Friday, January 26, 2007

Why is real estate considered a good investment?

I always thought that buying your home was considered a good thing because then when you're old it will be paid off, thus reducing your operating expenses in retirement. But reading the letters for this Cary Tennis column, I see that it's considered a good investment as an actual investment - a way to make money.

The more I think about this, the less I see it. Help me out here, tell me what I'm missing.

Let's assume you have a nice paid-off house that you paid off yourself over the years, and then it appreciated as real estate tends to do. So your house is worth more dollars than you paid into it. I understand that much.

But suppose you want to get at some of those dollars? My understanding is that you have two options: borrow against your house, or sell your house.

If you borrow against your house, you have a loan that you have to pay back. You haven't gotten at any new money, you've just borrowed some. This isn't a money-making investment, it's just another loan option that's especially important to pay back lest you lose your house.

If you sell your house, you still have to live somewhere. So you have to either buy or rent somewhere else to live. Your home equity is more dollars than you had before, but this is because real estate appreciates, so housing costs everywhere will have increased comparably. I suppose if you rent after you sell your house, then you can use your house money to pay your rent, but it the money still has to be spent. You have to live somewhere, after all. So you aren't really making money, you're just spending it differently.

I suppose it would work if you expect your housing needs to become smaller in the future. If you buy a big house to raise children in and then downsize after they've launched, you might come out with more money. If you're living somewhere expensive and then move to somewhere cheap, you might come out with more money. If you own property and then move in together with someone else who owns property, then you might come out with more money. But for everyday life where your housing needs remain the same, I don't see how you can actually make money out of it. What am I missing?

3 comments:

heather said...

it has to do with how you pay taxes on the money. you don't pay capital gains taxes on the sale of your primary residence...so people hop, skip and jump across town making about $10 000 a year for moving. The money you have invested in the house is not taxed at the rate it would be if it were in mutual funds (not RRSPs obviously) - though i guess that depends on where you live and the property taxes.
Land has always been a good investment, historically. It is non-perishable.

Scott M. said...

I think you'll find you're right overall... but your assumption that in "everyday life" your "housing needs remain the same" is a bit off.

What it comes down to is two types of property, personal and investment.

If we're talking about your personal residence, any (untaxable) capital gains realized only happen when you sell your house. You would sell your house: 1) To move to another location and maintain the same type of house, 2) To grow your family, 3) To shrink your family.

If you move to another location for work or something else, you only would get back or pay the difference in housing costs between the locations. When you grow your family, you will need to spend more on your home though your existing equity will mean you can either keep your payments and extend the amortization, or keep the amortization and up your payments.

But for personal residences, the key part of the investment happens when you shrink your family (kids move out). At that time you can move to a smaller house as you note. If you are retired, you can even move to a smaller community if you like (eg. the beautiful Elliot Lake iceflows).

Alternately you can invest in property as a full-fledged investment, not living there and paying taxes on the gains. Let's say you buy property in a sunny place in the US at 10%. In the states you don't have to pay Mortgage Insurance. It cost you $100,000. That means you paid $10,000 for that house. After the first year, let's say the house price appreciated by 5%. That means if you sell after one year your return was close to 45% (you still paid the mortage over the year)!!! That's quite good! Of course it would be in your best interests to hold it for 10 years or more of 5% growth so that your gains aren't eaten up fully through real estate commissions and lawyer's fees.

But in short, investment properties can be really rewarding. Your personal property should be seen more like a forced savings account than an investment... but still, savings are good and exactly what you need when you hit retirement.

impudent strumpet said...

Well that explains why I wasn't seeing the good investment aspect. I earn little enough that I find the taxes I pay to be negligible, and little enough that buying property just to see it appreciate in value isn't an option, but enough that I'm able to save pretty steadily by myself, (and keep it somewhere where I can access it without uprooting my entire life) so the idea of my home as a forced savings account is unnecessary. Plus I'm childfree, so I'm never going to grow or shrink my family.