Why home-buying is a great investment

John Kelleher responds to Joe Castaldo’s story ” Why buying a house is a bad investment.”

I refer to your cover article ‘Why buying a house is a bad investment’ by Joe Castaldo in your March 15, 2010 issue. This article is not a serious discussion of the topic that it purports to cover. It misses the most critical issues involved in understanding whether a home is a good or bad investment and confuses the topic with some misleading charts and facts.

Let me try to illustrate the errors in the article by referring to a summary chart the author shows on top of page 28 [not shown online] — a chart that compares housing returns in various cities to stock market returns. The chart and the article contain the following errors:

1. Exogenous benefits of an ‘owner lived in’ housing investment. When an owner buys a home and lives in it, the owner receives what economists call ‘exogenous benefits’ — meaning that (in addition to being an investment that you can buy and sell for a profit) a home is something that one can live in. You can’t live in a stock or a bond, so this ‘exogenous benefit’ makes a home that you purchase to live in quite different. Simply put, the owner doesn’t have to pay rent to live somewhere else. This benefit is very large, yet is not quantified in the returns when one buys and sells a home. So comparing housing returns to stock returns without considering this issue is misleading and wrong. For example – let’s say I lived in a home for five years and sold the house exactly for what I bought it for — so I didn’t lose any money but I didn’t make any either. It would not be correct to compare the 0% return that is seemingly earned in that case with an 18% return on stocks and say that the house was a bad investment. The owner of the house had a roof over their head for five years! That benefit could easily be worth hundreds of thousands of dollars but isn’t reflected in the numbers because the owner is effectively ‘paying rent’ to himself. This error is a serious one and should have stopped the article’s publication on its own.

2. Principal residence tax exemption. Amazingly, the article fails to mention the principal residence tax exemption on housing in Canada. Gains on housing are tax free, while the gains on investments are taxed! This is another huge miss that should have been caught and another reason why the chart and the article are wrong. By comparing pre-tax returns on stocks to what are effectively post-tax returns on housing, the article makes a critical error. So when an investor has a gain of $100 on a principal residence they keep $100. When an investor has a gain of $100 on stocks the homeowner keeps only about $77. (assuming cap gains tax of about 23%). This is another error that should have stopped this article’s publication.

3. Comparing investments with totally different risk profiles. One of the most basic principles in finance is that one should never compare returns on investments that have different risk profiles. Investing in stocks is generally more risky than investing in real estate — so you can’t make a chart like the one on page 28 and conclude (as most of your readers surely did) that housing is a bad investment because the returns appear lower than the returns for stocks. The author should have compared each asset to its own risk benchmarks (risk-adjusted returns). This is another huge miss that leads to a misleading conclusion.

4. Fees, commissions, and capital expenditures. Fees, ongoing capital expenditures, and commissions for a housing purchase are large and materially impact the attractiveness of a house as an investment. The friction associated with other investments is generally a lot lower. The author’s chart makes the comparison before all of these expenses which again makes the comparison silly. It is true that he chooses to mention this issue in the body of the article, but makes no attempt at quantifying this issue or estimating how it impacts returns. This would not have been hard and would have made for a more substantive contribution.

In addition to the errors above, the article uses poor examples to make points. These examples actually support the opposite view to what the author suggests! The author might have realized this if he had taken five minutes to run the math. Take the article’s assertion that leverage allows a buyer to make a $50,000 profit given a 20% down payment on a $500,000 house where the asset’s value appreciates to $550,000 in two years. Since mortgages don’t come free, this point is wrong, and materially so. Let’s do some work for a moment. If I assume just a 4% mortgage on the $400,000 of debt in your reporter’s example, the hypothetical profit drops from $50,000 to about $20,000 (yes, you have to pay about $30,000 in interest in those first two years). Now if I add in commissions, land transfer taxes, property taxes and so on the profit actually turns in to a loss. This is why it generally doesn’t make sense to buy a house for only two years. I respectfully suggest that these examples need more thinking and more homework.

Overall, the misses and errors in this article are really disappointing.

When a person buys a house to live in, it is actually an incredibly complex financial transaction. It is akin to a leveraged buyout of a company where the new owner lives in the corporate offices (thereby avoiding the need to rent elsewhere) and where the gains on the sale of the company can be enjoyed tax free. Many variables impact the true return on this decision and the only way to understand that return is to model it. Doing so requires some careful work and some basic training on financial principles.


John Kelleher