Most people do not treat buying their first homes as an investing decision. They buy it mostly for the feeling of satisfaction that comes from being able to live in a place they own.
But when it comes to buying a second home, does the average investor makes a good investment decision?
From purely an investment perspective, the utility of the investment boils down to the opportunity cost of the money that may have been used for other investments. So it makes sense to examine how home buying fares out as an investment for the average person.
Let’s assume the investor has already bought the first home and is considering a second rental property.
Scenario One : Buying The Property
Let’s say you are able to buy a home for $200,000 with $40,000 down. At 5% interest (one of the lowest interest rates), you need to pay about $1264 for 20 years to refinance the asset.
Now real estate prices have known to appreciate at 6% Y-O-Y. At the end of 20 years the total value of real estate would be $641,427. Assuming Price to Rent Ratio to be a median value of 20, you’d have collected (or saved) a total rent of $367,712 (Rent increasing at the same rate as property value).
If you exit that investment after 20 years, you’d have a total amount of $10,09,139 (Rent collected + Property Value). Since a part of the mortgage would most probably be refinanced through rent, I am ignoring the reinvestment value of the rent.
Your total cost of investment at the end of 20 years would be $303,423 (240 * monthly payment of $1264) + $87,644 ($40,000 adjusted for 4% inflation) + $22,000 ($10,000 Maintenance and other expense adjusted for inflation) = $423,067.
Your returns = $10,09,139 - $423,067= $586,072.
Scenario Two : Investing In Index Fund
If instead, you had invested the $40,000 (that was used for down payment) + $10,000 (that was used in maintenance, repair etc) and $1264 (that was used for mortgage payment) monthly in an index fund that has historically known to generate a return of 10%, at the end 20 years, you’d have a total cash of $1,251,494.
Note: I am assuming an index fund because the case in study is assuming an average person who doesn’t know anything about investing in stocks. Index fund is completely passive and best performing asset for anyone who doesn’t understand stock investing.
At the same cost, your returns would be $828,427.
That is $242,355 or 57.2% greater returns on your invested capital.
Therefore, for the given scenario, buying a home would not be a good investment decision.
Of course, the variables (Like Asset Appreciation, Price to Rent ratio, Interest rates, Index Fund Returns) in equation that have led me to conclude this have taken average values and any swing in those variables could potentially change the conclusion too. In fact, buying a home could become one of the greatest investment you will ever make in your life if you are able to swing these variables in your favour.
(Hint: Look for low price to rent ratio, low interest rates and high asset appreciation)