Dragon Slaying Time

Q : Tell me again, just what is it that you do?

A : I play with numbers.

Q : Isn't that boring?

A : Actually, it is quite fun. Numbers are poisonous to some myths.

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There are many people who firmly state that real estate is the safest and most profitable place to invest. Blanket statements often cover myths. I have urged my children to buy a home rather than rent, but there are limits to the benefits involved. Several laws of nature must be remembered whenever one invests, but with regard to real estate, the most important is the fact that the cost of living always includes rent. You can either pay a landlord, or pay yourself; in many cases of paying yourself, however, there are middlemen who can make it more sensible to pay a landlord.

The following is a case study taken from the CRIS MLS with public records data from Realist.com and the Summit County Auditor's website. It involves a home in the Kingsbury Trace Subdivision of Copley Township in Summit County, Ohio. Some assumptions had to be made in the course of the analysis; they are noted as assumptions, and they were made based on the prevailing data for the event. The home was built in 1998 and sold, new for $211,800 on 12-30-1998. The buyers put down $42,400 cash and took out a loan for $169,400. It was assumed that a 30-year mortgage was granted, at an interest rate of 8%; the monthly payment on such a loan would be just over $1243. The home was refinanced in April 2003; the new mortgage was for $168,000, and, based on the amount paid to principal by that time, it was assumed that the homeowner financed some improvements at that time. It was also assumed that the new loan had the same terms as the original loan. Kingsbury trace also has an annual HOA fee of $500; it was assumed that the HOA fee was stable.

When the home was purchased from the builder, it had no landscaping, no basement finish, and no deck or patio. The home resold 4-25-2006 for $242,500, and at that time it had a lawn with shrub beds, approximately 130 square feet of basement finish (an office), a concrete patio, and a treated wood deck. The cost of these additional improvements were estimated, from local market costs, to be about $5,000 for the landscaping, $3,200 for the basement finish, $2,000 for the patio, and $8,000 for the wood deck; the total cost of the home and subsequent improvements was estimated at about $230,000. The total cash outlay, including the downpayment and improvements, was about $60,600. The homeowner lived there for approximately 88 months.

Each year from 1999 through April 2003, when he refinanced the home for $168,000, it was estimated that the homeowner paid $14,916 in mortgage payments. It was assumed for simplicity of calculation that the rate and term did not change; I have reason to suspect that in this case it did not. It was assumed that he also paid the $500 HOA fee, and (based on typical insurance rates of about $3/M of home value), roughly $600 in annual homeowners' insurance. Finally, he paid, over the course of the 88 months, about $28,400 in Summit County real estate taxes.

In 1999, the interest on the loan would have been about $13,552; he would have paid about $1364 on principal. In 2000, the principal payment would have increased to about $1473, in 2001, $1591, in 2002, $1718, in 2002, $1856, in 2003, $2004, in 2004, $2164, in 2005, $2337, and in 2006, $841. This progression, totaling $15,348, plus the down payment of $42,400, and the estimated $18,200 paid out for the post-purchase improvements (which he appears to have rolled into the 2003 refinance), would represent the homeowner's pre-sale equity position of roughly $75,948.

What did it cost to live there for the 88 months? Well, first there was the total estimated interest payment of $94,036 (total payments - principal amounts). This we can assume was reduced by the income tax savings (at the 28% bracket), of about $26,330, or $299/month, leaving a net effective interest payment of $67,706. (Keep in mind that if the homeowner had no significant other Schedule A deductions besides the interest and real estate taxes, he might have been better off taking the standard deduction, and thus there would be no tax benefit to having the mortgage. We assume there was a benefit.) Then there were the HOA fees, totaling about $3500, homeowner's insurance of about $4400, and the real estate taxes of $28,400. When he sold the house, he paid a County transfer tax of 4 mils ($970), an estimated $606 in his share of title insurance, and a real estate commission of $11,700 (based on the information in CRIS). His total cost was roughly $117,282, or about $1333/month in rent.

Now let's look at the return on investment. The house cost $211,800, and we assume he improved it by about $18,200 for a total cost of $230,000. He sold it for $242,500, with closing costs estimated at $13,276; his net gain on the sale was -$776!! If we take his down payment of about $42,400, add his equity increase of $15,348, and subtract the $776 loss, we see that he started with $42,400 and ended with $56,972 (we have assumed that he refinanced the improvements and thus they were not an out-of-pocket expense). Using simple arithmetic (we don't want to complicate things, do we?), his $42,400 investment earned $14,572, with a rate of return of about 4.7% annually.

Whew! Lots of numbers to crunch. Most people would not bother. There are several questions that are pertinent. One, what would it have cost to rent a four bedroom home with similar amenities? Answer : probably about $2500/month, which might have been out of budget. Two, could he possibly have rented a similar sized home in similar condition in Copley for about $1250/month? Answer : Yes. Three, what kind of return could he have gotten from investment of his $42,400 in a good, aggressive mutual fund in that time period? Answer : probably about 12% annually.

Was this home a good investment for the original homeowner? That depends on some subjective factors. Would he have been happy in a lesser home (with a lower rent -- you have to question how much enjoyment was provided by the HOA amenities)? Did he have an income level that would have supported a higher rent? Was he looking at the purchase of the home as a portfolio investment? Was it critical to have his investment money readily convertible to more liquid assets?

You decide. In the end, we all have to live with the decisions we make. As I earlier stated, I recommend home ownership to my children. It may not be the best or safest investment for everyone. Anyone anticipating buying a home should get an appraisal (hey, I have to drum up business somehow) and run the numbers past a consultant (I do that, too). And never, ever (my bias is showing) buy the most house you can afford; it is best to live below your means and use the spare cash for other investments than for paying the rent.