When thinking about a home as an investment, there are different ways to consider the topic. A house can be a place to live, a place to raise a family, and perhaps even a place to retire, hopefully increasing in value at a rate faster than inflation during your stay. A house can also be an investment in a purer sense, meaning it’s purchased as an investment and produces both wealth through growing equity and a reliable stream of income. Both of those scenarios assume ideal conditions. In business, one of the first things you do is to make a business plan, part of which considers the challenges the business will face. In our financial lives we don’t always face ideal conditions, so it’s just as important to consider the positives and the potential negatives and to plan for each in your own financial strategy.
There’s a time for everything, as the old saying goes, and there are times when a buying a house of any sort may not be the right financial move. Many people think of renting as “throwing away money”, but we’ll take a closer look at the numbers because there are cases where renting instead of buying may be the best move you can make based on your finances and opportunities at the time.
The housing bubble that led to the housing crisis was our modern-day tulip mania. We’ll have other asset bubbles as well as investment money moves from one asset class to the next, but the housing crisis left many wondering if housing is really a good investment. We all need a place to live and unless you really like the great outdoors, a tent won’t be a viable option for the long term. A house gives us safety and comfort and a place to raise a family or a place where you can put your feet up and enjoy your own space.
Traditionally, homes have appreciated in value by 3% to 5% per year. The variance is based in part on markets but also varies depending on the data used to build a comparison. Housing prices may appreciate much more or much less in any given time frame than in another. Over the long term, the average is generally predictable, however. For our examples in this chapter, we’ll assume a rate of appreciation of 4%. It’s also useful to know that the long-term rate of inflation between 1913 and 2013 was 3.22%.
The rate varies by year, but inflation chews away at savings over time, reducing the purchasing power of money we’ve tucked away and money we’ve yet to earn. A house has traditionally been regarded as an effective hedge against inflation because home values often trend closely with the rate of inflation. If you buy a home for $100,000, twenty years later its value may have doubled, but other items cost twice as much as well. The home has simply kept its value, although on paper it looks like an increase in value.
Let’s look at how much a home might really cost over the course of a 30-year mortgage.
To borrow an earlier example, you’ve purchased the home for $100,000. In this case, you put down 20% which builds instant equity and allows you to avoid Private Mortgage Insurance (PMI), which is required for most loans if you don’t make a down payment of 20%. You’ve financed $80,000.
You’ll have closing costs when you purchase your home. These costs can vary more than you might think, but we can use a round figure of $3,000. Let’s assume you paid the closing costs up front rather than roll them into the loan.
Home purchase costs
Down payment: $20,000
Closing costs: $ 3,000
Total expense (so far): $23,000
During your 30-year mortgage, you’ll pay $74,604.63 in interest if your mortgage rate is 5%. You’ll also pay the remaining principal of $80,000.
Down payment: $20,000
Closing costs: $ 3,000
Total expense (so far): $177,604.63
You’ll also have to pay for home insurance due to lender requirements. You may also be forced to purchase flood insurance, but we can assume the home is in a low risk area. Your home insurance will add an estimated $100 per month to your mortgage payment.
Property taxes are also part of your mortgage payment. Depending on where you live, taxes can make a huge difference in your cost of ownership. In some parts of the country, you can expect to pay $5,000 a year even for a small home. Let’s assume an average and set the real estate taxes at $200 per month, or $2,400 per year.
Down payment: $20,000
Closing costs: $ 3,000
Property taxes: $72,000
Total expense (so far): $285,604.63
We haven’t done any maintenance to our house yet. At some point, every house costs money in maintenance expense. A roof for a small house might cost $5,000. Heaters or air conditioners can cost a similar amount. All of these are likely to be replaced during your ownership, as is the water heater, the gutters, and anything else that might break or wear out. You might also have a contract for termite inspections and treatment or for lawn maintenance. Expect an average cost of $100 per month for all these items, which is low, but it can be difficult to get a more exact number. Add another $36,000 for maintenance and repairs.
Total cost of ownership: $321,604.63
Your $100,000 home has more than tripled in cost, but there are some other numbers to consider. During your 30-year stay, you’ve also benefitted from appreciation. At 4% annual appreciation in your home’s value, your home would have increased in value to $324,340.
You’ve made nearly $3,000. But during that time, if you didn’t live in a house, you would be paying rent. Buying a house prevented that monthly expense. Assuming you would have to pay $1,000 a month in rent for 360 months (30 years), your $100,000 house has made you a total of $363,000 wealthier. The rent alone would be $360,000.
In many cases, you’ll also be able to deduct your mortgage interest if you itemize your tax deductions. This tax benefit can make home ownership more affordable, but its effects aren’t always obvious when you’re paying your monthly bills. You’ll see the benefit at tax time.
This example home purchase is intentionally simplistic to make the numbers easier to digest. Expenses like taxes, insurance, and maintenance will naturally increase over time. If you are renting, rent will also increase over time. A more detailed example that accounts for annual increases tips the long-term financial advantage even further toward buying over renting.
Home appreciation rates are usually much lower than the historical return for the S&P 500 (10%), but because you save the expense of rent, buying a house provides a great value in most cases. To fully realize the value, you’ll need to be able to put money down and cover closing costs as well as budget for future repairs and maintenance. Without planning for these expenses, your gains won’t be as great because you’ll be forced to use credit.
Homes have also been used as an investment in the more traditional sense of investing; real estate can create cash flow and the rent collected can purchase the house for you over time bringing wealth in the form of equity. Rental properties can also benefit from a tax rule that allows you to claim a larger expense than a standard homeowner. You can not only claim the interest, insurance, and repairs as business expenses, but you can claim depreciation as well. We’ll look at some examples of how the cash flow might look for a rental property as well as some of the caveats, such as vacancy rates and what happens when you sell a property you’ve depreciated for tax purposes.
A large part of the reason that the housing crisis became as big and as damaging as it did is because of leverage. In this case, leverage refers to borrowing money to purchase an asset. Leverage can be a powerful tool. It can also be dangerous if too much leverage is used, meaning you don’t have enough cash or equity to navigate difficult markets or unplanned expenses. Whether buying a home for yourself or as an investment property, keep a strong cash position or liquid assets that can be used to cover emergencies or interruptions to cash flow.
There are some elaborate ways to calculate your return on rental properties. We’ll be looking at some of the simpler calculations, like cash flow and building equity.
Let’s use our $100,000 house from previous examples. You’ve saved up enough to put down 20% on your investment property, so you’ll only finance $80,000. You’re also paying closing costs in cash, which we can estimate at $3,000.
The $20,000 down payment will be locked up in the home’s equity unless you sell the property or tap the equity with a home equity loan. The $3,000 in closing cost is a business deduction on your taxes.
The mortgage on the $80,000 balance will run $429.46 for a 30-year loan at 5% interest. That’s $5153.52 in mortgage expense. Assuming you can rent the property for $1,000 per month, we’ll adjust that for a 7% vacancy rate, which means your rental will be vacant 7% of the time as you are in-between tenants. Expect $930 in monthly rent, adjusted to account for vacancies.
Other expected expenses include insurance and property taxes. Assigning annual values of $1,250 for insurance and $2,500 for taxes gives us monthly expenses of $104 and $208, respectively. Expect insurance costs for a landlord insurance policy to be higher than a homeowners insurance policy. Typically, these amounts are included in your mortgage payment because the lender wants to be sure that the insurance is paid and that the taxes are up to date. We’ll include these expenses as separate line items below.
You’ll also need to budget for repairs and maintenance, which may run an average of $100 per month.
Your monthly expenses are:
Principal and interest: $429.46
Property taxes: $208
When compared to your monthly rent, you have a positive cash flow of just under $90 per month. Don’t spend it yet. You’ll want to continue building savings for larger repairs, like roofs, heaters, air conditioners, or any of the other systems that can break on a house. You’re the landlord, so it’s your responsibility to repair or replace these items.
If you’ve ever rented you know that rent increases over time. Your rental income will also increase over time, but so will the cost of repairs, maintenance, insurance, and property taxes.
Expenses will vary from one house to the next, but the goal is to do the research on rent, vacancy rates, and expenses before you buy an investment property. A house that sits empty for extended periods is a risk and can be extremely costly because your expenses remain even when there is no rental income.
If all the numbers line up consistently, your tenants will buy you a house. However, if the numbers don’t line up or there isn’t enough room for surprises, like an unplanned vacancy, a bounced rent check, or an unexpected repair expense, your down payment, closing costs, and any amounts you’ve invested in repairs or upgrades are at risk.
You can also depreciate a rental property, which can provide a tax benefit that varies depending on your tax bracket. Land isn’t depreciated, just the “improvements” are depreciated, which refers to the house and other structures. This depreciation often makes the difference between a profitable rental property and one that loses money every month. The caveat is that if you sell the house, you’ll have to “recapture” your depreciation, which can be costly. In some cases, the depreciation recapture taxes are significantly higher than the tax benefit from depreciation. Tax treatment for rental properties can be complex. Like any business venture, do your research before investing.
There are times in life when renting is the right choice. Many households get into financial trouble by buying a home before they have enough money saved. This can create a low equity position or even a negative equity position. As importantly, buying with a lower down payment makes the mortgage amount higher and leads to increased overall costs due to interest expense over time. There’s less room for error with a lower down payment and any of life’s financial surprises can put your home and the money you’ve invested in your home at risk.
Even after the housing crisis, there are many ways to buy a home with less than 20% down. In most cases, it’s better to wait until you have enough saved to make a significant down payment, reducing risk for your family and avoiding higher interest rates as well as additional expenses, like Private Mortgage Insurance (PMI), which most lenders will require if you buy with less than 20% down.
When you’re ready to buy, look for a home that meets the needs of your family, but which is also priced below your budget. If you’ve done the math and decided you can afford a $150,000 home, also look at homes that are $100,000 or $125,000. You’ll save money every month with a less expensive home, which you can then save or invest. A well-maintained house can be a home for your family for decades. However, over time, many of its components and systems will need to be replaced. Leaving some extra room in the budget by buying a more affordable home will give you the cash you need to make repairs as needed without using credit.
Also consider property taxes when purchasing. Choosing a town or county with lower property taxes can save you thousands of dollars per year. That’s money you can use to provide a secure future for yourself and your family.