My Personal Finance Journey

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Housing Appreciation Isn't All Profit

Contributed by mm | May 23, 2004 7:51 PM PST

In this Bankrate.com article, Greg McBride suggests that we should not think of home appreciation, defined as selling price minus purchase price, net all closing costs and commissions, as profit.

In order to get the true profit picture, Greg believes we need to "compare that accumulated equity stake -- net of all sales costs -- with the amount invested for initial closing costs, all monthly mortgage payments, annual property tax bills, property insurance premiums, and costs for maintenance and upkeep, plus any ancillary fees such as homeowners association dues or assessments."

In this mentality, Greg calculated in his example that for a typical $200,000 home with 10% downpayment and normal maintenance expenses, the home needs to appreciate 17.5% in the first year to break even (if the homeowner sells after one year). If the hypothetical homeowner wants to stay 5 years, the home needs to appreciate 9.0% per year. And 10 years? Count on at least 7.0% annual appreciation.

Well, it is fair and reasonable to include all home-related expenses, like mortgage payment, property insurance, homeowner due, maintenance and upkeep into the total cost of homeownership. And to Greg's credit, he even tried to calculate another set of numbers for itemized deduction filers (to account for additional tax benefits) and correctly pointed out that the simplified calculation does not include time value calculation.

However, the analysis is still flawed in two aspects:

Firstly, it appears to me that in calculating the version for itemized filers, Greg simply deducted 27% (the assumed tax bracket in the article -- which does not exist today, anyway) of the total mortgage interest and property tax amount, and this treatment is wrong.

Why? Because not all these tax deductions are incremental benefit to the homeowner. Typically, one cannot be qualified for itemized deduction without a significant mortgage interest and property tax payment. As such, the incremental tax benefit is only on the total itemized deduction amount minus the standard deduction amount ($9,500 per year for married filed jointly). Therefore, Greg almost understated the true cost of ownership by $9,500 * 27% for around $2,500 per year. (I blogged this long before referring to a Fool.com article of the same topic.)

Secondly, for a complete investment analysis, Greg not only needs to include all relevant costs (which he did), but also needs to include all relevant benefits. Home is not an investment like a stock, from which investor can only expect a capital gain or regular dividends. Home is, first things first, a shelter that offers real value to the homeowner, and second, an investment. By owning a home, the homeowner can get the benefit of either reducing his own rent (if he lives in the property), or getting additional rental income (if he rents the property out). As Greg excludes any benefits other than the final sales price, Greg is essentially saying our hypothetical homeowner, after buying the home, just left it closed without occupying it or renting it out, which is a highly unlikely thing to happen in real world. As a result, his calculation vastly overstated the necessary annual appreciation necessary to break even in a home purchase.

All in all, while I feel it is meaningful to include all housing-related expenses to get a true picture of real estate investment profitability, I can only say Greg didn't provide a helpful example for people to fully understand this issue.

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