Your Home is an Asset, but Not an Investment.
It is an understatement to say the world has experienced a radical shift in capital markets. Since September of last year, there are more layers of information and opinions on the direction of the world than we’ve seen in decades. The internet and the media do not always make it easier, but I hope this regular contribution to IBMadison.com will help you sift through the noise and give you some perspective.
In the past two articles, I wrote about the basic starting point for the financial planning process and investments. I would be remiss not to affirm with you that a home is a valuable cornerstone to your financial life, but it is not an investment.
This piece does not purport to speak to market speculation on homes, distressed property opportunities, or other anomalies in housing transactions. Rather, it is meant to speak to the typical homeowner and how to view a traditional home in one’s financial life.
There’s a difference between an asset and an investment.
An asset derives its value by some level of tangible (you can touch it) or intangible (you can feel it) value. An asset can become an investment when you can reasonably rely on the present value of future cash inflows over time.
A home is an asset, not an investment, because it does not offer that cash flow reliance. In fact, it is often more of a consumption good, understandably so because we need a place to live.
A home can become a valuable asset over time, though, and many do. If the house is maintained and the mortgage is paid off and it is well located, it maintains market value and serves as a hedge to your retirement expenditures and long-term care needs. But it’s not an investment because until the debt is paid off and expenses are under control on the home, there are no reliable future cash flows. Even then, it pays little in expected return net of fixed expenses compared to long-term expectations of bonds and stocks.
A home generally has no future cash flow except the “potential” for appreciation. For the most part, the land underneath your home is usually what appreciates … good land is limited and location matters. Good land historically has appreciated at a much higher rate than inflation.
This is why some locations like the Near East and West sides of Madison, downtown locations like Madison and Middleton, neighborhoods like Monroe Street, University Heights, the Vilas Neighborhood, and good school districts like Waunakee, Monroe, or Verona, or unique places where there are large lots relative to the market (in Dane county, usually over one acre) or just about anywhere on the lake, to name a few, are generally stable or rising, even in economic downturns. In all those cases, the land (i.e. the location) is limited and/or offers value due to location, services, and amenities.
In the meantime, the physical make-up of the home (i.e. the bricks and mortar) depreciates. Commodities, like lumber and metals, depreciate the second they are placed in unique, physical use, such as your unique home. When you install a door on a house, it does nothing to add extra value above the market and in fact, it is immediately worth less than you paid for it because you (presumably) already paid market price for the product and you can’t turn around, dismantle it, and sell it for a profit, especially after time and effort of labor.
In other words, you must spend money to keep it up, often you finance it, and we all pay the government for the right to use it. To recap, a home carries the following expenses:
- Interest Expense — assuming there’s a loan, currently 5.5% to 6.5% of the mortgage.
- Real Estate Tax — in Dane county, approximately 1.5% to 2% of the home’s value annually.
- Insurance — usually insignificant, but roughly 0.25% of the home’s value annually.
- Maintenance — for a new home, I recommend usually 1% of the value a year should be saved for upcoming expenses. For a home older than 10 years, at least 1.5% to 2% should be saved and often spent annually to cover keeping the home up-to-date to the market.
- Purchase and Sale Transaction Costs — Realtors, Attorneys, Bankers, generally expend at a rate of 2% to 9% of the home’s value whether it is a purchase or sale of a home. Whether one uses all or any of these individuals or not, they are part of the transaction process and are part of the marketplace pricing in almost all markets.
So as you can see, without the transaction costs, someone in Dane County could, annually, have a net outflow of 2.5% to 10% of the home’s value per year, depending on various factors such as the mortgage and individual’s tax situation.
Other than the last decade, homes have historically appreciated at about inflation plus 1% to 2%. Inflation has averaged 3% to 4%, with periods of times of much lower and much higher. Homes in desirable locations appreciate at a greater rate and homes in less desirable appreciate at lesser rates, or even depreciates.
The past ten years are appearing to be an anomaly based on excessive leverage and the current housing crunch. So, it’s likely (hopefully) we’ll return to an environment of modest appreciation rates on the home seen prior to the last decade, assuming no further drops in housing prices.
So, again, there’s anywhere from 2.75% to 10% of the home’s value going out the door per year. At best, without any debt and in a low real estate tax environment, one “may realize” a 2% to 4% appreciation rate, depending on inflation. At worst, the house will always be a net outflow.
A home is definably an asset. It can be a great one at that. A home, though, offers little if any reliability on the present value of future cash flows and subsequently is hard to justify as an investment. But purchased correctly, with an emphasis on location, one can derive the greatest potential for appreciation. Once the debt is paid off, you have the best chance of realizing a net benefit and accumulating real value so you can use it as a hedge for the future.
This article contains the opinions of the author. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products or services described in this website or that of the author’s.
Mike Dubis does not guarantee the relevancy, appropriateness, or accuracy of any outside information or links. Mike Dubis does not render or offer to render personalized investment advice or financial planning advice through this medium. All references that might be made to an investment or portfolio’s performance are based on historical data and one should not assume that this performance will continue in the future.
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