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How To Figure Out If A Home Is A Good Investment

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We’ve all been told that a home is a great investment but it can be difficult to quantify how good it really is. To answer this question, we need to ask ourselves a few more:

How does a property perform compared to the stock market?
How does a house perform compared to a condo/flat?
Will you earn a better return if you buy a home well within your budget or by stretching and buying something bigger?

Remember that since most people are buying a home using a mortgage, the property is a leveraged investment. This means that gains and losses are amplified. Owning a home is great in a rising market, but painful during a downturn.

To answer the above questions, we’ll use the following scenario.

  • Dual income family
  • Annual gross income: $125,000
  • Down payment: $140,000
  • Mortgage: 3%, 25 year amortization
  • Location: Toronto

According to this affordability calculator, this couple could afford a home up to $780,000. Am I the only one who thinks this number is too high?

Now that our fictitious buyers know what they can afford, they face the same two options as just about everyone else. Should they buy a smaller, less expensive condo to live in for a few years or do they buy a home near the top end of their budget?

Condos and homes have appreciated at a different pace over the last several years, which will need to be taken into consideration.

Option 1 – Condo – $500,000
Expected capital gain per year – 2%

Option 2 – House – $700,000
Expected capital gain per year – 4%

Using this scenario, here’s what the return could look like after 1 year:

Price

Down Payment

%

Mortgage

1 Year Return

%

 $ 500,000.00  $     140,000.00

28%

 $  360,000.00

 $    10,000.00

7.1%

 $ 700,000.00  $     140,000.00

20%

 $  560,000.00

 $    28,000.00

20%

 

At first glance, the home appears to significantly outperform the condo by around 13%! This calculation doesn’t take into account other factors however such as property taxes, maintenance costs and the difference in interest paid.

Here’s a second table to illustrate these differences.

Monthly Payment Interest Principal Property Tax Maintenance
$500,000  $   1,722.83  $     900.00  $     822.83  $     308.33  $            628.77
$700,000  $   2,679.96  $ 1,400.00  $ 1,279.96  $     433.33  $            875.00
Difference  $       957.13  $     500.00  $     457.13  $     125.00  $            246.23
Yearly  $ 6,000.00  $ 1,500.00  $         2,954.81

So what do all these numbers mean?

If the buyers purchased the property for $700,000, they will spend an extra $6,000 in interest per year. If they opted for the smaller property, this money could be invested in the stock market. At a conservative rate of return of 6%, they would have an extra $6,360 in their pocket per year.

Owning a larger home also results in higher property taxes. According to the City of Toronto website, the purchaser would spend an extra $1,500 per year on taxes.

Maintenance is a tricky topic, you never really know what’s going to go wrong in a home and when but you can certainly plan for it. Condo maintenance fees may seem expensive however fixing a roof, paving a driveway or replacing pipes can be just as much, if not more expensive.

I’ve seen many estimates for how much money to set aside for taking care of repairs from 1% to 4% per year. Unless you’re buying a period home in need of extensive work, the 1%-2% range seems more appropriate. With condo maintenance fees of $0.57 / square foot vs home maintenance of 1.5% per year, the home owner will pay approximately $3,000 more per year.

Taking these aspects into consideration, returns will look like this:

Price

Down Payment

%

Mortgage

1 Year Return

%

 $ 500,000.00  $     140,000.00

28%

 $  360,000.00

 $    16,360.00

11.7%

 $ 700,000.00  $     140,000.00

20%

 $  560,000.00

 $    23,545.19

17%

 

After factoring in the extra investment income and additional expenses, the $700,000 home losses some of its lustre however it still outperforms the $500,000 condo by a little over 5%.

When compared to the TSX, the returns on both of these properties are superior. The TSX has returned around 7% on average per year over a 10 year period.

Keep in mind that as time goes on, a property becomes less leveraged as more principal is paid back, this means that these returns will diminish with time. If all things remained equal over the life of the mortgage, the $500,000 condo would only return 2% on the $500,000 once the mortgage has been fully paid off. The following simplified table illustrates this.

real estate vs stock market return

By year 17, the investment in the $700,000 home has de-leveraged enough to return the same as the stock market. By the end of the mortgage, the investment will have de-leveraged completely.

To sum it all up:

Real estate can be a better investment than the stock market but it de-leverages over time.

Stretching to buy a more expensive property can result in a better return.

Homes can make better investments than condos.

As I’ve said before, buying a property to live in is an emotional decision. One doesn’t decide to buy a home solely based on numbers on a spreadsheet. The above example shows how tricky it can be to find out how well your home is actually performing as an investment. Keep in mind that you’ll still need to factor in real estate commissions, fees and taxes to get the full picture!

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11 Responses to "How To Figure Out If A Home Is A Good Investment"

  1. I c says:

    Should likely subtract your interest expenses from the returns in the second table to get the real investment return. The stocks you compare don’t have this expense.

  2. bill clay says:

    The main area people always forget when figuring out if a home they live in is an investment is how does one go about realizing on an that investment. If you buy a home for $500k and prices go up to $700k, amazing you “made” 40%. Except if you sell your home, you’ll purchase your next one for ~$700k (plus find additional funds to make up for the commission you paid to sell your home in the first place) so the reality is, you didn’t make anything as the sale price ~= the new purchase price…unless you die and leave it to your kids or unless you downsize which most people do only once. So all the middle class people who think they are ‘making money’ on homes, sure…they are correct on paper but the exit transaction and the purchase of another home takes care of all the theoretical gains.

    This doesn’t hold though for an investment property, but then the case can be made and debated do you purchase an investment property to rent vs. leveraging yourself into a REIT.

    • Andrew says:

      Couldn’t have said it better myself Bill. The key to making a “real” return is to not keep buying homes in mature developed areas. If homes in the best part of town are appreciating at say 3%, moving into another home in the same area that has also increased at 3% per year may be a wash. In order to truly benefit, one would need to move to a more up and coming area where the rate of return would be higher.

  3. Mike says:

    Could you run the numbers to see what would happen if interest rates rise and/or real estate values decline?

    • Andrew says:

      First, I’ll account for the interest expenses as I c mentioned which is a good point. I didn’t include this in the first place since we have to live somewhere. Taking this into account the returns become:

      500k: -0.3%
      700k: +5.0%

      As the interest expense decreases each year, this should improve.

      Here’s what would happen If interest rates moved up to 4.5%

      500k: -4.2%
      700k: -1.0%

      Predicting what will happen to house prices during a downturn is difficult. Remember that prices tend to drop very quickly and then take many years to recover.

      If property prices suddenly dropped by 10% and interest rates were 4.5%, here’s what things would look like:

      500k: -47%
      700k: -71%

      As I mentioned in the post, leverage amplifies gains as well as losses.

      As Bill mentioned above, at some point you would have to actually realize the loss, the last thing anyone should do is panic sell during a downtown.

  4. bill clay says:

    The main area people always forget when figuring out if a home they live in is an investment is how does one go about realizing on an that investment. If you buy a home for $500k and prices go up to $700k, amazing you “made” 40%. Except if you sell your home, you’ll purchase your next one for ~$700k (plus find additional funds to make up for the commission you paid to sell your home in the first place) so the reality is, you didn’t make anything as the sale price ~= the new purchase price…unless you die and leave it to your kids or unless you downsize which most people do only once. So all the middle class people who think they are ‘making money’ on homes, sure…they are correct on paper but the exit transaction and the purchase of another home takes care of all the theoretical gains.

    This doesn’t hold though for an investment property, but then the case can be made and debated do you purchase an investment property to rent vs. leveraging yourself into a REIT.

  5. Dave says:

    There is another way to test the value of a home. What does the mortage cost monthly vs. what could the house be rented for monthly. A house with a monthly mortgage payment much higher than what it could be rented for is an accident waiting to happen, IMHO.

  6. JTN says:

    Risky risky. Why is it that so few people remember that interest rates will not remain this low forever? One day, rates will rise then house prices will fall and people will panic when they realize that borrowing $500,000 and paying 7% interest is kinda hefty especially if their houses are underwater. Don’t say it won’t happen.

    • Andrew says:

      While 7% is probably a long way off, 4-5% is certainly possible. Perhaps my next real estate related post should be on all the downside risks given some of the recent news that has been coming out.

  7. Woz says:

    I may be completely wrong, but it seems like there’s some mistakes in the math.

    You didn’t subtract expenses from your 1 year returns. Instead you subtracted the difference in expenses from the house alternative and added the difference in interest as income for your condo. Earnings should be calculated as follows:

    Condo: Earnings = $10,000 – 12x[$900 (interest) + $308.33 (tax) + $628.77 (maintenance)] = -$12,045.2
    House: Earnings = $28,000 – 12x[$1,400 (interest) + $433.33 (tax) + $875 (maintenance)] = -$4,499.96

    Now you might be wondering why the numbers are negative. That’s because you didn’t take into account that you get to live in the property. For Toronto condos a typical P/R ratio is 20 ($500k/20/12 = $2,083 / mth) and 25 for houses ($700k/25/12 = $2,333 / mth).

    Your yearly earning then becomes:

    Condo: -$12,045.2 + 12x$2,083 = $12,955 = 9.2% return on your downpayment
    House: -$4,499.96 + 12x$2,333 = $23,496 = 16.8% return on your downpayment

    However, another issue with your analysis is you don’t typically calculate your return based on your downpayment. That’s because if you’re calculating it based on downpayment then you’re completely ignoring the additional risk you’ve taken by being more leveraged. Since you’ve assumed a constant rate of return (2%/4%) the most favourable investment is skewed towards the one that’s most leveraged.

    For example, why not buy four condos with $35k downpayment on each. Your tax and maintenance expenses increase four times and your interest expense increases to $4,650.

    Condo: $40,000 – 12*[$4,300 (interest) + $1,233.32 (tax) + $2,515.08 (maintenance) - $8,332 (rent income)] = $43,403.2 = 31% return on your downpayment.

    The obvious reason you wouldn’t want to do that is cashflow and risk.

    Institutional investors would make the comparison based on cap rate which is (income – expenses)/(cost) and doesn’t included financing costs or capital appreciation.

    The cap rates are then calculated as follows:

    Condo: 12*[-$308.33 (tax) - $628.77 (maintenance) + $2083 (rent income)] = $13,751 = 2.75% return
    House: 12*[-$433.33 (tax) - $875 (maintenance) + $2,333 (rent income)] = $12,296 = 1.76% return

    Therefore, as long as you can borrow money for less that 2.75% for condos or 1.76% for a house you would be cash flow positive. For investment purposes people typically don’t want to buy something unless it’s cashflow positive otherwise it’s considered a speculative investment, but based on your analysis I’m guessing you are interested in the speculative aspect. So if you want to add in capital appreciation of 2% for condos and 4% for houses your returns become 2.75%+2% = 4.75% for a condo and 1.76%+4% = 5.76% for a house compared with your assumed 6% return for stocks. For either of the investments condo, house, or stocks you can increase your leverage to increase your returns, but in doing so you’re increasing risk. If you leverage 5:1 as initially proposed your gains/losses increase 5 times the cap rate minus financing rate.

    Note: I used the numbers you provided for example purposes. Personally, I think you overestimated maintenance expenses and capital gains

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