Is Buying a Home Overrated?

Famed economist Alex Tabarrok certainly seems to think so. He cites a few reasons for why housing may not pay off as an investment:

  1. Significant concentration of wealth in a single asset
  2. Locking one in place geographically
  3. Sentimental attachment (preventing more rational choices regarding when and how much to sell)
  4. Historically appreciating less than the stock market

These are generally true, and I cite in my book all of these factors as caveats for any buyer to be aware of when considering a house. Indeed, a house is more than a place to live – it’s a complex investment at the same time, even after the mortgage has been paid. Choosing to buy poorly can lead to being underwater, unable to sell, and unable to move.

What Tabarrok neglects to mention is that the quirk of leverage allows us to dramatically increase our profit in the first few years. The government also subsidizes housing by making mortgage interest payments deductible from one’s taxes.

In terms of comparing housing to stocks purely in terms of financial payoff, let’s crunch the numbers with a bunch of assumptions. In general, a house rises slower but with less volatility and less significant drops in price as compared to stocks. So we can assume that our property value increases by 10% each year, while our rental yield is 6% of the total property price. Reserve 2% of the house value for expenses that arise (interest payment, property tax, advertising, maintenance). Here’s what it would look like, assuming a base $200,000 starting price and 20% down payment:

Year House Value Yearly Rent Yearly Expenses Total Equity % Equity Yield on Equity
1 $200,000 $12,000 $4,000 $40,000 20.0% 30.0%
2 $220,000 $13,200 $4,400 $56,000 25.5% 23.6%
3 $242,000 $14,520 $4,840 $73,600 30.4% 19.7%
4 $266,200 $15,972 $5,324 $92,960 34.9% 17.2%
5 $292,820 $17,569 $5,856 $114,256 39.0% 15.4%
6 $322,102 $19,326 $6,442 $137,682 42.7% 14.0%
7 $354,312 $21,259 $7,086 $163,450 46.1% 13.0%
8 $389,743 $23,385 $7,795 $191,795 49.2% 12.2%
9 $428,718 $25,723 $8,574 $222,974 52.0% 11.5%
10 $471,590 $28,295 $9,432 $257,272 54.6% 11.0%
11 $518,748 $31,125 $10,375 $294,999 56.9% 10.6%
12 $570,623 $34,237 $11,412 $336,499 59.0% 10.2%
13 $627,686 $37,661 $12,554 $382,149 60.9% 9.9%
14 $690,454 $41,427 $13,809 $432,363 62.6% 9.6%
15 $759,500 $45,570 $15,190 $487,600 64.2% 9.3%
16 $835,450 $50,127 $16,709 $548,360 65.6% 9.1%
17 $918,995 $55,140 $18,380 $615,196 66.9% 9.0%
18 $1,010,894 $60,654 $20,218 $688,715 68.1% 8.8%
19 $1,111,983 $66,719 $22,240 $769,587 69.2% 8.7%
20 $1,223,182 $73,391 $24,464 $858,545 70.2% 8.5%
21 $1,345,500 $80,730 $26,910 $956,400 71.1% 8.4%
22 $1,480,050 $88,803 $29,601 $1,064,040 71.9% 8.3%
23 $1,628,055 $97,683 $32,561 $1,182,444 72.6% 8.3%
24 $1,790,860 $107,452 $35,817 $1,312,688 73.3% 8.2%
25 $1,969,947 $118,197 $39,399 $1,455,957 73.9% 8.1%
26 $2,166,941 $130,016 $43,339 $1,613,553 74.5% 8.1%
27 $2,383,635 $143,018 $47,673 $1,786,908 75.0% 8.0%
28 $2,621,999 $157,320 $52,440 $1,977,599 75.4% 8.0%
29 $2,884,199 $173,052 $57,684 $2,187,359 75.8% 7.9%
30 $3,172,619 $190,357 $63,452 $2,418,095 76.2% 7.9%

 

Most of the data, if plotted, would look linear, as we’d expect given our fixed assumptions. However, I’d like to draw your attention to the last column – yield on equity – which is the annual rental income divided by our total equity. This is where leverage comes in and amplifies our gains. Normally a business generating $12,000 per year in gross yearly income (or $8,000 net) would cost more than $40,000 to buy, but we were able to finance it with a mortgage. As we plow our profits back into paying off the mortgage, we build our equity. This happens very rapidly in the first few years, and tapers off over time approaching the 6% yield, as our equity approaches 100%.

Visually, we can plot the exponential rise in equity in the first few years:

equity over time

This is why some house flippers sell the house after a few years, when the bulk of the equity accumulation has happened. They then take the profits and split that into buying 2-3 houses, starting the leverage process all over again from the beginning and benefiting from a 20-30% yearly increase in wealth into perpetuity. This rate just about doubles stocks’ average yearly gains.

Banking on leveraged gains like this can pay off handsomely, but it can backfire if prices drop rapidly. This is why this strategy can only be used on a (mostly) stable income generating asset like housing, where prices and rents rise slowly but surely.

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