When we think about real estate, we think about guaranteed earnings. Our mind goes to money coming into pocket. Property ownership is a fundamental attribute of the American Dream. The irony of this ethos exists in the fact that we don’t talk about how property ownership carves a reality out from that dream.
When we think about it, we hardly talk about what real estate gives us. When we talk about it, it’s spoken as if it’s a right of passage for everybody.
We speak about everything except the actual process of investing.
Everything in the area of real estate has to deal with the transaction or its treatment in a vacuum. When we dig deeper, we figure out the actual nature of the industry.
Agents/brokers make money when you transact on the property. In other words, if you buy or sell, they come out ahead regardless. They don’t care whether or not you actually make money renting or the property appreciating. The closing of the transaction is all that matters. There are costs on both sides of the transaction, too. There are fees during the transaction as well. After that, you’re on your own. If you want to sell that home in the near future, that process starts all over again.
An additional note to make of this is to research the history of the property you are looking at, paying attention to work needed or done, and the average valuation over its documented history. If properties are a steal to an agent or broker’s eyes, they wouldn’t leave them to their customers for free. Nobody in this world is so nice that they’re willing to give away amazing deals all the time.
When you purchase a home, you’re actually inheriting debt first. The person, or entity, handing you the loan takes the actual property as collateral when you fall off on your financing agreement. In 2008, when the mortgage crisis began, around $7 trillion in homeowner equity was lost.
This is because whatever equity that homebuyers had built up in their mortgage was sent back to the banks who had foreclosed on a home with a lower valuation than the original homebuyer had purchased it at. In simpler terms, Fred buys a home in 2005 for $600,000. By 2010, Fred realizes he can’t pay for the home anymore. The home is worth $500,000 now, and the bank takes the home back kicking Fred out. Fred had around $100,000 between his payments and his downpayment paid into the home. The bank takes that because the home is worth $100,000 less than Fred originally purchased it for.
People tend to think that a house, or property, is a guaranteed deal. However, if that was the case, the banks would be in the wrong business. At the height of the mortgage crisis, the graph above explains everything you’d need to know. The banks who originated the loans all exist today. The people who held those homes lost them. Banks wouldn’t hand out mortgages if they knew people were always going to be winners. Even then, most banks know that the majority of payments in the first half of the life of a mortgage go toward the interest. By the end of a mortgage, the purchaser has paid two to three times the value of the original property.
And that’s in the event that you actually pay off the home. We can run this thought-experiment:
You’re a working person. Making a respectable $115,00 a year, after-tax. You live in Los Angeles, like myself. A 1 bedroom here runs about $1,500 to $3,000 depending on where and what you want.
Let’s say after two years, you realize you want a house. You have around $50,000 saved, and you are going to place a down payment on [random property I found for sale in the San Fernando Valley].
Let’s say this property is approximately $690,000, you’ll be putting all that money you saved as a down payment because you want to place a dent into the principal value.
Here is the amortization chart for the next 24 of the 30 years on your mortgage. It’s got your interest, private mortgage insurance, taxes owed.
A lot of your cash is going toward the interest and the taxes and insurance. In fact, it will take about 15–20 years for your principal payment to begin to match your taxes plus interest on an annual basis.
But let’s think for a second. A house is an investment. Eventually, this thing will be paid off. It makes the middle class rich. This asset makes people rich.
Let’s now think that the financial ecosystem gets dicey. We won’t think horrendous situations like 2008, but let’s run a scenario where approximately half of that correction occurs.
You’ll have to replace your job for one that pays approximately 75% of what you used to get paid.
Your home valuation contracts to about 70% of its original value.
Your house is now $483,000. You’re still paying the $4,400 for your mortgage because the bank doesn’t care that tough times are upon us.
Additionally, you now make $86,250 after tax.
Suddenly, you’re in a pinch.
You’ve got repairs you can’t really afford.
You’re trying to figure out which payment you need to make. You want to know what is essential.
The bank is getting uneasy. With your credit falling behind in these uncertain times, they won’t let you refinance. They’re trying to cut back on bad business practices. However, they’re giving you the option to quick sell instead of moving into eventual foreclosure.
But nobody is really willing to purchase your home for anything close to what you paid. Everyone is in the same tough situation you’re in. The liquidity of the area has run dry.
Somebody lowballs your home and offers you $450,000. This is where it gets weird. The bank accepts it because they don’t want to go through the messiness of foreclosure. You have to take it because your financial situation will get worse and your credit will get ruined otherwise.
You were on your 13th year of the mortgage.
Your remaining balance on the house was $434,394. You have placed approximately $255,606 of principal into the home. Additionally, you’ve paid (approximately) $455,000 in insurance, taxes, and interest payments over the course of the same time.
The bank transacts, brokers, and swaps you out of the house you used to make payments on.
You get $0 out of the transaction because the house’s price and what you have left in balance is approximately the same. Even though you had actually paid principal into the home.
If you notice to that FRED chart above again, you can see that this isn’t actually a thought experiment at all. This is the story for millions of Americans, all who contributed massive amounts of their net worth into their homes only to watch the bank take it away from them. This leads us to our next point: The true cost of homeownership.
Renting is money lost while homebuying is money going toward equity. While this is true, mortgages build equity very, very slowly. Homes also require maintenance. Homes also require property tax payments and insurance — like we stated above, the home is collateral for the bank, but you still need to pay tax and insurance for them. A number no real estate agent would want to give you is the approximate cost of homeownership. This can actually be modeled by this equation,
where P is the cost of the home, r is the fixed interest rate for the mortgage, r_IT is the marginal income tax rate for the purchaser, r_PT is the property tax rate, N is the number of years of the mortgage, and r_M is the yearly maintenance cost. For example, on a $250,000 home at 6% interest over 30 years, 1% property tax, .75% maintenance costs, and 30% federal income tax rate, the cost of this home would be about $1,361 a month. Finding a rental for less than that is actually better than purchasing the home. Adding a down payment to this equation helps the relative cost of the home.
Real estate is guaranteed. Here is what Warren Buffet said in 2012:
“If I had a way to buy a couple hundred thousand single family homes and have a way of managing them, I would load up on them. I would take mortgages at very low rates… It is a very attractive asset class… If I was an investor who was a handy type, which I am not, I would buy a couple of them at distressed prices and find renters and again take a 30-year mortgage, it is a leveraged way to own a cheap asset. I think that is probably as attractive as an investment you can make.”
He never figured out the solution to the management issues involved with real estate. This is coming from a person who is saying that the investment “is probably as attractive as an investment” can get. Warren Buffet never went into the real estate world. He will probably die never entering it.
I glimpsed at this earlier, but all your interest is paid forward. Banks are smart, they don’t hand out mortgages because they believe in the public good. They’re in the business of profit. Below is an amortization schedule on a $600,000 home with $20,000 down at 4% interest with a monthly payment of $3,810.
Of that $3,810 per month, your principal, or the amount going toward the home, is going to be less than $900 each month for the first year. Your interest and principal payments won’t match until the year 2032. That’s 12 years away (It might be more if you add insurance and taxes, too). By then, you’ll have paid $250,000 in taxes, insurance, and interest. That’s almost half of the price in the house in things other than the house.
This list is not exhaustive. As with anything, it’s meant to start the discussion of actual value in homeownership, and how you can attempt to spot it. At a minimum, if it starts a conversation to question and challenge some of our native beliefs related to homeownership, then it succeeds. The purpose is not to dissuade people from homeownership; quite the opposite, this is designed to illuminate the false notions of investment that we tag to real estate so frequently in the industry.