Primary Residence as Your “Best Investment”

by Mr. Cheap

Welcome to Money Smarts! If you're new here, please read the "About" page to find out more about this site. If you would like to receive updates by email then sign up here or you can subscribe to the RSS feed. Thanks for visiting!

I always hear from people that their primary residence has been their “best investment”.  Usually this is accompanied by something along the lines of “it’s worth *8* times what I paid for it!” and a satisfied smirk.  As with many things, I suspect that people with this view are selectively interpreting the data to support the conclusion they want.

The actual return from a primary residence is tricky to calculate.  There is the sale price which can be compared to the purchase price, but there is also a massive amount of expenses that have been paid over the years (taxes, maintenance, utilities, etc).  On the other side, a primary residence lets you avoid paying rent, which must also be accounted for.

Last year, Ramit Sethi had a great post “Be the expert:  What’s wrong with this real estate comment?” where he quoted the following statement:

My father bought our family house in NJ for about $27k in 1964; sold it for $350k in 2000. Home ownership is terrific long-term investment.

and invited readers to critique it.

Erica Douglass, another blogger, gives an excellent analysis (along with other commenters), talking about how the house underperformed the market annually by an average of 4% BEFORE any expenses were paid.  Commenters calculate that the father could have put the money in an index fund, then spent almost $40,000 a year in rent and been in the same finanical position.

We’ve had a distortion in the real estate market over the last few years, and while I don’t think the sky is falling, I also don’t think it’s realistic to expect anything close to the returns we’ve seen over the last decade. This has been an extreme outlier, once in a generation, period in real estate.

Money Pit

People my age (mid 30′s) have never experienced it, but in the past real estate has had long period of no appreciation.  The view at those times were that houses are a money pit that you keep shoveling cash INTO (instead of ATM’s you can take cash out of as we’ve all been doing recently).  Rather than a massive crash where everyone is selling their home for 1/2 what they paid for it, I suspect what we’ll see is a long period of little or no appreciation as we pay for the party we threw last decade.

Rachelle recently posted a great quote from one of Warren Buffett’s letters to investors:

The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities — that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future — will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.

Never Buy Real Estate Again?

Am I saying that no one should buy real estate for the next decade?  Of course not.  I’m just arguing that, today, a primary residence should be viewed primarily as a consumer purchase:  something you’ll enjoy owning.  Like a car, it will possess some value, but buyers should be primarily concerned with whether they can afford it or not instead of what they hope the value will be in the future.  Similarly, investment real estate should be viewed based on its monthly net income, with very little expectation of appreciation.

For those of us who have done well recently in real estate, congratulations!  We shouldn’t expect to repeat it…

Be Sociable, Share!

Want to learn more about RESPs? Buy The Book:

Resp-Book

The RESP Book: The Simple Guide to Registered Education Savings Plans

Everything you need to know about RESPs.

See it on Amazon now

Welcome to Money Smarts! If you're new here, please read the "About" page to find out more about this site. If you would like to receive updates by email then sign up here or you can subscribe to the RSS feed. Thanks for visiting!

{ 25 comments… read them below or add one }

1 Michael James

A common “house investor” type is the person who can’t save unless forced to do so. Owning a home limits the ability to waste money on foolish things. Compared to investing in a stock index, home investing rarely looks good. But home investing looks very good compared to “investing” in clothes and cars.

2 Rachelle

There is a base cost of housing almost anywhere you live. One tactic I would suggest to new home buyers is to apply their rent money to their house purchase. This will mean just replacing one expense with another. When I bought my house I was paying $750 per month in rent.

It will mean lowering your standards but there is always to opportunity to improve the property further on. In my case the house boasted one kitchen cupboard, and I had to live with it for 5 years until I had the money to invest.

The problem really comes from the idea of stretching your budget, increasing your housing costs and getting a dream home.

3 Mr. Cheap

MJ: I think you’re right. Surprisingly I’ve heard this from people who have done quite well in other investments (such as mutual funds), but they still convince themselves that their home was a better investment.

Rachelle: Yes, I think that would be a great strategy too. Typically, I think people do the REVERSE: if they’re going to buy, they want to buy their dream house.

4 Mike

It is very difficult to measure the return of a house. The amount of leverage is a big factor as well. Most people compare a house return (very leveraged) to their regular investments which usually involve no leverage.

5 Potato

I am a big sky is falling guy, though it depends on the area we’re talking about (Vancouver and Toronto are much worse off than say Charlottetown).

I thought the flatline-until-we’re-back-to-fair-value scenario was likely back in 2006, when we were moving out of the high-rise apartment into something a bit bigger & quieter, and found it was just as cheap to rent a house as buy one since real estate had just had two or three good years… but it’s gone up another 30-some percent from there in the GTA. I think at this point some negative movement is inevitable.

Even I’m not saying never buy it again, just wait for that 30-40% correction to come in the next 3-4 years, and then buy :)

6 Mich @BeatingTheIndex

People also proudly boast how they made 50k on their house where in some instances if they added up the taxes, the interest and the maintenance fees they would barely break even or just declare a much lower amount for profit. That’s not taking into consideration if they paid a fee to sell it or not.

7 Mr. Cheap

Mike: Yes, I actually thought after this went live about the leverage element. I’m certain that the index fund would still dramatically outperform (it would be interesting to run the numbers as closely as possible, considering a 20% downpayment vs. putting the downpayment in an index fund, and including interest, rent, expenses, inflation, etc).

Potato: I agree that it’s completely market dependent (look at the US), and that Vancouver is in a much more precarious situation than the rest of Canada. I *HOPE* we see a 30-40% correction across the board, but I suspect this will only be with McMansions, not any real estate that I’d want to buy…

8 James

I somewhat agree and disagree with this post. You have to live somewhere — things like utilities and maintenance should be considered your personal living expenses, and not factored in when considering a primary residence an investment. Or at least as the poster suggest, to subtract the theoretical rent you would be paying. And as a recent homeowner myself, I hope others are enjoying their home as much as I am — compared to other investments, you don’t get any real tangible benefits from owning stocks other than the financial.

Anyway, I think the main benefit of primary residence (at least in Canada) is that it isn’t taxed. That’s a huge benefit if you’re in a high-income tax bracket.

9 Financial Cents

Great post.

I don’t know how this current real estate market is sustainable; certainly not IMO beyond a few more years. Although I have no tangible proof at my fingertips, I would argue that most people would be bankrupt if prime got back to “normal”: 5-6%, let alone what the average has been since 1975: 8.6%

http://www.canequity.com/rates/prime_rate.stm

Given the recent run up in real estate, I think we’re headed for a lull or better still a long plateau at best. I agree with you, I’m not against real estate as an investment (we had a rental property up until 8 months ago), just don’t expect “past performance to be indicative of future performance.”

10 PDUB

In the long-run house appreciation moves lock-step with wage increases. Apply that theorem when you are forcasting future house prices.

11 Patrick

@James: I rent, so I don’t pay maintenance or (some) utilities. How can you justify ignoring those costs when they are costs renters don’t pay? If you’re going to ignore them, you should let me ignore them too (that is, subtract them from my rent) when we discuss the relative cost of the two options.

12 larry macdonald

A precondition for house prices to tumble would be an inversion in the yield curve and we are a long ways from that.

13 mg

@Patrick… exactly! Also, let’s not forget rent control. The landlord fixes my broken appliances, maintains the common area and provides me with utilities… all included in rent! If I have a crappy landlord or want to move to a new city, I just leave with 60 days notice. A lot depends on what you want as a consumer, which is part of the point of the article. If you like living in your apartment and you know how to save, then you’re probably going to be just fine. You don’t need a house as an ‘investment’. If you want to host dinner parties, then you’ll need a house.

14 Rachelle

Good lord! There are many benefits to owning a home and most of them revolve around not dealing with landlords.

My very first landlord accused me of bringing in the hordes of cockroaches that appeared the very first day.

My second landlord would come in and steal small items from my house. He modified my lease and wanted to charge me $100 more a month.

I work in buildings myself and wouldn’t rent in 90% of them. I challenge you to find one building in Toronto that doesn’t periodically have cockroaches and now bedbugs. Then there’s the risk that your neighbors are total idiots, smoking pot, partying, selling drugs or running guns. These are all things I have dealt with as a property manager.

Plus as a tenant you are always at risk of the landlord dying, deciding to sell, losing his house, going crazy or a number of other unpleasant things that will cause you to have to move.

I’ll keep my house that I paid the exact same as my rent for.

15 Patrick

@Larry: You know more about yield curves than I do, but aren’t short-term yields currently artificially low because the central banks are keeping them low? What happens when the central banks start to increase their short-term rates? Rates on 20- and 30-year treasuries are currently lower than they were at the start of 2007 when the curve was inverted.

16 Jay

@Rachelle: “I’ll keep my house that I paid the exact same as my rent for.”

That line of logic doesn’t really account for lost opportunity.

Eg. A simplified scenario: you bought 10 years ago for $150k and your monthly mortgage payments are only $800. Maybe your expenses+interest work out similar to renting.

But what if you could sell now for $400k. How much income could your capital generate?

And, all that aside, the point is moot for new buyers in any major market or out west. In many cities it’s almost impossible to find a place where buying is the same cost as renting.

We just looked at a place to rent for 1700/month plus utilities. The house was listed at $475,000, but I think something comparable could be had for under 450k.

Even if you got a “deal” at $440,000 your interest costs alone would be about $1470 per month. If you paid part or all in cash, your opportunity costs would be similar (or more).

Taxes are about $250 per month.
Repairs/maintenance could easily average over $200.

Right there you’re looking at almost $2000 per month to own so a new buyer is either:

a) counting on the price to increase enough to cover the extra cost associated with own owning (plus the costs to buy/sell)
b) making the purchase with the knowledge that they are spending the extra money because of the “benefits” of owning
OR
c) deluded into thinking that it is a good “investment”

I think that the vast majority of first time buyers in the past few years fall into category c. The main problem being that they may have compounded the issue by overextending and that some may be in trouble when interest rates finally rise.

I still agree that ownership can be worth the cost, but I don’t think it is a great investment, and in the current market I don’t see how someone with an average income could crunch the numbers and actually justify the price.

17 Rachelle

@Jay

My house had one cupboard for 5 years and a basement apartment which was rented for $800 per month.

It’s in Scarborough.

It is also completely paid off.

I don’t give a rats ass about opportunity cost. Canada is too cold to live outside. I challenge you to shelter yourself with stock certificates. I also have a van which is old and paid off as well. I’m not selling it either so that I can walk because I’m losing opportunity cost on owning the van.

Buy a house that is reasonably priced in an area you can afford. That’s not $475K What you want is a cheap dream house that will check all your “must haves” Get Real!

Buy a crappy cheap house and make money on the improvements you make and appreciation. For instance Scarborough is mentioned by the REIN network as the #1 place in the GTA for future appreciation. It’s not rocket science. There’s no such thing as a free lunch.

18 Jay

@Rachelle: Congratulations, but you missed (or completely ignored) my point.

A house that is “reasonably priced” doesn’t exist where I’m from (BC interior). The houses in the neighbourhood where I bought 7 years ago were affordable at $200-250k. Now they are unaffordable to most at $400-500k.

Why should a new buyer get into this market? The cost of renting is much cheaper.

And if they still can, why shouldn’t a current owner get out? I think that a few hundred thousand in equity provides a little more opportunity than a van.

As I said before: I don’t see how someone with an average income could crunch the numbers and actually justify the price.

Your last post didn’t provide any reasons for buying except “make money on the improvements you make and appreciation”. Sounds like speculative investing, but what if the long term appreciation is too low to justify to investment? Or worse, what if it’s a money losing “investment”?

Try looking at the numbers before replying this time, and let me know if you have a valid reason to suggest buying right now.

19 Rachelle

I have done extensive analysis of this exact issue. I am in Toronto which is a major market and one of the overpriced ones.

Just earlier this year I was discussing this exact same topic on Canadian Money Forum http://www.canadianmoneyforum.com/showthread.php?t=2529. In that case the person would have been able to replace the rent he was paying with a condo. He did not have enough of a down payment to be comfortable in buying. I went and met with him and we both saw the condo unit which was ok but certainly far from great shape. It can be done.

He was paying 900$ per month in rent where he is now. The condo would have cost him a little less including all utilities and maintenance fees. The building is perfectly acceptable in better shape then most rentals. I know this for sure because I have and investor I rent for who I have been working for in that exact same building. I have been renting that suite in that building for 5-6 years now.

For myself and my numbers, my mortgage was $750 and the tenant paid $800 per month. Utilities ran about $150 per month and taxes were about $200 per month. I also had to pay utilities at my last place which was an industrial loft space. My landlord had my hot water tank hooked up to my neighbour who was a jeweler and had an electroplating machine. What I learned was that electroplating machines use tons of hot water. I had to pay the bill for that which was about $400 per month. My housing expenses decreased when I bought a house.

Because I’m the way I am I made double mortgage payments. The second payment goes 100% towards your principal. I also made annual maximum 10% prepayment towards the principal. The final payment was $16,000.

During those 5 years I had no social life, I worked 18 hour days regularly. By the time I was 30 my house was PAID.

If I sold my house for $400,000 K and put the money in the bank @ 2% today I would have to find a place for $666.00 per month plus utilities. I have my office down in the basement apartment now… but anytime I choose I can rent it out and get $850 or so per month in rent.

If I were to risk my money in the stock market I might achieve higher gains but also risk my principal.

Please Jay run the numbers and tell me why I should sell my house which is free and clear and keeps me safe and dry so that I can deal with bedbugs, other rude tenants that smoke weed and drink, cockroaches, landlords selling their houses, moving with my husband and son and all the hassles that come with that. My budget would be about $700 per month plus utilities. To replace my current house it would cost me $1400 plus utilities.

Plus I’m self employed which means that at times I have lots of dough and other times I don’t have a cent. My overhead here is very low in regular bills.

I have a freedom most people could only wish for. That’s priceless.

20 Jay

Rachelle,

“I have a freedom most people could only wish for. That’s priceless.”

I can’t disagree with that statement. If that’s what you’ve achieved and what you value, then owning is for you.

However, some people prefer the freedom of renting because it allows them to pick up and move. Some people look at it from a purely financial standpoint. Priorities for each individual will be different, even if they could accomplish what you did.

Your scenario didn’t just materialize though. Your “freedom” came at the price of some sacrifices:

“During those 5 years I had no social life, I worked 18 hour days regularly.”

Sounds great. I can see why you’re such a proponent of buying.

Even if you wanted to. Could you buy into the market now and accomplish the same thing? Probably not if the house is worth 400k.

If you had 400k and were extremely risk adverse you could put 300k in a 5yr GIC for 4% and 100k in a savings account at 2%. Than would generate about $1166 per month (before tax).

If you were a little less risk adverse you could probably invest in a conservative income producing portfolio that would generate over 5% annually after tax, or about $1700 per month. You would save $200 on property taxes, $150 on utilities, and probably a few hundred a month on maintenance and upkeep.

That would leave you anywhere from $1500 – $2350 after tax for rent/utilities, and that’s very conservative.

“If I were to risk my money in the stock market I might achieve higher gains but also risk my principal.”

Leaving your equity in your home isn’t risk free either. Your principal could very easily drop from 400k to 300k in the next few years.

Your situation is obviously more stable than a new buyer, but even then, I would still think that the choice to sell or rent would depend on your personal priorities.

The numbers for a new buyer just don’t add up. Most enter with less than 20% down, and even spending 250k to get into the market right now is extremely risky.

I know people who did that in 2008 and are already underwater. They’re adding a suite themselves and will probably be fine, but if either of them lost their job or had to move, they probably couldn’t even afford to sell (after selling they would be out of pocket upwards of 30k on a half duplex that originally cost about 260k).

Even if the market just stagnates they will remain in a precarious position.

So why would you recommend that someone take a huge risk, borrow 6 figures and “Buy a crappy cheap house and make money on the improvements you make and appreciation.”?

To do that, they would have to be speculating on appreciation, and as this post is all about – that’s not something it is wise to count on.

21 Rachelle

Jay,

I’m really sorry that I don’t know your area better.

I could buy into this market. That’s because I don’t suffer from the lies people believe.

First of all I don’t believe a house is an investment. It is more like a car to me than a stock. It’s something I need. (I can’t take transit because I’m claustrophobic.)

The value of the car to me is that it efficiently takes me from one spot to another.

The value of a house is that it keeps you warm and dry because it’s too cold to live outside.

The house and the car have an intrinsic value. I get very upset when my house and car leak or won’t start.

So for me the question isn’t could you a buy a 400K house but how can I purchase a place out of the cold and wet? I want to reduce my housing costs.

People see houses as status symbols and investments. They don’t want to sacrifice area or convenience or work hard. They want to have their cake and eat it.

To someone like me it’s like talking to someone who wants to buy a $2400 Louis Vuitton Purse but can’t afford it and complains how expensive purses are. How about a $20 purse from Walmart ? The intrinsic value of a purse is how much stuff it holds.

It doesn’t matter how much my house is worth on the market because it has an intrinsic value. The intrinsic value is the same no matter how much money it costs. I’m not buying or selling so I don’t care. The market dropped to less than I paid? Doesn’t matter!

I have friends who have told me to buy a new van because my old van is rough around the edges. It is starting to have rust spots, the back hatch doesn’t work properly and recently the window on the passenger side stopped going up and down. I now have tape covering the switch so I don’t forget and roll it down :) My van is 10 years old.

I have no plans to replace it anytime soon, the tires are still round, the engine and transmission work well. It does the job of schlepping my fat ass from point A to point B remarkably well. It doesn’t impress my friends or clients. I don’t care! If my friends aren’t impressed by me and my personal characteristics F@#$ them. How much extra will my clients pay me if I have a more expensive car? Nothing? F##% them too.

It’s the same with my house, it is not a nice house, it is 800 square feet including the garage, it has two bedrooms. The dining room is so small I had to shop and shop for a table small enough to fit.

If I had to buy a house today I could do it again. I could go live in Oshawa where house prices are more reasonable. I could rent out rooms, in short I would do whatever I had to do to make it happen.
The house next door was for sale for $400K and I seriously considered buying it. It has 4 bedrooms and a 2 bedroom basement apartment. My thought was to rent it out as rooms to pay it off. Developers are building townhouses on my street. The people on the other side of me are retiring in a few years. I could buy their house too. That would give me about 180 x 120 in lot space to build a townhouse complex.

If I lived in BC I would probably buy a mobile home or move further away from the city. In any case I hear the market is going down there just like here.

I wrote a post about it at my blog http://landlordrescue.ca/wordpress/counting-appreciation-speculation/

I’m not your average bear, I know this :)

I refuse to follow the masses. They want to buy a nice a house in a nice area? I want a place out of the cold. They lease cars? The most I’ve paid for a car is $1200. They work for other people? I can tell anyone I work for to stuff it at any time and go find someone else to work for. They want to make lots of money? I want to keep lots of money in my pocket. They care what people think of them? I don’t. They want to buy index funds? I buy warrants. I could go on.

22 Andrew

To Rachelle up there: You make renting sound like a constant battle against the dregs of society. Gun-running? C’mon. I’m 30 and have been renting in large Canadian cities (including Toronto) for twelve years, mostly pretty happily.

23 Patrick

@Andrew: Same here. Rented all over Toronto for over 12 years and I’ve enjoyed each place (though I’m glad I moved out a few months before this happened).

24 Rachelle

I worked in higher vacancy buildings that may have skewed my perception somewhat. :)

If you’re happy you’re probably paying more then I’m willing to for rent. I’d probably like living in a condo but I’d be unwilling to pay the price delta for doing so when I could move to Oshawa and buy a house for less.

25 Patrick

@Rachelle: That’s a bit of a non sequitur. If you’re willing to move to Oshawa and buy, you could move to Oshawa and rent, and save even more money. Besides, I could easily say that if you’re in a condo, you’re paying more than I’m willing to in condo fees, mortgage interest, property tax, repairs, and maintenance.

The only rational way to approach the financial side of the decision is to compare all the costs.

Leave a Comment

Current ye@r *

Previous post:

Next post: