Sometimes folks ask me what has been my best investment ever. I normally answer that this is not the right question to ask. We didn’t have one lucky break that made us rich overnight. We never owned the FAANG stocks (Facebook, Apple, Amazon, Netflix, Google/Alphabet) outright, only through index funds. No lottery winnings, neither literally nor figuratively (tech company stock options, IPOs, etc.). Building our Net Worth is mostly the result of many years of small and large contributions to brokerage accounts, never losing our nerves and staying the course through volatile periods.
But the other day, I ran the numbers on how well we did with the apartment we just sold in January (not pictured above!!!). Over a period of just under 10 years, the IRR was almost 16% and beat stocks pretty handily! Again, this did not single-handedly catapult us into Financial Independence, but in the ranking of good investments, it’s clearly way up there, probably even at the top!
Of course, all this assumes that we do the math right. And that’s what today’s post is all about…
Quick Recap: Why owning a home is an investment
This is already the second time I write about this topic, see my initial post on the topic, aptly titled “See that house over there? It’s an investment!” I also talked about this in the ChooseFI podcast last week. But the doubters keep at it. Most recently, in the ChooseFI Friday Roundup, Paul called in and left a voicemail to detail why he thinks a home isn’t an investment. Folks who claim that a primary residence isn’t an investment always use the same modus operandi: Conjure up arbitrary and, from an accounting and economic perspective, completely nonsensical requirements that an investment ought to have:
- “An investment has to pay a cash dividend or interest.” False. If a company owns its office building then that’s clearly an investment. Ask any accountant or economist. There is no cash dividend but only an implicit non-cash dividend in the form of not having to make lease/rental payments, analogous to the implicit rental income that a homeowner generates.
- “An investment has to be passive, hassle-free and maintenance-free.” False again. Commercial Real Estate requires maintenance, IT equipment requires electricity and maintenance by highly trained and highly-paid staff. Airplanes consume jet fuel and require extremely highly-paid pilots and cabin crew to operate. Pretty much every investment category that’s counted in GDP by the U.S. Census Bureau (see table below) violates this arbitrary requirement.
- “The (principal) value of an investment has to go up (at least in expected terms).” False. Most investments, like IT equipment, machines, vehicles, airplanes, etc. will decline in value and have mere scrap value after their useful span of life. In fact, even some financial investments will go down in value over time, e.g., a bond purchased at above-par value.
I even have a theory for why there is so much pushback to considering a home an investment: People in the FI community have become so enamored with their VTSAX that everything that’s not a Vanguard mutual fund or ETF, everything that’s not a passive vehicle paying a dividend or interest can’t be an investment. I wouldn’t be surprised if someone comes up with the additional requirement that an investment has to start with the letter V. So, to the folks who think that only VTSAX is an investment, here’s some food for thought:
What do you think is behind the VTSAX?
The answer: corporations that own capital (both physical and intellectual) in the form of buildings, machines, vehicles, airplanes, patents, etc. All of those are investments even though they may not qualify under your very narrow definition of an investment!
But I digress! Let’s crunch the numbers of the San Francisco condo I bought in 2008 and recently sold and why this investment was quite a bit better than even an equity index fund!
- A two bedroom, two bathroom condo in a large 269-unit complex. Walking distance to my office, two blocks away from the AT&T ballpark (home of the San Francisco Giants, World Series Champions in 2010, 2012 and 2014!!!), walking distance to the new UCSF Medical Campus.
- Bought in August 2008 for $832,500. The seller (developer) offered a lot of incentives including covering all the closing costs on my side. So, my net out-of-pocket expense was pretty much exactly the purchase price net of the mortgage.
- Sold in January 2018 for $1,350,000 gross. Broker fee 5%, SF City transfer tax of almost 1%, plus some other smaller miscellaneous fees for a total of about 6%. Net proceeds about $1,270,000 before paying off the mortgage.
- Along the way, I had four different mortgages, using refis to walk down the interest rate from 6.125% (ouch!!!) in 2008 to only 3.25% (from 2013 until the end).
- Property taxes started at just under $10,000 and kept rising to about $11,000 per year. Welcome to San Francisco, where your property taxes alone are as high as the entire housing payment of a nice single-family home in the Midwest!
- HOA dues started at $474/month for the condo association and rose to about $600/month in 2018. In addition, there was a $35/month HOA fee for the neighborhood association for maintaining sidewalks, parks, etc.
- Insurance is relatively cheap for a condo. The whole structure is already insured through the HOA, so we only needed insurance for our own personal effects and appliances. Just a few hundred dollars per year!
- Maintenance and repairs were minimal. All the major repairs to the building (roof, boiler, etc.) were covered by the HOA dues. For a pretty nominal fee, we hired a maintenance service to check the major appliances twice a year. We had a few dishwasher repairs over the years and replaced the microwave. Total cost over the years about $8,000.
So, let’s do some number-crunching:
Incorrect calculation 1: Point-to-point return net of transaction costs
That would be 53% over 9.5 years ($1,270,000 vs. $832,500), or about 4.5% annualized. Not very impressive. The S&P500 easily beat that return despite the Global Financial Crisis in between. But this calculation is incorrect. We didn’t put down exactly $832,500 in 2008 and we didn’t receive $1,270,000 in 2018. We had a mortgage, that reduced the downpayment in 2008 and also reduced the net proceeds we got in 2018. There were also tons of expenses along the way (mortgage payments, property taxes, insurance, maintenance and repairs). So let’s try again:
Incorrect calculation 2: IRR of the exact cash flows
Taking into account all the exact cash flows we get the following picture, see chart below. Uhm, that doesn’t look like an attractive investment. The downpayment of just under $180k plus the ongoing expenses put us almost $700k in the hole over the 9.5 years, and only the net sales proceeds (after transaction costs and paying off the remaining mortgage) brought us just barely above zero. A measly 0.26% internal rate of return (IRR) and $11k in the bank after 9.5 years!
The picture improves a little bit if we factor in the tax benefit of homeownership. Because I was subject to the Alternative Minimum Tax (AMT), the property tax was not allowed as a deduction. But the mortgage interest was entirely deductible under the AMT at a marginal tax rate of close to 50% (35% federal plus 10% California). Still only a gain of about $121,000 or a sub-3% IRR over the 10 years.
What are we missing? Very simple: we are missing the fact that we lived in the unit for free. So, in other words, the calculation above is rigged to wildly underestimate the investment return. The calculation so far is analogous to an airline buying a plane, maintaining it, flying it around the country completely empty without any passengers (!), then selling it after 9.5 years. In other words, counting only the expenses along the way and none of the benefits. It’s a miracle that we even made $121k because the airline flying around with an empty airplane would have lost millions over the years!
So, let’s do the calculation the right way, factoring in the implicit rental income…
Correct Calculation: IRR of the after-tax cash flows taking into account the implicit rental income
How much was it worth to live in San Francisco for free for almost 10 years? A lot! San Francisco is one of the most expensive metro areas in the country! So, let’s factor in the implicit rental income; I assume that the condo would have rented for $3,000 in 2008 and $5,000 in 2018, exponential growth in between. The $5k figure is actually the precise monthly rent we paid to the seller to stay for another two months after the closing and the $3k figure is what I remember was the going rate for comparable rental units I toured when I first moved to SF in 2008. So, we earned an implicit income of over $440,000 over the 9.5 years. Sounds like a lot but that’s still an insanely low 4.3-4.4% rental yield! But with a little bit of leverage that 4% rental yield makes all the difference in the IRR, see chart below. We now gained a total of $563,000 from this home investment and generated an IRR of just under 16%. Not even the S&P500 returned that much over the last 10 years (11.2% total return p.a. between 7/31/2008 and 1/31/2018).
What if a renter had invested the differential cash flows in the stock market?
This is an interesting exercise that Brad suggested during the ChooseFI podcast. Instead of comparing the IRR of the home investment with the S&P500 return one can also do the following thought experiment: What if we had not bought the apartment? What if we had instead invested the downpayment in our portfolio and then also all the incremental cash flows. All the while paying rent, of course, to make this an apples-to-apples comparison! Early during my homeownership tenure owning was still more expensive than renting (see how the cumulative cash flow line drops from -180k to about -200k in the chart above). So, those additional savings would have also added to the investment portfolio. But around 2013, owning became cheaper because rents were increasing and the mortgage payments were now lower (thanks to a perfectly timed refi in January 2013). So those incremental payments would come out of the renter’s portfolio. And finally, the roughly $700 net proceeds of the home sale will come out of the renter’s portfolio in January 2018. Let’s see if the renter would have been able to stay ahead of the homeowner. See chart below:
Ouch! The renter would have fallen behind by several hundred thousand dollars! Depending on the equity share between $229,000 (all equities, no bonds) and $318,000 (60% equities, 40% bonds). Also, notice that this calculation is actually still way too optimistic for the renter:
- The renter would have to pay taxes on the dividends along the way (taxed at 15% federal, 10% California State, 3.8% Obamacare) and the full ordinary income tax on bond interest income (35% federal, 10% California, 3.8% Obamacare). The renter would also be responsible for paying capital gains taxes in 2018. As homeowners, we were able to generate the 16% return tax-free because none of the implicit rental income was taxed and our capital gain upon selling was below the $500k exemption for a married couple (both federal and CA that exemption value).
- As a homeowner, I had the advantage of keeping a Home Equity Line of Credit (HELOC) that we could use as a low-cost emergency fund and to smooth out cash flow spikes in general.
So, taking into account all the costs and benefits, owning an apartment had a pretty impressive return. The relatively low implicit rental yield, a home price appreciation slightly higher than the rate of inflation, relatively low maintenance and taxes (as % of the price) and a bit of leverage generate an IRR of almost 16%! Pretty good!
Just to make sure, I’m not a spokesperson for the National Homebuilders Association, so, here are some important caveats:
- Owning a home can’t be a good investment every single time. If the rental yield and the home price appreciation are too low you will certainly get a sub-equity expected return. Homeownership also tends to be a bad investment when the holding period is too short. We need to spread the sizable transaction costs over a long enough time span, say 10 years, to make this work!
- “Don’t get high on your own (housing) supply.” I used this phrase in last year’s post to show that there is one subtle distinction between our good old VTSAX investment and a home: Investing in twice as many shares of an index fund is twice as good. “Investing” in a home twice the size of what you really need is bad. But that doesn’t preclude a home from being an investment any more than an airplane being an investment if an airline owns twice as many airplanes as they really need.
- So what, we made about $200k extra by owning rather than renting? It doesn’t make us much more affluent than we already are. We would have still been able to retire this year even had we been renters. The bulk of our net worth still comes from financial investments! Homeownership isn’t a requirement on the path to Early Retirementbut it may help at the margin!
We hope you enjoyed today’s post! Please leave your comments and suggestions below!
Picture credit: Pixabay (not actually our former home!)