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Is Buying A Home A Good Investment?

Buying a home has long been considered the American dream. But is homeownership a good investment? Or, much like a fancy sports car, is it just a status symbol? 

Articles by Nick Holeman, CFP®

By Nick Holeman, CFP®
Financial Planning Expert, Betterment  |  Published: November 6, 2019

The average US household does not receive any Federal tax deductions from owning a home.

In order to calculate an accurate return on your home, you must factor in transaction costs, cash flows and leverage. These are things many people ignore.

It takes the average homebuyer 4 years to breakeven on their home purchase due to the upfront closing costs.

The average rate of return you should expect from owning a home is between 8.6% - 10.0% per year.

A home can be a smart investment, but, on average, its expected return is about equal to investing in stocks.

Expected returns vary widely city-to-city, and are highly dependent on a city’s home price-rent ratio.

In order to analyze any potential investment, it’s advised to set aside emotion and internal biases as much as possible, and instead try your best to make a data-driven decision. With a decision as large as purchasing a home, that can be difficult, which is why a thorough analysis is so critical.

That’s also why the following research is backed by decades of data from sources such as the Federal Reserve Bank of St. Louis, the United States Census Bureau, National Association of REALTORS®, Federal Housing Finance Agency, S&P Dow Jones Indices, and more.

My hope is that after reading this, you’ll be able to answer the question “for the average American household, is purchasing a home as a primary residence likely to be a sound investment?” The answer to this question is part, but not all, of the overall decision to buy or rent your current residence. Note that this analysis is focused solely on primary residences, not on rental properties.

To do this analysis, the following research will walk through:

As an added bonus, there’s also a more granular analysis included at the end for 13 major cities. While having a national average is a great starting point, the city-level can give you a more personalized analysis.

Let’s get to it.

Average American Homebuyer

A & B are a hypothetical married couple that are meant to represent the average American home buyer. I chose a married couple because the majority (63%) of homebuyer households are married couples. They will be used throughout this research to more easily articulate what would otherwise be a very dense list of the various inputs and data points needed to calculate the investment return of owning a home.

A & B are buying a detached single-family home, as do 82% of home buyers. Detached single-family homes are far more common than townhouses, condos or duplexes. The home they want has 3 bedrooms, which is the median number of bedrooms in homes purchased nationwide.

A & B’s household income is $106,300, exactly equal to the national median income of married homebuyers. Their current monthly rent is $1,148, which is the median monthly rent in the US for an equivalent-sized 3-bedroom house5 . They also pay $16/month for renters insurance, which is the national average.

So to give a quick recap of their information:

  • Relationship status: Married
  • Household income: $106,300
  • Current rent: $1,148/month
  • Current renters insurance: $16/month
  • Type of home to be purchased: Detached single-family home
  • Number of bedrooms: 3 bedrooms

Upfront Costs Of Home Ownership

While making their decision, A & B need to choose if they should purchase their home with cash or take out a mortgage. Since 88% of recent buyers financed their home purchase, so do they.

Like about 90% of homebuyers who take out a mortgage, they choose a 30-year fixed-rate mortgage. This type of mortgage is far more common than mortgage with shorter terms (ie, a 15-year mortgage), or with adjustable interest rates (commonly called “ARMs”). Their mortgage has an interest rate of 3.56% (the national average as of September 12th, 2019).

The home they want is priced at $250,000, which is the median value of all US homes purchased. They make the median down payment, which is 13%, and thus finance 87% of the home purchase.

The closing costs associated with the home purchase are 2.0% of the purchase price, which is the low end of the typical range of 2 to 5 percent for home buyers.

So to recap the stats on A & B’s home purchase:

  • Type of mortgage: 30-year fixed rate mortgage
  • Mortgage interest rate: 3.56%
  • Home purchase price: $250,000
  • Down payment amount: 13% ($32,500)
  • Initial mortgage balance: $217,500
  • Closing costs: 2.0% ($5,000)

Before they bought the home, A & B had $37,500 saved up to put towards their home purchase. That money was split between a down payment and closing costs. Now they have a home worth $250,000 and a mortgage of $217,500, giving them immediate home equity of $32,500 (the same as their down payment).

Note that A & B actually have less money now than they did before the home purchase because of the closing costs. They, of course, hope to recoup that money and then some through future appreciation in the home. But this is an important point to make, because it usually takes a few years to break even after your home purchase.

Ongoing Costs Of Home Ownership

Congratulations to A & B, who are now proud homeowners. But as the two of them quickly find out, homeownership comes with many ongoing costs.

Using the inputs listed above, their mortgage payment comes out to $984/month, or $11,808/year.

A & B’s property taxes cost $2,709/year, which is the median property taxes for all US homes with a mortgage. This comes out to a property tax rate of 1.08%/year ($250,000 home price / $2,709 in property taxes = 1.08%). Homeowners insurance costs them an additional $1,083/year, which is the national average.

Since A & B’s down payment was less than 20%, they also must pay private mortgage insurance (PMI). Assuming they have a FICO score of 704, which is the national average, their PMI will cost about $1,196/year. Note that this payment will usually no longer be required once their home equity reaches 20% of the home value.

Lastly, they have to worry about ongoing maintenance and repairs that come with owning a home. The exact amount of these ongoing costs is difficult to predict, but a common rule of thumb is that you should plan on spending about 1% of the purchase price of the home each year on home maintenance. 1% x $250,000 = $2,500/year of maintenance and repairs.

All together, these costs add up to gross housing costs of $19,296/year. However, this isn’t the full story. By owning a home, it means A & B no longer have to pay rent or renters insurance. So these cost savings should be subtracted from their gross housing costs to find the true net annual cost of homeownership.

Their rent was $13,776/year, and their renters insurance was $187/year, so their total housing costs as renters was $13,963. After we subtract this from their gross housing costs, we are left with net housing costs of $5,333/year.

A quick recap is listed below.

Mortgage Payments: $11,808
Property Taxes: $2,709
Homeowners Insurance: $1,083
Private Mortgage Insurance (PMI): $1,196
Maintenance and Repairs: $2,500
Gross Housing Costs: $19,296
Saved Rent: $13,776
Saved Renters Insurance: $187
Net Housing Costs: $5,333

A & B assume that most of these costs will increase with inflation each year. The two exceptions to this are their mortgage payment and their PMI, which both will stay constant. And again, their PMI will drop off once their home equity meets 20% of the home value.

Annual Recurring Costs Of Homeownership

The annual recurring costs of homeownership.

Currently the Board of Governors of the Federal Reserve System is targeting an inflation rate of 2.00%/year, so this is the inflation rate we will use in their projections. Below is a table that details their annual expected cash flow. Expenses are listed in black, and money saved is listed in green.

You’ll notice that owning a home currently costs $5,333 more per year than renting. However, the mortgage payment, which is the largest annual cost of homeownership noted, stays static while rent would increase with inflation each year. This is why the net annual cost of homeownership goes down each year, until in year 23, when homeownership actually becomes cheaper than renting!

Tax Benefits Of Home Ownership

An often-cited benefit of homeownership is the tax deductions that come with it. The 2 most common tax deductions are:

  1. The ability to deduct mortgage interest you pay (subject to some limitations).
  2. The ability to deduct property taxes you pay (subject to some limitations).

However, A & B will only be allowed to take these deductions if they itemize their deductions. The Tax Foundation predicts that only about 10% of taxpayers will itemize, so the odds of A & B itemizing are very low. But let’s run the numbers anyways, just to double check if they will be able to itemize or not.

A & B are married, so they must choose a filing status of either “Married Filing Jointly” or “Married Filing Separately.” Like 95% of all married couples in the US, A & B choose to file their taxes as married filing jointly, and thus are eligible for a Federal standard deduction of $24,400. This means their total Federal itemized deductions must exceed $24,400, or else they will not be able to deduct their mortgage interest or their property taxes.

In year one of owning their home, A & B will pay $7,676 in mortgage interest, and $2,709 in property taxes. Together, these add up to $10,385 of potential itemized deductions from homeownership. This is less than half the $24,400 they need to itemize. A & B would need to have $14,015 in other itemized deductions such as medical expenses, charitable contributions, or state income taxes (subject to the overall limit of $10,000 for all state and local income/real estate taxes) in order to itemize, which is unlikely.

Standard Deduction (MFJ) vs. Itemized Deductions From Homeownership

Standard Deduction (MFJ) vs. Itemized Deductions From Homeownership

While it is true that homeownership can come with extra annual Federal tax deductions (mortgage interest and property taxes), the average homebuyer will not benefit from these potential deductions.

However, that doesn’t mean there are no tax benefits to homeownership at all. Even though the average American homeowner will not receive any annual Federal tax benefits, you still may be eligible to exclude any capital gain you realize upon selling your home from counting as Federal taxable income, up to $500,000. There are strict rules to qualify for this, but this can be a huge tax break on what may otherwise be a relatively substantial capital gain.

Estimated Real Estate Appreciation

A crucial input to estimating how good/bad you think an investment will be is estimating the expected return that investment will give you. This, of course, is extremely difficult to do, since nobody can predict the future.

However, we can look to historical data to see how the value of single-family homes has grown over time to get a reasonable expectation of how they will continue to grow in the future. Of course, past returns do not guarantee future results.

Whenever looking at historical data, it’s usually best-practice for your data to be as robust as possible. You can do this by:

  1. Having as long a time period as possible.
  2. Having data from multiple sources.

Both of these help to reduce short-term fluctuations and noise from your data, and help make it more reliable. With these two points in mind, we can look at historical housing price data from a few different sources to gain an understanding of how home values have risen and may rise over time.

United States Census Bureau

The United States Census Bureau Guided Search tool allows you to dig through a trove of historical housing data. The oldest housing price data available in the tool was for the year 2005 and reported the median US home value as $167,500. In 2017 (the most recent available), the median US home value was $217,600. Over that 12-year timespan, that comes out to an average growth rate of 2.2%/year.

However, 12 years is a very short period of time. This leads me to believe that this may not be a fully accurate representation of appreciation for the US housing market.

Federal Housing Finance Agency

The Federal Housing Finance Agency (FHFA) is a Federal agency that “is responsible for the effective supervision, regulation, and housing mission oversight of Fannie Mae, Freddie Mac (the Enterprises) and the Federal Home Loan Bank System.”

They maintain the FHFA House Price Index (HPI) which is a “broad measure of the movement in single-family house prices.” They publish regular HPI reports which are free and publicly available. The most recent HPI report available shows the compound annual growth rate of the HPI in the 28.5 years since January, 1991 has been 3.6%/year.

S&P Dow Jones Indices LLC

S&P Dow Jones Indices LLC is a company that maintains numerous indices that measure the performance of many aspects of global financial markets. One of those indices is the S&P CoreLogic Case-Shiller US National Home Price Index, which “measures the value of single-family housing within the United States.” One area it is made publicly available is through the Federal Reserve Bank of St. Louis.

In January, 1987, the index had a value of 63.754. In May, 2019, the index had a value of 209.658. Over that 32+ year time period, that comes out to an average growth rate of 3.7%/year.

Irrational Exuberance, Princeton University Press

Irrational Exuberance is a book by Robert Shiller on behavioral economic and market volatility. Shiller is an economist, professor at Yale University, best-selling author and 2013 Nobel Prize winner. Needless to say, he is a well-respected member in the world of finance and economics.

Part of Irrational Exuberance deals with his historical housing prices. In doing his research, Shiller dug up data showing home prices since 1890. This research is part of what came to be known as the S&P CoreLogic Case-Shiller US National Home Price Index mentioned above.

In 1890, the index had a value of 3.557. At the end of 2018, the index had a value of 205.070. Over the 128-year time period, that comes out to an average growth rate of 3.2%/year.

Conclusion On Real Estate Appreciation

These 4 data sources show that, on average, historical price appreciation for the US housing market has been somewhere between 2.2 to 3.7 percent per year.

Various Historical Measures of the Appreciation of U.S. Home Values

"Various

Because the US Census Bureau Guided Search dataset is too small of a sample size, I’m going to ignore it for this analysis. That leaves us with a range of 3.2% – 3.7% per year. Based off this tight range of historical returns, I am confident in using these numbers in our calculations. If we had historical returns that varied very widely from one another, that would be cause for concern.

Given that the dataset from Irrational Exuberance is more than 4x longer than the others, it is my belief that 3.2%/year is the most reliable to use when projecting out long-term expected housing appreciation.

However, we will also run the analysis assuming 3.7%/year, the uppermost value from our sources, in order to get a high and a low range of expected outcomes.

Again, we should point out that past performance does not guarantee future results. But we can use it as a reasonable estimate of what the future may hold.

Problems with Calculating Investment Returns

Using the data listed above, let’s assume that A & B’s home will appreciate in value at an average annual rate of between 3.2% & 3.7%/year. Some years will likely be more, and some will likely be less. Some years their home may even drop in value. But we will assume the overall average growth rate will fall within that range.

However, this doesn’t tell the whole story of what rate of return A & B will get on their home. That’s because that rate of return doesn’t factor in many important points.

  • Transaction Costs: The process of buying and selling a home is not cheap. The transaction costs associated with homes, often called closing costs, add up fast and must be factored in when you are calculating the true rate of return you expect on your house
  • Cash Flows: The annual change in value of A & B’s home also doesn’t factor in the ongoing costs they must pay each and every year to pay for, live in and maintain the home. Ignoring these cash flows will make their rate of return look far rosier than it is in real life.
  • Leverage: If A & B were all-cash buyers and put down 100% of the purchase price at closing, then their rate of return would more closely match the time-weighted return. However, because they, like most buyers, took out a mortgage, they are using financial leverage to purchase the home. This leverage will increase any gains they receive (and conversely, could increase any losses as well).

In order to help solve for these three problems, A & B must use a return method that incorporates these factors. This method is called the internal rate of return (IRR), and while it is more complicated, will account for 3 of these issues. Finding their expected IRR will give A & B a more accurate measure of the rate of return they can expect on their home purchase.

Internal Rate Of Return (IRR) Of Home Ownership

In order to calculate their expected return of owning a home, A & B must calculate their IRR from the date they bought the home to the date they plan to sell it. To do that, we first must make a few more projections.

A & B don’t know for sure how long they’ll stay in their newly-purchased home, but we will assume they stay 9 years, which is the median length of time homeowners stay before selling and moving.

By that time, using an estimated annual growth rate of 3.2%, their $250,000 home will have grown to $331,938. Their remaining mortgage balance at the time will be $174,453. So they have $157,485 in home equity.

Closing costs for a seller total roughly 8 to 10 percent of the sale price of the home. Let’s assume 8.0% (the low end of the range). Closing costs of 8% would equal $26,555.

And since they owned and lived in the home as their primary residence for the last 9 years, and their total capital gain is less than $500,000, A & B will likely get to exclude the entire gain from Federal income tax.

All of this leaves A & B with net sales proceeds of $130,930.

Home Value in 9 Years: $331,938
Remaining Mortgage Balance: $174,453
Home Equity: $157,485
Closing Costs: $26,555
Taxes: $0
Net Proceeds from Home Sale: $130,930

Now let’s map out all the cash flows so we can properly calculate A & B’s expected IRR. We’ll assume they bought the home in beginning of year 1, and sold it at the end of year 9. For simplicity, we’ll assume the annual recurring costs such as mortgage payments occurred in the middle of each year.

Cash Flow of Home Sale After 9 Years

Cash Flow of Home Sale After 9 Years

When we do this, we see that A & B’s expected annual IRR from homeownership is 8.56%/year. It’s also interesting to see how the annual IRR is affected by how long they stay in their home, as the graph below shows.

Assuming 3.2% Annual Appreciation

We can see that it takes A & B 4 years to breakeven and recoup the upfront closing costs. Their annual IRR peaks at year 10, and then slowly declines. This is because as they pay down their mortgage, they are less leveraged. Let’s also see what the annual IRR numbers look like if we assume appreciation of 3.7%/year.

Of course, the annual IRR is slightly higher. At 9 years it is 9.96%. This gives us a high and a low range of expected annual IRRs from home ownership. A & B can expect to earn between 8.56% – 9.96% per year from home ownership.

Expected Annual Internal Rate of Return of Homeownership

Housing Returns vs. Stock Market Returns

8.56 to 9.96 percent per year seems like a good return. But how does it compare to investing in the stock market?

In the 92 years from 1926 to 2018, the US stock market has had an average annual return of 10.1%/year.

But as savvy investors, A & B know they also have to pay attention to two key factors: fees and taxes on any stock investments they purchase. However, they quickly learn that these 2 factors aren’t nearly as concerning as they initially thought.

Fees

A & B would not be able to invest directly in an index. Instead, they would have to purchase an investment fund, like an ETF or mutual fund, to give them market exposure to those stocks. Many of these funds charge a fee, often called an expense ratio. Thus A & B’s net return would be the return of the index, minus the investment fee. If A & B work with an advisor, they would also have to pay that advisor’s fee on top of the expense ratio.

Let’s say A & B wanted to put 100% of their money into US stocks. They could purchase the Vanguard Total Stock Market ETF (VTI) which has an expense ratio of just 0.03%/year.

Let’s say they also wanted to work with a robo-advisor, to give them financial planning advice, tax loss harvest for them, and more. Let’s assume the robo-advisor’s annual fee is 0.25%/year and has no additional trading fees or account opening/closing fees. So their all-in investment & advisor fees would be only 0.28%/year.

Their net annual expected return based off the historical performance of the US stock market would look like this:

Gross Annual Expected Return: 10.1%
VTI Annual Expense Ratio: 0.03%
Annual Advisory Fee: 0.25%
Net Annual Expected Return: 9.82%

Fees do matter when it comes to investing, and they can be a huge drag on net returns if you aren’t careful. However, there are so many low-cost investment options available today that A & B can invest without paying high costs for doing so.

Taxes

A & B also have to worry about paying taxes on the dividends and capital gains their stock market investments would earn. Like fees, they can eat into your net returns. However, this concern might be overblown.

A & B can reduce the taxes on their investments by choosing from amongst the many tax-advantaged accounts available to them. I’ll focus on Roth accounts here because the tax treatment of Roth accounts, if the rules are followed, is very similar to the tax treatment of money used to purchase a home (after-tax contributions, tax-deferred capital gains, tax-free gains upon sale). However, it should be noted that there are also many other types of accounts that offer tax advantages besides Roth accounts.

At their income level of $106,300, A & B would both be eligible to contribute to a Roth IRA, up to $6,000/year per person, or $12,000/year as a household. In addition, if they have the option through their employers, they could each contribute to a Roth 401(k), up to $19,000/year per person, or $38,000/year as a household. The majority of US workers have access to defined contribution retirement plans, so this is a reasonable assumption.

Between Roth IRAs and Roth 401(k)s, A & B can save a total of $50,000/year into tax-advantaged accounts.

With these Roth accounts, A & B have the potential to not pay Federal income taxes on future dividends or withdrawals. Thus, their estimated after-tax return from investing in US stocks would be 9.82%/year.

Conclusion On Housing Returns vs. Stock Market Returns

The expected return from homeownership is 8.56 to 9.96 percent/year. The expected return from US stocks is 9.82 percent/year.

Based on the above assumptions, the expected returns from investing in the US stock market and purchasing a home are very comparable, both being in the high single digits.

Investing in stocks is considerably less work than maintaining a home, but being a homeowner provides a lot of satisfaction as well. At the end of the day, the argument can be made, and I think it can be wise, to own both stocks and your home.

Final Thoughts

For the average American household, based on my assumptions above, purchasing a home for your primary residence has an expected return of 8.56 to 9.96 percent/year. However, there are a few things to keep in mind.

  • It takes on average four years to breakeven from the upfront closing costs.
  • The expected return from homeownership is very similar to the 9.82%/year expected return from investing in US stocks.
  • The average US household does not receive any Federal tax deductions from owning a home, although the capital gains when you eventually sell your home will likely be Federally tax-free.

Remember, these are just average expected returns based on historical data, which do not guarantee future results. It’s possible you could earn a higher return than this.

  • You might buy a home in a trending neighborhood that sees housing prices jump. Real estate is, after all, not a single market, but a collection of local markets.
  • You might find a property that is undervalued because it needs a little TLC, but that you could easily put some money and sweat into to boost your return on investment.
  • Or you might decide, after you move out, to hold onto the property and turn it into a rental so it can continue making you money.

Any of these situations is possible. But it’s also possible for you to do worse than the average.

  • You might overpay for your home because you’re not viewing it as an investment.
  • You might also spend too much money on home renovations that meet your tastes and needs, but don’t actually increase the home’s value.
  • You might just get unlucky and buy at or near a market high, only to see your home value drop shortly after your purchase (think what happened if you bought a home around 2007).
  • Or you might decide to move out after only a couple of years before you can really recoup your upfront closing costs.

You may do better than the historical average, you may do worse. That is, afterall, how averages work. However, if you are considering purchasing a home, likely to be one of the largest purchases in your entire life, it’s usually wise to base your future expectations on a historical average that relies on decades of nationwide research from multiple sources, and that factors in as many details as possible. This analysis has done just that when arriving at the expected return of 8.56 to 9.96 percent/year.

You can use this information as part of the decision to buy or rent your current residence. Other factors should, of course, include the opportunity cost of investing your down payment and lower initial monthly cash flows, job stability, willingness to deal with ongoing maintenance, desire to settle down, school district if children are involved, and more.

I hope this was helpful.

Bonus: City-Level Analysis

Understanding the national average expected return on homeownership is a great starting point, but real estate is all about location, and thus each city is unique. Luckily we are able to get some city-level data to make a more granular analysis possible. Below is an analysis for 13 major cities across the US.

In addition to the National Home Price Index they keep, S&P CoreLogic Case-Shiller has city-level price appreciation data for many major cities dating back to January, 1987.

This data is publicly available through the Federal Reserve Bank of St. Louis. City-level data is also available for home values, property taxes, and rental costs through United States Census Bureau Guided Search.

Below is a table of these 4 data points for 13 major cities. The US national average is also included in the table for a reference point. The table is sorted by historical home appreciation, and you’ll see the national annual appreciation is roughly in the middle of the city-level appreciation, as we would expect.

City-level Housing Data

City-Level Housing Data

Data Sources: Federal Reserve Bank of St. Louis and United States Census Bureau Guided Search

By keeping all our other inputs from our national analysis constant, and updating these four inputs, we can calculate the expected annual IRR of owning a home for each of these cities. The results are listed in the chart below, with the national average marked in green.

Expected Annual IRR of Homeownership

Expected Annual IRR of Homeownership

You can see how much the expected return varies city-by-city. New York City’s expected return is only 0.66%, while Las Vegas is 13.29%. At first glance, this ranking may appear odd. Many of the cities with the highest historic real estate appreciation result in having the lowest IRRs. What is causing this counterintuitive result?

It turns out the answer to this lies in the relationship between current home prices and current rental costs. San Francisco has had historically high real estate appreciation, but the median home value is a whopping 48x the median annual rent! San Francisco, New York and Washington D.C. all have home price-rent ratios of 30 or above, while the US average is just 18. These high home prices mean the annual recurring costs are significantly higher than renting, which hurts your expected return.

Below is a graph that plots the annual expected IRR of homeownership against the price-rent ratio. You see a strong trendline appear showing the inverse relationship between expected annual IRR and price-rent ratio.

Home Price – Annual Rent Ratio vs. Expected Annual IRR

Home Price - Annual Rent Ratio vs. Expected Annual IRR

This insight is extremely important to know as a potential homebuyer. In many high-cost cities, you may be better off renting instead and investing the money you save from lower monthly home costs. Of course, housing data can vary widely, even within a particular city. For example, rent may be significantly higher in the Tribeca neighborhood of Manhattan than rent in Jamaica, Queens, despite both areas being in New York City. That’s why, even though this data can be extremely helpful as a starting point, it’s usually best to do a personalized analysis for your particular situation.

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