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# Calculating Real Estate Investment Return

Many people refer to their home as their “best investment.” Others argue that a home isn’t an investment at all because it may not go up in price or because you may never sell it.

In my opinion, anything that has a calculable (usually positive) rate of return is an investment. And it’s worth noting that buying a home can yield a positive rate of return even if the home never increases in value. (Conversely, it can have a negative rate of return even if the home does increase in value.)

### Rate of Return Involves More than Home Value

The rate of return on a home purchase involves more than just the home’s market value. If you only consider the change in home value, you’re leaving out:

1. Part of the price of the investment — maintenance costs and property taxes,
2. The biggest part of the payoff — the fact that it replaces your rent, and
3. The fact that the investment was probably leveraged (i.e., paid for using a loan).

I think it’s easier to first look at the purchase as if you were buying the home with cash. That way, it’s easy to calculate the expected return on the purchase:

Expected Real Return = D + G – C, where

D = imputed rental dividend (calculated as the size of the annual rent bill that you’d eliminate by owning instead of renting, divided by the purchase price of the home),
G = inflation-adjusted growth in home value, and
C = costs (insurance, property taxes, and maintenance), expressed as a percentage of the purchase price.

For example, if you’re currently paying \$1,000 in rent per month, and you buy a home for \$180,000, your imputed rental dividend would be 6.67% (\$12,000 ÷ \$180,000). From that, add the inflation-adjusted rate at which you expect the home to appreciate, and subtract any non-mortgage costs of owning the home.

Then you can determine how your return would be affected by using borrowed money for the purchase. (In short: It only makes sense to borrow if you expect a return greater than the interest rate you’d have to pay on the loan.)

### Rate of Return When Prepaying a Mortgage

A recent Get Rich Slowly post asked whether it’s better to prepay a mortgage or invest elsewhere. In the comments, several people asked questions to this effect:

“Isn’t it risky to put a bunch of money into prepaying your mortgage? After all, we’ve seen in the last few years that home prices don’t always go up.”

It’s true that home prices don’t always go up. But if you own a home, you’re already exposed to that risk — whether you decide to prepay your mortgage or not. The rate of return you get when you prepay your mortgage is simply equal to the interest rate on the mortgage. It’s got nothing to do with changes in the market value of the home.

### Why I’m Not Buying a House (and Likely Never Will)

For many people, owning a home provides an emotional benefit, so they’re happy to buy a home even with an expected return that’s somewhat less than the return they could get with other investments.

I find myself in the opposite boat. From where I’m standing, owning a home looks to be:

1. A huge pain in the butt,
2. Illiquid, and
3. Extremely undiversified.

…whereas putting money into an ETF portfolio is the opposite. It’s easy. It’s liquid. And it’s diversified. As a result, I’m only going to be interested in buying a home if it appears that the expected return is significantly greater than that of other investments.

Of course, given that there are so many people willing to accept a lower return (i.e., pay more for the home), that may never happen.

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1. Primary residence is not an investment. It’s a place to live. It’s not bad to own the place you live in. Long term (usually 10 plus years) you make out ahead of renting.

2. Mike says

Why is it better? And how would you go about determining that without looking at a rate of return?

3. Alexandra says

Have you read Milevsky’s “Your Money Milestones“? He makes a strong case against home ownership for most Americans.

4. There are some things you can do when owning compared to renting.

– Improve and make changes to the property
– real estate increases in line with inflation
– borrow against (if you have equity). Though I think this should only be for emergencies
– Besides property taxes it’s a pretty fixed monthly fee over the time you live in the property.

At least in the NY – Long Island area where I live Rent, income to property value is still way out of wack. I suspect in the next 10 years here rental rates will increase faster than property values.

If you are constantly on the move (every few years), then renting typically makes more sense.

5. Mike says

What I’m hung up on are your statements:

• “Long term (usually 10 plus years) you make out ahead of renting.”
• “If you are constantly on the move (every few years), then renting typically makes more sense.”

How do you determine those things without calculating a rate of return? (And if you’re calculating a return, what do you mean when you say that a home is not an investment?)

6. Mike says

I haven’t read that book. I will say though that I enjoy Milevsky’s willingness to actually delve into the numbers behind conventional wisdom.

7. I never said you shouldn’t calculate ROR. You most definitely should. A primary residence typically does not generate income (or cash flow positive) How can be considered an investment?? By doing the ROR you are doing it to determine which is cheaper – to rent or own. It’s purpose is to determine which will put more cash in your pocket at the end of each month. In the end ALWAYS need a place to live in.

If when you sell it you make money, that’s bonus, but it’s certainly not an investment. Rental properties on the otherhand ARE investments.

8. Mike says

Fair enough. IMO, anything that is likely to have a positive ROI is an investment.

By way of analogy, let’s say I had a student loan as well as the cash to pay it off immediately.

Instead, I opt not to pay off the loan, and I use the cash to buy low-dividend stocks (or any other investment whose value is based on hopes of appreciation rather than cash flow). If we account for the loan, my decision would be cash flow negative. I’d still call it an investment.

Or what about a loan to start a business? In the early years, such choices are often cash flow negative. I’d still say that’s an investment, because the hope is that it will eventually be cash flow positive — just as a house will be once you own it, given that it’s replacing your rent payments.

9. Rob says

I guess it depends primarily on where you live. Where I am at, prices are so low that its quite easy to find a home with a mortage substantially lower than renting, making it quite hard to argue against home ownership. I purchased a home about a year ago and my mortgage payment is 70% of what I previsouly paid in rent.

I must have looked at 20+ houses all that would have provided an “imputed rental dividend” between 9-10% and all comparable to what I was renting.

Of course, ask me again in 20 years if my home’s value at least kept page with inflation. *fingers crossed

10. A home which you’re living in is generally a consumption good with a really long period of consumption. 🙂

Capital gains > rate of income increase is generally speculation that a given area will increase in value; I believe that only properties that are being rented out and generating cash flow can truly be considered investments.

“It’s true that home prices don’t always go up. But if you own a home, you’re already exposed to that risk — whether you decide to prepay your mortgage or not. ”

Agree with you. The decision to prepay a mortgage should be based on current interest rates and where you believe that rates are headed.

11. If you can get better returns in other investments you should most definitely invest in other assets than your primary residence.

When interest rates were at 12% (in the 80’s) it’s kinda hard to beat that return.

12. You’d be dividing C by either the purchase price or the current value of the property too, right? At present, you appear to be adding a monetary figure to a percentage…

13. Mike says

Indeed. Thank you for pointing out my omission. The article has been updated.

14. Dylan says

I’m square in the, “your home is not an investment,” camp. Housing is a basic necessity, and whether or not it’s better to buy or rent is a question of comparing your total costs for each, not return on investment.

Also, I do not think it is “likely” to achieve a positive real (after inflation) return from a owning a home. It’s typically a net cost, which can be greater or less than renting.

15. Mike says

Hi Dylan.

I agree that housing is going to be a net cash outflow no matter whether you own or rent.

But if you’re currently renting, you’re already paying a cost. If you change course (by buying), and in doing so you reduce your net costs, isn’t that a positive rate of return?

Imagine that in your own business you had the option to reduce one of your ongoing costs by paying a lump sum right now. Yes, it’s still a net cost in that there’s never any cash coming in. But wouldn’t you consider that lump sum to be an investment? And wouldn’t you say that it has a positive rate of return?

16. Dylan says

“If you change course (by buying), and in doing so you reduce your net costs, isn’t that a positive rate of return?”

I wouldn’t characterize it that way. I get what you are saying, but I’d call it cost saving not an investment. The word “investment” has many meanings, but I do not consider owning a home to live in to be an investment like I would owning an ETF. By your definition, anything I could have spent more money on but elected not to would be an investment if I can determine the amount.

17. Mike says

“By your definition, anything I could have spent more money on but elected not to would be an investment if I can determine the amount.”

Not exactly. I’m arguing that anything that reduces costs you’re already paying (or, more precisely, costs that you will pay if you don’t change course) is an investment.

I don’t see a meaningful difference between something that pays you \$20 per month and something that reduces your monthly costs by \$20 per month (taxes aside).

That said, calling it a “cost savings” works perfectly fine for me.

18. Dylan says

So if I dump my monthly gym membership and workout at home, would that be an investment? I still think that’s a stretch.

As for an action that saves you \$20 vs. earning you \$20, yes they are essentially the same impact on you cash flow. A penny saved is a penny earned. But just because a particular course of action saves or earns money doesn’t make it an investment.

I generally use “investment” to describe something you do after expenses with surplus cash, not the surplus itself. The surplus is “invested” by using it with the intention of turning it back into cash at a profit at some point in the future. People usually don’t buy their home for the purpose of turning a profit and typically don’t fret that they don’t.

19. Mike says

“So if I dump my monthly gym membership and workout at home, would that be an investment?”

No. That’s simply changing your spending.

But if you were given the option to prepay (at a discount) for the next 3 years, then yes, I’d definitely call that an investment.

Of course, whether it’s a good investment is up in the air. And not coincidentally, I’d say that it depends on all the things that investment analyses always depend on:

• What’s the payoff (how much money does it save you)?
• How good are the alternatives for that cash?
• What’s the risk involved (how likely is it that you wouldn’t actually keep paying for all three years)?
20. Dylan says

I think this will be one of the few things we’ll have to agree to disagree about. I get your distinction; I just wouldn’t characterize it as an investment à la mutual funds. 🙂

In any case, I’ll agree that it’s a good idea to make you spending decisions based on the most favorable expected result.

21. Mike says

“I think this will be one of the few things we’ll have to agree to disagree about.”

Heh, yeah. Looks that way. In any case, thanks as always for reading and contributing your thoughts.

22. Ritch says

Mike,

As usual, a thoughtful and insightful article that provides much food for thought.

Your formula for calculating the real return from the housing “investment” is straightforward and makes sense to me. And I especially like the idea of separating the return on your housing expense/investment from the decision on whether one is better off taking out a mortgage versus paying cash outright to purchase the residence. However, in reality this latter part of the analysis is an academic exercise for the many folks who don’t have enough spare cash already accumulated to prepay their home purchase.

Here are some observations and suggestions if you don’t mind.

Regarding the issue of deciding whether it makes sense to borrow money for the purchase (“In short: It only makes sense to borrow if you expect a return greater than the interest rate you’d have to pay on the loan.”), I think there are two other financial considerations that can be involved in that equation.

First, there is an “opportunity cost” associated with cash that’s used to prepay the loan. For example, assuming the home buyer used a mortgage instead of paying cash to buy; they could park those funds in CD’s or Treasury investments and earn (in today’s interest rate environment) a pretax return of say 3%. If the buyer’s combined marginal federal and state income tax rate is 20%, their net after tax return on these interest earnings would be at least 2.40%; at a combined MTB of 25% their net return would be 2.25%.

Second, many folks will be able to deduct the mortgage interest and real estate taxes they pay on the purchased home on their annual federal and state income tax returns, which effectively lessens the interest rate they’re paying on the mortgage loan. Assuming a fixed interest rate of 5% on the mortgage loan, their net loan cost would be 4.00% or 3.75%, respectively, if they have a combined MTB of 20% or 25% and are in fact able to deduct the mortgage interest and taxes paid.

Taking these two items into consideration can have a noticeable impact on the decision regarding whether or not to use a mortgage. We can see that using the figures from your example with an estimate of the hosing expenses (item “C” in your formula) added in.

Scenario 1: Your example without including opportunity cost & after tax mortgage rate.
Step 1.
6.67% imputed rental dividend + 1.00% inflation adjusted growth rate – 3.00% estimated annual housing costs [5400/180000] = 4.67% expected real return.
Step 2.
4.67% expected real return – 5.00% pre-tax mortgage rate = (0.33%).
Conclusion.
Toss-up; no clear advantage either way.

Scenario 2: Your example including opportunity cost & after tax mortgage rate.
Step 1.
6.67% imputed rental dividend + 1.00% inflation adjusted growth rate – 3.00% estimated annual housing costs [5400/180000] = 4.67% expected real return.
Step 2.
5.00% pre-tax mortgage rate – 2.40% opportunity cost (savings) – 1.00% mortgage tax deduction (savings) = 1.60% adjusted after-tax mortgage rate with opportunity cost.
Step 3.
4.67% expected real return – 1.60% adjusted after-tax mortgage rate with opportunity cost included = 3.07%.
Conclusion.
These figures would suggest using a mortgage to make this purchase is acceptable.

For someone with a combined MTB of 25%, Step 3 would look like this:
4.67% expected real return – 1.50% adjusted after-tax mortgage rate with opportunity cost included = 3.17%, which leads to pretty much the same conclusion.

I’ve got to run for now; I may post more on this subject later. In the meantime, I’d appreciate hearing your thoughts on these suggestions. Am I missing something here?

23. Mike says

Hi Ritch.

I absolutely agree that it’s important to look at the after-tax rate on the mortgage when comparing it to whatever return you expect from the home purchase. I’d add, however, that unless your other itemized deductions exceed the standard deduction, your after-tax interest rate is higher than: pretax rate x (1 — marginal tax bracket).

I’ll admit that I’m not entirely clear on what you’re saying about opportunity cost here.

Are you arguing that, if an investor has the choice to either:

• pay cash for a home, or
• take out a mortgage

…then, when comparing the choices, we should subtract (from the mortgage rate) the rate they can earn on continuing to have that additional cash balance?

If so, I may be missing something, but doing so would seem to lead to questionable decisions — specifically, taking out a mortgage at 5% (4ish% after-tax) just to keep more cash on hand earning 3% (2.4% after tax).

24. George says

I that homes are illiquid and undiversified. As for being a huge pain, that tends to depend on personalities and desires.

I’m in the camp of not paying off the mortgage early provided you’ve negotiated a rate under 5% AND you know that your returns are higher in other investments AND you’ve got the discipline to invest it. Investing the money you might otherwise pay down the mortgage with provides liquidity. If you don’t have the discipline to invest the extra cashflow, then you’re much better off paying down the mortgage with it (e.g. 4% return on prepaying the mortgage beats spending the money any day of the week!).

If you are retired, then the mortgage better be paid for unless you have a lot more money than the average person. I like to think of a paid-for home as the savings account that you draw down when you’re 80-85 and are beginning to need extra care… it’s a rare individual who can reach that age and doesn’t require more care.

25. Mike says

“As for being a huge pain, that tends to depend on personalities and desires.”

Absolutely! When I said it above, I only meant that from my own personal perspective. For lots of other people, rather than being a pain, home ownership provides a real degree of happiness.

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