By Kevin P. Brosious, CPA, PFS, CFP
A friend from Arizona called the other day and told me he had sold his vacation home for $200,000. He purchased the home 30 years ago for $70,000. “Can you believe it?” he boasted. “I made $130,000: this was the best investment I ever made” I congratulated him on the sale and his tax-free gain. He is going to use the proceeds from the sale to help fund his retirement.
On its face, this was not really an investment: he and his family used the home as a place to get away and relax. They never rented the property out, and it was strictly a place for the family. I did not want to burst his balloon, so I played along with his “investment” angle. He was convinced that this was an investment, and considering the difference between the purchase price and the sale price he thought it a rather good one.
If just looking at the purchase price and selling price, one can use an Excel spreadsheet or a financial calculator to easily determine the annual return on his “investment.” If we use $70,000 as a present value and $200,000 as future value, 30 as the number of years, and solve for interest, we get an annual return of about 3.6%. Hopefully, he had other investments with returns greater than 3.6% per year over the past 30 years. But figuring the return is not really that simple.
Since the initial purchase, he made several improvements to the vacation home. He added a deck, remodeled the kitchen, and replaced the heating, air conditioning, and roof. For simplicity’s sake, let us assume a conservative total cost of $50,000 and that these improvements were all completed 15 years ago.
Property taxes are currently $2,500 per year. Assume his taxes increased by the rate of inflation every year since moving in, so starting taxes were about $1,050 per year. Other costs to consider would be landscaping, painting, homeowners association fees, closing costs, etc. While not a complete list of home costs, even with this abbreviated selection his annual return falls to about 0.8%. His real return after adjusting for inflation would be -2%.
I do not believe his home was underpriced, as it was comparable with other homes that recently sold in that area. It was on the market for over six months.
As we talked through his return, he came to the realization that his vacation home was not really an investment, and we talked about all the good times his family had over the years.
The next day I got a call from my friend, who is never one to let something go easily. He asked me if my analysis would change if he saved $4,000 per year on other trips that the family didn’t take because they used their vacation home instead. I know this was not the case because he told me about some wonderful vacations his family went on over the years. I played along and included this “cost savings” into the analysis. I told him with the cost savings his investment returned about 2.9% a year over 30 years. “Great, I knew I made a good investment.” He thanked me and hung up before any additional discussion. I still find it interesting that he considered an investment that returned just 2.9% per year a “good investment.”
So, is it possible to really make money through home (or second home) ownership? Professional opinions vary widely on the investment return for home ownership. The Betterment robo-advisor recently indicated that return on a home is about the same as investing in the stock market (about 10% over time). An article on Seeking Alpha agreed, and the author displayed a spreadsheet to back up his theory. Part of his spreadsheet contained imputed rental dividend,1 which ended up being a significant part of the analysis. Imputed rental dividend is a projection of the rent you would have to pay if you didn’t own a home. For example, if you purchased a home for $350,000 and your home replaced a $2,500 per month rent, your imputed rental dividend would be ($2,500 x 12)/$350,000, or 8.6% annually. William Bernstein wrote about this concept in his classic, The Investor’s Manifesto. He proffered a simple equation for determining return on home purchases: Expected Return = D + G – C, where D is imputed rental dividend, G is inflation-adjusted growth in home value, and C is costs (insurance, property taxes, maintenance, etc.). Using his equation for estimated return for all home investment is likely around 4.67% post tax. This is about what a 50-50 portfolio might return after tax, but certainly not the 10% that Betterment estimated. Also, return can vary greatly depending upon the region.
CNBC, on the other hand, posted the article, “Buying a Home Is Usually a Terrible Investment,” and went on to say that most homeowners don’t consider all the costs of home ownership, such as repairs and maintenance, mortgage interest, and property taxes. Business Insider said, “If you think buying a home will automatically build wealth – think again.” The article highlighted all the costs of home ownership and indicated that your return would be much less than investing in the stock market. They suggested renting was much cheaper. The most direct of all was author and real estate investor Gary Cardone, who stated, “Buying a house is for suckers.” Although interesting articles, none of these were backed up with any numbers. This makes them difficult to compare to others that were.
I lean toward the Bernstein method of determining home investment return. However, don’t expect these returns overnight because they often require five to 10 years to materialize. Also, if your investment returns are greater than the 4.67% mentioned above, you may do better renting rather than buying a home. Bernstein’s rule of thumb is to never pay more than 15 years fair rental value for any residence. So, if a similar home is renting for $2,500 per month, your limit should be $450,000.2
1 Imputed Rental Dividend is not applicable to second homes
2 $2,500 x 12 x 15
Kevin P. Brosious, CPA, PFS, CFP, is president of Wealth Management Inc. located in Allentown and Plymouth Meeting, Pa. He can be reached at firstname.lastname@example.org.
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