The Stark Company Middleton office is where I am based as a Middleton Realtor. Dave Stark, the President of the Stark Company Realtors in the Greater Madison WI area, has been blogging about changing the conversation about Real Estate to basically, counteract the "housing is no longer a good investment" stories ol late in the media and to point out why buying a house is one of the best investments a family can make. Leverage-using debt to increase your rate of return is the topic of this post. This is dense but worth the time it takes to read it.
Dave's Blog:
Last week, we discussed the concept of imputed rent, emphasizing the fact everyone pays rent, either to their landlord, or to themselves. There are a number of reasons this is important, and they bear directly on why real estate remains one of the very best investments a family can make. To briefly review, as Karl Case pointed out in his New York Times op-ed piece (cited in last week's post), imputed rent is "counted as part of national income by the Commerce Department. It is the equivalent of about a 6% return on your investment after maintenance and repair, and it is constant over time in real terms." Basically, the government is assuming that since you have to live somewhere, it's fair to count the rent you "pay to yourself" as part of the overall cost of living. For our purposes, it means two more things.
- First, because all residential real estate is built with a purpose, which is to have someone live in it, it's fair to say that in a very real sense, all real estate is income property. When a homebuyer buys a home to live in, they're taking on the dual roles of landlord and tenant. And as such, they're gaining the benefits of both as well. As tenant, they get a great place to live. As landlord, they have a stream of income (the rent they're NOT paying to another landlord) to use to pay down their mortgage.
- Second, because everyone will be making either a rent payment or a mortgage payment, it's necessary when comparing renting to owning that the owner subtracts the rent he would be paying from the mortgage payment. It's not enough to simply look at whether the house is appreciating in value, and then comparing that to the return you might get in the stock or bond market. In a very real sense, for comparison purposes, the imputed rent payment cancels some or all of the mortgage payment. And this is important when we consider the next advantage of real estate ownership, which is leverage.
As we pointed out in our first post in this series two weeks ago, the media has suddenly started writing the "housing is no longer a good investment" stories. Usually, these stories are predicated on the notion that unlike the past decade, housing will "only" appreciate at or about the rate of inflation going forward. Our contention is that the rate of inflation is more than enough to make housing a great investment, better than stocks, and reason is leverage. Most people buy homes with a mortgage, and make some kind of down payment. Let's assume a buyer buys a $200,000 home, and it appreciates 2%. That's $4,000. No big deal. But let's assume they put 20% ($40,000) down, and took out a $160,000 mortgage for the balance. $4,000 is a 10% return on the $40,000 they put down. That's leverage-using debt to increase your rate of return in percentage terms.
But wait, you say, you have to pay back the mortgage, so that $160,000 doesn't come free. No, it doesn't. But remember imputed rent! When comparing renting to owning, you have to consider the rent you would be paying elsewhere, and subtract that from what you pay to amortize your mortgage (and pay taxes, insurance, and so on). In today's market, with today's rents, with today's low interest rates, and the tax deductibility of interest and taxes, in many if not most cases, our hypothetical homeowner could actually pay less out of pocket than the renter would for the same house.
Let's compare two families, one who buys a $200,000 house with $40,000 down, and another who decides to rent a similar house and invest their $40,000 in the stock market. For this illustration, let's assume that the rent paid by the tenant equals the net house payment of the homeowner after taxes, so they're each paying the same out of pocket for the home they're living in. The tenant, a smart investor, gets a splashy 8% return per year on his stock portfolio, while the owner gets a measly 2% on his house. Guess who has more money at the end of 5 years? The tenant's stock will be worth roughly $58,000, while the homeowner will have almost $75,000 in equity.
Leverage, coupled with principal payments reducing the mortgage, means the homeowner builds wealth faster than the tenant. In fact, the homeowner's equity grew at a 13.4% compounded rate over the first five years. Not bad for a dead investment that no one wants to own anymore. And let's not forget that the owner's mortgage payment is fixed for life (assuming a fixed rate loan), while the tenant's rent will steadily increase over time.
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