I’m a big believer that everyone should evaluate their house as an investment. How can you make a several hundred thousand dollar purchase without at least trying to figure out what the payoff will look like? What follows is my take on how to tackle the complex investment analysis of an owner-occupied home.
What Does It Really Mean To Be An Investment?
I realize that home ownership is a polarizing subject. So before anyone bear tackles me to the ground, we need to clarify what it means to be an investment.
Here’s the Cambridge Dictionary definition of an investment:
The act of putting money or effort into something to make a profit or achieve a result
So here’s the important part: I am not saying that housing always goes up. I am not saying you should view your house as an investment because it will always make you money. Real estate is hyperlocal and the attractiveness of the opportunity varies by locality. What I am saying is that every house can and should be evaluated in an investment framework so you can determine what your expected return will be and compare it to your other alternatives.
Put simply, you dump a bunch of money into different pots at the beginning of a period. One of them may be buying a home. In doing this, you no longer have to pay rent, but you do have other annual costs like property taxes, and you have to take away money (in the form of a down payment and ongoing mortgage payments) from being invested in other opportunities like the stock market. An investment framework has you try and figure out which scenario would leave you with the bigger pile of cash when all is said and done.
After you see the numbers you can decide whether they in combination with non-financial factors make you excited to go ahead with the purchase.
People get into trouble when they follow blanket advice.
“It always makes sense to buy a house because after 30 years of payments you’ll own something outright instead of lighting rent money on fire.” Sometimes right and sometimes wrong.
“Home ownership is a broken concept and renting is always better.” Sometimes right and sometimes wrong.
The only way to tell which piece of advice applies to your particular situation is to apply an investment lens to your market.
You can choose not to do an analysis. But that won’t protect you from your subpar decision to rent instead of buy sucking a bunch of money from your bank account through the years or vice versa – you’ll just be blind and ignorant of it. I’d rather take the effort to get an approximation, myself, and I suspect you would, too.
Deciding To Buy A House
Deciding to buy a house should involve two steps.
- The evaluation of the expected IRR of the investment (again, this can be negative).
- The evaluation of non-financial benefits (i.e. you really want to own your own house, there are very few rental options that fit your needs, etc.) that may trump or mitigate the results of the financial analysis above.
How To Evaluate
While there’s a lot of math involved in a housing analysis, it can really be boiled down to a single page. I’m going to show you what it looks like in its final form, and then we’ll go back and talk through each step one by one.
Some of you might be hyperventilating right now. I used to have that reaction to spreadsheets before I worked in finance. But this worksheet should be encouraging! You can get a rough idea of a several hundred thousand dollar decision from a single page of math? Score!
I’ll do you even one better and tell you that the only things you need to enter are the blue cells. The rest is just arithmetic the spreadsheet can do for you. And an even better way to understand that sheet: there are really five drivers that account for the bulk of your return on housing. Those are really the only things you need to understand. Let’s go through them now.
There are really only five major drivers to an IRR analysis:
- Estimated appreciation during hold period
- Estimated rent roll during hold period (in the case of an owner-occupied home, it should be the rent you would have paid)
- Expenses (Property tax, maintenance, utilities, etc.)
- Value of tax deductions
- Timing and quantum of your dollars going into the investment
Appreciation: This is the percentage per year that the housing market is increasing in your area. Note that there are areas that have negative 5 and 10 year appreciation rates, and there are some that show double digit figures. For example, here’s a chart of the US showing state-level appreciation rates.
10-Year Appreciation By State (2005-2015)
Courtesy of Brian Larrabee
Rent: In an investment property, you would be using the market rate rent you can get from a tenant. This would be the revenue of your little housing business. Since we are talking about owner-occupied investments right now, you should input an estimate of how much you would spend each to rent a home sufficient for your needs.
We need to spend a moment longer here. For many people, this rent figure will be lower than what the unit would fetch at market rates. Why? Because many people buy a house bigger than they actually need, anticipating family growth or future space needs. My husband and I are looking at 3 bedroom units right now, because we expect to have future little Money Habiters running around. If we were to rent a unit sufficient for our needs right now, we would rent a 1-bedroom or 2-bedroom. Then in three or four years, we’d need a larger unit with an additional bedroom, and so on.
Because you are trying to figure out the IRR of buying this property vs the alternative of renting homes and dumping your money in some alternative investment (like the stock market), you want to use what you would have had to pay in rent, not what the unit could theoretically fetch on the open market. After all, you’ve got these bums (i.e. you) in there living it up who if they were renters wouldn’t be willing to pay that much in rent those initial years since they don’t need that much space.
Expenses: You can see all the different lines for common expenses. Not much to discuss here except to say that these expenses can also be highly localized. As an example, the areas of NJ close to NYC which have good elementary schools, the property taxes can be north of 2%. Putting them all down in one place is important.
Tax Deductions: You get a tax deduction on interest payments on a mortgage. You also get a tax deduction on property taxes. However, if you are subject to AMT, the AMT calculation will require you to add back the property taxes you paid in computing the AMT, so the bulk of that particular benefit may be nullified. It depends on your particular tax situation.
Timing And Quantum of Dollars Invested: How much you put into the home upfront and along the way for maintenance and upgrades affects the IRR. Below is an illustration.
Inherently this makes sense. In the first scenario, you are tying up all 50 dollars for five years to get a payout of 100 dollars. In the second, you are tying up an additional 10 dollars a year. In the meanwhile, those dollars can be deployed elsewhere to generate additional monies. This is often why taking a mortgage out increases your return on a home. At sufficiently low interest rates, you are borrowing cheap dollars to do work for you in this investment which will more than pay for those dollars and the cost of borrowing them, with you pocketing the difference.
Your goal in this process is to get the most information you can to help you decide what those five major drivers will look like.
Appreciation: You can look at historical data in your area, as well as any information you have about development planned for the area (parks, growing hub for jobs, etc.).
Rent: You can rent comparable units to most things you can buy in the areas I’m considering. To get an estimate, I went to zillow, Craigslist, and several realtors’ listings sites to get a sense of how much it would cost to rent a unit suitable for our needs in those areas.
Expenses: Most listing will have information on property taxes. You can get can go line by line on the others to get estimates (city data forums often have homeowners who share their utility bills costs, you can get a quote for homeowners insurance from an insurance comparison site, etc.)
Tax Deductions: You can use your last year’s tax return to determine what marginal tax bracket you fell into and whether you were subject to AMT. Factor in any major changes you anticipate to your tax situation in the coming years.
Timing and Quantum of Dollars Invested: Call a few mortgage lenders to get a sense for how much it would cost to borrow money. Then use the spreadsheet to do the heavy lifting for you to determine what works best. You can run 15 year vs 30 year mortgages, all cash vs a conventional home loan, etc. by using the spreadsheet and seeing how it changes your IRR.
One of the likeliest reactions you have right now is “what if I don’t know for sure what these things will be?” Appreciation is likely the factor you feel you have the least clarity on. To combat this, you can build yourself several scenarios – a low case, base case, and high case, and assign probabilities to how likely you think it is your market achieves that rate. You will notice in the sample I shared that it does exactly this.
My Investment Summary
Let’s go back to the final spreadsheet.
This was an actual property I priced out in the the Jersey City/Hoboken area one subway station away from Manhattan. Note that this was for a condo, so the figures I’ve inserted might look low in some categories (i.e. maintenance) because they are picked up in other places (HOA fees cover maintenance of the building’s roof, systems, etc.).
This analysis showed me that for my particular market, given the current level of property costs and rent vs home price dynamic, as well as my own hurdle for a return that would equal or exceed what I can get in the stock market, I must believe that the market will appreciate at least 4% a year during the time I hold the property. Furthermore, I must believe there is a real chance I can get lucky and see closer to 7%+ appreciation (what many investors call the tail on an investment – the skinny part of the bell curve of probability but with outsized returns).
This makes it clear to me that my research needs to focus on how confident I am that the market will see that kind of appreciation. So I took the results from the financial analysis and boiled it down to the 3-5 things I must believe to be excited about the opportunity, the same sort of investment summary I’ve written about before.
Here is a version of the deck I built.
Modeling tools are excellent, but they are only a tool. We used to joke at my old workplace that the only certainty about our models was that they were going to be wrong. No one predicts everything with 100% precision. But models are helpful both for direction and for range, and they help you isolate what the important variables are and how sensitive your returns will be to changes in those drivers.
Finally, I was a professional investor, but I was not a professional real estate investor. That means there may be nuances not fully captured about real estate in this process. It is just how I personally am approaching the investment analysis, and I welcome comments from experienced real estate investors to weigh in!
Where Can I Get This Snazzy Spreadsheet?
Wondering how you can get a copy of the spreadsheet featured in this article for your own analysis? It’s a resource in the absolutely FREE brand new Money Habit Library. Current subscribers, you should have already gotten an email with the password for the library. Newer readers, you can join the community at the end of the post and you’ll get access to the library as well. It contains other tools, guides, and spreadsheets to achieve FI.
For the investment of several hours, you will have a much more concrete sense of the range your housing investment might return to you. The beauty of the IRR calculation is that you can now compare it apples to apples with other investment opportunities for your money such as investing in the stock market. I particularly like owner-occupied real estate because the first $500k of gains for a married couple who has lived in the home for 2 of the last 5 years are not taxed at the federal level. As I have a significant percentage of my money in non tax-advantaged accounts, this is huge for me.
No one can tell you how important the non financial factors are, but the financial portion can be given much more clarity with a process like this. So happy house hunting everyone.
Homeowners and real estate investors, weigh in with your own experiences. How do you approach the decision of buying a home? How might you improve upon the framework provided here?
And want to get a copy of the spreadsheet featured in this article? It’s a resource in the absolutely FREE brand new Money Habit Library. You can grab it below.