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There
Are Big Profits In Real Estate, Says Fed
Peter G. Miller
When
Alan Greenspan speaks, Wall Street and Main Street both listen,
so catch this: "Over the past five years, the average capital
gain on the sale of an existing home net of transaction costs was
more than $25,000, almost a
fifth of the average purchase price."
Greenspan chairs the Federal Reserve, an independent federal agency
that both oversees most banks and strongly influences interest rates.
A Greenspan comment can easily cause the Dow Jones average to rise
or fall several
hundred points, depending on what the good chairman says.
"While home prices do on occasion decline," said Greenspan
in a speech to a community banking group, "large declines are
rare; the general experience of homeowners is a modest, but persistent,
rise in home values that is perceived to be largely permanent. This
experience contrasts markedly from volatile and often-ephemeral
gains in stock market wealth."
Greenspan estimates that 40 percent of new mortgage debt comes from
refinancing, a device used by homeowners to stay where they are
while taking cash out of their properties. What does it all mean?
In basic terms, buying a home is a very good deal. To draw from
Greenspan's estimates, if a typical home is worth $125,000 after
five years, and $25,000 is due to an increase in value, then we
could say that the home has
appreciated 4.56 percent annually. And while such annual price increases
are commonly cited in the media, they
miss the point.
Owners of our typical home did not pay the purchase price in cash.
They borrowed, and so by owning they received two benefits: shelter
and (usually) appreciation. If we say that monthly mortgage payments,
property taxes and insurance can be seen as "rent," then
to figure our return on the investment -- the down payment -- we
should look at how much cash was put into the property and how much
value can be extracted.
For a first-time buyer -- most likely the purchaser of that $100,000
home five years ago -- the National Association of Realtors reports
that in a typical case the purchaser would have put down 9 percent
of the sale price . If we run the numbers, for $9,000 our typical
buyer might expect after five years: $25,000 in appreciation
NAR says that a typical first-time buyer has a $6,800 down payment
(the rest of that 9 percent in cash paid up front went for closing
costs). So, if we take the $100,000 purchase price and subtract
$6,800, we are left with a mortgage of $93,200. At 7.5 percent interest,
this loan has a monthly cost for principle and interest of $651.67
per month. At the end of five years, because of amortization, the
remaining loan balance would be $88,183.45. In effect, the owner's
wealth increased by $5,016.55 ($93,200 less $88,183.45).
Interest on the loan is tax deductible. In the first five years,
the interest bill would total $34,063. If our buyer is in the 15
percent federal tax bracket, then tax costs would be reduced by
$5,110. There would also be a tax deduction in most states, but
not all. Property taxes are also deductible. If we figure an annual
tax of $1,000, then the total tax would be $5,000. Over five years,
the owner would save $750 (15 percent) in federal tax payments.
Let's see: We invested $9,000. At the end of five years we have
$6,800 in home equity from our down payment, $25,000 in appreciation,
$5,016 in amortization, $5,110 in interest-related tax savings,
and $750 in reduced federal taxes because of local property tax
payments. The grand total: $42,676 -- not counting state tax deductions.
Over five years, the buyer who put in $9,000 would have benefits
worth $42,676 -- a 36.5 percent annualized rate of return.
Will everyone do so well? No. Is it possible to lose money with
real estate? Yes. Will some people do better than the example used
here? Yes. Does past performance guarantee future results? No. The
bottom line: Real estate is typically a far better investment than
annual price increases suggest, something brokers ought to trumpet
and
owners ought to enjoy.
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