Monday, July 25, 2005

Your home...

It is estimated somewhere, by someone, that the average person stays in their first home something like 7 years. My wife and I have been in our house for almost 5 years now, and she is ready to move. I thought this might be a place that we would stay for a long time. I think I was mistaken. I do believe that we will own it for a long time though. The plan was always to own the home and pass it on to our children as a revenue generator, if not a home.

Early, I discussed buying a home, and buying a house. I differentiated between the two as one is a place for you to live, the other is a place for someone else to live. My belief is that the home should be bought to fulfill non-financial needs first, and then be considered an investment. The house on the other hand, purely an investment.

I would like to review the investment side of this piece, and it fits for both types of properties discussed, houses and homes. One of the points that is talked about in real estate discussions that is often times over looked when comparing real estate to other investments is the process of leveraging. Leverage takes place in many forms, but it is the rule in real estate, and it is the exception in many other forms of investment.

Before we get too far along in this, let's look at an investment example. Let's say someone has $40,000.00 to invest. On average, the stock market climbs at almost 12% per year. Similar returns can be said for California real estate. If this is the case, what should the novice investor do? In the long run, it is likely that an investment in real estate will prove to be a better investment. The reason is leverage. If one were to take their $40K and put it into company ABC which happened to return 12% over the next year, at the end of the first year, their $40K would have grown to $44800.00, an increase of $4800.00. Not many people would complain about that. But, if that $40K had been put into a house, with a standard down payment and a 12% return, after one year, that 40K would have turned into $64K! Why the big difference? Leverage.

Leverage is the art of using someone else's money. When you buy a home, you usually assume a mortgage from a bank. The bank loans you money to buy the house. Therefore, you use the 40K for a 20% down payment on the home, and you borrow 80% from the bank, or $160K to purchase a $200K house. The entire house price appreciates over the 12 months, but the bank does not expect to see that money, they only want you to pay them their principle along with the interest that you worked out.

There are two points that should be made at this time, one, you do have to pay the bank back, and two, one can leverage stocks as well. Let me take some time to expand upon both of these points.

One, paying the bank back. Yes, the bank loaned you the $160K in this example. It did not give it to you, so it must be paid back. Therefore, the $40K you invested is not the end of this investment, there is an ongoing maintenance that must occur. But guess what, that ongoing maintenance is something that you might currently be consider as rent! When you purchase a home, you no longer need to pay rent. Therefore, the money that was going for rent may very well cover the payments needed to cover the mortgage. Today things are a little screwy. In many parts of the country, rent is significantly lower than a mortgage payment and therefore this needs to be taken into consideration when looking at real estate as an investment.

Two, leverage and buying stocks. As I mentioned the beauty of buying real estate as an investment is leverage, but in all honesty, one can also use leverage to buy stocks. Using leverage to buy stocks is different though than using leverage to buy real estate for a few reasons.

1. Stocks move up and down much quicker than real estate. Buying and selling stocks can happen without much pain or intervention, where buying and selling real estate generally takes time. This makes stocks much more liquid and therefore allows the price to be more volatile.

2. Margin calls occur when the price of a stock drops beyond the comfort zone of the bank that lent you the money to buy a stock. In the stock market, the information is almost perfect. It is easy to tell the price of a given stock at a given time. If the company that lent you money to buy a stock sees that the price is going down they may want to make sure that you do not stick them with the loss by walking away. They will call you up and demand that you cover the drop in price. In contrast, banks do not do this. The bank assumes that a house is a long term investment and they believe that you will own it through may peaks and valleys and they are OK with fluctuation in the price as long as you keep up the maintenance of the loan.

Using leverage to play the stock market is generally something that is done by very seasoned investors, or novices who do not know any better. Leverage in the stock market can quickly change ones financial fortunes, but if you do not have the financial wherewithal to handle the margin call (which can be substantial) generally it changes financial fortunes to financial misfortunes.

With all of that said, one can see that I am big on investing in real estate. I am not about to jump into the bubble argument (at least not in this particular post) but I will say that if one is looking at buying a home, for the right reasons, then I believe it is a good investment, if only for the piece of mind that it offers. I am a firm believer in enjoying your home for its hominess, and if you do eventually move out, then I hope you can enjoy it for its houseness.

Until I get the urge to pen again,



Anonymous Chee said...

Well thoughts are here:

3:18 PM  

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