Tuesday, April 18, 2006

Your home is your best investment

DON'T over-invest in housing.
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Many people believe that their home is their nest egg and don't mind paying more for a unit with good resale value. Two of the most expensive four-room HDB flats sold this year, at more than $430,000 each, are in this Kim Tian block. --CHOO CHWEE HUA
That is the standard advice you hear these days.
Why? Because when you hit retirement, you may have a fully-paid home but no cash. It is called being 'asset-rich but cash-poor'.
That is where the story usually ends. But look a little deeper and you will find that a home is a very good investment. This story explains why in four easy lessons.
  • Lesson 1: What returns can you expect if you invest in a home? The data shows home prices have risen only 5.4 per cent per year since 1983. (Source: URA's private property price index.)
    Worse still, the risk is high. Housing has seen huge ups and downs over the past 23 years. Private home prices shot up 36 per cent in 1993 followed by another gain of 42 per cent in 1994.
    On the down side, prices collapsed 12 per cent in 1997 followed by another decline of 34 per cent in 1998.
    At our first level of analysis, home ownership seems to be a high-risk, low-return investment.
  • Lesson 2: While the return on residential property may be only 5.4 per cent, the return on your own home is probably much higher.
    Why? Because of leverage (borrowing). Here is an example: If you invest $100 and earn $5 at the end of the year, then your return is 5 per cent.
    But suppose the $100 investment has been financed by $20 of your money and $80 that you borrowed? Then the return on your investment is five times higher. It is 25 per cent ($5/$20). That is much better.
    Home loans cover 80 to 90 per cent of the home's value, which means your equity ownership is 10 to 20 per cent.
    Eventually, you will pay the loan down to zero and you will own 100 per cent of your home.
    It means the average equity over the life of your loan is (20 + 100)/2 = 60 per cent.
    Another way of saying this is that a home loan gives you 1.7 times leverage (1/0.6).
    It means that a 1 per cent rise in your home's price will produce a return on your investment of 1.7 per cent.
    Going back to the URA data, the 5.4 per cent rise in home prices translates to a return on your investment of 5.4 x 1.7 = 9 per cent.
    Hey, that's not bad. Leverage (borrowing) can boost your returns substantially. Better still, the risk remains low because people own their homes for a long time. That makes it easier to ride through the big ups and downs in the market. Economists say: 'The long holding period reduces the variance of expected returns.'
  • Lesson 3: I can hear you saying: 'Wait a minute, doc. You should have subtracted the interest costs of your borrowing. Did you forget to do that?'
    Surprisingly, no. There is no need to subtract it because in a practical sense, the interest you pay to the bank costs you nothing.
    This is possible because of something called 'imputed rent'. Economists call it an 'opportunity cost'. It means that staying in your nice home has value to you. How much? The best estimate is how much you would pay to rent an equivalent flat.
    Suppose it costs $1,500 per month to rent a place that would make you as happy as the four-room flat you live in now. That is your imputed rent.
    To keep it simple, let's say your monthly loan payments are also $1,500 per month. The bank takes $500 for interest and $1,000 is for principal repayment.
    Since the $1,500 imputed rent far exceeds the $500 monthly interest, it means you are living in your home for free.
    By the way, only a home comes with imputed rent. Stocks, unit trusts and fixed deposits don't have it since you can't live in them.
  • Lesson 4: It gets even better. Not only are interest costs offset by imputed rent, much of the principal is too. In this example, the entire $1,000 of principal repayment is offset by the $1,500 imputed rent.
    It is almost too good to be true. Not only are your interest payments free, your home is too. Does this mean you bought your home for zip, zero, nothing? Incredibly, yes, that is what it means.
    All this results in a very high rate of return on your home investment. Mathematically, it works out to infinity.
    What? You can earn an infinite rate of return on a home investment? Yes. It is a non-intuitive result. But non-intuitive doesn't mean wrong. It means amazing.
    DR MONEY'S QUICK QUOTE
    Not only is the universe stranger than you imagine, it is stranger than you can imagine.
    - Richard Feynman (1918-1988), Nobel prize-winning physicist

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    // posted by Shajahan @ 10:53 AM


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