Though I haven’t calculated it, I think the inflation hedge of owning vs. renting is overstated.  I haven’t had a year in three homes I’ve owned where the monthly payment has not increased due to property taxes.  In addition, the cost to maintain a home increases both with inflation (labor & materials price increases) and time (older homes have more stuff that falls apart).

I think the primary benefits of home ownership are intangible.  An owned home is a place to call your own.  It is a place that one can modify to personal tastes without calling the landlord for permission.  It allows for sweat equity to be retained.  I’m sure I could make a very long list if I thought about it.

I enjoy your blog.  Good luck to you.
——-

“I haven’t had a year in three homes I’ve owned where the monthly payment has not increased due to property taxes. In addition, the cost to maintain a home increases both with inflation (labor & materials price increases) and time (older homes have more stuff that falls apart).“

That is true, and I did not put this into the calculation just to keep is relatively simple. The payment is 70% of the cost of ownership, and that can be fixed. If you assume the other 30% of the cost also rises with inflation, then the inflation premium would be 30% less. Instead of 10% after 7 years, it would only be 7%.

Good catch.

Umm, there is a listing over on Calculated Risk, of a house that looks livable, in the inner circle of doom in the Coral Springs/Ft. Meyers area for, ta daa. . .$7000.  Cobra Driver, who posts over there sez it needs 8-10 thou of work.  The listing sez, estimated mtg payment $35.00 a month.

It’s bank owned, a cracker house on stilts (which was a good way to build prior to a/c, but still. . .

As many have stated, is a home an investment or a place to raise a family.  Thanks to this blog an others, (CR) I just took a low ball cash offer on my 10 y/o 4/3, 2000sf home in Corona.  Although my neighbors are mad, there are several REO’s in the neighborhood and I feel like I got out lucky to get out with $200/sf price.  I won’t miss the 91.

Being single with no kids, I could no longer justify maintaining such a large house.  I feel gratefull for the 200k profit but I don’t know if I will ever buy again.  Homes are a necessary if you are raising a family and you want good schools, roots. ect.  As we boomers age, I think the rank and file will see the light and perhaps become renters.

As for me,  I’m going to rent a beautiful 2/2 right on the river in Redding, CA.  I’ve already bought my kayak!

True. In addition, home equity has traditionally been the very important part of one’s net worth at late stage of life. I guess if we do not own our home we simply spend it all?

IR, could you account the factor of different tax brackets into your excellent tabulations one more time?

Congratulations on taking this $200k real profit. What kind of rental is this 2/2 on the river? monthly rent? and GRM?

“The investment value of a property can only be measured against other investment opportunities available to an investor.“

Should read:

The investment value of a property can only be measured against other investment opportunities of similar risk available to an investor.

This is a very important point and one that is overlooked in most analyzes and even to a certain extent in your explanation. The owner has no inside information that would lower this risk, since resale is mainly a market driven process. Therefore, market risk premiums should apply. One way to estimate the discount rate for the down payment would be to look at the cost that PMI adds to the loan relative to amount it allows you to lower the down payment from 20% to 5%. This would get you risk premium for the 75% of the 20% down payment, so it’s probably a little low but better than estimating using the mortgage rate or the ROI required by apartment investors.

The way I try to explain this to my friends is to ask them what they would want to get in return for loaning someone to buy a house that put up 20%. Then ask them if they would take the same amount for loaning them the 20% down payment if they got financing for the other 80% somewhere else.

Another issue with the rent/own savings is renters do not need to perform upgrades on their properties. If it becomes unattractive, they just move to another place at market rent. Owners have to fix the roof, replace the AC, shore up the foundation, repaint the exterior, etc.

Typo: “they may do not”

I did not take taxes into account for this analysis for a couple of reasons. First, when I calculated the cost of ownership (see the rent vs. own post,) I included the impact of any tax breaks there. I consider this part of the consumptive value rather than the investment value. Second, since the capital gains tax exclusion is so large, and since it is subject to the whims of our government, I did not figure in the loss of profit due to taxes at the final sale at some point well into the future.

Sounds like a great vacation house or art studio. What a deal for the right person.

So true.  In 1991 we bought an SFR built in the early 70s to use as a rental.  Now having moved in, we did a complete remodel that cost upwards of $100k.  We paid almost exactly $200k in 1991 and now to update it we had to put another $100k into it.

So, IR, would you calculate the “cost” as $200k in 1991 dollars plus $100k discounted back to 1991?  Or should we view this as $200k inflated to 2008 dollars plus $100k (or does it even matter)? 

Given the current state or Irvine housing and assuming a 4% inflation rate, I show we wouldn’t even break even ($200,000 in 1991 money at 4% is $375,000 at the end of 2007, plus $100,000 remodel cost is $475,000).  Not sure if we could net that after transaction costs.  The rental income helped out, but it sure seems like it was a lot of work for not too much financial reward. 

I guess the real benefit is, as you’ve said many times, we are now using it as a home.  Financially, we would be better off if we had put the down payment money (plus the years of negative cash flow) into stocks and were renting the same house.

IR,

If you are trying to really do a “back-of-the-envelope” calculation on owning costs, then you really can come up with more accurate numbers for repair and maintenance costs.

For instance, in my condo we have something called a reserve analysis…  assume roof needs replacing every 25 years and cost of new roof is $20K then annual roof cost is $800 or $67/month.  Similarly, AC systems are rated for 15 years at a cost of $3000 or $17/month.  Exterior repainted every 15 years.  Carpets replaced every 7-10 years at $3 sq foot.  Make an excel spread sheet.

Don’t forget landscape maintenance, you will need a factor for lot size.  And if there is a pool/spa, those costs can be estimated also.

Most renters don’t know or underestimate home maintence costs.  If you buy new you can defer for several years but then things start to hit you all at once.

I covered maintenance issues in the post rent vs. own. I put in 1.5% per year in maintenance costs, and many criticized the number as being too large.

http://www.irvinehousingblog.com/2008/01/14/rent-versus-own/

Another reason a home is not a very effective inflation hedge is that it is purchased with borrowed money.  As inflation rises, interest rates go up, that tends to drive house prices down (since it becomes more expensive to buy when interest rates are high).

In addition, an asset can only be an effective inflation hedge if it is not purchased at an inflated value relative to fundamentals.  For many years, housing has appreciated at a rate far greater than inflation, leaving it overpriced relative to fundamentals.  Now that the crazy lending has ended, and the ‘house prices never decline’ mania is debunked, prices will decline in real terms.  Although housing might be an inflation hedge if it is purchased at a reasonable valuation, in this cycle it will not prove to be one.

This is a good analysis.  I think its interesting to compare investors’ willingness to accept low cash flow in real estate vs. in growth stocks.  In the latter case, it makes some sense (though it is speculative).  In the former, not so much.  For example:

* Investors are willing to accept no dividend from growth companies like google, because they assume that retained earnings are being reinvested at a high rate of return, and will yield even more dividends in the future.  Consequently, someone who invests in google accepts a low current dividend yield because he imagines big dividends down the road (and expects the stock price to increase to reflect those future dividends).

* Theoretically, a real estate investor could have a similar situation.  He could collect rent all year, achieving a return of 12% after expenses.  But instead of taking his dividend, he could invest in improvements to the property.  If these improvements allow him to raise the rent substantially in future years, his property is a little like google (in the short term), in that he is accepting a low dividend now but investing the retained earnings at a high rate of return.  Because his rental income increases, he could also expect the property to appreciate.

* However, during the boom real estate investors began accepting lower and lower returns based on assumed appreciation, but the appreciation wasn’t based on fundamentals (re-invested earnings at a high rate of return).  We now know the appreciation was based on a speculative mentality and crazy lending.  The point is that during the boom the investors were truly hoping for a miracle - they were hoping that despite declining dividends and absent high-return investments in the asset, their asset could rationally appreciate.

One of the reasons that property is such a unattractive investment is that you cannot re-invest the earnings (assuming their are some) at a high rate of return.  Frequently, investments in rental properties earn less than they cost (you are paying $1 for every 50c in earnings).  That is why it is particularly difficult to justify a low dividend investment property, as opposed to a low-dividend stock, which may be legitimately achieving a high rate of return on retained earnings.

A real financing innovation for housing would be to find a way to buy a percent ownership overtime. That would allow you to avoid the risk of buying at the wrong time by effectively spreading out the purchase price over several years. It would also require someone to do the same with the selling, but with future markets, there should be a way to securitize the transactions.

With respect to inflation implying high interest rates implying housing price being less. This only works to the extent that prices are limited by affordability. If you allow homeowners to increase their DTI ratio, or they game the system to do that (something that IR indicated happen in the late 70’s with DTI’s approaching 50%), then high interest rates will not push housing prices down. The issue is the spread between mortgage rates and inflation. That is the after inflation cost of money.

You are all missing the most basic fundamental, which is that housing, when owned outright (and in California, when owned for more than 30 years), is the most risk-free investment a person can make.

I know tons of little old ladies who bought in the 70s, whose yearly costs to live in California are around $100 a month, where rent is $4000 a month for a similar property.  Now, sure, if these little old ladies had put their $16,000 (plus housing expenses and costs) in another investment vehicle, then they could possibly have a couple million dollars in cash right now, living in a rental.  And I understand that’s the point that is being made above.

BUT, when you hit sixty, you move your stocks out of volatility so you can start living off the returns.  Then you’re real ROI becomes more like 6% and sometimes lower.  In addition, if you happen to need access to your cash during a bear year,  your overall return could be around 6% (weighted over time).  Or if you were invested in bear stearns, you could be wiped out.

I’ve been invested in the stock market with large sums of money for about 10 years, and my return is about 8% (per year over a 10 year span).  Some years it was 15%.  Others (dot com bust) it was 3.5%.  8% is my average.  And that’s a nice, safe average.  But I know people with more aggressive portfolios who two years ago had a 20% return, and this year they have a 5% return (for the LIFETIME of their portfolio).

What everyone fails to say, is that all of this is like playing poker.  We can talk about statistical probability, but we’re not addressing the fundamental issue of “bad luck.“  Sure, the statistics say that you will beat the dealer 98% of the time with the hand you have, but what happens if God just plain doesn’t like you?

When I started reading this blog a year ago, I was with everyone here, hoping prices would tank.  But then reading blogs like Housing Panic, I worried we were looking at something that would undermine our economy itself.  If the weakness in the housing market creates another Great Depression, then (ironically) the one thing that could save me from the vagaries of unemployment, stagflation, and a plumetting stock market is the house I own that no one can take from me.  (well, if I don’t purchase in a fire, flood, hurricane, earthquake zone)

But, if this is merely another S&L crisis (at worst), then I don’t want to buy a house for another 10 years. 

It’s just all where your comfort zone is.

“You are all missing the most basic fundamental, which is that housing, when owned outright (and in California, when owned for more than 30 years), is the most risk-free investment a person can make.“

We’ll have to verify this in 2040.

IR said: “All homeowners have unrealistic expectations of appreciation.“  I think girlbear proves that to be an overstatement.  If only all sellers acted like that, the real estate market would be close to stabilizing.  Congratulations.

Out of curiosity, if you want to share, what percentage off of peak pricing did you end up taking?

True, maybe, but it all depends on timing.  If you buy anytime between 2003 and now, you’re going to get hammered simply because you paid way too much for something. 

As to whether 2040 will bear out jemyr’s prediction—well, I’ll be dead by then so it really won’t matter.

Did you see this on CR?  Land at .15 cents on the dollar in SoCal (inland empire)

http://calculatedrisk.blogspot.com/2008/03/land-at-15-cents-on-dollar.html

Exactly, it all depends on timing, for everything you put your money into.

However, I wish I hadn’t said housing was the most risk free “investment” you could make.  What I really believe is that (if you purchase in a neighborhood that has a long term history of no crime) owning a house OUTRIGHT is the most risk free thing you can purchase with your money, as a human being who has to actually live in this world.

It’s that Native American adage of “you can’t eat money.“

But I’m not saying to buy a house now. Buy now and get hammered.  I’m just pointing out that it’s the ultimate hedge against disaster.

Hedge against disaster?  In California?  Land of earthquakes, flood,  wild fires, earth slides and coastal erosion… 
Insurance for many of these is very expensive and limited in coverage, far from making you whole after a loss. 

Risk free investment?  I had a rental duplex tilt and rotate during the 1989 Loma Prieta quake in Santa Cruz, repairs ran 25% of the original value.  Place next door fell into the basement, a total loss; didn’t rebuild for 10 years.

I am planning to move to Irvine (from far far away- outside US) and I’ve been searching for in-depth information on the housing market. I believe IHB is the most insightful, informative and helpful site on the subject ever. Well done to IR and other commentors.

I’d like to ask for your valuable input on a business concept I am considering for a while:

Let’s assume that XYZ company specializes in property development and investment overseas. Thru this company, you can buy houses, condos or pieces of land in certain countries and sell at prices more than 25% of your purchase in just one year. you may of course choose to keep it for longer and enjoy more ROI. Would you be interested to invest? What factors do you consider to make such a decision?

Thanks,
CTI

I would personally go with the Nigerian money transfer scheme first, but that’s just me.

This is an excellent analysis. One thing that maybe needs to be added is that the U.S. is virtually the only country in the world where the rental equivalence part of owning one’s home is not taxed. For example, in all countries in Europe that I am aware of, the tax authorities determine what the equivalent rent of your residence would be, and you have to pay income tax on the “self rent” value of your home. This makes perfect sense, because it is an investment asset PLUS you do derive a benefit from it (rent free living). The “self rent” tax is a tax above and beyond (and in addition to) mere property tax.

The U.S. has a distorted tax regime where any residences that you inhabit yourself are taxed only as a property, while the benefits you derive from them are not taxed. This is in addition to the mortgage interest deductibility, which further distorts property ownership by allowing banks to charge a higher interest rate spread (since 30% of your interest is really paid by Uncle Sam).

It all sounds GREAT.  I’ve got a better investment, though, that will provide 35% return.  Really.  Guaranteed.  I’ll send you wire instructions to my Cayman Island bank account.

Oh, sorry to hear about that Kosovo housing deal.  I guess after they declared their independence, the Serbian government seized all the landholdings of foreigners.  Or was it the Mexican government that gave priority claims on the land to some guy who had a great great grandfather that used it for a chicken beheading ceremony.  Or was it the Nicaraguan government that nationalized your property.

Investing in foreign real estate is a minefield and foreign investors have lead boots.

I don’t know if buying a house is “risk free,“ whether as an investment or otherwise, and even if you own it outright, you can still lose value—a lot of it in the current climate.  But I think you are identifying a tension that I’ve noticed on IHB—namely, those who view owner occupied housing as a purely financial decision versus those who view owner occupied housing as something more intangible.  This was illustrated in one of the polls that asked about whether people would pay a premium to own as opposed to rent.

I agree with you that there is something stabilizing and comforting about owning a home (whether you own it outright or you have a comfortable mortgage and a significant rainy-day fund), as long as you don’t view your home as an investment that needs to generate a certain return.  Unfortunately, many people in the last 3-5 years bought more than they could afford, are in debt up to their eyeballs and came to rely on their houses as sources of additional income.  They are “owners” in only the broadest sense of the word—in reality, they have less stability than any renter because they no longer control their destiny.

Is there no limit to what government will tax if given the opportunity?

You are right, Micheal F.  It may appear distorted, but it is Uncle Sam’s way of encouraging home ownership.  When home prices were reasonable in relation to income, all this added to the allure of the US as the land of milk and honey - where a twenty something person starting his or her career couldown a decent home, a decent car and put ample food on the table, while not worrying about gas prices.  But all that appears like a distant dream and the white picket fence is beginning to rot.

I’m very interested in investing, but first I think you need to log in to your eBay account and reconfirm all your bank account information.  I was told that your account has been suspended.

Demographics have always played a big part in the value of RE.  Part of the reason so many of the War generation made money on RE is the fact they were followed by the baby boom; which pushed up the population and demand for housing rapidly.  Unfortunaltely, Baby Boomers will be selling into a smaller increase of population, and one with smaller families.

Was that a rhetorical question?

skek;

Thanks for the congrats and for the inquiry.  Yes, I feel I am an informed party due to monitoring these blogs.  I was also fortunate to buy in ‘98, paid 180k 4/3 2036 sq ft on a 80 x 200’ lot. 3 car garage.  Very nice development.  Peak was probably between 650k and 700k.  (‘05) I took a 400k cash offer but sold “as is” nothing wrong with the house but I didn’t have the “granitewoodfloorstainlesscrownmolding” kitchen/home.  It was in very nice condition, great backyard (fireplace/fountains, large sweeping hill view, no nieghbors can see into back yard).  So I don’t have to replace any cracked tiles (white tile in kitchen) and he is buying the fireplace/fountains and some of my furniture. (he is single and loved my decorating style!)  It is a win/win for both of us.  He had been looking for only forclosures so my house showed beautifully altho I had not painted in 10 years and he loves white applicances! I had aggressively tried to pay off mgt so I actually came away with over 230k.  I felt, why be greedy, I doubled my money in 10 years, pretty good investment.  Sorry, probably TMI but I feel good about it and so does the buyer!

not TMI at all, girlbear; I know I’m not the only one here interested in the experiences of well-informed sellers and buyers in this market. it sounds like you did very well by yourself, congrats. maybe IHB and calculated risk should start a sidebar chart of “money saved/earned by faithful readers.“ I’d be willing to bet the amounts were considerable. as a side note, neat that your buyer liked white in the kitchen—I do too, as I find lots of wood cabinets dark and overbearing and I don’t have the time/energy to keep stainless clean. I think this is a money-saving preference…though my IHB reading has convinced me to put off my US home purchase to 2010/11 so I don’t have to worry about it for a while!

I realize you’re trying to keep the examples simple.  Is the basic assumption in the example calcs that the rent = ownership cost for your NPV?

In your final example, doesn’t that mean the mortgage payment tilts in at about $12,000 with the additional $4000 and change taxes, HOAs, maintenance, insurance, etc. 

Of course we’d make the calc horribly complex figuring all the tax consequences, but given the often high HOA and Mello roos in several communities, they often typically flush any tax savings on the interest write-off.  So in the end, the 11.6% breaks even after seven years if your mortgage interest is equivalent to rent?

I feel like I missed something.  Granted, I can build a more complex model and get essentially the same results.  Frankly, a simple back of the envelope or thumb rule is likely what really drives the market as I don’t think many, if any, sit down and make complex calcs except large professional investors.

Good post IR.  However, I think you might have gone over a lot of people’s heads judging by the number of comments today.

That’s why it’s important to look at the historical numbers. I think IR would have done a great service by trying to tie in the number crunching approach with the historical numbers in a single blog. They are actually pretty close.

Perhaps Michael F should move to a socialist country

girlbear,

I agree with belle, not TMI at all.  Thanks for sharing and congratulations on selling your home (and doubling your money).

Seems like risk and trust are major concerns…(at least for buster and skek)... what sort of guarantees would let one feel assured for foreign investing?

I purchased a 2/br condo at $30k in 2003 and sold it at $110k in 2006, the same is now priced at $150k. I know this might seem unbelievable to people who don’t live here but it is very much true.

Can I have your views on the issue, IR?

Thanks for your feedback.

CTI

P.S. needless to say, I am not trying to sell anyone anything here. I just feel there is a very promising investment opportunity where I live and want to know if it appeals to people over there.

I don’t think you were taken very seriously. Your offer sounds like a Nigerian email scam.

Anyplace witnessing the kind of appreciation you are seeing is building a bubble which will pop. Asset prices do not quadruple in 3 years on a sustainable basis. Project forward as to what these will be worth in 2020, and you will see the absurdity of it.

Does “Real Estate Investment” include the abandoned Over the Hedge sets I saw along I-5 in the middle of the Sacto Delta?

Middle of the delta, nothing except rice paddies and rice dryers clear to the horizon, and there’s this 40 acres of McMansions (with back yards a whole TEN FEET deep!) and nothing else plopped down next to a rural onramp.  No support facilities (groceries, pharmacies,gas stations, etc) in sight.  Just forty acres of yuppie pink McMansions, walled and gated, with billboards pimping “INVESTMENT Real Estate!!!!“.

“Nothing more remains; around the walls
The lone and level rice fields stretch far away…“

Just looking at the first example:
I put $40,000 into the deal.
After 30 years I get $544,000 back.
That give me an Internal Rate of Return of very slightly more than 9%.  And that analysis does not consider any positive (or negative) cash flows from the rental income that will at some point be greater than the carrying costs.  Depending on the GRM at time of purchase, it may be fairly soon.

However, your analysis does very well illustrate why it is necessary to consider a Real Estate purchase a fairly long term investment.  Transaction costs are pretty high for all aspects of it.  Buying, financing, selling, renting, move outs, all reduce cash to the owner.