Monday, March 22, 2010

Response: Why buying a house is a bad investment

I just reread this Canadian Business Article on Why buying a house is a bad investment and I agree with it almost totally. I read it online first, then I got my magazine finally in the mail and reread it again. It might sound weird for a blog that talks about property investment to be agreeing that buying a house is a bad investment. Hear me out and I'll explain.

The article is mainly talking about a persons primary residence. They have a wonderful quote by Adam Smith in the first paragraph ""a dwelling-house, as such, contributes nothing to the revenue of its inhabitant." When speaking of a primary residence this is very true... unless you also rent out extra rooms or your basement you get no revenue from your property and in fact it is faced with a large list of expenses (Property tax, fuel, maintenance, mortgage payments, insurance). At the end of the day your primary residence can be considered a liability... it is an ongoing expense to keep a residence that you will have to pay for until you no longer own the house.

As well, I do believe many Canadians are out there putting 5% down and buying the biggest house they can afford because of this mistaken belief that their house is an investment and that the outsized appreciation gains of the past decade are going to keep going ("real estate always goes up"). History has shown that real estate appreciation lags equity markets and while leverage can help in this regard magnifying the smaller gains... leverage can also have the reverse effect of magnifying your losses.

So why do I invest in real estate if it is such a bad investment? Well, buying investment property is different. Ya ya BS I can hear you all say. How is it different? First of all when you buy investment property you're buying it to rent out! REVENUE ... cashflow... passive income... whatever you want to call it... you are getting money from your tenants that is covering your mortgage and expenses while giving you a bit of extra cashflow as well (hopefully)

Of course like any investment you have to do your due diligence. Just like all other investment types you must do your homework and know what you're doing to be successful at it. AND just like any investment there are no guarantees. People have gone bankrupt investing in real estate (Just take the states as an example).

There are many things I love about real estate as an investment. The most important is control. You get to pick the city, area, street, etc. you want to invest in (you get to do the research and make your own choices about where the trends show you a good investment). You also get to negotiate... whether it is on price, terms, conditions or even things like financing (vendor take back mortgages, cashback deals). If a deal doesn't work for you after you've done your analysis you get to walk away. Again you make your money when you buy... and you get to decide when you do that, when the conditions are just right for you. Even after you've bought the property you have the ability to develop it further... whether you do something like subdivide a double lot and sell one... develop it... or just improve a rundown house so that it attracts higher rents(I love watching that show Income Property on HGTV where they show your expected rents after a renovation)... you have control over how you add value to your property or get value out of it. (You don't get this type of control over a publically traded stock... it's more a buy and pray... I do invest in stocks as well...I try and use the Couch potato portfolio... since I have no control over the market I might as well buy the market and make market returns)

Second is leverage. The banks are willing to loan you 5 dollars for every dollar you put down. Leverage obviously magnifies gains... if you put down 30K on a 150K house and this house goes up 10% you've made 50% because of leverage (15K). Of course if the house drops by 10% you also lose 15K... thing is if you're buying this property for the long term... AND you're renting it out for say 1100 a month... this easily covers your mortgage and other expenses and you're just looking at cashflow any appreciation is a bonus and not your primary motivation.

Quick numbers (Being conservative, all numbers rounded up, but coming from one of the properties I'm buying in Regina)
120K (150K - 30K downpayment) at 5% for 25 years is about $700/month
Property management $95 / month
Property Taxes $65 / month
Insurance $45 / month

Cashflow $195 / month
Yearly $2340 / year

Or about 7.8% cash return on your original 30K investment. You can of course get even more cashflow if you say locked in with a lower interest rate. (ING Direct Unmortgage is at 5 year fixed 3.89% reducing your payment to ~$625 / month with a rate of return of 10.8%) How about if you spread out your amortization to 35 years with that ING rate? ~$525 / month... rate of return of 14.8%(or $4440/ year). Again it is all under your control and it all depends on what you want... whether it is paying off the principal or keeping a high cashflow to supplement your income. At the end of 5 years you can relook at your investment... if the property has appreciated a lot... you might think of selling it for the appreciation value... if it hasn't moved you can keep it for the cashflow... or even if it has appreciated the cashflow covers the property... so in 25 to 35 years it will have paid itself off.

Meanwhile as long as rents keep up with inflation you have a passive income that is basically indexed to inflation. Your own Defined Benefit pension plan =)

So while your primary residence that you live in yourself IS a liability (though a fully paid off residence is useful to leverage the equity off of for investing... but that's for another time heh)... investment properties that are cashflow positive can definitely be a very good investment in my opinion.

What do you guys think?

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