Is your home an investment?

Sharing a room with the extended family while growing up in a small Indian town, one of my biggest dreams was to buy my own apartment one day. I shared this dream with many others around the world, not just in India. It’s typically the biggest purchase for a middle class family. People want their home to be a great space, well-served by amenities and conveniently located. Some of these are intangible qualities.

But the real question is - is a house a consumption item or an investment?

My quick take on this topic...

Residential real estate is an asset...

A house is not like any other consumption purchase such as clothes, gadgets, cars, etc which are depreciating assets. The big difference is that a house can generate income. Anything that can generate income is an asset.

And assets usually go up in value over time because the income is likely to keep increasing with inflation. So if I were to estimate the income over the long term, say 20-30 years, and ‘discount’ it in today’s terms, by comparing it to what I could have earned in the bank, I can calculate a fair value of what I should pay for it today.

If I happen to pick a location where demand is growing and supply is limited, the property could see an increase in capital value too, which actually reflects higher income in future.

If I borrow money from the bank at an interest rate that’s less than the current or future rent, I am ‘leveraging,’ which could enhance returns further.

While this calculation sounds simple enough, of course in reality, it’s a bit more complicated. We don’t know exactly what the future income will be because the demand and supply of properties in the area could change (due to zoning, new infrastructure etc). Similarly, the interest rate we are charged, or could earn, in the bank could change.

But prone to bubbles...

I am simplifying a bit, but when people buy and sell properties, they don’t always calculate the fair value but go by non-financial or emotional factors. So I may buy a place at a much higher price than fair value because I want to live next to my family. Or I may not want to sell a place because I grew up in it.

Ideally, there should be a limit to the effect of my emotional, irrational behavior, since I take a loan from the bank. The bank doesn’t have any emotional attachment, so it should value the property at fair value and only lend to me accordingly, after keeping a margin of safety.

However, there are plenty of people who don’t borrow from banks to buy homes. Of course, banks may mis-value the property as we saw in the US housing crisis. And in India, there is also plenty of “black money,” i.e. illegal cash used to buy property. So valuation of homes, i.e. residential property, tends to get out of whack more easily than other asset classes.

...With high transaction costs

I think the cost of borrowing is crucial when deciding to buy. If the interest cost is higher than what you can rent the property for, you should worry!

In addition to the issue of fair value, there are significant costs to buying and selling property. People also tend to forget the ongoing maintenance costs.

Given these costs, buying a house is definitely a long-term decision. I would encourage people to rent in the early years. Renting allows us to figure out which locality, or even which city or country we might want to live in long term. We can invest any savings in investments such as equities to accumulate a large enough portfolio, which we can then use as a deposit when the valuations are right.

Watch the video for a fun take on this topic - https://www.youtube.com/watch?v=116xm-M1hMw

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This is a short post for beginners. Please share to spread financial literacy. For more such posts, please visit TheMoneyHans.com. I also tweet at @themoneyhans