A personal property is not an “investment”

It drives me crazy to hear people talk about buying a personal residence (PR), and justifying it by saying things like: “well a home is an investment”, “I’m tired of throwing money away on rent”, and “I know people who made a lot of money when they sold their house”. 

Generally, a PR is a terrible investment! I am 100% an advocate of people purchasing cash-flowing real estate in order to build wealth and retire early. But most of the time, home-ownership is a decision that sets people back many years on their financial journey. It robs them of time, money, and options. 

At the end of the day, all decisions are made from an emotional standpoint. Humans are emotional creatures. Those decisions are then justified and rationalized later. And no decision evokes this greater than perhaps decisions on housing and ownership of that housing. Their true emotional needs often seem to fit the following: they want to be seen as successful; they want to increase their comfort, security, and convenience in their life; and they may want a greater sense of control. 

Make no mistake, these are all valid and rational reasons to own a home, but they do not make that a good investment from a financial standpoint. It may make great sense once you’re a bit older, because at that time you’ll have money to spend on things, without worrying about the effect on your bottom line.

Let’s look at an example

Jane is a hard-working and smart girl who makes $80,000/yr. and lives in Denver. She is 28 years old, has no kids, $30,000 of savings, $60,000 in her 401k, and minimal amounts of debt. Jane feels, rightly so, that she has done very well in her career so far, and feels that she has earned the right to purchase a home. Additionally, she wants to set down some roots, decorate the home to make it hers, and live alone finally without roommates. 

She speaks with a lender, who tells her that she can qualify for up to a $350,000 house on a 30-year loan at 5% interest rate. With that in hand, she hires a real estate agent and begins looking for homes. She finds a lovely, but smaller starter home in Denver that will suit her needs for now, and buys the home for $320,000. She puts down 5%, or $16,000, and pays $2,000 in closing costs to acquire the property. 

Jane loves her new home and sets about doing minor repairs, getting furniture, decorating, and buying supplies and equipment to run the home. This all costs her another $2,000. So now we are $20,000 into the home. The monthly payments for the home are as follows: $2,000 for PITI (the mortgage payment) +$200 for utilities + $100 for the HOA = $2,300 every month!

Yes, Jane is building equity, but not much. Each month, she builds $420 of equity. The property may also appreciate, building wealth. But it may decrease in value, which would destroy her wealth. Since this cannot be controlled, it can be reliably counted on and represents a risk to Jane. 

House poor?

So let’s summarize and see where we are at in all of this. Jane used to rent a room in someone else’s very nice home for $750, utilities included. Now, she is $20,000 less wealthy (she can’t spend her home equity), and is paying $1,550 more per month. After accounting for her principal pay down, her new financial situation is $1130 worse than it was when she was simply renting.

At $80,000 of income, over two grand for housing is a lot of money and will hamper her ability to save. She will certainly not be able to retire early unless something changes! If your house payment prevents you from having any excess cash, you are effectively poor. Because of your house. You’re house poor. 

This example highlights how someone can do all of the “right things”, and end up house poor. Jane bought too much house for her income and decided to live alone in an expensive market. This situation could have been improved by buying a cheaper home (hard to do in Denver, and other expensive markets), renting out the rooms, or purchasing a home as a fixer upper and improving it while living in it. 

Housing prevents wealth from building early on

Home-ownership is a trap that I see many young people fall into. It slows down your wealth accumulation for the following reasons:

1. You tie up your down payment, which often gives terrible returns. 
2. There is a large time sink in managing the property.
3. You’re too emotionally invested in the property to treat it as an investment. 
4. There are ongoing costs of ownership such as taxes and maintenance.
5. You likely bought the home for personal needs and not to maximize returns. 
6. The type of house that you bought would generally not perform well financially as a rental.
7. You’re now physically tied to that location, which prevents maximizing other opportunities in life.

You tie up your down payment, which often gives terrible returns. 

In the example above, Jane put 5% down on her home. She has $20,000 in equity in the home which is the difference between what she owes, and what the property is worth. Because this property doesn’t put any cash into her pocket each month, the return is negative (on a cash basis anyway). Average home appreciation in the US is around 3% historically.

The example was in Denver, where appreciation has averaged around 6%. Even so, a 6% return is not too great. You could simply put this money into the stock market and get around 9% returns, with WAY less work and hassle. Don’t forget, if she wants to get this money she will need to sell the home. This usually has an 8% cost to transact, in addition to any taxes on the gains. 

There is a large time sink in managing the property.

When you think about investments, you should also consider how much time is required to manage the investment. If you had to work for hours per week fixing and managing stock, you would say no thanks. 

You’re too emotionally invested in the property to treat it as an investment. 

Rental property investors and landlords are just regular people. They enjoy having beautiful homes as well. But rental housing often doesn’t justify making everything look really beautiful and fancy. The rents are usually not high enough to compensate for the extra expense.

That is just one example of the way in which rental property is treated differently. Home-owners tend to have lots of pride and emotional attachment to the home. Therefore, they spend extra money on things which an investor would never do.

There are ongoing costs of ownership such as taxes and maintenance.

Back to the stocks, if you had to put another $3,000 per year in, just to maintain your $20,000 of stock, you would pass. This is not the case with PR.

You likely bought the home for personal needs and not to maximize returns. 

Is the home in an area where there are high rental demands? Do renters in your area really care about built-in cabinets, custom kitchens, and granite counter-tops in the bathrooms? Most importantly, do they pay for those extra amenities?

The type of house that you bought would generally not perform well financially as a rental.

Is the cost of the property low enough that you can rent it out profitably for excess cash flow? For most PRs, the answer is no.

You’re now physically tied to that location, which prevents maximizing other opportunities in life.

I underestimated how important this factor would be when I purchased my first property. Because of my home purchase, I was forced to work for a couple of years in a job which I did not enjoy. Because my industry was not a major employer in the town that I was living in, I was unable to find a better role. Even though I was paid much less than I should have been, I was trapped under the need to pay the mortgage for several years. 

Approach property as an investment from the start.

The remedy to these situations is to consider whether or not the property makes sense from an investment perspective before you ever consider making an offer. You need to know roughly how much, and how you’re going to make money on this property before you purchase it. Often times, this will mean that you’re living in a less nice place than you would prefer, have roommates, live in a construction zone, and more. 

Something I told myself during this time was that this was not my forever home. Remember the saying, “Live like no one else will today so that you can live like no one else is able to in the future.”