Sunday, November 20, 2016

Making the case for buying a home

Although this blog is primarily focused on dividend growth investing and the ever increasing accumulation of periodic dividend checks, I wanted to step back and talk about housing since it's such an important topic since everybody has to deal with it. Housing is an absolute necessity that everybody requires and is an important part of everybody's daily life. I have always wanted a house to live in and one that I can call my own. I would like to own my own plot of land and not have to share walls with neighbors who play trance music all night. I want to be able to plant my own tree and plants. I want to have my own clean indoor parking garage and not have to worry about other drivers hitting my car. I want my own backyard where I have a dog run around. My target home is in the standard "American" style home with 2 car garage, 3 or so bedrooms and 2 bathrooms, a kitchen and living room, and a back + front yard. I don't want a large McMansion but I don't want one that's too small either. I am targeting 1200-1400 sq ft.

I live in San Jose in California. The price of housing here is very expensive due to the high number of tech employees and companies hiring. Although the price is high, I am considering and putting together a plan for November of next year to find a home to purchase. I am targeting a starter home in the $750-850,000 price range with a 20% down payment. This is a hefty amount so I will have to take some of my dividend growth stocks and liquidate them to help pay for the down payment :(

By November of next year I will have saved some more cash from my job, but I will still need to liquidate around $70k of my current holding of stocks (I currently have around $240k in dividend stocks) to help pay for a 20% down payment.

The mortgage rates when I checked now were around 4.1% and the property taxes are around 1.1%. The mortgage rates have a likelihood to go up even further since the Fed is likely to increase interest rates in December 2016. Trump's desire to increase US infrastructure spending may also cause interest rates to rise further (as seen in the spike in bond yields after he took office). Higher interest rates will lower prices of homes since it will cost more to borrow. I hope by November of next year the prices of homes will decrease relative to the increase in rates (if rates do increase) so that I can decrease my down payment.

To convince myself that buying a home is a financially sound decision I compared two extremes of life:
1) Buying a house and living in it for life
2) Renting for life
For those that don't want to read through the math, the summary I found is that owning a house is substantially cheaper and the quality of life in owning far exceeds what one can get from renting for life in the equivalent price category. Those that are still young should start young since the benefits are even greater the younger one is.

Buying a home and living in it for life (+60 more years for a buyer in his late 20s):
I am going to use a reference $850,000 home in San Jose (picture shown above) that is 3-4 bedroom 2 bath, front and back yard, 2 car garage, and 1300 or so sq ft. This is the cookie cutter old school American style house.

Down payment: For a $850,000 home at 20% down, one will need to pay right at the start $170,000

Mortgage: For 30 years, a mortgage at a 4.1% rate with 1.1% in property taxes and some small amount for property insurance will cost around $4200 a month. Assuming the buyer is in the 28% tax bracket since one needs an income to support this mortgage, one can get around $750 back a month in tax returns if one itemizes the mortgage interest and tax. That means in 30 years one has to pay 30 yrs * 12mo * ($4200-$750/mo) = -$1,242,000

Tax: After the mortgage you will still need to pay 30 years of property taxes at 1.1% to hit 60 years. This amount is 30yrs * ($850,000 * 1.1%) = -$280,500

Maintenance: Houses need maintenance or else things just break. Assume worst case you need to spend 1% of the house's value every year which is $8500 a year or $708 a month. For the entire lifetime this totals 60yrs * $8500 = -$510,000

Just from looking at payments, the total payment costs in 60 years of the above items summed together is -$2,200,000

One needs to remember however that after 60 years, the home owner can have the option to sell the estate and give it to his spouse or heirs. Assume the house had 0 appreciation throughout the 60 year period (highly unlikely) and the owner can sell for the original price of $850,000. Then the home owner in 60 years of living in the house has actually spent just $2.2M-$850k = -$1,350,000

If you consider that the home price will accumulate with US usual inflation of 2% a year (highly likely since the US prints money like crazy), then the final home price will rise from $850k in 2017 to $2.73M by the year 2077. If the buyer wants to liquidate or pass the asset on to his heirs, the home owner actually has no net cost since he will profit by around +$500,000

Now let us look at the total cost of ownership of a rent-for-life...

Renting for life (+60 more years for a person in his late 20s):
I will use average renting cost right now in the San Jose bay area. Since I have lived here for 4 years and shopped+lived in 3 different apartment complexes, I have a decent understanding of apartment prices in the Silicon Valley area. A 1 bedroom 1 bathroom apartment here will be $2300 assuming one chooses one with a decent standard of living. Very small and less than desirable (unsafe, unclean, etc) 1 bedroom apartments can range from $1800-$2200. Recall that this is a 1 bedroom apartment compared to the 3-4 bedroom house used in the previous scenario.

I will assume rents increase at 2% a year to keep up with historical US inflation rates. This is actually very conservative since bay area rents have been actually growing at 8%-10% annually (I started with $1400-1600 a mo in 2010-2012 then $1700 a mo in 2013, then $1900 a mo in 2014-2015, then $2300 a mo in 2016 and now I have to move since it's increasing again). The prices shot much faster than the average inflation rate after the economy in the bay area came out of the 2008-2009 great recession.

60 years of Renting a 1 bedroom/1bath apartment in San Jose:
For non-math readers, this equation just means summing up all 60 years of $2300/month rent and include the 2% annual inflation rate.
= -$3,150,000

Renting is abhorrently expensive and I can attest first hand that the increase in rent year after year to keep up with inflation will completely screw over anybody. Even if I reduce the inflation from 2% to a measly 1%, the total cost of ownership is still $2.25M which is more than the cost of owning a 3-4 bedroom home for 60 years. From this point of view it's completely not worth it since the quality of life in a 1 bedroom apartment is not comparable to a single family home.

To make the comparison even more clear, I will use the best price one can get for a very small single family home (say 2-3 bedrooms) in San Jose. This will on a good day be $3500 a month.

60 years of Renting a 3 bedroom single family home in San Jose:
= -$4,800,000

It will cost one over 4 million dollars to rent for life in a single family home.

Although my dividend portfolio annual income will take an income hit next year since I will have to liquidate some shares to fund the down payment, I think the lifetime financial decision to own verses rent is clear. I would rather suffer the initial upfront burden of the 20% down payment and secure my future financially than continue to suffer the effects of rental appreciation. An investor must also remember that one cannot sleep on shares. An investor can however live in a house if he has to. With renting, one has nothing to show at the end of one's life, whereas a home owner has the option to sell or pass on his home after he no longer needs it.

The case study above in San Jose, California shows that renting will put you behind $3-5 million while buying will at the very worst case put you behind $1.3M if your house somehow doesn't appreciate in 60 years, but one will likely profit at the end of the day by owning a house for 60 years due to the effects of inflation.

For those in different cities, you can do the same study to see how renting vs buying stands. If rents are substantially cheaper for some reason than buying, then one should consider the option of renting as well.


  1. Young Div -

    Very good analysis, indeed. Obviously, geography plays a HUGE part in it - I live in a nice Eastern Suburb of Cleveland, allbeit I bought my house in 2011, but a 3 bedroom 2 bathroom 1400 sq foot home was less than $100K : ) However - this is all relative, as I think geography and timing of luck plays in with it.

    Therefore - I would say - yes owning a house for some will be worth it, for some it may not be. For most people with a family - a house more than likely is for sure in the future and makes financial sense to do so.

    And yes - I think if I keep the rate I am going at, my house will be paid off in the early 40 year range of my life; since I've been making an extra 4.25 payments per year. Even if I went back to a normalized schedule, I have already chipped off a few years.

    I'll also state - it depends if you want to have a yard to tend to, the hot water tank to tend to when it goes out, the roof when it ages and decomposes, and the furnace/Air conditioning unit when it dies. All relative - as you built that in, but just from a time, stress and all of that flavor that can go into it. Numbers are numbers, but if you rent, one typically just picks the phone - makes the call and the date/timing is set for those repairs to be fixed. I just had to work with my Uncle and had to cut a few copper pipes and solder a new one together to fix a leak in her basement. Lets just say - that wasn't what I had planned on for my Saturday : )

    Love the article - would love it if you had a duplex and could build some rental off of it while you had still a home, with a yard and space. However, you'll enjoy having a house for the family, no doubt, in the future. Try to locate a place where you are relatively close to all things that you enjoy and your loved ones, it'll make your life easier, I promise!


  2. I also live in San Jose, CA and the housing here is pretty nuts!

    I think there's one big thing missing from your wonderful analysis. You should include what happens to the $170k if you keep in the market and continue to rent. With renting, you get to keep the 170k in the market and have it compound. Assuming you get keep the $170k in the market for the next 60 years and assume a conservative 6% CAGR, your 170k in 60 years will be $5.6 million. It jumps to $9.9 million if you use 7%. So if using 6% return annually on the 170k and rent, you actually would have a net of $800k (if renting the SFH), which beats your $500k profit if you buy a house in San Jose. The 7% return, you are profit by $5.1 million! So looks like renting would be a better choice financially.

    Of course, having your home, backyard, ability to do things around the house and etc does have a lot of intrinsic value and that is up to you to decide if you want to purchase a home or not.

    BTW, I'm one of those people who does actually LOVES trance music so I guess we shouldn't be neighbors then ;). haha!

    1. That is actually a good point. The down payment will be heavily missed since it cant be invested in equities and will sit there hoping to accumulate with the price of the house. Stocks in the long run do exceed housing (ignoring leverage).

    2. peter le,

      if you are going to use the assumption of 7% growth on that 170K, then you must go one step farther and use $4200 per month for 30 years at 7% growth.

      the house is paid off in 30 years. taking the mortgage payment and applying that to investments (i have faith that young div won't aimlessly spend that much every month on frivolous things) over the course of the remaining 30 years:

      $50,400 per year, 30 years, 7% growth === $4.76 million plus $500K from selling it == %5.25 million.

      Theoretically, he will again, come out ahead of your %5.1 million total.

      At the end of the day, it is a win/win all around. There is not really a wrong answer, just different perspectives of what is important in life.

      some people enjoy the freedom of being able to pack up and move whenever they want and renting allows that with 1 year leases, others, like myself enjoy having "roots". when you own a home there is a sense of community and family (in my opinion) -- looking at the houses in my neighborhood that are renters, the places are a wreck, the landscaping is overgrown and awful and it is not until they move or get kicked out that the owners of the house come in and renovate back to new again. rinse, repeat.

      this type of post pops up on blogs every where and it is never a one size fits all. do what you feel is best for you and your family young dividend.


    3. there was one thing that you could comment on that i missed and that is the fact that rent is cheaper than the 4200 over the course of the first 30 years and therefore, the extra $700-1500 bucks or so could be invested.

      however, using the 3 bedroom house (family in the future) that is $3500 per month. $4200 is a mortgage. but, throw in the $700 of tax breaks and you are at the $3500. I consider it even.


  3. Yes tax returns from owning a home is favorable if your family is in a particular income tax bracket. From a month to month basis, it starts to get much more attractive than renting. The hard part is one needs to get the down payment.

    For a 28% tax bracket I calculated that you will get 22%-25% back for the amount one pays in Interest + Property Tax.

    A $850,000 house at 20% down payment will have now a ~$4200 mortgage. At a 4.1% 30-year rate and 1.2% property tax this is around $850 in property taxes and ~$2168 paid in interest every month for the first few years. For the tax refund, 25% of $(850+2168) is ~$750 so one's monthly mortgage is actually $4200-$750= $3450 in this case.

  4. Hey ADD, thanks for that part of investing the additional money after paying off the mortgage. I totally missed that part! Looks like owning in San Jose vs. Renting is almost equal.

    But again, if all things are equal it is definitely a personal decision. Having a place you call home is very valuable to some people and I get it! I actually own my own home as well! I've just come to realize that is not as clear cut to buy a home as many would say.