Common Belief: My primary residence is a real estate investment.
You want a great return on all your investments, right? In this post you’ll learn that a homeowner consumes shelter and does not own a real estate investment.
What does it cost to buy a house?
Loan Closing Costs: The closing costs to buy a house vary depending on the mortgage company and state of residence. According to bankrate.com, the 2010 average closing costs were $3,741 on a $200,000 mortgage. In other words, a $250,000 home purchased with a 20% down payment would have about 1.5% in closing costs, not including taxes and other prepaid expenses. Acquisition costs can include legal, title, appraisal, inspection, discount points, and lender fees.
Other Closing Costs: Other costs not included in the average listed above can include decorating, appliances, moving, storage, breakage and theft. Let’s add another 1.5% for these costs.
Total estimated costs to buy a house: 3% of the purchase price
Annual Cost of Ownership:
Home Maintenance: The average annual maintenance cost can be 1-3% of the house value or more.
Other out of Pocket Costs: Includes property taxes, insurance, homeowner’s association fees, water, gas and electric, garbage, and telecommunications and other costs. Total annual cost of ownership can exceed 3-6% of the house value.
What About Mortgage Interest? At this point we’ll follow sound investment analysis by ignoring the cost of borrowed money to buy the house. In an earlier post I explained the correct way to evaluate an investment is on an unleveraged basis, or before debt.
Other Intangible Ownership Costs: Can include foregone leisure time to do yard work, routine maintenance and repairs.
Total annual cost of ownership: 3%-6% of the house’s value; lets call it 4.5% average cost per year
Exit Costs: the cost of selling the house may include a broker commission of 3-6% or more, staging costs to prepare the house for sale, moving and storage costs, along with more of the intangible costs listed above when you bought the house.
Total exit costs: 4%- 7% of the house’s value; let’s call it 5.5% average exit cost
Uncommon Sense: The historical average house price appreciation has been about 5% per year over the last 19+ years according to the Federal Housing Finance Agency. The “investment” return is offset by:
- If we divide the total purchase costs over seven years the average buyer owns a home, “return on investment” decreases about 0.4% per year for the buy-in costs.
- The annual costs to operate your house can be 4.5% or more per year, which is a drag on the “return on investment.”
- The exit costs at sale can be 5.5% or more. Again, if we divide the total exit costs over the 7 years the average buyer owns a home, we can apply about 0.8% per year to the exit costs.
So what is the real “investment” return for a primary residence?
The average unleveraged annual return on your real estate “investment” is somewhere in the -0.8% area. If you take into account a 2.5% average rate of inflation the real return falls to -3.3%. No rational person would pay cash for an investment with such an abysmal rate of return. Borrowing money to fund the purchase would compound the problem through negative leverage, i.e. the interest rate on the loan is far greater than the return on investment that in our example is already negative.
A better way to view your primary residence is to consider it consumption of shelter, not an investment in real estate. Many people gorged on residential real estate because the credit market was willing to lend the money. It’s like having two dinners because a restaurant owner loaned the money for a second meal. The indigestion from consuming too much house can lead to financial diarrhea from too much debt.
Are you consuming the right amount, type and quality of shelter for your station in life?
- A Guide to What Is Included in Closing Costs (brighthub.com)
- Survey: Mortgage closing costs 37% higher (usatoday.com)
- Cash-on-cash return is the lifeblood of investment properties (theglobeandmail.com)
- Doubling Down on Housing (online.wsj.com)