Primary Residence as Your “Best Investment”

by Mr. Cheap

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…

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