I got into a friendly argument with another financial writer recently. I said houses count as investments. He said houses didn’t count.
We chatted about this a bit. And after discussing, we agreed to disagree.
You don’t care about that, of course. Except I think our points of disagreement suggest actionable insights for people buying homes and wanting to get the best financial outcome possible.
See if you agree.
Why Houses Should Count as Investments
To start, let me explain why some people (me included) count houses as investments.
Consider this situation. You rent me a single-family home for $1,000 a month, or $12,000 a year.
Say the home’s value equals $200,000. Further say that you incur $4,000 a year in “landlord “-type operating expenses for taxes, insurance and repairs. To keep this simple, assume the property carries no mortgage.
In this example, you as landlord earn $8,000 a year in rental income. The rental income equals the $12,000 in rent minus the $4,000 in expenses.
Further, you can calculate the return on your investment as 4 percent. You just divide the $8,000 of net rental income by the $200,000 home value.
And all of this looks exactly like an investment, right? Right.
Let’s move on to a question…
What happens if I receive a $200,000 windfall, plan to use the money to purchase my own home, and you graciously allow me to buy your house? (This means my kids can stay at the same school. And you’re the sort of person who thinks about stuff like that.)
In this case, if I buy your rental, I think I also get a 4 percent return on investment. Just like you did.
If I buy, I stop paying you $12,000 in annual rent and instead pay $4,000 in property expenses.
That “trade-off” nets me $8,000 in savings.
The $8,000 of net savings represents a 4 percent return on the $200,000 home purchase price.
No, wait, I can guess what some folks say at this point. Some folks will say this example is too simple. Some folks will say once you lather on the complexities of real life, a house loses its investment quality.
But I don’t agree. Rather, I think the complexities of “real life” just complicate the arithmetic.
The Complication of a Mortgage
Think about a complication like a mortgage, for example…
Say I buy your $200,000 house using a $20,000 down payment and a $180,000, 5 percent mortgage. To keep the math simple, say the mortgage charges 5 percent interest but requires no payments toward the principal.
In this case, the financial impact of buying changes. I still save $12,000 a year in rent and pay $4,000 a year in property expenses. But I have a new expense: $9,000 of mortgage interest.
And now my family in effect loses $1,000 a year on the housing investment according to this math:
| Rent savings: | $12,000 |
| Less: Property tax expenses: | $4,000 |
| Less: Mortgage interest: | $9,000 |
| Equals net cash outflow: | -$1,000 |
Losing $1000 on a $20,000 investment (the down payment) means a -5 percent return (so minus 5 percent annually).
Obviously, that’s not good. Is this sort of house purchase really still an investment? Good question. Maybe not… but maybe so.
One also needs to think about all the other complicating factors that impact the investment. Like inflation, for example.
Inflation Impacts First Year Return But Not Cash Flows
So, what about the effect of inflation? Let’s continue with the example where I use a $20,000 down payment and a $180,000 mortgage to buy the $200,000 house I rent from you.
Remember that looking just at my cash flows, I lose $1,000 the first year on my $20,000 “down payment” investment.
But say the property appreciates by 2 percent that first year because of inflation.
In this case, though I do pay out $1,000 in cash the first year, the property value increases by 2 percent, or $4,000.
In effect, then, I haven’t lost $1,000. I’ve actually made $3,000 due to the combination of the $4,000 of property appreciation and the -$1,000 of cash outflow.
That $3,000 of profit equates to roughly a 15% return on the $20,000 investment: $3,000 divided by $20,000 equals .15 or 15%.
And now maybe the house does look like a good investment. Maybe.
Note: Most of the time, studies show, people in most countries apparently do earn pretty decent returns on housing.
And One Other Point About Return Calculations
So now one other clarification…
When you or I do our return calculations we need to count all of the economic benefits. And all of the economic costs.
For example, you and I want to consider any tax benefits of property tax and mortgage interest deductions.
Further, we need to recognize economic costs like selling expenses if we’ll pay these to realize the investment’s appreciation as a benefit (surely we will right?).
Typically, we also want to look at the full period of ownership. If you or I own for ten years, we want to look at the ownership benefits and costs for ten years.
Finally, we may need to include softer economic benefits and costs. Like access to higher-wage jobs. Or needing to pay for private schools for kids.
By the way, these additional inputs to the return formulas don’t mean that housing is or isn’t an investment. Or a good or a bad investment.
Rather, these additional inputs just complicate our return calculations.
Note: If you build an Excel spreadsheet that looks at the imaginary situation just described where I buy your $200,000 rental property, and you assume ten years of ownership, 2 percent annual inflation and a 6 percent sales commission, the annual rate of return equals about 8.2 percent. That rate of return is a nominal internal rate of return…
And now, finally, I want to talk about why some folks, as practical matter, don’t see houses as investments. Because even if I don’t agree with these people, their discomfort with the “houses are investments” argument provides actionable insights.
Factor #1: Using “Houses as Investments” Argument to Justify Spending
So a first practical issue…
Some people probably use the “houses as investments” rationale to buy a bigger house. Or to justify spending scads on improvements.
Which is a giant problem…
If you rework the math, the extra expenses of owning a bigger home may eat up the cost savings I described just a few sentences ago.
I can’t, for example, financially justify buying an $800,000 McMansion because then I won’t have to rent your $200,000 rambler.
Further, say I do buy the house you’ve been renting to me. And say on paper, that means I should enjoy $8,000 of annual net rent savings. If I then spend $40,000 to renovate the kitchen and the bathrooms? Hey, big problem, right?
And so, I guess, one of the things you and I need to not do? We can’t use the “houses as investments” argument to spend the net rent savings that home ownership can provide. Do that, and we’ve potentially screwed up the investment return.
Factor #2: Riskiness of Rent Savings and Resale Values
Another problem, potentially, of the “houses as investments” position?
The folks who don’t believe houses are investments point to the riskiness of the rent savings and appreciation an owner hopes to enjoy.
This criticism of the “houses as investments” philosophy might also be re-framed as concern about buying a risky asset.
I agree the riskiness is a concern.
This same risk, by the way, shows up in many of the big decisions adults make: spending money on education, marrying someone, timing retirement, and so forth.
And so the possible actionable insight? People shouldn’t rely on the historical goodness of housing investments to compensate for poor or foolhardy decisions.
You and I want to make smart picks. Something affordable. Something we’ve carefully inspected. Hopefully someplace that works for us and our families for years if not decades.
A Final Comment
Which leads to a last comment. And it’s redundant. Are houses investments? Or more importantly good investments? Well, they can be. Maybe they often even should be for most folks.
But we all need to be careful in our decisions.
Related Articles You Might Find Useful
We’ve blogged a bit about what the recent “Rate of Return of Everything” study means for people considering home ownership and real estate investment. If you’re wrestling with real estate decisions, you might find these posts about that research, Lessons from the Rate of Return of Everything Study and Rate of Return of Everything Line Charts useful.
We summarize the new mortgage interest deduction rules in another post.
Finally, if you want to use Microsoft Excel to precisely calculate the rate of return on a housing investment, you may find these posts useful: Small Business Investment Returns Astronomical and Small Business Net Present Value Analysis.
Interesting financial points you make. I was wondering if my house in California was a good investment when I stumbled across a number of articles like JL Collins “Why your house is a terrible investment”, which lists 20 characteristics that a terrible investment might have – a house has all of them! Even in volatile California where an entire retirement portfolio can be funded but one sale of your own house if timed right, I proved quantitatively that my own house only increases in value with the rate of inflation in real terms. But after all that I concluded my house was the “right investment” for me due to the intangibles of having more control over one’s environment and the stability provided by not having to move children to new schools, losing relationships with family and friends, etc.
Agree that housing can also be viewed as the right “pure consumption” choice… but it can be looked at purely as an investment that produces an annual return. Whether a particular house is a good investment or a bad investment depends on the actual percentage…
Jim Collins is a great writer, by the way. I enjoy reading his work. Also, I think he makes some good points in his blog post, which I’ll point to here just for reader convenience:
https://jlcollinsnh.com/2013/05/29/why-your-house-is-a-terrible-investment/
But a couple of points to highlight: First, the primary benefit of home ownership will be the net rent savings. Second, as noted in the article, relatively recent research indicates that in most countries, most of the time, housing beats equities. I linked to this other blog post of my in the article which compares equities, housing and bonds, but I’ll link to it again:
https://evergreensmallbusiness.com/rate-of-return-of-everything-study-in-line-charts/
You forgot to mention the cost of taxes and the risk of rising rents or having the rental property convert to condos or go off the market. One should also consider the risk of having to move due to job loss or transfer. It’s easy to leave an apartment but can be a real financial blow if forced to sell a house I n a down market.
When I bought my house in 1967, the guideline was to spend no more than 25% of your family income on a house. That guideline has since gone up, but if people stick to that guideline it would be harder to get into trouble. But then perhaps no one would be able to buy a house in today’s market.
I don’t think I forgot to include benefits or costs… I specifically said you wanted to be thorough in your analysis,
Also I agree with you that housing burdens someone with considerable risk.
Following the “Ok to post re older threads” rule, I had a question re your comments on 199A:
********
Steve says
February 9, 2019 at 10:17 am
Hi Harry,
I think Reg. Sec. 1.199A-3(b)(vi) says you adjust for other deductions that take into account the gross income from the trade or business. And that you allocate other deductions proportionally if you need to allocate.
I.e., I don’t read the final reg to say that you would only adjust for deductions that “take into account the gross income” AND “work proportionally”.
This becomes clearer if one sees the entire paragraph–something I should have done above:
(vi) Other deductions. Generally, deductions attributable to a trade or business are taken into account for purposes of computing QBI to the extent that the requirements of section 199A and this section are otherwise satisfied. For purposes of section 199A only, deductions such as the deductible portion of the tax on selfemployment income under section 164(f), the self-employed health insurance deduction under section 162(l), and the deduction for contributions to qualified retirement plans under section 404 are considered attributable to a trade or business to the extent that the individual’s gross income from the trade or business is taken into account in calculating the allowable deduction, on a proportionate basis to the gross income received from the trade or business.
********
For a sole proprietorship, could it be that the reason the “proportionate basis” qualifier is there is to differentiate between profit sharing contributions made by the employer which are calculated as up to a 25% proportion of business profits and employee elective deferrals which are capped $19K flat?
To me that would make sense, in that employer profit sharing contributions to employees other than the proprietor would have already reduced net business income via Line 19 on Schedule C, and to maintain consistency with that 199A-3(b)(vi) requires you to also reduce Schedule C net income for QBI purposes by the amount of employer profit sharing contributions made for the proprietor.
Employee elective deferrals made by employees with W2 wages paid by the sole proprietorship have nothing to do with the QBI calculations, why should employee elective deferrals made by the proprietor from the net business income on Schedule C reduce QBI? The logic being that once a wage is paid or a net business profit is determined, whether the receiver of those earnings in either form elects to contribute to a 401K it shouldn’t impact the amount of the wage (or net profit for QBI).
Thanks very much!
Hi John, so good question… and I think what I said in respond to Harry’s query turns out to be right. But this clarification: Employee elective deferrals would already have reduced QBI because they’ve been deducted from the business’s income.
For example, it makes no difference to the QBI whether or not some employee making $40,000 elects to defer part of their income. Either way, the full $40,000 gets deducted (indirectly) on the business tax return.
Also this clarification: If the business owner operates as a sole proprietor, the total owner contribution to the 401(k) does make a difference. I.e., the full owner contribution (both profit sharing and “employee” elective deferral) reduce QBI and so reduce the QBI deduction. This is what many of us tax nerds thought after reading the prop regs, I think.