brokerage statement.
Like all financial asset purchases you are guaranteed to start your purchase in the red by the amount of the fees involved in purchasing the asset. Homes are an unusual financial asset in that they’re extraordinarily expensive from an up-front cost perspective. You have realtor commissions, closing costs, inspection, appraisal, insurance and a whole slew of other potential costs such as moving or maintenance. This is before you’ve even stepped foot into your “investment” and before you’ve started paying the real fees (like your mortgage, which will cost you almost 75% of the cost of the home over the life of a 30 year mortgage AND the maintenance)!
For simplicity, let’s take an example of a home worth $200,000 and assume some relatively modest up-front costs. Let’s also assume, like most Americans, that we have a fixed rate 30 year mortgage at 5.5%. Let’s also assume some fairly conservative estimates for commissions (which I split because one could argue that both the buyer and seller pay the fee), closing costs and inspection. Nothing too complex (I know, I am oversimplifying!). But the total comes out to about 5.25% of the cost of the house. That’s similar to buying an A-share mutual fund, which is something that you only do if you’re suffering from sort of degenerative brain defect.
But we’re really just getting started with the fees involved in this financial asset. Over the life of a home you’ll have to pay taxes, mortgage payments, property insurance, utilities, water, disposal and routine maintenance. These are all fixed costs and whether you rent or buy you’ll have to pay some of these fees no matter what. So let’s throw out utilities, water and disposal with the assumption that your rental option has those costs embedded. But when you own a home you’re still paying the mortgage, taxes, property insurance and you’ll have to maintain the property yourself.
According to the 2009 American Housing Survey these costs come out to about 7-8% of the value of the home per year. Here’s the breakdown:
Now, that mortgage “cost” includes principal payments so let’s just take the average national mortgage rate according to the AHS and assume that the 30 year mortgage will cost you roughly $165,000 over the life of the mortgage (this is JUST the interest paid). Using a basic amortization schedule it’s pretty safe to assume a monthly interest payment of $800 or $9,600 per year. That brings our annual costs down to about 6.5%. You could also back out part of the taxes due to the mortgage deduction so let’s be generous and assume that our home costs us about $10,000 per year or roughly 5% of the mortgage. Even in the best periods where real estate returns 4.8%, the total return is still negative! That’s one expensive financial asset and it brings our real, real return down to -5% per year assuming we break-even after inflation.
The Bottom Line
Don’t worry. This post isn’t intended to wreck the “american dream”. None of this analysis means that buying a house is a bad idea. You have to live somewhere and this analysis does not compare the specifics of renting versus the specifics of buying a house outright, buying a house with a mortgage or using the property as an income source. The analysis is simply intended to put the total costs and real, real returns in the right perspective for those of us who buy a house with a mortgage and live in that home (as most people do). In my personal opinion, I view buying a home as a less expensive way to live than the option of renting (but I guess you could make both arguments depending on where you live). Plus, there are numerous intangibles involved in owning your own home that make it a wise purchase. But we should stop thinking about housing or talking about it like it’s an amazing “investment”. Whether you rent or buy you are experiencing an expense. The real costs of that expense will depend on your specific situation. But in both real returns and real, real returns (including taxes and fees) the returns are unlikely to be anything to write home about. And certainly not what I would refer to as a good financial “investment”.
(Figure 1 – Real house prices)
Update – Here’s a good analysis from Morningstar showing the comparison of stocks vs bonds and housing over the long-term.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.
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