January 12, 2010

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 :) ).

41 comments:

Ravi said...

Hi Rohit,

Very well explained. From the explanation,I could infer that cash flow wise, you get better owning a house after the 20th year as the interest outgo will become 0% which brings down the total cash outflow to 3 to 4%. Also the interest cost of 5% is on the asset price and it does not increase as years pass by..The interst cost comes down where as the rent that we pay will keep increasing with time.
As I see it people get carried away with the returns they get. The look at the absolute value without looking at their compunded annual return rate. Since realty investments take huge capital, the return looks huge. If one can leverage from bank at that same rate and invest in stock market they could make better returns and it will look bigger in absolute value terms compared to stock market. The point is the risk one assumes during leverage. It does not matter if its real estate or stock. They do not understand that if the real estate value goes down big way like it did in US, the banker will come knocking our door to pay up more (to keep up the equity %) as the total asset value has come down. Its as bad a risk as leveraging to invest in stocks.

Regards
Ravi

income.portfolio said...

Rohit,

I am with you in saying primary housing is not an investment.

It really does not matter what asset you have (real estate or gold or anything else), when you overpay, you lose.

Value is getting misunderstood (or miscalculated) in times of cheap credit. People forget significance of cash flow when credit is easily available.

Best Wishes,
TIP Guy

Anonymous said...

I think its better for people who don't understand the complex world of securities. 2-3 percent positive return is better than losing over long time period for common person.

Real estate investment is a forced long term investment which is usually good. Value of a house is unlikely to go to zero unlike in stocks sometimes. Also it can be leveraged financed unlike stocks where all the money has to be invested upfront.

But I still believe stocks are better long term investment. even indexing over long term can give better return than real estate.

Nilesh said...

i slightly agree with you. its not a FINANCIAL investment only.

i too did some maths. even if house appreciate ~ inflation, you are still better off since you are saving on rent as well.
i have seen many cases including my own parents where it was sound investment (land bought at 40psft was quoting at 800psft in 2003 after 20 years before real state boom at my place, that was 16% CAGR).

but you are completely right in saying that one should not overspend on it for # of reasons
1) one should live within their means. our parents followed this strictly and as you said they got it right in this aspect.
2) not a liquid asset. hard to encash in case of emergency.
3) one has to be diversified in their portfolio. not everything in single house which is not yielding.

Anonymous said...

Hi Rohit,

A nice post. makes brins to think. Keep it up
/Santosh.

mkd said...

Hi Rohit,

Nice post.

One of the most important take-away (which is generally not pointed by many people) is that for someone who is at the early stages of earning life and does not have the inclination or financial competency to explore investment opportunities, it is probably better to buy their primary home.

It will probably help them get better financial discipline in terms of planning and saving for the EMI. Although they might get lower returns (only on notional basis since they are no selling their primary home to lock into the gains) than what they would have got elsewhere, it is always better option than losing money while trying to perform financial stunts.

rmathew said...

Coincidentally, I wrote a blog post a couple of days ago that shows how I would go about valuing a house that I plan to stay in.

By the way, a downside of owning a house is that it reduces your mobility (e.g. moving elsewhere in search of better career opportunities). It is not a very liquid asset if you're thinking of it as an investment.

Ramesh said...

Another consideration is the opportunity cost of the capital being locked away and not earning returns (i.e., if you can put your money to work at a 10% annual compound rate, say, in stocks, you'd have compounded your net worth MUCH faster 10, 20, and 30 years from now compared to owning a home). Over a 30 year horizon (a typical home loan term length), you're better off being a part-owner in a consumer goods company in India which is almost certain to grow earnings for you as well as give you inflation protection. Over the very long-term (250-300 years), the data available from almost all markets around the world suggests that real estate investments only keep pace with inflation, so your real return is zero (a distinction lost on most people). Of course, all this is predicated on the assumption that your objective is to maximize your terminal net worth - which might not be the case if you want to feel good about "having your own place."

Madhav Shivpuri said...

Rohit, nice post as usual which justifies buying one's primary home. I guess the math doesn't work so well for 'investing' purpose.

For an NRI, the same math gets even worse because the loan term is max. 7yrs. Also, I am not sure if the EMI's are tax deductible. As a result I have always invested in land in the hope of long term/ speculative returns. I wish the math would help us own houses from an investment perspective.

sumi said...

Thoroughly enjoyed reading this post. Especially the last example lol. I am tired of having this argument with my parents who insist on investing every single penny in real estate, citing the same examples you've written about. Psychologically gold and property make them feel secure.

The other thing I would like to talk about is that even with the market at the current levels there are still a few value picks at fair valuations from a long term perspective.

I just need to research further before I post on them.

Furkan said...

Really nice post, Rohit. Especially, seniors in the society dont get the idea that they have to think in real terms not in absolute terms. During high inflationary period in Turkey last four decades they saw the price of real estate investment went up thousand times. So someone who purchased an apartment did much much better than who consumed his all income. So the way they think is in real terms and they dont compare the returns with other alternative investment tools. It can also be related to the fact that most people dont have enough time and will to investigate other opportunities. So they choose the easiest way and common sense.
Actually i also tell my friends to buy their primary home because they will be saving that way, i never advice it as the best investment idea though.

Ninad Kunder said...

Hi Rohit

Rent yeilds in India dont work beyond 4-5% max. Typically the owner pays for the maintenance. So if you do a rational analysis it is far better to rent than own a house. But as you correctly pointed out there is a emotional side to it and the emotional joy tends to outweigh the rational decision.

The other variable in the Indian context ( And the reason for which real estate investment is popular) is black money. The Indian system has a lot of black money which cannot be effectively deployed and earned returns on in other asset classes. Real estate tends to become the only medium of deploying that capital. So u need set different set of rules of comparison between ppl with black money and ppl without :-).

Cheers

Ninad

Vic said...

Hi Rohit,

Good post.

I liked ur note " 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" as mkd pointed out the same. this happens to most of us..:-)

Not that I support RE as an investment but wouldn't it be reasonable to consider the appreciation factor as well in your calcs? Of course, considering the primary house was a Value buy.

Don't be so sure of your final question..:-) I might be one of those who would do it. :-)

Thanks.

Anonymous said...

Rohit,

Hope you received my receipt for donation to CRY. Thanks
Gian

Amit said...

I really like your post. And you have beautifully brought out the non-financial reasons of owing a house. Even I have started earning 2 years back and done a lot of calculations to conclude that renting is better than buying most of the time. But then everything is not for financial reasons.

Mitran said...

For the next generation, your getting a home.

Anonymous said...

One aspect of Real Estate investment is it force you to save in order to pay EMI and build your assets. For those who are renting, not many people would save / invest excess money (difference between EMI and Rent). They would probably spend it on things which they do not need.

If one is not taking a loan and has hard cash to buy the house, its a different case all together

Rohit Chauhan said...

Hi ravi
what i think you are arriving at is the equity in the house appreciates by this formulae

home appreciation % * leverage

so if the house appreciates by 10% and you have 50% loan, then your equity is up by 20%. thats true..except this is more of an opportunity cost ..you dont make this money..more if you have a house you dont have to worry about price appreciation.

if you are buying to stay..i think leverage is not an issue as long as you have bought the house within your means. however if you are investing ..thats a different story and maybe a different post :)

Rohit Chauhan said...

Hi TIP guy
yes, easy credit and a bubble in price has everyone thinking in india that real estate is a one way ticket to riches. we'll see how it turns out

rgds
rohit

Rohit Chauhan said...

Hi anon
investing without knowing about the asset class is dangerous ..it is financial suicide to do it with leverage. even if real estate does not go to zero, take some leverage and you can lose all your principal and more

finally in india housing loans are full recourse loans ..so you cant walk away from the property ..the bank can take your other assets too

buying an investment with weak knowledge and leverage is a bad idea

rgds
rohit

Rohit Chauhan said...

hi nilesh
A primary home works out from an inflation and security point of view ..you are right ..having your own house spares you the agony of rent escalations and you are not at the whims of the landlord.
at the same time when you buy a house the last thing you should be thinking is by how much it will appreciate
if you stay in the house a 16% cagr does not make you wealthy ..but not buying could increase you cost of living

rgds
rohit

Rohit Chauhan said...

Hi mkd
i think buying a house forces a person to save and prevents him or her from foolishly investing ..more so if you are just starting out

rgds
rohit

Rohit Chauhan said...

Hi rmathew
i saw your post ..the formulae is a mathematical way of analysing the same problem ..i have tried to simplify it in the post.

you are right ..owning a house reduces mobility and thats a negative ..but not a big one i would say

unless you are stuck with an inverted mortage
rgds
rohit

Rohit Chauhan said...

Hi ramesh
A good stock is more likely to give a higher return than real estate. i think there is quite a bit of data which substantiates it.
the problem is people see the stock market everyday and think it is more risky as prices fluctuates ..whereas price in real estate dont fluctuate so much and people equate that with low risk
low volatility is not low risk and vice versa
rgds
rohit

Rohit Chauhan said...

Hi madhav
i think for an NRI property investment is a major headache with the legal and other issues .

rgds
rohit

Rohit Chauhan said...

Hi sumi
yes there are some value picks ..but not as cheap or attractive as earlier

rgds
rohit

Rohit Chauhan said...

Hi furkan
you are right ..primary home is a hedge against inflation of rental cost..so its a defensive play ..you are not making money , but avoid a high rental cost in the future

rgds
rohit

Rohit Chauhan said...

Hi ninad
now black money is a problem i dont have :)

no white or black or purple money here :)

Rohit Chauhan said...

Hi vic
i am not against real estate as investment ..at right price any asset can be a good investment.
my point is that your primary home is not a financial investment ..when it appreciates you are not getting richer
rgds
rohit

Ninad Kunder said...

Rohit

But u surely have the green money with the greenbacks :-). Though I dont know which side of the grass is greener off late.:-)

Cheers

Ninad

Sachin Purohit said...

Conventional "wisdom" is almost Aristotlean and deserves to be challenged scientifically, with the aid of numbers. In that broad sense, I agree with the conclusions derived by you. I also agree with your myth-busting of these accepted truths like "Real estate will always continue to appreciate".

However Renting Vs Owning: The calculation is assuming that the owner of the rental property is not going to build into the monthly rentals, the cost s/he has had to expend on maintaining the property and the principal he has had to pay for owning the house. In the short-run, the supply-demand scenario may force him/her to rent it out for less. But not in the long run. Of course, you have closed this matter by one single line that - you are going to cover this point in a different post.

Also say Shashi Kapoor in Deewar, stayed in rental apartment and Amitabh bought a bunglow which he is going to pay up for in the next 20 years. If they were to meet each other in the middle of a road 20 years hence, who do you think would be more satisfied with his decision assuming even the Maa was staying with Amitabh? While Shashi would still be paying the rentals, Amitabh and his future generation would be only paying the maintenance cost.

Rohit Chauhan said...

Hi gian
i have recieved your reciept. will respond soon..sorry for the delay

hi amit
i agree ..buying a house is important even if the calculations make renting attractive sometimes

rgds
rohit

Rohit Chauhan said...

hi sachin
that was a total bouncer :)
deewar and amitabh in a post for buying a house ..i could never have imagined that :)

not sure what you mean by not considering maintenance cost when buying ..i have considered that..on the single line explaination of why rental equates to interest ..i will try to explain in a post as it is a bit complicated and i need to put my thoughts on a paper to explain it in simpler words
rgds
rohit

Rohit Chauhan said...

Hi ninad
he he ...greenbacks have turned yellow and may soon rot.

being married and having kids is an expensive proposition :) easy come and easy go

RK said...

Well analyzed! a primary home is definitely not an investment but having one is really really important. We all assume that every person is sensible and intelligent enough to make wise and smart decisions with his money but that's not the case. So buying a home makes sure a major portion, at least for most, of the savings goes into something that gives protection and contentment. After all the basic needs are still roti, kapada and makaan!

rk
http://thedumbinvestor.blogspot.com

Anonymous said...

Rohit,

have you looked at Amrutanjan Healthcare Limited lately. Any thoughts. ?

Regards,

Anonymous said...

Hi Rohit,
Agreed, it is not a great investment and as with any asset class, what price makes a huge difference. And you can still lose by buying a house - though not seen obviously yet in India.
Few other points:
1. You get stuck to a place by buying. You don't tend to move out even if your office moves 20 km away and end up paying for petrol! This could make a considerable difference.
2. Even for rental there are HRA related tax deductions.
3. Have you also analyzed how it works out if you've paid without a loan or more realistically, repay in 5-6 years due to your additional income through principal repayments?
4. Other negative: Absence of title insurance and the way real estate business is managed in india. Consumer is not the king, builder is.
-Venkat

Rohit Chauhan said...

hi venkat
true ..i did not consider the tax benefit of HRA. that would make the argument against buying stronger. there are several other negatives too. but you know what as a home buyer myself who analyses each financial decision ..i dont regret it.
there is a huge emotional component for me and family which numbers cannot capture

rgds
rohit

Anil Bilawala said...

Hi Rohit,

I have been following your blog since sometime now and respect your views on security analysis. I read all the comments and would like to present the following point of view
- While I agree to your headline and conclusion; some facts need to be considered
- Rent will increase as per the capital value of underlying asset ie home. So one can assume that you will always pay 5-6% of 'Market Value' as rent
- When the underlying asset value increases, if you owned your house; your rent equivalents ie interest + maintenance will largely remain same in the future (thats why sometimes it is prudent to buy a older bldg with low maintenance outgo)
- Besides you should consider the transaction costs (forget the emotional trauma) of moving houses every 33 months or with 30 days notice. Brokerage, Relocation, Damage, Leaves, etc
- Real Estate is another avenue for investment. If you understand it well, buy at the right price and sell when overpriced, you will prosper
- You can leverage your house like any other investment instrument
- The home loan is a cost effective way of leveraging and saving the capital (one has) to invest in Capital Markets!!!

Cheers,
Anil

Rohit Chauhan said...

Hi anil
your own definitely works as a hedge against inflation which is your first point. as i said in the comments, buying your first home will prevent you from becoming poorer, but will not necessarily make you richer..so its a defensive instrument
to your second point ..if you look at a home as an investment, then yes i agree ..price is crucial

on final point i disagree ..i will never use home loan to invest in capital markets ..its not worth the risk for me
i would never use leverage asset (a home) to put money in the markets ..that would be a financial suicide for me

rgds
rohit

Anil Bilawala said...

Hi Rohit,

What I meant by home loan being low cost leverage is that if I had 5 lacs capital with me, I would rather take home loan and only put 20% = 2 lacs as my share & take a home loan of 8 lacs. The balance 3 lacs will usually be available to me for investment in Cap Markets, which is normally the case. Most borrowers don't use their entire monthly savings to pay off home loans. They also put their savings into equity investments, FD, etc rather than pay off the home loan and make the house debt free.

This is an round about way of using the home loan money to invest.

Cheers,
Anil