People seem to think that you should own property as soon as you can afford a down payment. Because… Real estate is tangible. Real estate is trendy. Real estate is sexy. But is buying a house a good investment? I think it can be, but it can also be an overrated investment.
Not everyone makes money in real estate, just like not everyone makes money in the stock market. Whether real estate is a good investment depends on a number of factors, including the price you pay, what you do with the property, how diversified you are, and the location.
5 reasons why buying a house might not be the best idea
1) Leverage magnifies gains and losses
Many proponents of real estate argue that because you use leverage in real estate, i.e., you borrow money, you can make a lot of money with little invested on your part. For example, let’s say you bought a $100,000 condo with $10,000 as a down payment and borrowed $90,000 from the bank. In a year, let’s say the market went up by 10%, and now your property is worth $110,000. You have a 100% gain on your investment. You put in $10,000 and gained $10,000.
But leverage can also magnify losses. What if the market dropped 10%, and your property is now only worth $90,000. You essentially lost every dollar you invested. As experienced in 2008-2009, real estate is not guaranteed to go up. In fact, there does not have to be a recession for property prices to decrease. Demographics of a city change all the time, and just as an up-and-coming neighborhood can increase property values, an older area of the city with less migration can result in a decrease in property values.
2) Survivorship bias
With the stock market, survivorship bias is the tendency for failed companies to be excluded from performance studies because they no longer exist. This causes the results to skew higher because the results include only the companies successful enough to survive until the end. A mutual fund’s selection today includes only the funds that are successful now, closing or merging the losing ones to hide their results.
Survivorship bias is also seen in real estate. I know people who made money in real estate and assume it’s a sure and safe way to make money, but that’s bullshit! More people lose their shirts investing in real estate than you will ever know. However, we conveniently forget these cases.
To sustain long-term growth through investment, you have to be an expert or at least understand the following areas:
- Financial implications: Taxes, mortgages, and depreciation
- Neighborhood dynamics: Spotting trends
- People skills: Securing good tenants, working with agents
- Property management: Ability to maintain the property
- Forecasting: How much will the property be worth in the future, knowing what to charge for rent
- Data: Mortgage rates, the economy
3) Lost opportunity cost
For the majority of U.S. history, housing prices have increased only slightly more than the level of inflation. The stock market, on the other hand, has had better overall returns. Let’s look at the stock market versus real estate return between 1976 and 2017. During this period, the dot-com crash and a financial crisis occurred, but even through those major setbacks, the stock market massively outperformed real estate.
This does not mean homeownership is a bad investment. It simply means homeownership, on average, has underperformed. If you have an edge in the real estate market, whether through contacts or personal knowledge, you can outperform the S&P 500. If you do enough research, you could also pick individual stocks that would outperform the S&P 500. For those unfamiliar with the S&P 500, it consists of the 500 largest publicly traded companies in the U.S.
4) Costs of homeownership
There are a lot of costs when purchasing a home. Home inspection, appraisal, and legal fees; mortgage default insurance (Canada) or private mortgage insurance (U.S.); utilities and taxes; maintenance and repairs; and transportation costs if you now live farther away. If you treat your home as a place to live when making the purchase, then you incur these costs no matter what. But if you think of your home as an investment, then these costs will eat into your returns.
Estimated costs on purchasing a $225,000 property:
- Down payment: Usually between 5% and 20% of the purchase price
- Lawyer fees: $1,000
- Title insurance: $225
- Home inspection fees: $300 to $500
- Appraisal fees: $300
Total estimated upfront costs: $1,825 to $2,025 + $11,250 to $45,000 down payment
- Property tax: Depends on your area but can be between 0.5% to 2.50% of the market value of your house per year
- Utilities (power, water, sewer, heating): $300 per month
- Property insurance: $50 per month
- Home maintenance (repairs, plumbing, lawn care, snow removal, etc.): 3% to 5% of your home’s value per year
Total estimated costs: $13,075 to $47,025 upfront costs + $12,075 to $21,075ongoing expenses per year + monthly mortgage payment
Between upfront and ongoing expenses, in addition to your monthly payment, that is a lot of money being spent, with only a fraction of it paying down the principal. If you decide to sell your property, add another 5% of the market value of your house as an expense for a realtor.
5) Longer Amortization Periods
In Canada, any mortgage loan with less than a 20% down payment is considered a high-ratio mortgage and must be insured by mortgage default insurance, commonly known as CMHC insurance. The amortization period with a CMHC insured mortgage cannot be any longer than 25 years. However, if your down payment is 20% or more of the purchase price, you can amortize your mortgage up to 30 years with most lenders. Close to 30% of Canadians choose an amortization over 25 years.
In the U.S., about 90% of Americans choose the 30-year mortgage, making it by far the most popular amortization period.
The appeal of these longer amortization periods is your monthly payment is lower, thus making it more affordable and freeing up cash flow for other priorities (like investing it!). However, most people end up spending the difference of what they ‘save’ on their monthly payments instead of saving or investing it.
Also, the interest impact can be HUGE. In fact, the interest on a $225,000 mortgage, at a 4% rate over 25 years, can nearly equal the purchase price.
|Scenario A (15 Years)||Scenario B (25 Years)||Scenario C (30 Years)|
|Amortization period*||15 Years||25 Years||30 Years|
|Total interest paid over entire loan||$116,718||$209,420||$255,558|
*For Canadians: Assuming you can refinance at a consistent 4% after 5 year increments. Likely the interest rate will change.
If you’re going to take out a mortgage, get a shorter amortization period if you can afford it.
Should you buy a home?
I am not opposed to owning real estate; hell, I own multiple properties. However, do your research and remember that real estate is not a sure bet for making money AND can be very expensive. The stock market has outperformed real estate over time, so do not consider homeownership an investment. However, homeownership has its place in a well-diversified portfolio. If you are deciding if or when to buy, the following suggestions may help, depending on your financial situation:
- You want pride of ownership. Real estate is a tangible asset that you can see and enjoy. It’s hard to put a price on that.
- You want to take advantage of low interest rates. If you are going to buy, the time to buy is when interest rates are low. For example, having a 3% interest rate instead of a 4% interest rate on a $225,000 house can result in saving $119 per month on your mortgage payment.
- You know how to take advantage of the tax deductions real estate provides. Tax deductions like depreciation and interest expenses can be powerful if used properly, but it’s best to talk to your accountant before you buy.
- You want forced savings. If you find it hard to save in the stock market, then owning a home within your price range can help you do that by allowing you to pay down the principal each month. Do not take out a HELOC (home equity line of credit) and spend what you saved.
- You know the market is down, and you are getting a deal. It is difficult to know if the market is down temporarily or if it is a fundamental issue such as changing demographics, the economy, etc. If it’s the former, then you are building in a margin of safety and don’t have to worry as much about dropping real estate prices.
- You are diversified. If you own other assets, then it’s not a bad idea to buy a home. Just try not to find yourself house rich and cash poor. In other words, avoid putting the majority of your wealth in your home.
- You have a large down payment. Having less than 20% subjects you to an insured mortgage that costs more as well as paying more interest over time.
- You want to use your retirement accounts. There are ways to gain real estate exposure using your retirement accounts, whether investing in REIT’s or real property.
If you are interested in buying and want to know what to look for, I explain the process at length in my book, Kicking Financial Ass. Real estate is not always overrated and can be a good investment, but do thorough research and know what you are getting into before making a potentially costly mistake.
Legal Disclaimer: The views expressed by Mr. Dumont on Money Sensei are solely his and not intended as investment advice nor a guarantee of any financial return. Mr. Dumont is not an investment or tax professional, so the information contained on the blog is not a substitute for professional advice. The contents of this blog are accurate to the best of his knowledge at the time of posting, but rules and laws are ever-changing. Please do your research to confirm that you have the current information.