Is a House a Good Investment? (Part I)

	Henry Kaelber Hoffman, White & Kaelber
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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. 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.

Some clients ask questions about housing prices. First time buyers might ask if now is a good time to buy, while clients who already own may ask if trading up is a good investment or if downsizing is a good financial move. We have also had clients 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?

This letter will discuss some critical questions to ponder for anyone considering buying, selling or remodeling a home. Then, I'll follow up in a subsequent writing with a look at the bigger picture and discuss a methodology to help guide you toward making better decisions.

The Rent Versus Buy Alternative

Most real estate experts realize that renting is an alternative to buying a house, but often they simply list the pluses and minuses of buying versus renting rather than help guide your decision to buy or not. So how do you decide what to do?

The best way to answer the question of whether a house is a good or bad investment is to think of houses the same way we think of stocks. When financial analysts consider buying stock, the proper question is not whether it is a good company, but whether the stock is cheap or expensive. Is it worth the asking price? When we consider buying a house, we should ask the same question – not whether it is a good house, but whether the house is cheap or expensive. Again, is it worth the asking price?

It is widely believed that the intrinsic value of a stock depends upon its expected future cash flows. The same holds true for a house, with the wrinkle that one of the financial benefits of owning a home is not having to pay rent to someone else. Therefore, the primary cash flows from owner occupied housing is the rental payments a homeowner would otherwise have to pay.

In this letter, I will begin to discuss a well established procedure that is widely used to value bonds, stocks, business projects and commercial and industrial real estate transactions. It can also be used to value owner occupied houses.

One effective way of addressing this issue is to determine the net present value of anticipated cash flows from owning a house. The intrinsic value calculations for a house are a little involved, but let's begin to walk through some of the considerations.

A Simple "All Cash" Scenario

Consider the unlikely case where you pay cash for a house, similar to how you might pay for a stock. Just like a stock, your rate of return consists of both income and capital gain. The income from a stock comes from the dividends. If you pay $100 for a stock that currently pays an annual dividend of $1, the income is 1%; if the stock price increases by 6%, your total rate of return is 7%.

For a house, the income is the rent you would pay reduced by the expenses associated with owning it. For example, as a renter, let's say you would pay $33,000 a year – or $2,750 per month – for a particular house. Home ownership would implicitly provide $33,000 that you would otherwise pay someone else. On the other hand, as a homeowner, you will have to pay real property taxes, insurance, maintenance and some utilities that would ordinarily not be paid by a renter. If these expenses are $15,000 per year, then your annual net cash flow is $18,000. If the house is priced at $450,000, then your return on net cash flow provides a 4% return ($18,000 / $450,000 X 100%).

Now let's consider the capital gain component. To make this simple, assume that housing prices will be expected to rise commensurate with inflation. If inflation is expected to grow by 3% per year, then you might assume that housing prices will rise by 3% a year too. Adding a 3% capital gain to the 4% income gives a total return of 7%.

Although this analysis is for a single year, it works year after year if income and home prices increase at the same rate. However, since over the last five years housing prices have risen substantially higher than net cash flow (income), we might actually expect that either housing prices will grow at a much slower rate or rents must rise at a faster rate going forward. Maybe it will be some combination of the two.

For many, it is hard to assume that anyone would purchase a home without taking out a loan (using leverage) and incurring mortgage payments.  In Part 2 of this series, I will discuss how this impacts the analysis. The general rule for using leverage is that your financial success depends on whether your investment return from the house – income plus capital gain – is greater than the mortgage rate. If it is, the extraordinary leverage involved in most home purchases can make a house the most profitable investment you will ever make. If it isn't, it can be one of the most costly mistakes you'll ever make.

Stay tuned for Part 2 of this article, appearing on May 20, 2005.

Henry Kaelber will be available to take your questions until Monday, May 9. Please use the form below to submit your questions.