Whether it is a penthouse in New York City, a beach house in Corolla, NC or a farmhouse in central Virginia, owning your own home is a significant part of the American Dream.
Yet the financial reality is that a home is the single largest investment most people will ever make. For many, it becomes their most profitable investment; for others, it can be a financial and emotional disaster. In fact, movies like 'Pacific Heights' or 'Duplex' might provide you some extreme examples of disasters.
How can we tell whether a house is likely to be profitable or not? Residential real estate is usually valued by looking at 'comps', the prices paid for recent transactions involving comparable homes. Comps can help us judge whether the price of a particular house is high or low relative to the prices of other houses in a given neighborhood, but they tell us nothing about whether housing prices are high or low in an absolute sense.
First time buyers might ask if now is a good time to buy, while others who already own may ask if trading up is a good investment or if downsizing is a good financial move. Some may ask if we are in a 'housing bubble' and if they should sell their houses and rent until sanity returns. All of these are great questions. In fact, shouldn't a transaction this large be analyzed with at least as much care as other investments?
Another important consideration is the 'rent versus buy alternative', among many others, which are discussed below.
The Bigger Picture
Two issues that are crucial to understanding the financial implications of home ownership are: (1) the return on your home is the net rental savings plus the capital gain, and (2) leverage works in your favor if the total return is greater than the mortgage rate.
A more complete analysis is complicated by several other factors:
- Unlike other expenses, fixed rate mortgage payments don't grow each year;
- Most mortgages have a finite life;
- Part of each mortgage payment includes a principal pay down ' which builds equity;
- The interest portion of every payment is tax-deductible and declines each month.
Now, with these concepts behind us as the 'building blocks', you can now begin to assess whether a particular house is likely to be profitable or unprofitable & cheap or expensive. This assessment can be accomplished by calculating the net present value ('NPV') with after-tax cash flows being discounted by the homebuyer's required rate of return. There are plenty of calculators to help you accomplish this via the internet; or if you're uncertain about going it alone, a financial advisor can help.
In this calculation, the initial cash flow is equal to the down payment and other closing costs. The following net cash flows, until the expected sale of the house, consist of each period's rental savings net of the mortgage payments and other expenses associated with home ownership. The final cash flow is the home's expected sale price net of broker's commission, other selling expenses, remaining mortgage balance and any prepayment penalties. Because the cash flows are guesstimates, it is generally sufficient to work with monthly or annual assumptions. Don't be sidetracked by accounting labels. All we really care about here are dollars coming in and dollars going out.
The homebuyer's required rate of return can be determined from rates of return available on investments. The initial down payment ties up funds that could otherwise be invested in stocks, bonds and other assets; and, as the years pass, the net rental savings free up funds that can be reinvested elsewhere. The required return can be based upon current interest rates, but since there is considerable uncertainty about the net cash flow from a house, you may want to use a required return similar to that applied to stocks and comparable risky investments.
After you've done your NPV calculations, or had someone do them for you, you'll need to interpret the results. A positive NPV would indicate that the house is not too expensive and you should buy; alternatively, a negative NPV would indicate that the house may be too expensive and you should rent generally. Why generally? Because a negative NPV could turn positive depending upon how long you plan on keeping the home!
It's not uncommon for the after-tax cash flow from buying a house to be small or negative for the first few years. But as time passes, with growing net rental income and fixed mortgage payments, the after-tax cash flow can become positive. In addition, the homeowner's equity is growing, but can easily be dissipated by substantial selling costs if the house is sold soon after purchase. These transaction costs underlie the sound advice that most people should not buy a house unless they plan to keep it for a while.
Don't be dismayed by the fact that you cannot provide exact values for future cash flow data. We actually don't need to know input values to the last penny. The best way to handle imperfect knowledge is to try a range of values to understand your best and worst case scenarios.
What Matters Most?
For most households, emotions play a significant role when involved in decisions relating to home ownership. Yet making the wrong decision can certainly cause a significant hardship down the road.
Determining whether a particular house is a good investment can be a complex process. However, using NPV analysis as a tool can help you navigate through some of the more basic ' yet significant ' questions of home ownership such as:
- How do I know if I'm ready to buy a home?
- How does purchasing a home compare with renting?
- Should I sell my home and rent until sanity returns?
- Is the home I'm looking to buy a good value or too expensive?
- Is an older home a better value than a new one?
- In my locale, is one neighborhood-school district-etc. a better value than another?
- Should I renovate my existing home if I'm going to sell it soon?
- How can I keep track of all the homes I see?
- How large of a down payment should I make?
Being honest with yourself when answering these questions, combined with the calculations you make, will help determine whether buying a home is a good investment for you.