Housing: Place to Live vs Investment

Picture of a house with a $ sign on it

Whether you want to buy or rent you need to determine how much of your money you want to spend on housing.  The more money spent on housing will subtract from retirement savings, food, travel, entertainment, and more.  There is no correct budget that is right for everyone.  You must determine your priorities when making the budget.  Once you have an ideal amount to spend on housing you are halfway there.

Why total house payment can exceed rent, but still be Cheaper

Now if you decide to buy a house the total mortgage payment plus property taxes, insurance, and maintenance can actually be higher than than comparable rentals.  This is because if the home is lived in long enough and the majority of it has been paid off, then you now have an asset that can be sold to offset the higher amount spent while living there.  Conversely, If you were to rent you could invest the money you saved each month with the lower rental rate by not buying.  So in the end if you buy a house you get some home equity, if you rent you have larger investment assets.

Stay Diversified

Before you buy a house, understand that if you sacrifice other investments completely that you are non diversified.  Having all or the majority of your wealth in a home can work out just fine under ideal conditions, but if housing lags stocks and bonds in the future, it could turn out to be an unwise decision financially.

Therefore, beyond just making a budget for how much you can afford to spend on housing it is important to consider how many you would like to contribute to retirement savings.

Homes are the least liquid Asset

Further it is important to understand money in a house you live in is very illiquid.  Stocks can be sold in minutes logging into your computer or even a cell phone.  To sell a home, you must list it for sale, find a willing buyer, and pass escrow to collect your money.  As long as you are able to live in the home for a long time, and have an emergency fund plus some diversified investments, then you are better insulated from loss, should you need to sell the house and move for any reason.

How to compare monthly rent to the purchase price of a Home

The New York times has a wonderful calculator to compare rental rates to home prices.  You still have to give estimates for many unpredictable factors moving forward, but at least it takes into account opportunity cost in buying vs renting.  Earlier I mentioned that it is possible to have a higher payment on a home you own vs rent and still come out ahead.  Using the calculator can help you determine what these levels are.  It will show what an equivalent monthly rental rate would equate to in terms of total purchase price of a home.

So buying a home at the right time, or accepting one with less features can actually save you money over renting long term.  The problem is most of us do not know how much we really should spend, and find it all too easy to go well beyond our budgets.  By setting a budget including healthy retirement savings and using the calculator you can determine an appropriate price to pay for a home.

Is Owning a Home Really That Different Than Renting?

Many people will lead us to believe that owning is always better than renting.  This seems true on the surface, but there really are not statistics that back this up implicitly.  Rather, at different times in cyclical economic conditions renting and owning can shine at different times.

Property Taxes an obstacle to true Ownership

Many believe that if you can pay off the mortgage then you will be assured of a roof over your head no matter what.  Yet this is not actually a true expectation.  Ownership does not mean you can do anything you want with your property either.  Ownership has drastically changed throughout history.  Even in feudal times land was granted by the king and in return the landholder had to work the land, growing crops to return to the king to continue having use of the land.  In the current system ownership can be thought of as a set of rights.

Government code and policy on property Rights

Many would argue that once you own a  home you can do whatever you like with it.  There are many levels of freedom that you can enjoy and customize your home to your delight, but these actions must fall within the guidelines of the rights you have of use.  There are many things you cannot do without prior approval, permits or fees.  This is due to city zoning laws, city permitting requirements, community CC&R’s, and other ordinances.

Now that we have made the distinction between ownership and right to use let’s look again at the difference between buying real estate and renting.  Almost any form of real estate can be rented so if you buy a single family house, because you don’t want to live in an apartment this is not a great argument as someone can just rent a single family house as well.

A major advantage to renting is having the right to move.  Say a new neighbour moves in next door that you cannot stand, or you have a better job opportunity in another state you can make the move very easily.

Home Ownership Pros

  • If purchased with a a non-recourse loan you have some protection in the event of a natural disaster destroying the home or choosing to walk away if the home goes down in value.  In the stock market we can think of this as owning a put option.  The morality of this move would have to be taken into account by each individual.
  • Helps stay diversified by only putting a small portion of total net worth into the home, and can possibly make more money in other investments.
  • Significantly reduces living costs.  More money to invest each month elsewhere not having to pay rent.
  • Essentially earn the money saved on the interest rate.  For instance if mortgage rates are 4%, by paying cash you are saving yourself from spending 4% of the purchase price for 30 years on a traditional length loan.
  • Feeling of security that the home is paid for.
  • Emotional satisfaction in pride of ownership
  • Can customize
  • Can save money doing maintenance yourself or defer it altogether if cash is tight
  • Cannot be evicted for no fault of your own as long as you pay mortgage and property taxes
  • Can grow equity in the home in rising markets

Renting Pros

  • Can move relatively easily and cheaply
  • Will not lose money if the building is destroyed in a disaster
  • Ability to rent the size and location needed at the time in your life to save money, but can still move to something else when goals and desires change.  Essentially assured that you are only paying for what your current needs are.
  • Can easily move for better job opportunities or if you no longer like the neighborhood
  • Less money at risk in falling markets
  • No opportunity cost – Can invest in higher yielding assets

Is Now A Good Time To Buy A House?

Buying a home can have large ramifications for ones financial future.  Being able to buy at the bottom of a cycle can be very beneficial, whereas the top can be costly.  The only way to lessen the impact of these concerns is to come up with a reasonable budget to spend on the home.

If you spend the max amount a mortgage company approves you for, then the housing market prices can greatly affect your life both for the better and worse.  Purchasing a home well below the max approved loan amount will help to limit the magnitude it will have on your finances.

Important question to Ask

The only question you must ask is “Does this house serve my needs?”  Even better, “Am I excited to live here?”  If the answer is yes to both and it is in your budget, then it is hard to go wrong at this point.

In regards to the housing market if you purchase at the high of the market, but are not highly leveraged and can easily make your payments, then you are not affected.  Granted if the market drops heavily a few months after you buy, it will still be disappointing, but not life altering.

Resist The Fear Of Missing Out

Another concern people have is that if they don’t buy something now that they will miss out being able to buy ever.  It is important to believe that if you save your money and make diversified investments that you will have an opportunity at some point to buy.  Even if home prices keep going up, if your stock, bond, and other investments go up too you can keep up to an extent.  With the leverage that mortgages allow it is possible that the home prices will still outpace your investment returns.  While this is a risk, it is better to take, than buying something you do not like.  Now consider the alternative if home prices substantially drop in price?  If you purchase something you only would be happy to live in for a few years, you may be forced to stay much longer than intended.  If you continued to rent instead you would have an easier time living somewhere else if desired.

Considering a Home as a Financial Instrument

The only striking difference between owning real estate and renting is in the term of ownership and cost.  Essentially thinking of housing as a financial instrument.

Earlier I argued that whether you rent or own your home your actual experience does not differ all that much.  Please remember that anything that can be owned can be rented so you must make comparisons between comparable structures only.  IE buying that nice house with the private yard or renting that same exact nice house with a private yard.  Now generally speaking over time it costs more to rent that place than it does to buy.

Opportunity Cost

If you could only keep any extra savings you accumulate in a bank account paying 0% interest I would tend to agree that everyone that possibly can should buy a house right now.  The big advantage to buying is that overtime the principal is being paid down and effectively locks in your housing costs other than property taxes, maintenance, and insurance. A good hedge against inflation is housing costs.  However, that extra savings you have does not only have the alternative option of 0%.  It can go into stocks, bonds, or even real estate that you rent to someone else.

The less you put into your home, the more you have available for other productive assets that will increase your retirement income.  One should question the argument that owning a home is always being better due to its protection from rent increases.  Rather this protection comes at a cost of your initial down payment and annual property taxes.  This same money that could instead earn a return in other investments.

In a simplified example you can put your money in a house and lock in the majority of your right to use costs for life.  Or you can rent a place and own stocks and bonds and use the investment income to pay for rental rate increases.

Why Owning Real Estate as a Landlord May be Better Than Living In It.

I have heard people say that the first home you buy should be an investment property.  This seems very odd at first, but when you think about it, there is a lot of sound logic behind that statement.  Above we we have outlined the true costs of ownership.

Real Estate market value only returns 1% per Year

One of the main reason is the opportunity cost of putting large sums of money in a home. Robert Shiller has won a noble price for his work studying housing and came to the conclusion that on average single family homes gain 1% per year in market value.  This will be the return whether you live in it or rent it out.  A lot of people buy a home to live in thinking it is an investment, but it should better be thought of as a consumption item that has a marketable floating price.

The difference between the two results in that the house you live in costs you money each month in mortgage interest, property taxes, insurance, and maintenance.  The rental property, if managed well, will provide money each month in the form of rent (similar to a stock dividend) before subtracting operating costs.  Now generally unless you can contract out a lot of the responsibilities you will have to spend some time managing it.  Therefore, Investment real estate should be thought of as running a small business.   The more work you do yourself the greater the return will be.

Now just because you can make profits renting our real estate does not mean there are not better investment options available.  It is important to weight risk and return of all available investments.  Therefore, the timing of the purchase will have a great impact on how well it performs just as would the timing of buying stocks and bonds.

REITS – How to be a landlord without answering the phone

If you have a strong believe in rental real estate being the best place to invest your money you may best be served by investing in REITS.  These are companies that invest in hundreds and thousands of different types of real estate.  This may include office space, retail, single family homes, apartment complex, and even trailer parks.  You can buy ETF’s that own a mixture of all of the above.  The benefit to reits is they are professionally managed.  You do pay for this service as management costs are deducted from profits before any money is returned to shareholders.  Depending on the company these fees can be quite reasonable due to economy of scale.  They can hire employees to oversee many developments at once, think bulk discounts at the grocery store.

Benefits

  • Diversification!  For most buying even a single rental property would be a big deal.  If anything goes wrong with the house itself, the neighborhood, or bad tenants could lead to substantial lossed.  REITS can have a few properties drastically underperform, but still turn a nice profit overall due to the large scale of its portfolio.
  • Expert Professional Management.  The individual real estate investor can have high and low levels of experiance.  Either way it still would be a challenge to compete with the big boys so why not join them.
  • Truly passive income.

Major Difference

  • If you purchase rental real estate with a mortgage you will be employing leverage.  Many REITS also are using loans on their properties so their returns are magnified as well, but likely not to the extend that an individual real estate purchase would.
  • With REITS you cannot do work yourself to add value.

A Third Option. Living in a Tiny House?

Tiny House or Trailer

Tiny Homes are essentially trailers.  There are different jurisdictions by state / county, but in general they are treated as some form of a mobile home.  Most mobile home parks only accept manufactured type trailers without wheels.

At the moment there are not that many places you can legally live in one of these.  Yet there have been movements in some cities to expand these possibilities.

Parking on friends or family’s Land

For most Tiny Home buyers they will need to find a mobile home park that will accept them.  If they are fortunate enough to have family or friends with a big plot of land in a more loosely zoned county this could be a fantastic opportunity.

Buying your own Land

If friends and relatives are not an option then buying land will give the owner some good benefits.  The value in real estate appreciation is in the land.  People miss this when they go home shopping.  The structure is a liability and money will have to be set aside for maintenance for the duration of ownership.  The land for the most part is indestructible.  By owning the land that you place your tiny home on, you are effectively putting most of your money into the one part of real estate that makes money.  This is great, but it is very hard to find anywhere other than very rural small towns that will allow you to live in something on wheels without another primary structure in place.  Further, even if you can find the place, there will still be large costs to hook up utilities to the Tiny Home / Trailer.  For the amount being spent to get on the grid it might make more sense to build a small stick built house, or a small manufactured home.  This may have a wider reach of buyers if you later decide to sell.

A Tiny Home is not a camping Trailer

I know many people want to buy the Tiny House for portability so they can use it for traveling.  The problem with this approach is that they are not built to be towed around on a whim, like a normal camping trailer.  Most need special transport to move from location to location.

Summary

Real Estate and home ownership comes in many different forms. From homes you own or rent to live in. To investments that you physically manage or own as part of an investment company passively. The possibilities are vast and it is important to understand the differences so you can make the decision that suites you the best.

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