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How to Really View Your Home as an Investment
Homebuyers are typically told that they’re making a great investment by purchasing their primary residence.
Houses are sold as wealth-building tools – a way to escape “throwing money away” on rent. But is it really correct to view the home you live in as a proper investment, like stocks or bonds?
The answer may depend on the context of the question.
Outside of professional real estate investors, most average Americans think of price appreciation as the main way their home will make them richer over time. People often point to anecdotal examples, like a grandparent who bought a home for $15,000 in 1960 that’s worth $150,000 today and assume it’s a no-brainer.
It’s important to realize that even an example as seemingly amazing as the one above only represents an annualized appreciation of 3.5%. That’s right in line with inflation over the same period. There will be booms and busts, but in inflation-adjusted terms, the average real appreciation of single-family homes is pretty close to zero over long periods of time.
There’s good news though: While your home’s value probably won’t outpace inflation, it’s saving you money in the form of foregone rent payments along the way.
However, you need to be careful how you calculate the rent you’re saving. Most people estimate this by approximating how much their home would rent for annually, and assuming that’s what they are saving in rent each year by owning instead. That’s actually not quite right though.
Imagine, for a moment, that you are simply not allowed to own a home. You are forced to rent. What type of rental would you select? How much would you pay per year, knowing that the money is being spent without building any equity? Your honest answer to this question is a more realistic estimate for the rent you forgo by owning a home instead. Consider this as the annual “income” you collect from your investment beyond inflation.
Now, the bad news: Owning a home comes with expenses too. You need to subtract annual insurance costs, property taxes, and an estimated cost of maintenance from the rental “income” calculated before. Once you do that, you have an accurate figure for the annual real return on your investment. Divide that by the value of your home, and you have an annual real rate of return that you can compare to other investment options, like stocks and bonds.
You may notice that any discussion of a mortgage has been left out here. It’s true that using a mortgage for leverage can boost the cash-on-cash return of a real estate investment, in the same way that margin trading can boost stock market returns.
All forms of leverage come with increased risk though, so in order to compare apples to apples, you should keep things simple at first and consider real estate returns as if you were paying cash for your home.
Traditional thinking leads people to believe that buying bigger and bigger houses is no problem at all, because the returns on that investment scale with the price paid. Based on the framework developed above, you can see that this simply isn’t true.
Price appreciation is gobbled up by inflation, so the only thing left in your return-on-investment calculation is forgone rent payments. The amount you’re saving in rent doesn’t increase when you buy a bigger house, so by spending more, you’re diluting your return.
The logical conclusion is that buying a less expensive house costs you less money (and makes you richer) over time. It almost sounds like common sense, but it’s a fundamental point that is lost on too many people, who are often pumped up by real estate agents on the merits of buying more.
This is one way that your primary residence is very different than investment instruments like stocks or bonds. If you buy twice as much of some stock market index fund, you’ll make exactly twice as much money as a result, and your percent return will remain constant. When you buy a bigger home for yourself, you’re paying extra for luxury, and it makes sense that your overall percent return, in purely financial terms, should decrease.
One more pitfall people sometimes fall prey to is inappropriately considering the value of their home in retirement calculations.
Your home equity most certainly counts as a part of your net worth, but the main way it can be turned into investable capital is by selling your home. If you’re not planning on selling your home, it probably doesn’t make sense to consider that home equity in retirement income projections.
Suppose you own a $250,000 home outright, along with $750,000 in investments, and no debt. Your net worth is $1 million. If you’re planning to retire using the 4% rule, you might conclude that you can safely withdraw and live on $40,000 per year, but that’s not really correct.
In the case of retirement, it’s better to think of a paid-off home as something that is reducing your cost of living, rather than as an income-producing asset. The hypothetical retiree above really only has a safe withdrawal rate of $30,000 per year (4% of $750,000) if they’re using the 4% rule.
The house you live in can certainly be a wealth-building tool, but it’s important to have realistic expectations about how it might perform as an investment.
The primary benefit you get from your home is the ability to eliminate the expense of rent from your life. It’s up to you to make sure that benefit is worth what you’re paying. Don’t be sold into the idea that the more you invest into your home, the wealthier you’ll become. It’s usually not true.
