My wife and I bought our house in mid-1993. We’re at the young end of the baby boom, but we bought our house when we were fairly young. As a result, we’ve lived through the huge run up in house prices older boomers have enjoyed. In 25 years, the price of our house has gone up about 160%. So, how has this compared to our investment portfolio?
Well, in that same period of time, our portfolio has had a cumulative return of 1030%. That might seem to end the comparison, but real estate is typically a leveraged investment. We paid off our home quickly, so we didn’t get much advantage from the leverage. But what if we had used leverage?
The average discounted mortgage rate over that period was about 5%. Suppose we had put 10% down and made payments on a 5% mortgage for 25 years. The Internal Rate of Return (IRR) on our investment works out to 5.8% per year or a cumulative return over the 25 years of 307%.
It might be tempting to add in a return from not having to pay rent, but it’s doubtful that the rent on a comparable house would have been more than we’ve paid in property taxes, insurance, maintenance, repairs, and upgrades.
We figured out early that it didn’t make sense to pay high mutual fund fees on our investments. If we had paid an extra 2% each year, our cumulative investment return would have been 580% instead of 1030%. This brings the 307% real estate return closer, but our investment portfolio still wins.
What’s the point of all this? Even though we owned a home during one of the best periods in history for real estate, our other investments performed better. There may be some people whose homes outperformed stocks, but far fewer than most would guess. When we think about our homes being worth a couple hundred thousand dollars more than we paid, it’s easy to forget about the costs of ownership and the long period of time it took to get that return.
Looking forward, real estate can continue to appreciate, but certainly not at the same pace it did for baby boomers. For now, young people are better off financially renting rather than owning. This is true even if they choose to rent a single-family dwelling rather than an apartment. To get full advantage of the lower cost of renting, they need to sock away some of their monthly savings to invest.
You could add that it's also a reason not to over-invest in your home. I have a modest condo, and sometimes wonder if I should take go for a larger, more luxurious, better located (ie, more expensive) condo instead, this kind of analysis tells me I'm better off staying put and investing the cash that would go to a larger mortgage.
ReplyDeleteDid you take taxes into account ? Specifically, the fact that principal dwellings are exempt whereas non-registered savings aren't ? How could we add this to our calculations ?
@Anonymous: I agree that it doesn't make sense to over-invest in your home. The way I look at it, my home is an expense. I own one because I want one, the same way I own cars, computers, clothing or anything else. I bought the house I wanted to live in. I didn't buy a house as an investment.
DeleteI didn't take taxes into account in the article. Most people don't have reason to pay taxes on their investments because they can't use all their RRSP and TFSA room. (Note that despite what people think, growth in RRSPs is tax-free when you properly take into account the inflated amount you can contribute due to the near immediate tax break.)