Last week's column compared the performance of residential real estate with a comparable investment in the Dow Jones industrial average. My e-mail was just sizzling on Monday morning thanks to several readers who pointed out that my math had failed to take leverage into consideration.
"Look at ROI (Return on Investment)" screamed the readers. Their comments reminded me of the current candidate for mayor of London of whom a commentator said, "Apart from being a philanderer, he's a great family man."
To review the bidding, a home in Orinda appreciated from $100,000 to $900,000 over 30 years, which represented about an 8 percent return. The same $100,000 invested in the Dow during that time would have appreciated to $3.3 million which represented a 12.5 percent return.
What astute readers were quick to point out is that a house can be leveraged.
The downpayment back in 1977 was probably 20 percent or $20,000. The "profit" of $800,000 had to be calculated on the original $20,000 — not on the $100,000 purchase price. Let's assume that someone invested only $20,000 of his or her own money in the property and maintained that equity level for 30 years — by endlessly refinancing the $80,000 initial mortgage. Now, the cash invested is not $100,000 but only $20,000. An $800,000 profit on $20,000 represents a 13 percent compound annual rate of return. It beats the Dow by half a percent. \
But to be fair, stocks can also be bought using leverage by "buying on margin." We can invest by putting up just 50 percent of our own money and borrowing the rest. Interest on these popular margin accounts generates 25 percent of Charles Schwab's annual revenue. Setting aside the interest expense for the moment, the return on a 30-year Dow where we have tied up just $50,000 of our own money works out to be 15 percent per year. We've beaten the Orinda property and we've only been leveraged 50 percent instead of 80% --- higher profit with less risk.
In both the mortgage and the margin account, there is an interest cost on the borrowed money. As readers pointed out, the interest expense on the home loan is offset by the value of shelter. We have to live somewhere, and we have a choice of paying rent on the one hand, or the mortgage interest on the other hand.
In the leveraged home purchase, the interest we pay does double duty. It pays for borrowed money and it also covers the cost of shelter.
Interest we pay on a margin account at a stock brokerage firm only covers the cost of borrowing money. It doesn't provide shelter.
Moreover, interest on money borrowed to buy stocks is not tax deductible. So, margin borrowing is far more expensive than home loan interest. For most of us, one-third of what we pay in tax-deductible mortgage interest is paid with money that would otherwise have disappeared in taxes. In effect, the state and federal governments are paying a third of our home interest expense. No such subsidy exists for interest on margin accounts.
So now let's compare two leveraged investments. A home with an original 20 percent down-payment and a margin account with 50 percent of our money borrowed.
Interest on margin accounts today is about 6 percent, so if that's what we pay on half of our investment purchased with borrowed money, the cost to the whole portfolio is 3 percent. Our net investment return (15 percent minus 3 percent) is back down to 12 percent, nudging the home into the lead at 13 percent. We don't have to factor in a comparable interest cost on the home mortgage because we would have paid the same amount to rent shelter. Bottom line: For the long-term owner, a home is tough to beat thanks to leverage, tax laws and the practical reality of a need for shelter.
For those readers who questioned why home equity is equivalent to, or at least more similar to, a bond instead of a stock, it's because home equity normally doesn't change in value as quickly as stocks. The stock market managed to rise or fall more than 3 percent in one day at least eight times over the past year. House values are much more stable. Values rise and sometimes fall, but most of us don't care as long as there's a roof over our heads. Setting aside the recent self-destructive behavior in the mortgage industry, home ownership is a tremendous wealth-building tool. I was wrong last week.