If you are looking for optimized investment scenarios, then you probably know by now that real estate is not your best bet. Traditionally, real estate investments average only 6.5% return on investments while the stock market averages 11% return on investment. However, traditional real estate investments are safer than stock markets because real estate has a land scarcity element to the investment. A Stock is nothing but a piece of fancy paper that signifies ownership in a company but real estate has a physical property that cannot be destroyed (maybe unusable but not destroyed). This point is why I would always pay more to live in the city rather than in the suburbs. Homes in the suburbs were large homes built on large lots but if you run out of room, you can always subdivide the land to build two- even three homes on a land that used to have one large home. This scenario is very difficult in the city since the homes were built almost a century ago and on small lots and you only have so much space in the city.
Next, although real estate only nets you 4.5% less than stocks, the total money earned in the long run can actually be more than just using the money on the stocks alone. How? By leveraging your earning power. Leveraging investments is a difficult concept for many people however, it's one of the most important concepts in personal finance. Let's say for example, you earn a paycheck of $5,000 per month (take home pay) and see how the earning breaks down (the scenario is a hypothetical one).
If you rent: If you own:
Salary - $5,000/month Salary - $5,000/month
Rent - $2,000/month Mortgage - $2,000 (after benefits from blog part I)
Car loan/insurance/gas- $500 Car loan/insurance/gas - $500
Groceries and other necessities - $500 Utilities, food, other spending - $500
Personal spending - $500 Personal spending - $500
Remaining $ - $1,500 Remaining $ - $1,500
As you can see, by renting, you basically throw away $2,000 in month everyday and you could argue that it could be the same with the mortgage if you have an interest only loan. However, at $2,000/ month, you could afford a $250K loan to purchase a home. And, you have a 6.5% return on your investment component that earns you $16,500 annually ($165K in 10 years), which you would never have made. Remember, that you'll always need a place to live and if you're spending the same money AND if you think long term, this decision is a no-brainer.
Now taking the same example, buying your first home is still better than renting and investing your $ into stocks because your overall return is higher due to your higher leverage. Meaning that, since you'll always need a place to live, you'll always pay that $2,000 per month (or whatever it may be) to live. So let's say that you rent, and you invest in stocks that net you 11% annually. Then, your stocks are only earning you $1,800 annually (not accounting for compounding effects; 10% of $1,500 x 12 months). In this scenario, you're losing almost $15K by not purchasing a home. Yes, you could argue that $1,50o per month can be used to get a margin account that nets your more money in the stock market. This is true but 1) you will not get as much leverage as your home since your home has tax benefits, and 2) if you're really trying maximize your investments, then why not buy a home AND use the same remaining money into the stock market? This way you'll earn on both ends.
The next question is then, what about this bubble and that you don't ever want to buy at the peak of the market? The answer to this question is the same with all investments. You can't look at things short term. Let's look at the stock market again. The dot-com bubble dramatically increased stock prices in the late '90's and early '00's. Then the crash came and people lost lots of money with no leverage (at least in the short term). So, did everyone lose money?
NO! Although the bubble burst in 2000, by 2007 the S&P 500 is back to where it was before the bubble burst. This is a hard lesson that you should invest for the long-term! For people who did invest in the long term an still lost money - well, you invested in speculative stocks.....that's a whole new risk and I won't cover that here. This same logic applies to real estate investments:As you can see, we had a small real estate market downturn back in the late '80's and only to have it picked up a few years later. I'm just expecting the market will take a little bit longer to pick up since the growth rate of real estate investments have been significantly higher than before.
In conclusion, I decided to buy my first home based on the thinking and the analysis as described. Of course I've done even more analysis based on the locality of the DC market but I'll save those for later.
