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The REAL Long-Term Return On Owning A Home: 0%


Liberty
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I think too often, people forget to do the math on the opportunity cost when buying a house.

 

I totally agree, though most people don't trust the stock market and don't think they have any true "opportunities" other than building home equity. 

 

Opportunity cost is the main reason I've never owned a home. 

 

 

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I think too often, people forget to do the math on the opportunity cost when buying a house.

 

Amongst those getting the math wrong are the authors of that article.

 

Perhaps if they move out of their grandmother's basement they would realize that people who don't own houses need to pay rent.

 

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That's true but also need to factor in transaction costs and liquidity, which is huge here.  It's not so easy to move if you own a home.  If you rent, you can be out in a flash.

 

But as rent approaches an all in cap rate of 7-8%, it definitely makes sense to consider buying vs. renting. 

 

 

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My thinking is that if you purchase and live in a single family home that would otherwise rent at a cap rate of 7%, then you have a 7% real return.

 

The stock market does not return 7% real.

 

 

Yep, a 7% real return, after income tax.  You would need to earn ~11% from a taxable account to get an equivalent return.

 

The stock market does not return 7% real, but Siegel's work would suggest that it might return around 6.5% in real terms.  With such a small difference in expected returns, the only meaningful advantages that housing offers is the ability to easily leverage returns and the income tax aspect.

 

I bought my house at a cap rate of about 7.5%, and it's been a good deal so far!

 

SJ

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Perhaps if they move out of their grandmother's basement they would realize that people who don't own houses need to pay rent.

 

 

Well, most people pay rent on the money they borrowed from the bank  ;)

 

Oh, so we're assuming they don't have cash?

 

So what do they use to buy the stocks?

 

The article compares stock market returns vs using that same cash to buy a house.

 

I could buy a house in Sacramento for $150,000 in a decent area, or I could put $150,000 in S&P500.

 

One of them has 10% real returns (Sacramento), the other has nowhere near that.

 

And that 10% real is after-tax, because the "would be" rent paid is always in after tax dollars.

 

Owner-occupied ownership of single family homes makes more sense than investor ownership of single family homes for this reason -- the owner/occupier gets 10% after-tax, the investor gets 10% cap rate before paying income tax.

 

Which, is what StubbleJumper just said.

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My thinking is that if you purchase and live in a single family home that would otherwise rent at a cap rate of 7%, then you have a 7% real return.

 

The stock market does not return 7% real.

 

 

Yep, a 7% real return, after income tax.  You would need to earn ~11% from a taxable account to get an equivalent return.

 

The stock market does not return 7% real, but Siegel's work would suggest that it might return around 6.5% in real terms.  With such a small difference in expected returns, the only meaningful advantages that housing offers is the ability to easily leverage returns and the income tax aspect.

 

I bought my house at a cap rate of about 7.5%, and it's been a good deal so far!

 

SJ

 

It's funny though that the article claimed the real rate was 0%.

 

Were that to be the case, every rental out there would have a cap rate of 0%. 

 

And that was from the Harvard Business Review?

 

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One ratio i find helpful is the rent to buy ratio:

 

http://info.trulia.com/index.php?s=43&item=113

 

 

You could slide the scale down a bit, if you think you could get a higher return in the stock market than average.  So if you get 15%+ in the stock market, maybe any ratio of say 13 (instead of 15) might be a bad buy.  Thats just an example and I'm just estimating

 

Furthermore, as buffett said, he doesn't regret buying his home even though he could have made much more investing.  owning a home has some incalculable benefits

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The really long term real return on real estate is more likely approx. zero percent as documented in this very thorough study covering the period 1628-1973:

 

http://arno.unimaas.nl/show.cgi?fid=10696

 

Problem is, there are larges swings along the years, and it's very easy to get caught in thinking based on just a single lifetime experience. For all of us living now, the personal experience is likely somewhat different higher than zero, but unfortunately this doesn't change the really long term propable real return.

 

Cheers!

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The really long term real return on real estate is more likely approx. zero percent as documented in this very thorough study covering the period 1628-1973:

 

http://arno.unimaas.nl/show.cgi?fid=10696

 

Problem is, there are larges swings along the years, and it's very easy to get caught in thinking based on just a single lifetime experience. For all of us living now, the personal experience is likely somewhat different higher than zero, but unfortunately this doesn't change the really long term propable real return.

 

Cheers!

 

I don't think anyone is referring to capital gains being a positive real return. If you own your house outright, capital gains net out inflation and owner's equivalent rent is pure real return. But there is no need to own your home outright.

 

I've never actually done this math on paper, but I think the math is something like:

 

Capital gain + OER - opportunity cost on equity - mortgage interest - property taxes - upkeep = net gain of home ownership.

 

And taxes are a huge benefit: Capital gains are tax free up to 500k in the US, OER is tax free, mortgage interest is tax deductible. Property taxes are deductible (unless you pay AMT).

 

The big unknown is the opportunity cost on equity. But assume the following:

 

- you buy at a OER/price ratio of 5% (5% is a little low in my area, Boston, which I think is lower than normal for the US)

- with a 20% down payment

- borrowing at roughly 3% after tax (Just using 4.5% pre-tax which is low but doable right now and assuming you have offsetting income in a high tax bracket)

- with taxes + upkeep at 1.5% (taxes 1%, upkeep 0.5%. That's most MA taxes. Upkeep is probably a bit low but in the ballpark...)

- property values increase at a real rate of 0%, meaning at inflation

 

your math when you first buy is:

 

inflation + 0.05 - (x * 0.2) - (0.03*0.8) - 0.015 = 0, where x is the opportunity cost rate of return to break even on home buying.

 

solve for X:

 

x = (inflation + 0.05 - 0.024 -0.015)*5 = 5 * inflation + 0.055.

 

If long-term, inflation is 2%, your return on equity when you FIRST buy is 15.5% and your real return is 13.5%.

 

If we (really stupidly but simply) average equity at 50% over the life of the loan:

 

x = (inflation + 0.05 - 0.015 - 0.015)*2 = 2*inflation + 4%.

 

So your nominal return is 2x inflation plus 4% and your real return is: inflation + 4%.

 

That assumes you never refinance and never move, so I'd consider it a worst-case for trapped equity, but even still I don't think it's a bad real rate of return. It won't turn out very well in a deflationary spiral, but it'll do nicely if we ever get big inflation. And 30 years is a long enough time horizon that we WILL inflate out of debt in that time. If your trapped equity is just a portion of your investment portfolio, I think it provides a nice inflation hedge. For those that like diversification, it provides that too.

 

Also note that (in the US) as taxes go up (very likely), the return goes up unless those taxes come in the form of removing the mortgage interest deduction. I believe that's a political impossibility though. So it's likely that buying a house is an inflation hedge and a tax hedge.

 

Also note that if you buy at a cap rate of 7.5%, your real rate of return at 2% inflation starts out at 26% and averages 11%. But the chances of prices STAYING at a cap rate of 7.5% I think are small. But either it stays there or you likely have some significant capital gains on top of inflation. Either one is a fantastic outcome. Real rents could drop dramatically, but I'd bet against that in the long term.

 

Anyway, I know this is a drastically simplified model, but I think it's a decent one. I just think given where long-term rates are, buying a house is a no brainer. If I could buy rental property with a guaranteed tenant for the life of my 4.5% loan, I would do it in a heartbeat. That's what buying a house is. I just think it's a great time to buy a house if you think you'll stay put for a long time. Mostly because mortgage money is just so cheap...

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Well the article forgot to mention brokerage costs or mgmt fee costs for stocks over the long term:

so 4.5% should be about 3.5% to 4% for stocks and that means the long run return to stocks is about 2.5% or so.

 

 

The key difference is leverage I guess. The bank isn't going to lend you 300K for stocks. But on property, yes they will.

Therefore the quantum of returns from real estate is larger than that of stocks if you're good enough to at least get 0-5%.

 

e.g.

 

5% return in stocks over 30 years on 100K = 332K

 

vs.

 

5% return on property over 30 years at 100K + leverage of 200K = 997K

 

Also, different govts. have different types of govt. incentives.

e.g. some govts reduce property taxes altogether, whilst others give you co-contribution towards your first home e.g. the govt. will give you 10-20K for first home owners. etc etc

 

Mobility is good or bad depending on who you are.

If you're a govt. that is trying to promote skilled immigration, then getting skilled immigrants to buy a house is beneficial for the economy b/c it establishes 'roots'. Ask the Singporean govt. whether or not home ownership is a social objective or not. And they will probably reply with yes.

 

Note;

note how the article says;

In the end, what makes money is human ingenuity -- building new things and creating value. Things like rocks, or a constructed house that's wasting away every year in need of repairs is not where the money is.

 

You could also say that about the investment management industry ... things like trading and buying/selling pieces of paper, is not where the money is.

 

 

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The best way to look at home ownership is the same way you look at buying a car. It is a purchase of something you need to use on a daily basis(a place to live/a method of transportation), not as an investment. 

 

I rather own vs. rent simply because I don't want to have to ask permission to paint the walls, re-do the basement, put in a pool, etc...

 

To me it is a quality of life decision, not a financial one.  If I make any return > 0% at the end that is just gravy.  If my return is 0% it is an excellent deal.  If my return ends up negative, it was money well spent.

 

Returns as high as 0% are very, very, very rare when it comes to automobiles or most other things we buy to use regularly.

 

--Eric

 

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I own because my wife wants the peace of mind of bringing up a family in a property that we know we can live in for as long as we like and can change it to suit our needs as required (within reason).

 

Can’t see any rate of return on any investment that can compare to my wife being happy.

 

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Agree with the comments above. I also own a home, and the decision was not an investment related one. On a financial perspective, it would have been far better to keep the stocks.

 

You simply don't live in your stock portfolio.

 

I've sold some Found Financial Heaven to buy Found a Family Home  ;)

 

Cheers!

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The really long term real return on real estate is more likely approx. zero percent as documented in this very thorough study covering the period 1628-1973:

 

The real return on businesses is zero if you disallow their earnings.

 

Similarly, real estate offers no returns when you disallow the cap rate.

 

But neither scenario is realistic.

 

For some reason though, perhaps it's the real estate crash, it is becoming popular to pass around articles suggesting that real estate offers zero returns.

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Howard Marks - It has been demonstrated time and time again that no asset is so good that it can't become a bad investment if bought at too high a price. And there are few assets so bad that they can't be a good investment when bought cheap enough ... No asset class or investment has the birthright of a high return. It's only attractive if it's priced right."

 

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I own because my wife wants the peace of mind of bringing up a family in a property that we know we can live in for as long as we like and can change it to suit our needs as required (within reason).

 

 

 

Can’t see any rate of return on any investment that can compare to my wife being happy.

 

WOW this guy gets ,it they do not teach you this at Wharton ,Mr. Buffett did not get it prolly the best investment advice to appear so far on the corner.

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How can a board full of value investors miss (or at least not point out) that the return isn't necessarily 0% over the long haul? IT DEPENDS ON HOW MUCH YOU PAY FOR THE HOUSE PEOPLE!!

 

As an example, I came across a distressed seller who was needing to sell her home ASAP. I was in a position to pay cash, but got a mortgage on it (having the cash made for an effective bargaining tool since it was spring of 09!), and literally bought it for 1/2 of what it was worth. If the thing doesn't appreciate at all, I could sell it in 30 years (while letting it sit vacant) and make money. However, I have rented it out, and received rents for nearly what I paid for it... All with under a grand in net repairs (I even replaced the oven with that).

 

There are exceptions to every rule, and if anyone uses this as a reason for not investing in real estate, they are insane. A lot of what I am seeing in the real estate market here, is that a few bad houses are pulling prices down for the nice ones, which is absurd. I have also noticed, in certain areas, a nice house pulls up the bad ones (in terms of asking price). It is pretty absurd how some people come to value real estate assets... They should be viewed in much the same way that we view stocks (price, to value).

 

Other points that the article doesn't make: While home ownership does reduce workforce mobility, it also makes for stronger family ties. For example, since I, my brother and his family, my parents, and other family members all own real estate in Kentucky, we have stronger ties than other families I know, who have moved away (largely in part to the fact that they didn't have a house tying them down.) There is certainly a human cost of mobility, which, when economists don't focus much on utility, is forgotten, despite the fact that it is VERY important.

 

 

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The really long term real return on real estate is more likely approx. zero percent as documented in this very thorough study covering the period 1628-1973:

The real return on businesses is zero if you disallow their earnings.

 

Similarly, real estate offers no returns when you disallow the cap rate.

 

But neither scenario is realistic.

 

For some reason though, perhaps it's the real estate crash, it is becoming popular to pass around articles suggesting that real estate offers zero returns.

 

It's only if you would have paid the rent anyway, that this "rent" should be included in the equation for the owner occupied home.

But then we are not really looking at real estate as an investment, but rather as a place to live.

 

Beyond this point, the "rent" should be disregarded.

 

It's really two different questions:

1) suppose you have found the home that you will live in. Should you rent or buy?

2) for any additional funds, should you buy "more"/"better" house to live in or should you buy e.g. stocks or bonds or X for the additional funds?

 

This is different for businesses, where the business earnings should be included in the equation no matter the size.

 

Btw, the studies were also around during the boom times, but people dismissed them outright. People would rather believe the fairy tale than face the historic facts.

 

Cheers!

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