by elmads

This might be a confusing blog for my readers, because just recently, I posted a blog titled “Is the home we live in an investment?”, and I emphasized there that most homes can still be an investment, but its returns will most likely disappoint most people when compared to other forms of investments.

Nevertheless, there are factors that need to be taken into account because there are certainly homes that will yield higher returns than the average performance of residential properties within a specified country. And, one of which that will substantially influence such beating returns is location, Location, LOCATION.

I just want to thank a friend of mine who gave his two cents about homeownership price appreciation, after he read the blog I made previously about it. We had a very engaging and fruitful discussion.

Also, to another close friend of mine who lives in Canada and shared his experience as a home owner in the said country. I am deeply thankful for their insights as this gave me the drive to make a second blog. A blog that will serve as a devil’s advocate for the previous blog that I made.

A home can be investment, the question is, will it be a good investment? We’ll dig deeper into the numbers with real life examples based on other’s experiences.

Mortgage

Definition of some terms relating to mortgage.

• Mortgage – This is the Loan taken out by individuals from banks to finance buying a home.
• Home Equity – This is the total amount of money you paid on the home. This is computed as total value of the home minus your mortgage.
• Positive Home Equity – This is if the current market price of your home is well above the mortgage you took out of it.
• Negative Home Equity – This is if the current market price of your home is below the mortgage you took out of it.
• Mortgage Rates – This is the interest paid by the borrower to their lender. The Mortgage rates fluctuates and changes depending on several factors such as supply & demand, local and/or global economy, and central bank rates.
• Two Main types of Mortgage Rates –
  
  ¬Fixed Rates are the locked in mortgage rates that you’ll be paying, like for example; 3% fixed mortgage rates for 5 years.
  
  ¬Variable mortgage rate, this is heavily influenced by the interest rates. In here the mortgage rate follows the changes in interest rates, and that’ll be the rate that we need to pay in a given year, if it goes up so as our mortgage rates and vice versa.

Majority of individuals, for most of the time will take out a loan to finance a home purchase. And, knowing the basic information and how a mortgage works will be vital with our net investment homeownership returns in the long run.

Calculating Mortgage Payments

For math inclined individuals, computing the mortgage payments and the amount of interest that will be paid is not complicated. The formula will guide us all through out the process.

We only need 3 variables in here, the Principal of the loan, the Annual Mortgage Rates and the Number of years to pay the loan.

NOTE: This computation doesn’t account Variable Mortgage Rates.

• Principal Payment = Banks will not loan the full amount of money to purchase the home for the buyer, instead they will require a down payment from the borrower. The down payment varies, but some banks will allow the lower end of 5% of the total home value that the borrower wants to purchase.
  
  What we enter in the “Principal”, is the amount of money we actually owe to the bank, NOT the full market value of the home purchased.
  
  For example, the home is worth £200,000, then we gave a down payment worth £40,000 while the mortgage loan is £160,000. Our Principal in this case is the owed £160,000.

• Annual Mortgage Interest Rate = this depends on what type of mortgage you took, is it variable or fixed term? But just like what I stated above, this formula won’t be able to calculate variable rates, only fixed term rates. So in this portion, we will make assumptions based on the past to current data, and we’ll also make projections.
  
  There’s a catch here, we must make the Annual Mortgage Interest Rate to Monthly Interest Rate. Don’t worry, this is a straightforward process as we just need to Divide the Annual Mortgage Interest Rate by 12 months.
  
  For instance, the annual rate is 3%, by dividing it by 12 months, it will give us a monthly mortgage interest rate of 0.25%. This will be vital for us to arrive into the mortgage monthly payments

• Number of years = this is based on the contract signed for the mortgage loan. Like with our Annual Mortgage Interest Rate, we will also need to get the total number of months. We’ll do this by Multiplying total number of years by 12 months.
  
  Eg, 30 years times 12 months gives us 360 months. This is also important to get the mortgage monthly payments.

Applying the Equation

Shall we put the equation to the test? Let’s say we have Mr. L who plans to purchase a 2,200 square foot home selling for $345,000. He took out a mortgage loan and placed a 10% down payment, which is $34,500.

The mortgage then is worth $310,500 with 30 years to pay. Let’s assume that within those 30 years time period, the Annual Mortgage Interest Rate will be at fixed 3% (only as an example).

• How much will then be Mr. L’s total monthly payment?
• The average monthly payment on interest?
• The total (30 years) amount paid on interest?
• And the total paid including interest after the 30 years period?

• The total Monthly Payment will be worth $1,309.08
• The Average Monthly Payment on Interest will be : $446.58
• Total Paid Amount (Principal + Interest) after 30 years : $471,268.99
• Total Interest Paid after 30 years with fixed 3% mortgage rate : $160,768.99 (this is computed by subtracting the total paid of $471,268.99 to the Principal of $310,500).

This is the breakdown and how to compute it. The higher the Mortgage interest rate is, and the higher the amount of mortgage we have, the more we will pay interest on it.

NOTE: The Monthly Payment on Interest is not an accurate fixed monthly payment. What do I mean by this? with prepayment mortgages, after the first few years we'll be paying the same total monthly payment, but the percentage amount of what we pay will be more on for paying the interest first. Then over time, this reverses. See area chart below.

The Real Life Example and Its Home Price Appreciation

The above data I gave for the computation is an actual real residential home with an actual family who bought that house. I got the following details from a friend of mine who lives in Greater Toronto Area, in Toronto Canada.

For privacy purposes let’s just call this friend of mine, Mr. Leonard.

Mr. Leonard bought a 2,200 square feet home consisting of 6 bedrooms, 2 kitchens, 3 bathrooms, 1 main floor powder room, 3 living rooms, 1 dining room, 2 car garage and a basement. He bought the said home back in 2007 at a selling price of 345,000 Canadian Dollars.

He placed a down payment worth $34,500 or 10% of the selling price. While, he financed the remaining $310,500 through mortgage.

The variables, numbers and the results of our computation are exactly the same the one we did above. Therefore, we move forward to the next step, and that’s taking into account the costs.

When I spoke to Mr. Leonard, he said that he can’t specifically remember anymore what were the accumulated costs for the home, but what he does remember is the the approximate amount they spent for both maintenance and renovations. It was roughly 70,000 Canadian dollars since they bought the home in 2007.

Mr. Leonard and his family has been living in their home for 15 years, from 2007 to today 2022. They said that their home’s conservative selling price, in today’s Canadian property market is worth 1.5 million CAD.

I tried to compute Mr. Leonard’s returns on his home with his consent. How much would he gain If he sells his home today, in its current market price, while taking into account the basic costs. This is to see if the home he lives in has been able to beat the Canadian Dollar inflation, and if it has given him great returns on his investment since he bought it in 2007.

The following below are my assumptions.

1.) The mortgage interest rate that Mr. Leonard paid from 2007-2022 is at 3% fixed rate. I looked into the average mortgage rates in Canada from 2007 to today, and 3% is around that ball park area.

2.) The total renovation and maintenance costs were worth $70,000.

3.) With the plan to sell this year 2022, at 1.5 million Canadian Dollars.

As you can see from the photograph above. There are two rows, the first row is the Face Value where costs including mortgage are not included. The home was priced at $345,000 in 2007, and will be sold at $1.5 million. That gives it a Compounded Annual Growth Rate of 10.29% each year for 15 years.

Whereas, the 2^nd row is the “Including the costs”. What I did here is that I added the “Interests Paid within the 15 years period + other costs”, the “Estimated total renovation and maintenance costs” and lastly the “home price bought in 2007 – this is the initial down payment + the whole mortgaged amount to be paid to the bank”.

This gives me an estimated Compounded Annual Growth Rate of 7.44% for 15 years. That is a decent return on investment.

With the outcome of this computation. We could surmise that Mr. Leonard could possibly gain $989,090.51, with an investment yearly return of 7.44% since 2007. This is only if he sold his residential home in Greater Toronto Area (GTA) Canada today at the conservative price of $1.5 million.

Note: this computation is not accurate as it lacks a lot of factors that can affect its returns, either it can further go down or up. This is just based on hypothetical assumptions and simulation of what we can expect. All hypothetical models are best done with the worst case, most likely case and best case scenarios to encompass as much as possible the probabilities. Nevertheless, in this blog I'll not be doing such different scenarios as this will make it too lengthy as it is now.

The Opportunity Cost

We’ll now compare the estimated 7.44% CAGR of Mr. Leonard’s residential property to the Canadian Dollar inflation and other investment vehicles. We want want to see if Mr. Leonard would have done better in terms of investment returns if he just invested his money in other assets than the home he is currently living in.

The following below are the investment vehicles where we will compare the investment return for Mr. Leonard’s residential home.

1.) S&P TSX (Toronto Stock Exchange) Composite Index – “The S&P/TSX Composite Index is a capitalization-weighted equity index that tracks the performance of the largest companies listed on Canada’s primary stock exchange, the Toronto Stock Exchange (TSX).

It is the equivalent of the S&P 500 index in the United States, and as such is closely monitored by Canadian investors. Since the S&P/TSX Composite Index is comprised of Canada’s largest and most prominent 230-250 companies, it is often used as a barometer for the health of the Canadian economy.” -Investopedia

2.) The S&P 500 Index, or Standard & Poor’s 500 Index – “It is a market-capitalization-weighted index of 500 leading publicly traded companies in the U.S. The S&P 500 index is regarded as one of the best gauges of prominent American equities’ performance, and by extension, that of the stock market overall.” -Investopedia

3.) iShares S&P/TSX Capped REIT Index ETF – It Seeks to provide long-term capital growth by replicating the performance of the S&P/TSX Capped REIT Index, net of expenses. It gives exposure to the Canadian Real Estate Income Trusts (REITs) and to different types of REITs in a single fund, such as the retail, residential, office and industrial.

What better way to compare returns of a residential property than with Real Estate Investment Trust (REITs). To have a basic overview about REITs, you could check my blog titled “The 5 Basic Asset Classes”.

4.) The Canadian Inflation – Investing is all about superseding inflation.

Below are the CAGR of each variables. To make it uniform, I only took the data from 2007 to 2022, which is the same time period where Mr. Leonard acquired his residential home and plans to sell it.

As depicted above, Mr. Leonard’s average return from 2007 to 2022 would have substantially beaten the popular market index of Canada, which is the TSX composite. While, it slightly superseded the returns of Canadian REITS but has trailed behind the S&P 500 index.

It is without doubt that Mr. Leonard’s home ownership return have been stellar when compared to the Canadian Dollar average inflation within the same time period. It is at a whooping 5.54% real returns (7.44% – 1.9%).

NOTE: Real Investment Returns, are returns where inflation has been deducted already.

Based on above investment assets used to compare Mr. Leonard’s returns. We could then say that his capital placed to purchase his home did magnificently well, in fact it has also been an above average return compared to the Real Estate Price trends in Canada. See Below photograph.

The returns generated by the Teranet–National Bank House Price Index tracks average home price changes in 11 Canadian metropolitan areas: Victoria, Vancouver, Calgary, Edmonton, Winnipeg, Hamilton, Toronto, Ottawa-Gatineau, Montreal, Quebec, and Halifax.

The returns of this weighted index only had a compounded annual growth rate of 6.28% from 2007 to 2022, whereas Mr. Leonard would have 7.44%. He indeed would have outperformed the mean home property market returns in the 11 metro areas in Canada.

A DEFINITE WIN FOR MR. LEONARD! WOOT! WOOT!

What if Mr. Leonard invested instead in the S&P 500 during 2007-2022?

As we could see back on the comparative table of returns a few paragraphs above. It was only the S&P 500 equity index that was able to beat Mr. Leonard’s home ownership returns, which was 8.09% and 7.44% respectively.

The question here is how much would Mr. Leonard need to invest per month for him to be able to reach the aggregate gained amount worth $989,090.51?

I did the computation and it showed that If he invested in the S&P 500 from January of 2007 to January of 2022, he would need to invest $3,000 every month or $36,000 per year. This would give him a nominal return of $984,350.08. Not too bad, that’s a good alternative.

Nevertheless, there’s still a significant problem with that. Only a few of the world population would be able to invest the required sizeable amount of money worth $3,000 monthly / $36,000 yearly.

Probably you’re thinking, why just acquire debt? then invest the loaned capital in the equity markets, just like with what most people do when purchasing a property by utilizing a mortgage. This is not a wise decision, because unlike real estate where its prices rarely fluctuate that much, equity prices on the other hand are volatile in nature.

In equity investing there is this thing called margin calls on debt, it occurs if your account falls below the maintenance margin amount. A margin call is a demand from your brokerage for you to add money to your account or closeout positions to bring your account back to the required level.

If you don’t have money to add to your broker account while on margin debt, then you’re forced to sell at a loss instead. And when that happens, the amount of debt will also balloon and crush you, because debt doesn’t just magnify gains, but also its losses. Gain or Loss, you still have to pay back that debt. This is the reason why using leverage in marketable securities is a ultra high risk and ultra high reward play, which is not applicable for the majority, if not all investors.

Not all residential home price appreciation will be like Mr. Leonard’s

A house you live in, most especially like Mr. Leonard’s, will be a great investment in this matter compared to other investments. In here you’ll be having decent to great returns on investment by harnessing one of the greatest powers in the money game, which is debt.

Nevertheless, I will emphasize here that Mr. Leonard Lives in Greater Toronto Area (GTA) Canada. A city that is known to be one of the World’s Least Affordable Housing Markets.

Remember in my previous blog “Is the home you live in an investment?” that a residential home price of 4-5x GROSS HOUSEHOLD INCOME is expensive but manageable, then the infographic above shows this to us. The most least expensive in the least affordable housing market is London, which only requires 8.2x the GROSS HOUSEHOLD INCOME. 😅😂

If you were able to buy a residential home in these big cities, it will be most likely that your home’s compounded annual growth rate is above average than your whole country’s residential housing average CAGR.

My point being, the location, Location, LOCATION of where you live in is very important. It doesn’t automatically mean that if you own a home, it will always then give you wonderful returns in the long run, like Mr. Leonard’s. You will be surprised to know that most residential homes have disappointing returns, if treated as an investment.

Examples of Disappointing Residential Home Price Average Returns

1.) S&P/Case-Shiller U.S. National Home Price Index – “It measures the change in the value of the U.S. residential housing market by tracking the purchase prices of single-family homes. The index is compiled and published monthly.

The national index is widely viewed as a barometer of the U.S. housing market and the broader economy. In media reports, it is often called simply the Case-Shiller Home Price Index.

The S&P CoreLogic Case-Shiller Indices do not cover everything. The big exceptions include newly constructed houses, condominiums, and co-ops.” -Investopedia

The index was at 63.734 in January 1987 and went up to 281.759 in January 2022. Over the span of 35 years, this index shows that the average residential housing prices in the US had an annual compounded growth rate of 4.34% (this is nominal returns – the homeowner’s costs, mortgages and inflation are not yet included, meaning the real returns will be less than this, or worse be negative). Investing in other asset classes would definitely be better than the average homeownership price appreciation in the US during the said time period.

An underwhelming return, but then if you look into a specific city within the US, such as San Jose, California and San Francisco which are included in the most least affordable cities in the world, their price appreciation will tell you differently. Again, it all comes back to location, Location, LOCATION, then the population and development of the area.

2.) Let’s now go to the UK, specifically Northern Ireland and its Northern Ireland House Price Index – I used Northern Ireland for the second example because I’ve noticed that their home prices have not yet recovered from its peak in 2007. Or, to put it simply, the home prices today are still way lower since the Global Financial Crisis/Housing Crisis of 2008 occurred. See photograph below.

To give you a grasp of what happened here. I’ll make a hypothetical example, let’s just say that Mr. Leonard lived in Northern Ireland United Kingdom, instead of Toronto Canada.

He then bought a home in Northern Ireland UK, the same time in 2007, with a price of £198,950.44 (The average residential home selling price during that time). He took a loan and gave a 10% down payment, which is £19,895.04. Subsequently, he took on a mortgage for the remaining amount to purchase the home. What would then have been Mr. Leonard’s residential home CAGR if he would like to sell the house today, in 2022? for example purposes, we’ll just use a 2% fixed rate on his mortgage for 30 years to pay.

Mr. Leonard would have negative returns with costs included. I used conservative assumptions already for this scenario by the way. This is what you call a NEGATIVE EQUITY, where the Average Selling price of the home today is lower than the Mortgage amount you initially took.

While, this happened in Northern Ireland, London’s residential home prices on the other hand have skyrocketed.

Different cities and geographical location, but within the same country with varied home prices. Yet, this doesn’t mean that the whole Northern Ireland residential housing have below average returns compared to others, there are still some areas where the returns are decent.

Again, this is where location, Location, LOCATION, including population growth, and development will be key for home property price appreciation.

NOTE: If a person exactly bought a home in the 1st quarter of 2013 in Northern Ireland, which was by the way the bottom of the 6 years decline of their housing market. Then that person’s average returns from 2013-2022 has been around 5.33%-6%. However, most people who live there didn’t know that 2013 was the bottom of the housing market decline, not unless they did their due diligence to study their domestic residential housing market. My point being, if you really want and consider your home ownership to be your investment, study your country’s housing market so that you could maximize your returns. Always do your research and due diligence when investing.

To sum it up

I’ve found examples that suggest that most residential home prices would give disappointing returns on investment in the long run when compared to other asset returns. This is when we look at homeownership as an investment.

I still stand in the belief that a home, is first and foremost for our family, for our safety and security and not to be viewed as an investment. If the home appreciates, either it be slower or faster than the average home prices in your country, then consider it a bonus, but if it doesn’t that is still fine.

On the contrary, if we solely see our home as an investment, that’s also okay as long as we’re comfortable with our decision. Don’t forget about location, Location, LOCATION, and to do your own study, research and due diligence about the housing market in your area, your country.

Furthermore, we must also make sure that our home is not the only asset we have in our balance sheet. Just like with any other investments, we must diversify.

Diversification will cushion the blow of any unpredictable downside that may occur to a specific asset class, which is also undeniably applicable with the home you live in. To know more about the basics of diversification you could check my blog titled “Diversification”.

Let’s keep on learning (this where we’ll know how to gain wonderful investment returns, and be familiarized with what’s a great and a poor investment), Diversify (don’t put your eggs in one basket), Keep on saving and investing, and let’s spend less than what we earn.

Knowledge is my Sword and Patience is my Shield,

elmads

This blog is for informational purposes only and not a Financial Recommendation. Not all information will be accurate. Consult an independent financial professional before making any major financial decisions.