Hi Friendos,
I hope you are not spending this fine spring weekend indoors working on a last-minute tax return. If you are and need a second opinion on something or just have a question, don’t hesitate to reply to this email.
At my full-time job, I recently had the opportunity to work with an economics professor who has studied residential and commercial real estate for decades. His way of understanding the money side of home ownership struck me as clear, consistent with how I think about analyzing a home as an investment, and clarified my own thinking on why the investment analysis aspect of owning a home is not all that important, but the consumption analysis is crucial.
This professor analogized returns from home ownership as being like returns from owning stocks in that there are two ways you can receive a return on your investment: (1) periodic dividends, net of holding costs (property taxes and home maintenance costs) and (2) capital appreciation (or depreciation) received when selling a home. Your total return is the sum of those two components.
The dividends a homeowner receives are in the form of housing services: every month they get to live in the home and don’t have to pay rent to someone else. Economists call this “owner equivalent rent” and it is a big component of the consumer price index (CPI) – the official measure of inflation. This stream of in-kind dividends is generally the largest benefit someone gets from owning the home they live in and might be equal to something like 5% per year, ballpark.
A homeowner does not realize capital gains (or losses) until they sell. At that point in time, the sale price should reflect the value of that home’s future stream of dividends which the buyer expects to receive. Selling a home monetizes those in-kind dividends for the seller. Capital gains might be something like 3% per year, ballpark.
As a simplified example to measure total returns to home ownership, consider a home that was purchased for $500,000. Imagine the home could be rented out for $39,000 per year (=$3,250/month * 12). After paying property taxes of $6,000 per year and setting aside $8,000 for maintenance and repairs (not all of this is spent each year, but larger infrequent repairs will use this up over time), the owner nets $25,000 per year from the property. This is a dividend rate of 5% per year (calculated as $25k / $500k).
In this stylized example, suppose the owner decided to sell the property after one year and receives net sale proceeds (after paying broker fees, lawyer fees, and other transaction costs) of $515,000. Their capital appreciation is $15,000 (=$515,000 – $500,000), or 3%, over that one-year period. Their total return is 8%, comprised of the 3% capital gain plus the 5% dividend discussed above. You can imagine extending this example over multiple years, accounting for dividends that might change over time, considering the effect of inflation, and incorporating other elements that impact the cost of home ownership.
This analytical framework is the same one that lies behind the New York Times “Rent vs Buy” real estate calculator. I spent some quality time with that calculator back when I was buying my first home and I think it is absolutely the right way to analyze returns to a real estate asset. It also did not help at all in my own rent vs buy decision! Why not? I think because a home you own and live in is partially an investment product and partially (mostly) a consumption good. Investment calculators can’t help you decide how much to spend on a consumption good.
When you own a home, you fully consume your dividend every month, by living in the home and enjoying the benefits of the shelter and all of its amenities. It’s deeply different from other kinds of investment dividends where you have a choice to spend them, reinvest then, or give them away. With owner-occupied housing, your only option is to consume the stream of housing services, constantly. More expensive and fancier homes provide larger dividends, and cost more to purchase.
The capital appreciation part of owning a home – that really is an investment, just one that often has small (or zero, or negative) returns. But I don’t think that means it’s a bad idea to own a home – it just means that the more helpful analysis is to look at your budget and decide how much you want to spend on housing vs retirement saving vs giving vs other spending and everything else.
I recently saw the Zillow estimate for the value of my parents’ former home, which they owned for 33 years. During that 33-year period the estimated value of the home increased by 2.6 times, not much more than the rate of inflation over that time. Economists would say they did poorly on this investment, but I totally disagree with this conclusion. The investment analysis does not consider:
- They had two wonderful dogs while they lived in that home, something many rental homes do not allow.
- They got to paint walls, put up wallpaper, have or not have rugs, and otherwise decorate their home in just the way that brought them the most joy.
- There are effectively zero available rental homes in that neighborhood, which they thought was “idyllic,” so if they hadn’t owned their home, they would have had to live in a totally different neighborhood or town.
- Homeowners usually live in a home for longer, which gives more opportunities to get to know the neighbors and be involved in the local community. This is especially helpful for shy people.
- They took pride in maintaining their home and keeping it in good condition. I too have felt a pleasure in maintaining my condo that I did not experience as a renter.
It is so easy to find discussion of housing as an investment and it can get very technical and overwhelming very fast. I can certainly hang with these conversations, but I think it’s a bizarre way to think about where and how to live. If you have the financial means to own a home, I think you should first decide what kind of housing services you would like to consume, and then think about the most financially effective way to accomplish that goal.
-Stephanie
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