Primary home is not a financial investment

I have a lot of time on my hands these days ! With the market at the current levels, there is not much to buy. I am in the analysis/intellectual gymnastics mode these days, analyzing companies and thinking of odd ball stuff. In continuation of that spirit, I decided to write a post on the above topic. The advantage of a blog is that you can write anything you like. It’s a different issue if others would read it or just skip it.

This is a very contentious topic. I am not discussing about real estate as an investment. The post is only about a primary home – the home in which you are likely to stay.
I have also found myself in a minority of 1 when I discuss this topic with any friends or relatives. Lets try to look at the financial aspect of this topic first and then look at the non financial or emotional aspects of buying a house.

I can summarize a few ‘accepted’ financial truths in buying a house as follows
1. It is better to buy than rent. Money paid via rent is a sunk amount, whereas if one buys and pays an EMI, one is ‘investing’
2. A house always appreciates in the long term. As a result it is a smart decision to ‘invest’ in a house.
3. A house is a hard asset in comparison to financial assets which are just paper assets. So in the interest of diversification, one should buy a house.

Debunking some myths
The problem with accepted truths is that no one wants to think about them or question them. Everyone just accepts them as absolute truths such as ‘The sun rises in the east’. I have found it easier to discuss and argue about other topics about which people don’t think they know as much (such as stocks), in comparison to real estate, where everyone thinks they are a born guru just because they bought an apartment in the last 5 years which has appreciated by x%.

Let look at each point in detail now

Buy v/s rent
This is the most irritating argument I have heard on this topic. Everyone claims this as the truth, but I doubt if most would have actually done the calculations on a piece of paper ( I have !! yes, you cant get any more geeky than this :))

Let take an example and some cash flow numbers. Please don’t argue with me on exact numbers as they may vary a bit, but the overall conclusion will still hold. Let say you buy an apartment for 1000000 (10 lacs) for an easy round number.

A typical EMI for a 20 year loan @ 9-10%, would be in the range of 9000-10000 give or take. Additional costs of owning a house would be maintenance costs (repairs, painting etc), association fees and taxes. These are sunk cost which you need to spend to maintain the asset and no one will re-imburse you these cost when you sell the asset

EMI approximately = 11-12% of asset value. lets assume 5-6% of EMI is interest payment and rest goes to principal(varies during the tenure, but approximately 50% of the EMI is rent over the life of the loan)
Association Fees = 1% of value
Maintenance and upkeep = 1% or more
Taxes = 1% or more

Cost/ month of owning = EMI + maintenance cost + association fee + taxes
So total cash outflow = 5-6%+1+1+1= 8-9% of asset value (without tax benefit). If one consider 30% tax benefit then the number comes to 6-7% (you can do the math)

This component of your cash flow is not adding to the asset. Interest paid or association fees don’t add to the asset. Maintenance cost is equivalent to a depreciation expense. Only the principal paid adds to the equity.

If one rents a house, one would pay the rent (typically 5-6% of asset value) and association fees.
Rental cost/month = 5-6% +1% = 6-7% of asset value

Now you can play with the numbers as you like as I have not included some numbers such as utilities which are same whether you rent or buy. In addition we can get into all kinds of variations such as renting a room or doing something of such sort, but in the end if you buy a home just large enough to live, a lot of these variations may not be feasible.

The conclusion is this – The cash outflow on an owned asset which does not add to the asset (build equity by reducing the loan principal) is quite close the total rental and other associated cash flows of renting a house.

The difference in the numbers for rent v/s buy will vary by a bit if you modify some of the EMI and rental assumptions. However the real estate market is also reasonably efficient in the long run and these numbers tend to converge over a period of time (why ? ..thats a different post)

Real estate always appreciates in the long run
Says who ? can you claim it based on some data or are you just pulling that out of your ***** ? The long term (20-30yr) data for real estate across countries and time period has shown that real estate typically provides a 1-2% excess return over inflation.

Please don’t give me this type of example to prove your point
My ________ (fill uncle, nephew etc) bought this apartment/ land in a god forsaken place and then suddenly a new company came up and the real estate doubled overnight. It is the equivalent of saying that Infosys has gone up by 100 times in the last 20 years and hence all stocks should give that returns.

Finally long run does not mean, that if you buy an over priced asset, you will not lose money. If you don’t believe it please read about the investors in the US or in japan (in the 90s).

The key conclusion is this – If you overpay for an asset, you are toast !

House is a hard asset
That does not mean anything. If one can touch or feel a house, it does not mean that it is better than any other asset from a financial standpoint. An asset is attractive if it gives a high risk adjusted return, irrespective of its form.

For example – gold was always considered a hard asset and hence highly valued in India (not in other countries). In spite of this classification, gold returned close to nothing from 1970s till 2003. In the recent years, investors can now buy gold ETF and inspite of being a paper asset they have made good returns. The point is that the physical form of an asset does not change the characteristics of the investment. By the way, I am not justifying gold as an investment.

So should one not buy a house ?
No, the above analysis is not to arrive at that conclusion. On the contrary, one should buy a house, but for a very different set of reasons. I would say our parents got it right on this count. I would list the following reasons to buy a primary home

- Buying a home gives one peace of mind. It is a different feeling to live one’s own house and not in a rental one. It is a very satisfying experience. I cannot describe it, but those of you who own a house would know it.
- It is the smartest investment for a newly working professional. A lot of young people who starting working, get some cash in their bank accounts and get itchy with the cash. They go all around investing the cash in silly ways and end up losing money. In this respect, if they went and bought a house (within their means) it would be a sound investment and would also prevent them doing something foolish
- I now get into a slightly sensitive area – If the unfortunate occurs and the main earning member were to pass away, owning your own home makes a huge difference. I can tell that from my own experience.

Conclusion
I would say the primary reason for buying a home is that it provides a roof for your family and happiness and security. The accepted truths on financial aspects are delusions which people use to justify over spending on their house – buying more than they can afford.

Final question – have you heard of anyone who used to live in 3000 sqft house in a posh locality and when his house appreciated by 200%, decided to sell the house and went to live in a village in a 500 sqft hut ? Once you and your family gets used to a lifestyle, you will never want to downgrade it !!. So next time if you are getting giddy over the appreciation of your primary home, please think about what that means, if anything. (sorry for popping that bubble :) ).