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2) If you add $300K in upgrades and your house appreciation is still 25% a year, then this is like flushing money down the toilet. Note: the 75% figure is curious. Almost every study I have read in the past ten years on home improvement argue that you only get back 75% of cost. This is not the same as a 75% return!! So the $300K increases home value by $225K.
Just to clarify, I am saying you get 75% of the money back on improvements, the same thing as you. That is factored into my calculation. My language was unclear.
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3) Note, all along I am simply comparing the house to inflation. Were we to compare the house to alternative investments of the same risk, your opportunity costs, the primary house would look rather awful as a financial investment (it is of course more than that)
Stocks are riskier than real estate. But you're leveraging real estate 4:1 in most cases. I would actually argue that real estate is riskier or certainly a comparable risk because of the leverage. If you are buying a house in cash it is less risky than stocks...but people don't often buy houses in cash. That is an interesting discussion though, which depends on many factors.
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4) So we are talking about a -2 to 4% nominal return per year for most houses over the long run--no where near 9%.
Investors look at cash on cash return. Your cash is your down payment. Your return is what you get out at the end. Your return is the combination of paying off the mortgage plus appreciation on the house. If you look at 100k * 1.09^30 (your cash on cash return in the market) is about the same as 500k * 1.025^30 + 300k *.75 (value of your house). Both calculations lead to ~1.35M in assets after 30 years. Both require a 100k initial investment. That's how I arrived at my numbers. The monthly outlay/expenses are irrelevant since they exist if you rent or buy. It's an overly simple model that doesn't take into account many considerations, but it is good enough for the purposes of this discussion.
The reason you get 9% cash on cash return on a house that yields 2.5% in annual appreciation is through the magic of leverage/debt. For all the negative talk about debt on this forum it is why so many large businesses do it. If you study LBO (leveraged buyouts) it really highlights how much debt can magnify returns (or cause you to go broke).
Just to clarify, I am saying you get 75% of the money back on improvements, the same thing as you. That is factored into my calculation. My language was unclear.
No sweat. I thought that was the case. But clearly home improvements are to be enjoyed--they are extremely poor investments (-25% nominal return).
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Originally Posted by drshang
Stocks are riskier than real estate. But you're leveraging real estate 4:1 in most cases. I would actually argue that real estate is riskier or certainly a comparable risk because of the leverage. If you are buying a house in cash it is less risky than stocks...but people don't often buy houses in cash. That is an interesting discussion though, which depends on many factors.
BE careful. Say you are in California in 1993. You put $100K down on a $500K home. You pump in $300K in granite and imported toilets. Home price shoots to $800+$225K. You sell. Voila, on $400K, you earned $525K...131% return!! Great use of leverage, esp for the young and more investment oriented (where roots are not so important).
But...say you are in California in 2005. You put $100K down on a $500K home using an ARM. You pump in $300K. The house price stays at $500K. The ARM resets. You have to sell. Not only do you lose your $100K, but you lose all $300K in improvements. Yikes! Negative infinity on the returns.
Leverage? Can be the greatest thing since sliced bread or a one way ticket to the line at the soup kitchen! And I did not even take into account the temptation of millions of Americans to leverage their paper equity and pull out another $200K for golf lessons, that rad Hummer, or the 5* vacation. Be careful.
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Originally Posted by drshang
Investors look at cash on cash return. Your cash is your down payment. Your return is what you get out at the end. Your return is the combination of paying off the mortgage plus appreciation on the house. If you look at 100k * 1.09^30 (your cash on cash return in the market) is about the same as 500k * 1.025^30 + 300k *.75 (value of your house). Both calculations lead to ~1.35M in assets after 30 years. Both require a 100k initial investment. That's how I arrived at my numbers. The monthly outlay/expenses are irrelevant since they exist if you rent or buy. It's an overly simple model that doesn't take into account many considerations, but it is good enough for the purposes of this discussion.
Doc, I must have missed this definition of investment objectives. I look only at risk-adjusted real ROI. Your comment on rent versus buy is well taken, but not something I agree with. People tend to buy far more house than they would spend non renting. I was looking at Kauai rental prices (fantasizing about a year stint on the garden isle. A decent 3BR home is possible for $1500. A mortgage payment would be $2700 (conservative). Quite a diff. Also upkeep is far more expensive. Then there is the transaction cost of selling.
I think your numbers are overstating the ROI of the primary home. If you can pick a trough and sell at the peak, then your numbers may very well work out. If you guess wrong, you are history (as I have shown). If you are mid cycle on the buy and sell, then the ROI is quite modest. A well balanced portfolio and some modest investment plays will generate far greater returns.
Of course, the home is more than the investment play (whether horrible or good). I would never understate this value of home and family. However, I am afraid that an entire generation of Californians have received a rude awakening as to the nature of liquidity and credit in real estate. Those that cashed out early are such a small % versus those that bought in 2004-2006 and are sadly sucking wind. My heart goes out to them.
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Originally Posted by drshang
The reason you get 9% cash on cash return on a house that yields 2.5% in annual appreciation is through the magic of leverage/debt. For all the negative talk about debt on this forum it is why so many large businesses do it. If you study LBO (leveraged buyouts) it really highlights how much debt can magnify returns (or cause you to go broke).
No magic in alchemy, just false hopes and poor science.
Run your numbers again, with an appropriate cash flow that accrues to the savings from renting. Also, through in the TI in PITI (taxes and insurance), maintenance and costs of refis. Then the cost of the sale. This is real world. What happens? The ROI falls dramatically.
And I am being nice about not touching the assumed sales price of the home. We have just lived through an amazing expansion in real and credit terms. One cannot preduct the future. But take note of this. My Mom's house in a modest part of Silicon Valley. was valued at $400K in 1989. Today, it might fetch $600K. About a 1.95% pa gross net appreciation. Over that time, inflation has soared and ROI in the market, even with this crash, has gone up 500% (uses Russell 2000, a very broad index) has gone fro 168 in 1990 to 886 today. That is a gain of 8.7% per annum.
Yes, the sale of house by a couple can mean $500k in cap gains tax free, but the losses of most in this market, cannot be written off by most. And with stocks, long-term cap gains tax is 15%. This is tantamount to knocking the ROI from 8.7% to 7.8%.
I think what is clear in all these numbers, is that NOTHING substitutes for negotiating aggressively at times when prices have gone through huge corrections. As they sale, the money is made at the point of sale.
But as for a general rule of thumb? ROI on houses is actually quite modest... This said, this is probably a decent time for a young couple to consider a purchase. As the Baron de Rothschild once said, you buy when there is blood in the streets.
S.
P.S. Trust me, I love the idea of leverage. In the right hands, it is like magic. In the wrong hands it is fire.
P.P.S So buy in a cheap and upcoming area filled with potential--and you can do very well--esp if single or family is mobile.
P.P.S. An easier discussion would be with investment properties,
Your cash is your down payment. Your return is what you get out at the end. Your return is the combination of paying off the mortgage plus appreciation on the house. If you look at 100k * 1.09^30 (your cash on cash return in the market) is about the same as 500k * 1.025^30 + 300k *.75 (value of your house). Both calculations lead to ~1.35M in assets after 30 years.
Why should you include the $300K (or $225K) you spent on improvements as part of your return? This sounds like the Beardstown ladies' brand of accounting.
Why should you include the $300K (or $225K) you spent on improvements as part of your return? This sounds like the Beardstown ladies' brand of accounting.
You don't have to include it, it just reflects reality: people will likely update/upgrade their home over the 30 year period. The flaw in the $300k is I am not discounting it or amortizing it over the 30 year period, but like I said in my previous post, the model is overly simplistic.
Doc, I must have missed this definition of investment objectives. I look only at risk-adjusted real ROI. Your comment on rent versus buy is well taken, but not something I agree with. People tend to buy far more house than they would spend non renting.
Well it's difficult to take this into consideration: in my example I am assuming you would rent or buy the same property, and the price would be the same. If it is cheaper to rent than buy the same place then the numbers (even my numbers which you deem over optimistic in favor of buying) clearly conclude that the stock market will earn you more money than your house. I mean it's not really fair the cost of renting a 1BR condo compared to buying a 3BR home, of course, since the assets are so different, but that does reflect the behavior of many renters.
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I was looking at Kauai rental prices (fantasizing about a year stint on the garden isle. A decent 3BR home is possible for $1500. A mortgage payment would be $2700 (conservative). Quite a diff. Also upkeep is far more expensive. Then there is the transaction cost of selling.
I agree with you...if you are going to buy here you may as well light fire to $30k or more.
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Run your numbers again, with an appropriate cash flow that accrues to the savings from renting. Also, through in the TI in PITI (taxes and insurance), maintenance and costs of refis. Then the cost of the sale. This is real world. What happens? The ROI falls dramatically.
To do this properly would take much longer than my back of the envelope example...but it would be interesting. If I have time later today I will try to run something more detailed because I think it would be useful for the forum to see. You are right though: if you save money from renting compared to buying (for the same place), your returns will not be great, and will trail those of the stock market.
If I run this model what it will come down to is the appreciation number on the house. If you appreciate it at 2.5% vs 3% vs 3.5% it will have a tremendous impact on your overall return of the house. But I can easily incorporate a sensitivity analysis into the model. I mean my opinion is with yours: housing price performance over the next 30 years will almost certainly be much worse than it was for the last 30 years.
Just for full disclosure, I am a selective renter in Los Angeles. We rent a place that would cost double compared to the cost to rent. It is the same type of place we would buy. If the prices decline to the point where the monthly payment is the same as the rental payment, I think it makes sense to buy. Until then, I am renting.
EDIT: let me also make the point that I don't consider 9% return to be all that great for an asset you have to leverage 4:1 AND maintain (and hold!) over a 30 year period. I mean the maintenance of a house when you own it costs money, but also a significant portion of time, certainly more than calling your landlord. The maintenance level on buying an index fund or set of index funds that you balance on an annual basis, is much smaller. Of course it's very difficult to factor the value of that extra time into your model.
You don't have to include it, it just reflects reality: people will likely update/upgrade their home over the 30 year period. The flaw in the $300k is I am not discounting it or amortizing it over the 30 year period, but like I said in my previous post, the model is overly simplistic.
If you include the $300k, that will inflate the returns on the house. It invalidates the comparison between the rates of return of house and stocks.
You started with $100K in stocks with no further contributions, while you added $300K to the original capital outlay on the house and counted the $300K as part of the "return". That's not a fair comparison.
If you include the $300k, that will inflate the returns on the house. It invalidates the comparison between the rates of return of house and stocks.
You started with $100K in stocks with no further contributions, while you added $300K to the original capital outlay on the house and counted the $300K as part of the "return". That's not a fair comparison.
Fair enough...the 300k gets discounted a fair amount over time and to a certain degree it's negated by the cost of rental price increasing more than the cost of a mortgage increasing, but it's definitely a flaw. Again, it would be much more time consuming to design a flawless financial model for this type of thing over a 30 year period, and even then, you are making a lot of assumptions that won't hold true for a large segment of the population.
OK this is pretty messy and I pasted an excel spreadsheet into Google docs so it may be unclear but I will explain. You can PM me if you want the excel version and want to mess around with it and improve on it or make changes.
The net present value of owning a home over 30 years (I'm only discounting inflation) is 890,277. This includes maintenance (increases 3% annually), improvements (weighted to the end of the period), property taxes (increase at inflation - 1.25% prop tax rate), insurance (increase 3% annually), and a selling cost at the end of the period. This assumes a 20% down mortgage with a 5% interest rate and does not take into account loan fees. Insurance and property taxes will vary tremendously from market to market; I used what I consider to be fairly average numbers.
The net present value of renting over 30 years, assuming a 500k house rents for 2,500 a month increasing at 3% annually, and including insurance, is 878,106 with a 3% discount rate (same as owning). This doesn't take into account moving costs from one place to another.
Basically what the numbers work out to is the cost of renting and the cost of owning, over 30 years, is pretty much the same. The higher your discount rate the more renting will be slightly cheaper, but in general it's pretty close. These numbers change a lot depending on inflation - if there is high inflation owning a home will likely be better since rent will likely increase more. Consequently, if there is no inflation renting should be better as your price won't increase as much.
This model doesn't take into account taxes, but taxes are too individual to really count them effectively. It also doesn't take into account the mortgage interest deduction, but that number varies tremendously from person to person so I can not accurately account for that. But while the amount you have in the end from stocks (1.32M) is slightly higher than the house (1.21M), the effective tax rate on the house should be a lot lower than stocks.
The #1 indicator of whether or not you are better off buying a house or investing the down payment is your entry point. You can debate the impact of expenses, improvements, etc. but all of that is really insignificant compared to your entry point in terms of renting/buying. Price change is important; stock returns is important. But that stuff is impossible to control; you can control your entry point.
EDIT: found a mistake. I improperly accounted for the improvements adding value to the house. If you assume 75% of the price of those improvements is added to the house at the end (just adding up the values * .75, not doing future value or anything like that, yes this is a somewhat lazy way to do it), it will increase the value of the house by 168,750 to about 1.38M. I assume 3% appreciation on the house. If you use my original 2.5% appreciation then the total value will be 1.22M.
This model doesn't take into account taxes, but taxes are too individual to really count them effectively.
Which is to say that its completely useless. The tax ramifications between renting, owning with mortgage or owning out right play a significant role.
Also, the basis for all of this is a $500k home renting for $2,500. The only areas where this is the case are areas with inflated real estate (e.g., coastal California). In areas with prices more in line with historic norms those numbers are completely off base. Furthermore, the consistent 9% annual rate on equities is just wishful thinking.
Rubbish in, rubbish out.
Lastly, I'd like to remind you that this thread is about buying a house cash.
Which is to say that its completely useless. The tax ramifications between renting, owning with mortgage or owning out right play a significant role.
Also, the basis for all of this is a $500k home renting for $2,500. The only areas where this is the case are areas with inflated real estate (e.g., coastal California). In areas with prices more in line with historic norms those numbers are completely off base. Furthermore, the consistent 9% annual rate on equities is just wishful thinking.
Rubbish in, rubbish out.
Lastly, I'd like to remind you that this thread is about buying a house cash.
My guess is you couldn't produce a better model if your life depended on it.
The problem with incorporating tax information is 10 different people have 10 different tax situations, and the differences vary tremendously between all 10 people. Plus I am not a CPA and don't pretend to be able to take into account every tax issue.
You can change the rental rate very easily, and you can change the rate on equities if you think it is incorrect. People's opinions on financial markets, taxes, expenses, performance of the real estate market vary considerably. That doesn't make the model invalid.
Part of the usefulness of models like this is you can input what YOU think into the model, YOUR rental rate, prop tax rate, expense allocation, etc. and determine if renting or buying is cheaper over a 30 year period. Some people will pay 3% property taxes, others will pay $1000 a month for insurance, and the beauty of financial models are their flexibility to account for different situations.
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