Uzair’s Theory on Buying a House

Usually most of my theories have no numerical or real life basis. They are usually ideas I test out in my mind, using my own built in simulation engine which may or may not reflect the real world. However, this time I do have a legit counter argument using facts and figures to the commonly held belief that “buying this always better” and “real estate is a good investment”. False. Here’s why:

First of all, all the numbers I will use are based on facts and since this is not a school report I’m not going to do a bibliography. If you can read this you can probably use Google and confirm these facts yourself. And if you’re incapable of doing that, you should probably buy a house.

1)      Property of real estate always goes up

That is true in the long run. On the other hand, the value of the stock market also always goes up by a much higher percentage. Real estate barely outpaces inflation while, investing in just the market yields a healthy return. Also a fact that many seem to overlook is that in the 1960’s, it took a worker to work the same amount of hours as it does for a worker today to buy the same home. House prices were lower back then, but so were salaries. Another thing that people seem to forget it is the fact that it’s land that goes up in value, not the house itself. Look at all the 25+ year old houses. Hell, even 15 years old and they look outdated. That house is not worth more money and I dare you to convince me it is. It has outdated technology that will cost 10s of thousands of dollars to catch up to modern standards. This will definitely chip away at your returns if you plan on buying a house as an investment property. I bet right now you’re thinking, “but zomg Uzair, in the past decade property has gone up by sewwww much”. That’s definitely true, but if you didn’t buy it then you’ve probably missed out on this once in a lifetime boom. What really happened was prices in Alberta were undervalued and all this “boom” did was allow them to catch up to their actual values. The same is happening in Sask. right now. But this has gotten in the minds of the everyday person who doesn’t really know how the economy works but hears his friends talking about how much the value of their house has gone up and how real estate is always booming and the bubble crash is only going to happen in the states blah blah blah. This is what is called “the recency effect”, a cogitative basis which clouds the decision making process. In the past decade real estate has been booming and it’s easy to become fooled by this hot streak. People have forgotten the harsh realities of the 1980’s are where the economy was in much much worse shape than it is now. 20 years ago interest rates for mortgages averaged at 11.4%!! Interest rates are at about 3% right now, they are not going to get any lower this. Traditionally, personal financial experts have said that your mortgage should not be more than 3 times your gross income. Which makes sense, you don’t want to over extend yourself. But because of the extremely low interest rates in the last decade, house prices have outpaced inflation because people can afford that much more. Or they think they can. The affordability index for a 1,200 sq ft mortgage in Canada is 42% of PRE-tax household income. That’s much higher than a mortgage of 3 times your salary. To make matters worse is the fact that 70% of Canadians are now homeowners, which is similar to the number in the United States before the bubble burst. This is now a matter of supply and demand, the majority of sellers are now in the 65+ age group and the majority of net buyers are between the ages of 25-34. Canada’s aging population, especially with the baby boomers about to hit that age soon, means that there soon will be an excess supply. Another factor that can’t be ignored is the artificially low interest rate. As I said before the interest rate is the main driving force behind the house prices because salaries are definitely not keeping up. So if interest rates reach what they should be historically, at 5% to 6%+, the house suddenly becomes unaffordable to a large group of people. For a 300,000 mortgage at 3% right and payments of $1479/month. In 5 years, that $260,000 mortgage with an interest rate of 7.23%(average 5yr rate between 1990-2000) now becomes $2165/month! That is the difference between owning a home and being out in the street. To make matters worse, consumer debt in Canada is almost at United States at its worst. Another factor that doesn’t look good for the real estate market. And if you can’t make the payments, the bank seizes your house and there goes that huge down payment that you spent so long to save up.

2)      What if the market drops?

Now I already bought up the fact that land values do go up over, even though it barely outpaces inflation, it still goes up. Now here’s real estate’s biggest concern in terms of it being an investment. The results are asymmetrically, meaning that if you do well in the real estate market and it goes as expected the returns are not that great. It’s mostly like a shelter for your money. However, if the value of the house drops then the nightmare begins. Because a house is so highly leveraged (often between 80% to 90%), even a -1% drop in price destroys your equity and your huge down payment. The market value doesn’t even matter really because the true value of your house is what someone is willing (or able) to pay for it. You can have the most highly prized property but if no one is able to pay for it then it’s useless.

So to summarize, real estate is an extremely illiquid, highly undiversified and leveraged investment with a limited upside and potentially catastrophic downside. On top of that it has high holding and transaction costs which eat away at your ROI.

Those were the economic reasons why real estate is not a good investment. Other factors that people seem to overlook when buying a house is the fact that you are trapped. When you take a mortgage, you become a slave to your job and to corporations. You can’t just pack your bags and go whenever you want. Hate your boss? Hate your job? In a rut? Too bad. You have a mortgage to pay. This is especially true if you are young and have the rest of your life in front of you. You have essentially anchored yourself in one region for at least the next 5 years and limited your opportunities because you fell for the myth that it’s always better to buy a house. If anything goes wrong in your house, that’s yours to fix. It’s your headache, not your landlords.

Using very basic and modest calculations, here is the cost analysis of buying a house versus renting the same house with a roommate and investing the difference over 10 years. This number gets worse for the owner overtime as the power of compounding interest helps the renter’s investments.

 

Home purchase model
Purchase price 330000
Downpayment 30000
Interest rate 3%
Principal amortization (years) 25
Property tax rate 0.50%
Annual maintenance 950
Housing association dues (annual) 4200
Annual insurance 1000
Assumed annual appreciation 2%
Assumed marginal income tax rate 30%
General inflation 2%
Monthly mortgage payment 1461.14
Cost of renting similar home 800
Assumed rental price inflation 2%
Assumed annual (after tax) return on cash 4%
Year 0
Buying scenario
Home Value 330,000
Debt 300,000
Equity in home 30,000
Interest on debt
Mortage payment
Paid principal
Insurance payment
Housing association dues
Maintenance
Property tax
Income tax savings from interest deduction
Total cash outflow in buying scenario
Renting Scenario
Cashflow that could be spent on home-purchase/expesnes
Rent 9,600
Savings when renting 30,000
Home value after 10 years 402,268
Debt after 10 years 210,961
Home Equity after 10 years 191,307
Transaction costs of selling in year 10 24,136
Net cash if home sold in 10 years (assuming no capital gains) 167,171
Savings after 10 years if renting 172,712
Present value benefit of owning vs. renting for 10 years -4,546

And this is with all the benefits of being able to move wherever you want when you are young. And if you invest in the stock market you will make more money, especially if you utilize your allocation models. Right now this is just putting in high interest savings account and you still end up ahead. And best of all the money is liquid, unlike the house where that’s the property value but you aren’t guaranteed to receive it. In the future I will do different cases.

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Comments

comments

5 Comments

  • Zarko

    July 1, 2012 at 6:12 pm

    It’s a very good article Uzair but you can’t base all this off a minimum down payment. You need to show people the range of possibilities and the threshold down payment percentage they have to achieve to actually profit, which is possible!

    • uzairah

      July 1, 2012 at 6:16 pm

      I know Zarko, but the purpose of this was to base it off the average homeowner in this economy with it’s artificially low interest rates. I haven’t even bought up what will happen if interest rates go back up to what they should be historically. On top of that in my blog I’m going to avoid cogitative biases from my part so I will also draw up situations where real estate is beneficial. The thing will real estate though is that even when it is beneficial, there really isn’t much of an upside especially to the individual investor. I have some ideas on how individual investors can make money but I have to do more research into them.

  • Jason

    July 6, 2012 at 3:33 am

    You bring up good arguements however you failed to mention what is a good investment other than sleeping with your money under your pillow. In reality most of life has a risk and everything has a down side. In the past you have talked about using the money for a down payment of a house into the stock market however histoically there is more stability in real estate compared to the stock market. You can always talk about exceptions but in the end it comes down to individual risk tolerance. For example you could buy a cheap car for $10k and sell it for $15k in a month however what if you are unable to sell it for more than $5k- now you are stuck with a “modified house” without a toilet…still good job on putting some thought behind the housing concept

  • click

    July 7, 2012 at 2:51 pm

    If you could message me with some hints about how you made your blog look this cool , I would appreciate it.

  • H. Law

    October 22, 2012 at 8:45 am

    This is my first time i visit here. I found so many interesting stuff in your blog From the tons of comments on your posts, I guess I am not the only one having all the enjoyment here! keep up the good work.