Dubis Counterpoints Dubis: Imputed Rent: When a home is an investment.
Thank you for the feedback from the last article regarding the home not being an investment. The feedback was well received, polite, and constructive, while it offered me insight to what’s important to readers.
The last article seemed to strike a chord with some readers. The primary source of contention from my last piece was a matter of semantics, not necessarily a real difference of opinion. My goal for the last piece was to simply offer readers a way to segment a home purchase decision from their investment considerations.
A few readers asked for me to expand on the idea of imputed rent. I glazed over it in the last article because it is an abstract concept, but I submit here with the right mode of thinking, a home could be an investment.
Let me explain.
As I mentioned in the last article, a home purchase is ultimately a lifestyle consumption decision. The cost of supporting a house is high and something that must be calculated in the home purchase decision. It’s easy to confuse a home with an investment because a home purchase requires so much money to consume, while at the same time, the property is tangible and may appreciate over time.
The key word of distinction that links an asset and an investment is the concept of “value.” When an investment delivers cash flow net of your costs to purchase and own, that is of value. When a home appreciates and provides you shelter service net of annual carrying costs and inflation, then this is also of value.
The house, though, requires an ongoing net cash outflow in the form of taxes, insurance, maintenance, and often interest expense before your realize a net positive compared to renting.
In exchange for that cash outflow, though, you didn’t have to rent somewhere else, paying for shelter elsewhere. When you take a mortgage for a home, you are essentially paying an expense for the money you borrow. This reduces your imputed income, often at a far greater level than simply renting a comparable property.
If you didn’t have a mortgage, it is likely you would receive a non-cash positive income for the shelter benefit you receive.
With that understanding in place, we can calculate whether imputed rent is a net positive or net negative, and subsequently whether a home could be an “investment.”
I’ll attempt to use a simplistic example of what I mean: two exact homes next door to each other. One is for sale, one is for rent. Let’s assume both the home and the rental are priced relative to the market (i.e. no distressed sale, no distressed landlord, nothing but market). We might find the following:
- Home value: $200,000, which we’ll also assume is the municipality’s assessed value.
- Part of the mortgage payment is reduction of principal. That doesn’t count as an expense.
- The tax as a percentage of assessed value is 1.5%. Annually $3,000 a year.
- Comparable rent will assume is $15,000 per year.
- Maintenance is 1.5% of $200,000 = $3,000. (Depending on the age of the home, this could be very low).
- Mortgage rates on a thirty year loan are 5.5%. (We will ignore closing costs since over 30 years, they don’t move the dial).
- Home owner’s insurance is $500 per year.
- Your marginal income tax is 25% and we’ll assume you deduct both the interest and real estate tax. (Note, one always receives a standard deduction, so the deduction benefit of interest and real estate taxes is not clear cut, but also not worth nitpicking about).
- You will put 20% down, or $40,000.
- Your required discount rate for your money is 7% because a home’s value is volatile (we are seeing this now) and you should be rewarded at a greater rate for parking your money in your home than putting your money in a portfolio.
Here’s the math of owning for one year:
|Rent Saved||$15,000||You didn’t have to pay this.|
|Real Estate Tax||<$3,000>||Â|
|Tax Savings of Interest and Tax||$2,935||Value of interest and tax.|
|Opportunity Cost of Money||<$2,800>||7% on $40,000|
|Cash Flow||<$2,285>||Negative return in year one.|
Note: There are multiple scenarios one could run and each variable should reflect the market or the unique situation of the purchase. These numbers are essentially made up and it’s important one confirms the market rate for each of these variables.
In this example, we see that the house returns a slightly negative cash flow to renting in the first year. I do not assume for appreciation. If the home appreciates more than 2%, you are likely break even, assuming you do not pay any fees on the sale.
Overtime, your mortgage interest expense decreases, so the cash flow improves as well. If rent comparable, though, is less, then the cash flow is worse. If rent was higher, then the math gets better.
There are additional variables to consider as well. For example, if one is forced to sell a year later and needs to incur the costs of traditional services in the sale such as a realtor and attorney, then it is likely the math looks much worse after one year. In this case, an additional $14,000 (7% of $200,000) in closing costs could be incurred.
Finally, we observe that if one pays off the mortgage, then it becomes very clear that cash flow could be positive relative to rent. This is an ideal goal if one wants to think of their home as an investment.
Life isn’t this simple, though. Homes differ. People differ. Time horizons of home ownership differ. Many rentals do not maintain value as well as an owner maintained property. There is a quality of life of owning that for the most part, exceeds the quality of life of renting. We can’t mathematically quantify this because it is unique to each person.
Ultimately, under the premise of imputed rent calculation, we can objectively analyze whether renting a home versus owning is of investment value. We can then qualitatively decide on our own whether the purchase matches our lifestyle.
At the end of the day, whether a home is an asset or an investment, it can be valuable to your long-term wealth position if you are armed with the right thought process in advance.
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