Last week I did a post looking at if your house was a good investment or not. A classmate named Karthee from ChicagoBooth made a really smart comment:
“Isnt the house purchase a Leveraged Buy out? You didn’t actually put in all the $785K, but took all the profits (1.15M – 785K) – so shouldn’t the return math be based on your down payment rather than the cost of the house (unless you paid for the house in full – which most people don’t)”
Before we dive into the issues, a quick thought: Karthee and I got our MBA together 10+ years ago. He was a tremendously smart guy and has been very successful since we were at U of Chicago. When I did my post looking at the value of college, I left out the value of personal relationships that you can develop with your classmates and the network you can build. I did that deliberately because so many college grads are struggling to pay student debt and make ends meet. A strong personal network that doesn’t translate into professional opportunities seems like a bit of a luxury.
That said, the people I met at ChicagoBooth are absolutely the smartest and most talented people I ever spent so much time with. I don’t know if that alone was worth the cost of attendance, but as I get older and my professional career takes on a new look and feel, being connected to so many really amazing and scary smart people becomes the more dominant value I enjoy from my MBA experience. You know, other than meeting my wife and the mother of my children there.
On to Karthee’s comment
I think he’s mostly right, but a little bit wrong. Let’s talk about how he’s wrong first and then we’ll get to how he’s right.
His comment has less to do with the performance of the asset (did the house increase in price?) and more to do with how the purchase was financed. Definitely in that he was right that we bought the house with a mortgage, paying a 25% down payment. The house cost $785,000 and we had to “invest” $196,250 as the down payment. Then every month we made a mortgage payment of $2,811, of which about $1,000 went to paying off our mortgage (the rest was interest).
He’s absolutely right that if you look at our investment as $196,250 and our gain as $365,000 that changes the numbers substantially. But should you? Maybe. More on this when we talk about how he’s right.
If you just look at the assets’ performance—the house compared to the stock market—the house didn’t do as well. In our particular case, our house increased about 46% over the five years we owned it; the stock market increased about 76% over the same time period (about 90% if you include dividends which you should). The broader data shows that houses on average return about 0.4% annually while stocks have historically returned 8-10%.
How Karthee’s right
Should we consider how you finance an asset purchase when you make an investment choice? Certainly, money is money. Again, if we were doing apples to apples, you could put 25% down to get a house and compare that to if you bought stock on margin and leveraged it 3:1 (put $1 of your own and borrowed $3 to invest). In that scenario you would have the same results that the stock market does better.
However, that’s a bit of a theoretical construct and Karthee’s point is much closer to reality. Not many ordinary investors buy stock on margin; I certainly don’t. About half to two-thirds of people borrow money when they buy a personal residence (I was shocked that it wasn’t higher). So in that way, the default for home tends to be “leveraged” while that’s not the case for stocks.
Furthermore, interest rates when you borrow for a mortgage are much, much more favorable than if you bought stocks on margin. Our mortgage is 2.2%; if I bought stocks on margin the rate would be about 6-9%. Also, our mortgage is tax deductible which brings it down to an effective rate of about 1.5%. I’m no tax expert so I don’t know if interest on margin purchases are tax deductible. If not, that further supports Karthee’s point.
Certainly in a practical example of making the choice between buying a house and renting and then investing the money, reality is closer to Karthee’s point. That said, most of the return comes from the decision on how you financed your house, not that you bought a house that increased in value.
We can put a little table together that figures this out. The last row includes an adjusted CAGR which accounts for all the costs—realty fees, home improvements, plus the “value” we got from the house acting as a shelter. We’ll also include the returns if we invested the money in the stock market and invested on margin (maxing out at 1:1 margin ratio at an 8% interest rate).
|
House paid with cash |
House paid with mortgage |
Buy stocks |
Buy stocks on margin |
||
| Cost to house (2010) |
$785,000 |
$785,000 |
$785,000 |
$500,000 |
|
| Money “invested” |
$785,000 |
$250,000 |
$785,000 |
$250,000 |
|
| Sale price of house (2015) |
$1,150,000 |
$1,150,000 |
$1,511,450 |
$595,375 |
|
| Profit |
$365,000 |
$365,000 |
$726,450 |
$345,375 |
|
| Gross return |
46% |
146% |
93% |
138% |
|
| CAGR |
8% |
20% |
14% |
19% |
|
| Adjusted CAGR |
9% |
21% |
This leads to some pretty insightful results. To Karthee’s very correct point, when you look at your house as a leveraged-buyout, the profits are greatly magnified. In our case, instead a 9% return assuming no mortgage, when you factor in our mortgage we would have a 21% return. That’s enormous, and that’s really Karthee’s whole point.
You can compare that, as I did before to investing in the stock market. The stock market had about a 14% return, so a house with a mortgage would have done much better. However, if you leverage your investment in a similar way to how you did with your house, they end up about equal—the house is at 21% and stocks bought on margin have a return of about 19%.
19% and 21% are close, but the house is slightly ahead. That speaks to some inherent advantages you get when borrowing money with a house. For the stocks on margin, I assumed the most you could do is borrow at a 1:1 ratio (you could only borrow as much money as you were investing). Keep in mind for a mortgage, we got a 3:1 ratio; we borrowed $3 for every $1 of cash we brought to the table. Also, I assumed that when you borrow on margin you pay an 8% rate; that is much higher than the 2.2% rate we have on our mortgage. Those two factors—ability to leverage at a 3:1 ratio and to borrow at such a low rate—give the house a great advantage.
So with all of this KARTHEE IS RIGHT. If you consider a house as a leveraged investment, our housing experience did outperform the stock market.
What if we weren’t so lucky?
Our house appreciated at a particularly high rate, but most houses only increase at about 0.4% when you strip out all the home improvement and other stuff we talked about last week. But to Karthee’s point, your house is a leveraged investment and we know that should increase the returns you experience as a home owner.
If we assume a very vanilla situation, if you put 20% down on your mortgage and the house appreciated 0.4% annually, the math would tell you that you would realize a 2% return per year due to the leverage you have on your house. Obviously 2% is significantly lower than you could get in the stock market, on average.
Plus, that 2% number is a bit of a best case. Over time, you’ll be paying off your mortgage so your investment will creep up over 20%, decreasing the impact of the leverage. Also, as we mentioned last time, when you sell your house you’re likely going to have realty fees which basically act as a massive transaction fee which can really zap your profits.
We’re at 1500 words. Karthee had a really great point that we should look at our house as a “leveraged” investment and that definitely enhances the positive returns if you house does increase in value (we didn’t touch the nightmare scenario of an underwater mortgage ☹). In our case, the leverage put us ahead of what we could have done in the stock market, so that did make our house a good investment, I suppose.
However, the data shows that even with leverage houses tend to underperform the stock market pretty drastically. As I said last time, that doesn’t mean you shouldn’t own a home. We do. There are a lot of great reasons beyond the investment angle to do so. Let’s just be weary of thinking they are these great investments.