June 18, 2013

Why a House to Live in is Always a Good Investment.

Another off topic article, but good information for equating personal finance and business financial decisions.

Our homes are typically our largest purchases in our lives.  I try here to add a little business thought to the process.

To understand and project a return-on-investment, the investment must be looked at from and with a business mindset.  This is true whether we are in business or making personal investments.  This is not a simple process when our home is the investment - there are intangibles and emotions to consider (which I won't here).  There are also location and demographic considerations (big ones).  These complications are compounded by the fact that the economic environment is different and more volatile than in anytime I know of in modern history.  Subsequent articles will utilize this information to determine whether real estate, be it commercial or residential, is a good business to be in beyond the home you live in. I will make several assumptions in these articles and will identify them so you can use your own assumptions. A final note - buying a home is not this complicated; being in the real estate investing and/or the property management business is far more complicated.

The first thing that needs to be determined is a baseline number - that being the cost of a place to live - it's a requirement.  This is a major factor in making owning the home you live in an attractive investment.  Let's say the cost for you to rent a place to live is $1500 per month; this is your baseline number.

Assumption One: We have the 20% down payment for the house we can afford (No PMI) and $0 closing costs.
Assumption Two: We intend to be in the house for 15 years.
Assumption Three: An average of 6% inflation and a opportunity cost of money of 4.25%.  These two items traditionally track each other pretty closely and it's better to assume this than predict why they may not in the future.
Assumption Four: We are in a 25% incremental tax bracket.

We are purchasing a $350,000 home, putting 20% down and paying a fixed 4.25% on a 30 year mortgage.  This equates to a $1,872 monthly mortgage payment including taxes and insurance.

Assumption Five: approximately $8,600 in interest and $7,500 in property taxes per year (note: interest is not straight line and taxes are different everywhere).

This is a $16,100 deduction and in a 25% tax bracket this represents $4,025 reduced tax bill.or approximately a $335 savings per month.

The net difference between renting and buying is $1,872 less the tax benefit of $335 less out baseline cost of $1,500 equaling a net difference of $37 (seems close).  Lets add $300 per month for maintenance and repairs (roofs, water heaters, furnaces, etc over 15 years). total difference is $337 per month (this is really really rough).  The present value of $337 over 15 years (using the assumptions above) is approximately $44,800.

At this point we can project our total investment $114,800 for our $350,000 home ($70,000 Down payment plus the $44,800).

At 6% inflation, the future value of the home will be approximately $839,000 after 15 years (super oversimplified - many other factors including and especially location).

The return = The $839,000 value less the total investment of $114,800 (for the $350,000 home) equaling $724,200 or a 14.2% annualized return over the 15 years - not bad for a very conservative investment (this is not the way you calculate your capital gain nor is it the way the IRS thinks as maintenance costs generally do not go back into your basis, but they would be considered in a businesses P&L).

Just note, that my article last week on gold prices predicts both high inflation and high interest rates in our near future.  This volatility increases the risk in any investment (as well as the reward if you guess right).

A forthcoming article(s) will consider the additional elements of real estate / property management as a business (income, depreciation and capital gains taxes).


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