One of the things that I learned from the previous generation is just how much a home can appreciate over the 25 years that you might own it. It’s not uncommon to know a few relatives who bought their homes for a little over $250K and yet their homes can now sell for almost a million dollars. It all sounds very easy. Buy a home, pay it off and ultimately it becomes your retirement fund. An even greater bonus is the fact that you need a place to live, so why not make it your primary investment as well?
To many it would seem like a no brainer and the logical choice to follow in the footsteps of our parents and grandparents who invested in a house as early as possible, but there’s a reason why I feel that a house will never be my best investment. I’m not totally against home purchasing. In fact, buying a home can give a real good sense of accomplishment, encourage saving for the otherwise big spender, and most of all provide shelter that is an essential human need. Where I certainly have the most reservation is when people seem to feel that it’s the best and only investment that one can make. That’s a very naive and ignorant statement to make.
I’m a firm believer that the only way to gain wealth is through the use of compound growth in investments. I would also be lying if I said that I didn’t think that a four fold gain in housing prices over 25 years was a bad investment. In fact, anything that quadruples in value after 25 years would equate to a compound annual growth rate of approximately 5.75%. That’s an amazing return on such a long term investment.
Despite the outstanding returns that a house offers, no one ever talks about the true cost of home ownership and the exact cost for which they paid for their home. No one really remembers how much they paid for their home in total. They just know how much the purchase price was when the house was bought and the mortgage was started. The truth of it remains is that the final price of the house was not the amount that it was initially bought for but something a bit higher. Sometimes a lot more higher.
Unlike our fortunate, American friends, Canadians do not enjoy low, fixed interest rate mortgages that can last the entirety of the mortgage. What often gets excluded from the cost of our homes is the amount of interest that is paid. Even with the low interest environment that we enjoy right now, a small starter home with a current value of $600 000 in expensive cities like Vancouver or Toronto can very well cost over $750 000 after the 25 year mortgage is done (that’s also assuming a 20% down and interest rates not going up for 25 years). Now with that little bit of interest factored in, if you were to sell that original $600 000 home 25 years later at $2.4M, then the annual compound rate of return is now only 4.75%. That’s a full percentage point already taken off the overall return.
Negative Cash Flow
If you have ever read the book “Rich Dad Poor Dad”, written by Robert Kiyosaki, he would have told you that a primary residence is actually a liability and not an asset. Why’s that? Because unlike other “investments”, your primary residence generates negative monthly cash flow.
Think about it. The house, as an investment, actually requires the owner to spend money and pay each and every month just to maintain the investment. Maintenance fees, property taxes and interest payments all leach off the monthly cash flow. Imagine if owning ETFs required you to deposit more money each and every month you owned them. If you missed a payment you would forfeit all your shares. That would be preposterous!
All those tiny little expenses that add up over time when you own a home for 25 years. The furnace replacement, the new roof, the new hardwood floors, etc… On top of that, owning property makes you the proud owner of new taxes. The government seems to think you still owe them justice through property taxes. Those property taxes, that never seem to go anywhere but up, always seems to give you a good poke in the gut. All these expenses can easily add over $5000 a year to home ownership. Over the course of the 25 years, that adds up to over $125 000. If we factor these additional expenses in our calculation, selling your home for $2.4M in 25 years drops the annual return to only 4.2% compounded annually.
As I have mentioned earlier, Canadians don’t enjoy 30 year fixed rate mortgages. We actually don’t even know how much we will end up paying for our homes after we buy them. We just understand that we have to make our monthly payments, otherwise we get thrown out on the street by the bank.
With interest rates being at historic lows, there is very little room for rates to go even lower. At this point, we’d have to assume that interest rates have nowhere to go but up. What a lot of our parents didn’t tell us before is that when they bought their $250 000 home, the interest rate was actually near 7% or maybe even 15%. Yikes! That means that a mortgage amount of roughly $200 000 actually had the same payment as someone with a $300 000 or higher with today’s low rates. This has meant that people can now borrow over 50% more money to buy their homes now than they would have been able to in the past. That’s quite significant.
If interest rates were to rise, the most harmful things that can happen is crimping monthly cash flow. Higher rates, means higher interest payments. It also hurts the bottom line when it comes to the amount of growth one can get investing in their home after 25 years.
Real Estate As Investment
There are many rules to abide by if you want to use real estate as an investment. I won’t mention them all here, but the biggest thing to remember is that using your primary residence as your only investment isn’t as grandiose as it may seem. It may hold its value in the long run and provide you a decent return, but it far lags even the historical inflation-adjusted returns of the S&P of 7%.
The only real way to boost real estate returns is to own rental properties. This has many advantages over your primary residence. One obvious factor is that you get to collect rent which will help offset the expenses that I’ve mentioned. Instead of paying expenses out of pocket you now generate a positive cash flow. These are the kind of assets that you want.
The one thing where rental properties won’t have an advantage over your primary residence is the interest rate. The fact that a rental property is usually highly leveraged means that any interest rate increases could have a profound effect on your ability to maintain positive cash flow. You never, ever want to be a landlord where you end up subsidizing out of your own pocket to keep up with the mortgage payments. Why the heck do you want to pay for a house for someone else to live in?
A primary residence is a great savings tool. That’s what I consider it. You force yourself to pay the mortgage because you need a place to stay. Despite the fact I may have to continually pay money into it every month, I would still feel like I got it back in the end if I sold it. If anything, a house guarantees that if I retire I won’t be bankrupt and broke because I spent all my money renting and on other frivolous things that depreciated in value (think cars). From all those positives, you can think of a house as a really good savings account.
To that end that might be it for a house as an investment. For one, a house barely registers any growth in the long run because of interest payments, maintenance and inflation. Though it may be true that a recent bias has swung towards real estate as a better investment, let’s not forget what the S&P 500 has returned the last 5 years (in CAD dollars) 8.9%, 4.4%, 13.5%, 41.5%, 24%, 21%.
When it comes to finding other investments, there are plenty of other asset classes that can average that 4% return. The S&P index has historically averaged 7%. I can easily find a Reit ETF giving me commercial and residential real estate exposure returning north of 5% per year. Preferred shares can net me a 5% dividend every year. More diversity equates to less risk, which is what one should strive for when making investments.