Home Prices, Inflation, Leverage & Home Equity
Paragon Real Estate Report, October 2013
First and foremost, any home purchased needs to work as a home: it fulfills your housing needs at an affordable monthly cost – ideally, a cost, after tax deductions and principal pay-down, less than or similar to that of renting the property. However, though it cannot be compared on an apples-to-apples basis to investments such as stocks, bonds and CDs (that you don’t live in), it’s worth looking at the issue of homeownership as a financial investment as well.
If you increase your screen-view zoom to 125%, the charts will be easier to read.
An average SF Metro Area home purchased in 1988 appreciated by 244% as of July 2013, while the overall CPI inflation rate was 97%. If the home had been sold at the recent bottom of the market, the difference would have narrowed to 165% appreciation vs. 95% inflation. Purchase and sell timing always matters and if one has to sell at the bottom of the market, it affects the return on any investment. As the chart illustrates, home-price appreciation usually outpaces inflation by a significant margin over the longer term: this is a good thing for homeowners and doesn’t include other benefits such as living in the property and the capital gains exclusion on the sale of a principal residence.
This analysis applies well to homes purchased with all cash and no financing. Leverage alters the picture substantially.
If one leverages one’s home purchase by taking out a loan, then the growth in one’s home equity dramatically outpaces inflation over the longer term. For the sake of simplicity, in the example above, we’ll assume that home price appreciation and inflation both run at 3% per year, and that the buyer put down 20% in cash plus closing costs, and financed the remaining 80% with a 30-year fixed rate loan. In this scenario, each year that the inflation/ home appreciation rate is 3%, one’s home equity asset grows by about 15%, plus the principal repayment on the outstanding loan (which is a major component – like a forced savings account – in the growth of equity over time). Indeed, the higher the inflation rate, the greater the equity growth. If home price appreciation outpaces inflation as well – as it has over the past 25 years – that accelerates the increase in home equity further. Moreover, the financing cost is currently subsidized by the mortgage interest tax deduction, if that applies to your financial situation.
This is why, using reasonable leverage, real estate is typically considered a good long-terminvestment – short-term can be much riskier – as well as an excellent hedge against inflation. Of course, if leverage is abused as it was in the years of subprime lending, underwriting standards decline, predatory lending and home-refinancing frenzy (i.e. "using one's home as a piggy bank"), other risks arise.
In earlier times, when people didn’t move around as much, one bought one’s home, paid it off over the years and when retirement came, had a home owned free and clear – a huge financial asset to be used as appropriate.
In this chart, the increase in the annual cost of homeownership with a fixed-rate loan is compared with the increase in rent at a 3% inflation rate, and the increase in rent of a home subject to San Francisco rent control, where annual rent increases are limited to 60% of CPI. As seen, if one locks in a fixed mortgage interest rate, the increase in ownership cost is limited to the increase in property tax costs (limited under Prop 13) and maintenance expenses, while the entire rental cost may be subject to annual raises. Over the longer term, one’s ownership costs become more and more attractive when compared to rental housing costs subject to inflation. If one owned the home for the full 30-year loan period, the monthly mortgage payment itself would disappear.
We have generated two sample rent vs. buy scenarios for San Francisco here:
And you can perform your own rent vs. buy scenario calculations here, using your own financial circumstances, assumptions and projections: Rent vs. Buy Calculator
Important caveats: Trying to compare buying a home to other financial investments on an apples-to-apples basis is impossible, because there are so many other variables at play: the use and enjoyment of the home, how the cost of homeownership compares to renting, physical condition decline over time (without further investment), risks and returns on other types of investments, home tax deductions, the capital gains exclusion on profit from a principal residence sale ($250k for single owner/ $500k for couple), market timing and other factors. All the analyses above are simply sample scenarios, looking at homeownership from a number of angles using a variety of assumptions. It is unknown whether they will apply to future trends.
As said in the first line of this report, first and foremost, any home purchased needs to work as a home: it fulfills your housing needs at an affordable monthly cost. If that’s where you start, with a fixed rate loan, and you don’t refinance out growing home equity, and you don’t have to sell during a market downturn (which, admittedly, isn’t always possible to avoid), then you should come out all right and more often, very well.