Thursday, July 26, 2007

The Returns from Housing

Following up from my recent posts I thought it would be useful to write down a simple equation that really sums up a lot about the decision of whether to buy a house or not: Rate of Return = Rent Yield - Costs/House Price + Rate of Appreciation The return from owning a house is the rent you would otherwise have to pay minus costs that include insurance, maintenance, and property taxes plus the gains in the price of the property. I'm not including mortgage interest here so I can compare the return on a house with the return on other unlevered investments. The investment decision comes down to whether this rate of return is higher or lower than the return on other investments with similar levels of risk (yeah it is more complicated than that as I'm ignoring the correlation with other assets etc.). Rates of return in bubble areas such as most of California, the coastal Northeast US, Sydney Australia, and probably the UK among many others can only be high enough to pass the investment hurdle if the rate of expected price appreciation is high enough. Enough Wealth pointed out in a comment on one of my posts that high end real estate can appreciate in the long-run faster than the rate of economic growth, but it is hard to imagine that the average house can. In fact Robert Shiller's research has shown that the average house in the US has appreciated slower than the rate of economic growth in the long-run. It is very likely that prices have overshot and that future rates of appreciation will not be as high as in the recent past. In order to restore equilibrium house prices have to fall in order to raise the expected future rate of return. This is the housing bubble argument in a nutshell. So what about mortgage interest? It makes sense to borrow money to buy a house if the expected rate of return (assuming no uncertainty in this return) is greater than the interest rate on the mortgage. And this only if you have passed the investment return hurdle. I think this makes sense though I'm kind of thinking out loud :)


Adventures In Money Making said...

Returns on rental real estate are significantly more difficult to measure than other investments like stocks and bonds.

For one, its not very liquid. Secondly, the complicated tax benefits make calculating the total gains tough.

I like to view real estate as a store of value. Over the long term, it should keep pace with inflation. And if you can get someone else to pay your mortgage, you'll definitely make money.

example,a house that currently sells for $500k sold for $50,000 30 years ago. that equates to a below average return of 7.98%.
But what if you had put down only 20% and the rent paid the rest of the mortgage?
Now your rate of return is 13.93% which isn't bad, considering you got a tax break for 27.5 years against your other income too!

Of course this is overly simplistic, but most detractors of real estate as an investment don't any investment real estate!

just my 2 cents.

mOOm said...

I'm thinking about owner occupied property here but the same ideas apply to investment property too. If you can get a positive cashflow as in your example (assume you mean the rent paid the mortgage, tax, insurance, maintenance etc?) then sure it is likely to be a fantastic investment. But in my example in Canberra or in most high price areas in the US today you won't get a positive cashflow. Nowhere near it and the only way to make money is if there is a lot of price appreciation. I'm not against investing in property, but the numbers have to make sense.