It’s a hotly debated question. Is it better to buy or rent? We covered this question in detail in Podcast 59. Many argue that buying is best because on average homeowners have a higher net worth than renters.
Rather than looking at averages, however, today we are going to look at an actual case study. My wife and I bought our first home in 1993. We sold it 11 years later. I've got all the numbers we need to dive in and see just how well we did. The results will surprise you.
Our First Home
My wife and I bought our first home back 1993 in Northern Virginia. We bought a home built in 1964. It was a ranch with three bedrooms and 2.5 baths on less than a quarter acre. It had no garage, but did come with a walkout basement that was partially finished, including a working fireplace. The home cost us $190,000 (NoVa is a very expensive place to buy a home).
Eleven years later we sold the home for $435,000. A casual look at these numbers seems mind-boggling to me. We went from $190,000 to $435,000 in just 11 years. Before we get too excited about these results, let’s dig into the details.
The Investment Return on Our Home
On just those numbers alone our compound annual growth rate was 7.82%. Here's how I calculated that number in excel:
The formula for calculating the CAGR is simple. Divided the ending value by the beginning value. Then raise the result to the power of 1 divided by the number of years. Finally, subtracting one from the result converts it to a percentage.
7.82% doesn't sound overwhelming when compared to the long-term returns of stocks of about 10%. Of course, the return on the home is tax-free, which is a significant advantage (more about that below).
Unfortunately calculating our returns is not that easy. We have to consider a number of other costs, starting with transaction costs. These costs typically include the cost of obtaining a mortgage, inspections, appraisal, and realtor fees when you sell. In our case, we paid about $1,000 in fees when we bought the home (the sellers paid the rest), and $35,000 when we sold the home. The fees on the sale include some work we had done on the home.
These transaction costs increased our beginning value to $191,000 and decreased our ending value to $400,000. Using the CAGR formula above, our annualized return dropped from 7.82% to 6.95%. Still not a bad deal, but we did shave almost a full percentage point from our returns.
Cost of Improvements
We also improved the home in the 11 years we lived there. The three major improvements were remodeling the kitchen, a bathroom, and converting a deck into a 3-season room. Total cost of these improvements was about $30,000. Adding in these costs raises the $191,000 (purchase price plus transaction costs) to $221,000. Running these numbers through our CAGR formula lowers our annualized returns to 5.54%.
My estimate of maintenance costs comes in at $1,000 a year. We had no major repairs (e.g., roof, furnace, air conditioner), but did have to replace the water heater and had some furnace repairs. Everyday maintenance takes up the rest. Adding $11,000 brings our total investment to $232,000 and our compound annual growth rate drops to 5.08%. And we're not done.
Taxes and Insurance
Paying taxes and insurance is a fact of life for homeowners. After considering the tax breaks we enjoyed on the real estate tax payments, I estimate we paid $30,000 (unbelievable!) over the course of 11 years in taxes and insurance. That raises our cost to $262,000 and further lowers our CAGR to 3.92%.
The mortgage complicates the analysis somewhat. For now, let's just focus on the interest expense. After factoring in the tax deduction we enjoyed, we still shelled out $81,000 (gulp!) in interest over those 11 years. These costs increased our total investment to $343,000 and reduces our CAGR to a measly 1.41%.
The Affect of Leverage
Now let's dig into the mortgage. We of course didn't actually pay $190,000 when we bought the home. Our total out-of-pocket costs were about $10,000. We borrowed the rest. So let's first look at our actual out-of-pocket costs over the 11 years we owned our first home:
- Down Payment: $10,000
- Improvements: $30,000
- Maintenance: $11,000
- Mortgage Payments: $132,000 (including taxes and insurance less tax breaks)
- Total Investment: $183,000
Now let's look at what we received when we sold the home:
- Sale Proceeds after costs: $400,000
- Less Mortgage Payoff: $167,000
- Cash Received: $233,000
With the benefit of leverage, our CAGR does increase a bit. Plugging the cash received of $233,000 and the total investment of $183,000 into our formula increases our CAGR to 2.22%. Nothing to write home about, but at least we are moving in the right direction.
Two More Factors
There are two additional factors that we need to consider. First, we've run the calculations as is if we paid all of these costs in year one. We of course made the down payment and a few mortgage payments in the first year. But the majority of these costs were paid over the course of the remaining ten years.
To factor in the timing of these payments, we need to move beyond CAGR. Instead, we need a way to calculate our annual investment in the home and compare it to the results when we sold. What we are really looking for is called the internal rate of return. In excel the formula is XIRR. XIRR factors in annual investments over a number of years and calculates the ultimate return on those investments. Here's how I set up the calculation in excel:
Note that the first year reflects our down payment and a partial year of mortgage payments. The last year reflects our cash received from the sale less the mortgage payments we had made that year. The result is a return of 4.20%. Note that if you listen to the podcast, I calculate the return at 3.8%. Why the change? I made some adjustments to the timing of the cash flows to more accurately reflect our experience with the home. While 0.40% may not seem like a lot, over an 11 year period it adds up.
The second thing we need to account for is the tax breaks. We didn’t have to pay capital gains tax on the sale of our home. Calculating what is actual capital gains would have been is a bit complicated. But we can estimate the impact of this benefit by dividing our returns of 4.2% by 1 minus our tax rate. Capital gains were at 15% then plus about 5% in state taxes resulting in a factor of .8. So dividing 4.2% by .8 gives us a pre-tax return of 5.25%.
First, a home is absolutely an investment. It generally doesn't generate rents. But it does affect our finances in a very significant way. This means we should think about the financial implications when we buy, sell or improve our home. These won't be the only considerations, of course, but they are important.
Second, the above calculations did not consider the fact that we didn’t have to pay rent. In other words, we would not have had $183,000 to invest over those 11 years had we rented. We would have had $183,000 less rental expenses. I didn’t take that into account because the purpose here was not to compare buying versus renting. As I mentioned above, we covered that topic in Podcast 59. The goal here was just to look at the raw numbers of owning a home.
Third, while the returns of a home don't compare to the long-run returns of the stock market, a home can be an excellent investment. Paying down the mortgage is an automatic savings mechanism, and the tax advantages are second to none.
Care to share your numbers? Leave a comment below with how well your current or former home performed as an investment.