For most purchasing a home is the largest dollar and emotional investment they will ever make. There are lots of HGTV-type shows out there today that promote the idea of using a house/condo as the staple of an investment portfolio plan (I too have been tempted by that handsome man Scott McGillivary). The big question is whether a house is a wise investment vehicle given the risk versus the potential rate of returns of other options (stocks and bonds).
BY THE NUMBERS
For the purpose of this analysis I’m going to use figures exclusively from Canadian markets and use a timeframe between 1980 and 2012. Using a larger timeframe averages out some the ups and downs (anomalies) and will give a better indication on the smarter choice in the longer run.
The average rate of return on a house in Canada between 1980 and 2012 was 5.4% (“Real” rate factors in inflation, but to compare apples to apples we’ll ignore inflation). That means if you purchased a $100,000 house in 1980 it would now be worth approximately $538,000 in 2012 ($100,000 x 1.054% ^ 32 years). Looking strictly at the dollar return of $438k it appears making the purchase in 1980 was a wise decision.
Source: “SPECIAL REPORT: TD Economics”; TD Bank, March 2013
THE TRUE RATE OF RETURN
What the above returns fail to calculate is the additional costs of owning the property over this 32 year time period. Items such as mortgage interest, property taxes, and repairs and maintenance should be considered as well since those are costs associated with owning the property versus if you were to rent instead. Also, most home owners don’t have 100% down payment for their house so I’m going to make some assumptions here. (Note: if you have less than 20% as a down payment you’ll be required to obtain CMHC mortgage insurance which will likely run you a couple grand extra)
For all you normal non-accountants I’ll save you the boring spreadsheet detail and give you the bottom line – it works out to an annualized rate of return of 2.2% over the 32 year time period. For my fellow number humpers, check out the spreadsheet below.
Per the Canadian Couch Potato average returns in the Canadian stock market between the 1970’s to 2012 was about 9.1%, after factoring a 30% tax rate this comes out to about a 6.4% return, which beats the above 2.2%.
There’s a lot of hype around the Canadian real estate market these days and whether a massive decline/correction is in store. Brilliant economists have released numerous articles supporting and nay-saying this potential correction. The main takeaway I get from this is no one really knows.
In the above example I only looked at a house as an investment product, not something you live in and enjoy. One argument is that you need a place to live in anyways so buying a house makes sense. The main reason I looked at the home as an investment product only is I often hear people talking about what a great investment real estate is and that everyone should buy a house, to which I disagree.
While I do think real estate has been a good investment for some, there is much better investments out there that don’t require you to put all your eggs in one basket (just ask anyone in the US that bought a house right before the Great Recession a few years back). One of the major recommendations for investing is to diversify your portfolio to minimize risk. When purchasing a house you tend to be all in.
For those that purchase a second property for rental purposes you’ll be hit up for taxes on rental income as well as capital gains once you sell the house. This really is no different than being taxed on investing income (with the exception of TFSA and RSP) however, it requires some additional care (such as getting the right tenants and collecting your rent) than the typical couch potato investment portfolio.
“I’m homeless. I live in my car…But it’s a Mercedes, yo’!” – From Gee to Gent, MTV reality series
Houses, like cars, have become a bit of a social status metric in society. We tend to measure a person’s wealth by the size of their house. Living in more expensive homes typically requires higher property taxes, maintenance and keepin’ up with the Jones’. In the book The Millionaire Next Door two PH.D authors note that the average millionaire lived in a home valued under $320k and had lived in the house for an average of 20 years. My point here is the average well-off millionaire tends to buy one house and stick to it, rather than consistently upgrading, which seems to be the typical progression in society.
Home ownership should never be your only plan for financial independence. In order to use the profits of home value increases you’ll need to sell the house and then you’ll also need another place to live! A good rule of thumb when buying a home is to ensure living costs (mortgage, property taxes and utilities) don’t exceed 30% of your gross income. This will allow you to continually beef up your investment accounts, which should be the back bone for your retirement savings.
If you’re having trouble deciding between buying and renting check out this buy or rent calculator. This New York Times calculator factors in a lot of different financial info, including opportunity cost, to determine if renting or buying is best suited for you from a financial perspective.
At the end of the day you need to decide how important owning a house if for you and your family. If there are multiple qualitative reasons and it makes sense financially, go for it. However, if it is strictly an investment or status decision that will live you house poor, you should probably think twice.by