# Real Life Real Estate

*If you look up my address on Zillow it shows I paid $174,000 for my home in January 1999 and Zillow says it is worth $416,000 today. Was it a good investment? At face value it would appear so, but let’s dig a little deeper to see how it compares to other investing, and then let’s see if I would have been better off renting instead. *

*WARNING, THERE WILL BE SOME MATH AHEAD!*

In the 18 years and 5 months (224 months) I have been in my home I have seen the “face value” price of my home grow by $242,000 (239%), from $174k to $416k – a compound annual growth rate (CAGR) of 4.78%. Let’s compare that to the stock market as a whole. On the day I bought my house the S&P500 closed at 1,228.10 and on the day I am working on this blog it sits at 2,433.14 for a CAGR of 3.73% – so I beat the market by over 1% across the same timeframe I’ve owned my home if I were to sell today. That’s a good sign, right?

**An Analysis:**

What are the determining factors on home ownership as a worthwhile investment versus renting a house and investing in the stock market instead? You could spend hours building a spreadsheet that would do a rent vs. buy calculation, and you’ll find vocal proponents of both strategies but thankfully the fine folks at CalcXML have a calculator in place on the World Wide Web that is wonderful. So does Charles Schwab. These will allow you to do *math*, which will always win over some pundit of unknown origin flapping his/her lips together (we’ve got plenty of those in the financial arena). In addition, the NYT has a great calculator to determine your rent vs. buy savings and what you would need to pay in rent to equate the savings of a home buyer. We will also look at a simple price/rent ratio below.

**Putting Math to Work:**

Remember when you sat in algebra class and wondered when in the hell you were ever going to use those equations in real life? Well grab a pencil and dust off a calculator because you can use these calculations to get *ahead* in real life – toast your math teachers this evening, will ya? [*warning, more math ahead…*]

**Consider 2 Scenarios:**

*Scenario 1* – a person places a down payment on house, assumes a mortgage, pays interest, taxes and upkeep, and at the end of the mortgage period owns a house that has appreciated in value.

*Scenario 2* – a person *rents* a house, invests the same down payment in the stock market, and also invests any monthly savings that the buyer must use for interest, upkeep, and real estate taxes.

In both scenarios we consider the same initial downpayment / investment and the same monthly payments, with *Scenario 1* ending in a purchased house and *Scenario 2* ending with an investment portfolio in the stock market.

The outcomes of these will depend upon several variables (maintenance costs, real estate taxes, HOA fees, etc), but it turns out the price/rent ratio (*home price divided by yearly rental cost*) which compares the 2 scenarios one over the other is a ratio of roughly 15 to 20 – kind of like a p/e ratio for your home, and a proven metric nationwide.

As long as mortgage interest rates continue to run under 5%, then a price/rent ratio below 15 means buying a home is usually the better deal in the long run. Above 20 and you should probably rent your home and invest in the stock market instead, in order to maximize your wealth building. Between 15-20 it’s kind of a coin toss that would tilt toward renting in most cases.

**Timing & Location**

There is a lot of analytical data that shows the house/rent ratio hovering around 13 to 15 as a historical norm in our country (which obviously trends well for home ownership in most parts of the US). During the real estate bubble of 2007, this ratio averaged increased up to 24.5, so it is also a decent indicator of nationwide trends in relative terms.

Today, Carmel, CA has a ratio of around 46.8 – meaning no one in their right mind should be buying a home in Carmel, CA. Conversely, Friendship, NY sees a ratio of 2.8 which would most likely represent a real estate market that is dead (liquidity is always a valuable metric – as in, can you *sell* your home?). San Francisco and Honolulu lead the list in terms of metropolitan areas (ratios over 40), while Detroit and Cleveland are at the bottom (ratios under 10). These ratios in these areas probably require very little explanation…

Let’s take a look at how it works in real life…

**Buying:**

When I purchased my home in ’99, rentals in my neighborhood were priced at around $1,000/month or $12,000/year, which meant I would not want to pay more than 12,000 x 15 ($180,000). At $174,000 I was well-positioned with a 3.4% cushion on a house/rent ratio of 14.5 – that’s a buy, under a ratio of 15. According to all 3 calculators I listed up above I have done very, very well against renting.

Today I could command $2,500/month ($30,000/year) in rental income for my home that is worth roughly $416,000, so the house/rent ratio is 13.9 (very close to the national average). If the Zillow estimate is accurate @ $416,000, then Zillow still has me priced at a good buy…

**Renting:**

When renting, your landlord will attempt to pass on the costs of taxes, maintenance, and mortgage costs to the renter, right? But he can only charge so much in rent as he must adhere to the maximum price the market will bear. So how do you figure out what works best for *YOU*?

Let’s say you are shopping for a home to rent in Nashville and a landlord is asking $3,000/month to rent a home that would sell for $515,000 in the neighborhood you are considering. Is that a fair rental price in your area?

According to (*I love this domain name*) smartasset.com, the current price/rent ratio in Nashville sits around 19 (meaning renting in Nashville would currently be the better option for most folks). You can use the same price/rent ratio to your advantage while shopping for a rental.

Divide 515,000 / 19 and you’ll see $27,105/year or $2,260/month is closer to an ideal price to pay in Nashville based on local averages. At $3,000 the landlord is placing a hefty 25% premium on the rental price compared to the rental market as a whole. You might shop around a bit to see if you could find a rental in the same neighborhood for $2,300 or so – or attempt to negotiate a bit using your newly rediscovered Jedi-math skills.

If you were looking to *buy* that same home and other homes are *indeed* renting @ $3,000 in that neighborhood (check carefully), then your price/rent ratio is 14.3 and that home is a good buy since it is under that ratio of 15 for investment purposes.

**Net Asset Value (Advanced Math):**

Another formula is to consider the home’s Net Asset Value (NAV). This one gets a bit trickier, so buckle up and grab a sip of your favorite beverage as we calculate the NAV of my home.

This calculation takes the annual rental income times 1 minus the upkeep ratio: *annual rental income x (1 – upkeep ratio)*. With a rental of $2,500/month in my home, an upkeep ratio of 40% (most upkeep ratios should be typically run 30-40%) that gives me 30,000 x .6 = 18,000.

Now divide that number by the risk free rate (30 year T-bills) + the risk premium (typically 1 to 2%). I’m going to add 2.8% + 1.5% = .028 + .015 = .043 so the NAV of home is 18,000/.043 = $418,600 which is within 1% of the Zillow calculation above.

This is how you use that high school algebra to your advantage in accurately determining the value of an asset! If you invest in rental properties, you would want to be intimately familiar with this formula, along with the formula to determine your capitalization rate (net income / sale price).

**Three Keys to Real Estate:**

Again, there are many variables at play and as they say, there are 3 keys to real estate: *Location, Location, Location (down to the +4 zip code in many areas). *You should also throw in 3 more L’s – *Leverage* (mortgage debt), *Liquidity* (the ability to sell into a viable market), and *Lead-time* (your purchase timing ahead of any/behind bubbles). Add in maintenance & repairs (do you own a money pit?), taxes (are you in a high or low property tax area), interest rates (currently very low), and HOA fees (if any).

**Man On The Move Style:**

Like most folks, I bought my house using leverage – essentially a loan to buy “stock” securitized by the “stock” itself. Replace “stock” with “home” and you’ll see the power of the home mortgage when used responsibly as a “forced savings account” into an appreciating asset.

I “juiced” the returns of my leveraged home purchase (mortgage) by putting far more than 20% down on my home (meaning I financed as little as possible so I’d enjoy faster appreciation). I also refinanced my mortgage whenever I saw I could grab a half point deduction in the interest rate, thus lowering my total borrowing costs. In addition, I paid the mortgage off as quickly as possible, less than the 15 year term. This lowered my cost of leverage (mortgage interest payments) and maximized my return on principle. In the end, I have an asset that is fast approaching 1/2 million dollars and I am quite pleased with my Return on Investment (ROI).

Note – When buying a home I would not recommend messing around with 30-year mortgages, adjustable-rate mortgages, or the funky front-loaded / interest-only mortgages where you attempt to pay off the principle in the final 10 years of payments in an effort to lower mortgage payments for the first 20 years (paying interest only and no principle). Run from those! Your goal is to build equity as quickly as possible and pay that sucker off as soon as you can!

**Summary:**

In the end, the moral of this story is **building equity**. Rent or buy, you must do so in an analytical fashion to ensure you are setting yourself up for long term success. If you buy smart and use a mortgage responsibly, you will build equity in an appreciating asset (your home) that can become a large portion of your overall net worth. If you rent, you will have money that the homeowner spends on repairs, taxes, and interest to invest. When invested wisely you will build equity in stocks and bonds that can equal the asset value of a home buyer’s home and become a large portion of your net worth as well.

Hopefully this will be of benefit in determining what market conditions determine which route (buying versus renting) you should take. Cheers!