People assume that buying a principal residence makes sense from an investment standpoint. Why throw money away on rent, right?
Not so fast. Investing is all about leverage.
The question should be, what else could you do with that money?
In The Wealth Renter, Avery argues that your down-payment money may be better leveraged in other ways.
Let’s take a simple example. Suppose you want to buy a condo or cottage for 300k. Let’s assume you put down 20% (60k). At 4% interest, these payments will run you 1250$ / month. Add 200$/month property taxes and the same in condo fees or, in the case of a home, 250$ in maintenance (no upgrades!!), and you’re running 1950$ in monthly payments. None of these expenses is tax deductible. You’re building equity at a rate of about 500$/month. Your ROI in terms of building equity is 6000$/60,000$ or 1%. Sound like a good investment?
“What about market appreciation?” you say.
Okay, let’s assume 3% appreciation per year. (This takes the ups-and-downs of real estate cycles out of the picture). You’re now making 4% on your money. Still sound like a good investment? Remember: your payments are made with after-tax dollars. None of the work or maintenance you do is tax deductible, and neither is your mortgage interest. Sure, you won’t have the capital gains hit when you sell. But still, 4%?
Let’s consider the same scenario, but with a rental property. Your cost structure is the same (1950$ / month), but now you’re making 1950$ in rent. Also, you expense all sorts of things to help create a loss in the early years of ownership, creating tax advantages. You can also expense your mortgage interest.
What about paying rent?
Sure. We all agree you need to live someplace. Let’s make your rent 1000$/month.
Your out of pocket is half the amount it would cost you to own.
Now, let’s say you’re still making 3% appreciation like in scenario one, but you’re also saving 1000$ per month because your tenants are paying your mortgage and building expenses. Add 12k to the initial 6k being capitalized. You’re now making a 30% return, plus the 3% market appreciation. 33% return. Versus 4% as a homeowner. See Avery’s point?
People may argue that there are drawbacks to renting. You can’t upgrade or really customize the place you live.
I’ll tell you right now, if one of my tenants offers to redo a kitchen for me, I’d happily agree to reduce his or her rent a bit. Consider what happens if you spend 5k redoing your landlord’s kitchen in scenario two.
Suppose you negotiate a 100$ rent reduction in exchange for 5k of renovations. You now save 13,200$ on your living expenses in comparison with scenario one. Subtract 5k for the kitchen renos from your savings, and you’re still ahead by 8,200$ over the person who bought their home. Now add the 6000$ of equity. That’s a 24% return!
Still think becoming a landlord redoing someone else’ kitchen is such a bad idea?
I don’t want to bash home-ownership. I live in a house that I own, and if I took out my calculator, I expect I’d be horrified at my cost structure. That said, before succumbing to current market nuttiness and tying up vast amounts of capital in a project with a questionable return, you may want to reconsider renting, and save your first purchase for a rental property. This is especially if you prefer to live in a more expensive, trendy area, where the ratios and prices are right now out of whack.
Good luck and play smart!
Yours in investing,