- Investment Workshop 59: Are Robo-Advisors Compatible With FIRE? - June 22, 2020
- Reader Case: Grounded in Vancouver and Dreaming of FIRE - June 19, 2020
- Real Estate Agent Gets Crushed by Real Estate Math - June 8, 2020
In our previous post, we broke down the math behind home ownership attempting to answer the question “In 2012, if we had bought a house instead of investing, would we have been ahead?”
The short answer is no. The longer, more detailed answer is HELL no. The results, which surprised even us, show that even in this weird time period of 2012-2015 when houses and a 60/40 portfolio appreciated at about the same rate (7-8% per year), the added, hidden costs of home ownership ate up most of the price appreciation. In the end, the return earned by investing thumped home ownership by a whopping 2.61X!
But in many ways, that scenario is unrealistic for the average person, as it compares taking $500k and shovelling it into a house or the stock market. Who the Heck has $500k saved up?
No, the average investor doesn’t have anywhere close to that, and must buy a house with a mortgage. It’s the only way to realistically get into the real estate market and participate in that sweet, sweet housing appreciation, and Real Estate agents are all too happy to let people do it. This is called Leverage, they say, and Leveraged Investing is your friend, because it allows you to participate in the gain on a $500k home investment while only putting in a fraction of that cash in yourself.
Leverage is your friend? Really?
Let’s Math This Shit Up
OK let’s say our intrepid investor, who we’ll called Homey the Homeowner, is looking at that same average Toronto house from the previous article. The one that he could buy for $497,130 in 2012 and whose value shot upwards to $622,120. Again, this is a $124,990 windfall in price gains, and represents a fat juicy 7.8% year-over-year gain. Mmmmmm, we definitely want to get us some of THAT action, right?
The minimum down payment you have to have in Canada is 5% for a mortgage from a respectable bank. That means Homey needs to put in $497,130 x 5% = $24,856.50. The remaining $472,273.50 will be the initial mortgage balance. At the time of writing, we can get a 5-year fixed mortgage for the holy-shit-rock-bottom interest rate of 2.25%.
I plugged this information into a mortgage calculator at www.canadamortgage.com, and got this as a result.
You can play around with the calculator yourself to see how it all works, but basically, each bar is your monthly payment (in this case, $2,057). The blue/yellow parts of the bar is the part of the payment that went towards your principal, and the red is that part that went towards interest on your loan. And the numbers at the bottom are where your mortgage stands at the end of 3 years.
Now, at the end of those 3 years, remember we are sitting on a nice juicy gain of $124,990, so Homey decides to sell. After a brief listing period with a real estate agent, Homey receives a nice fat sale for $622,120. He then pays off the remaining balance on his loan to get a total of $622,120 – $428,530 = $193,590.
Now remember, that full amount isn’t profit. Over those 3 years, Homey paid a total of $43,744 (principal) + $30,318 (interest) = $74,062 in mortgage payments, plus his initial downpayment of $25,000. Expenses incurred in the process of owning this house need to be deducted from the final windfall to calculate profit. So his actual gain is $193,590 – $74,062 – $25,000 = $94,528.
Great! $95 grand. Who wouldn’t be happy with that?
Remember this table from the last article?
|Real-estate agent commission (5% to sell):||$622,120 x 5%= $31,106|
|Land transfer tax (municipal AND provincial)||$12,085.20 (source: TREB LTT Calculator)|
|Property Taxes:||$3,420.12 (2012) x 3 = $10,260.36 (source: Toronto Property Tax Calculator)|
|Lawyer fees:||$500 x 2 (buy and sell) = $1000|
|Home insurance:||$100/month * 36 = $3600 (source: Toronto Home Ownership Costs)|
|Maintenance:||You should set aside 1-3% of the price of your home for maintenance per year. So let’s say 1%. $4971.3 x 3 years = $14,913.90 (source: Toronto Home Ownership Costs)|
|Gas, Electricity, Water (included in our rent):||$125/month (hydro) + $125/month (gas) = $250/month * 36 = $9000 (source: Toronto Home Ownership Costs)|
|TV Cable (included in our rent):||$25/month * 36 = $900|
|Furniture||We would need to buy furniture to furnish the addition bedrooms. Assuming 10K and a 50% resale value = $5000|
|Total costs over 3 years||$88,365.46|
Oh. Right. That.
Yeah, all those costs still apply whether you have a mortgage or not. So that means Homey’s windfall was, over the past 3 years, eaten up by all these extra costs of home ownership that he wouldn’t have had to deal with as a renter. That means his actual gain is $94,528 – $88,365.46 = $6,162.54.
That’s right. Of his $124,990 windfall from record-breaking home price appreciation, with a mortgage and taking advantage of “Leveraged Investing,” Homey gets to keep a whopping $6,162.54 of it.
This silly little blog has only been up around 3 months as of the time of this writing, and one of the most surprising and rewarding parts of doing this is talking to you, our readers, in the comments and over email. We’ve learned an incredible amount just talking to you, and one of the most surprising things we learned was this:
The reason people don’t have money is NOT because they’re irresponsible with it.
Quite the opposite. We’ve talked to so many people, from Canada, the USA, and abroad. Time after time, email after email, we meet people who aren’t going out and buying fancy sports cars to drive to the casino. They’re hard working, honest people who are doing the best they can to provide for themselves and their family. They’re apparently doing everything right, yet they have no money. Why? Well, we think we have an answer. Over time, by doing more and more case analysis like the one we just did, what we’ve realized is this:
The reason people don’t have money is because it’s being stolen from them.
That’s right. I said it. Stolen.
Only these thieves don’t wear black bandanas and stick a gun in your ribs. These thieves wear $1000 suits, smile, offer you coffee, and tell you how smart you are while robbing you every time you sign a contract you don’t understand.
Homey here got gifted a $124,990 windfall by the twin forces of a rising housing market and cheap money. And yet he only got to keep less than 5% of it.
So who are the thieves here? Where did all his money go? Let’s break it down.
Oh, sorry, did you miss your piece? Here it is highlighted.
That’s you. The homeowner who took the risk, did the supposedly “right” thing, and rode a massive housing price wave to a six-figure windfall. You got 5%. Who got the rest?
- Your real estate agent. They made off with the biggest chunk. 31k, or 25%. For placing a few signs and hosting an open house, your real estate agent got a quarter of your rightful nest egg.
- The bank. They took another quarter. Cheap money, they said. Smart move, they said. Sign right here, they said. Boom. 30k gone. 24% gone.
- The government. Ouch. Land transfer taxes and property taxes are the next biggest chunk. 18% to a government that will likely waste it on first class flights for senators.
- Contractors. Those people you call whenever a pipe bursts or a basement floods. They took 12% of your money for their services.
And the list goes on and on and on.
And meanwhile, those same people will come out and congratulate you on what a smart investment choice you made, using leverage like a BOSS. Here’s how. They take your gains and divide it by the relatively small amount of equity you put down. So here, you equity was $25000 (your downpayment) + $43,744 (mortgage payment that went towards principle). That means on your $68,744 investment, you made $6162.54, meaning you made a return on investment of $6162.54/$68,744 = 9%!
Woo! 9%! You are SO smart, they will tell you!
Well, of COURSE they’ll tell you you’re smart. See how misleading that while you made $6162.54, they made $118,827.46! Of course they’re going to pat you on the back! They just stole all your fucking money! And they’re hoping you’ll do it again, because housing always goes up Up UP you know!
Now what if he had invested that amount in that 60/40 portfolio instead?
To simulate this, we will have Homey invest the $25,000 down payment as a lump-sum at the beginning of 2012, then we will divide up the amount he WOULD have spent on home ownership + mortgage over 3 years, subtracting the rent he would have to pay. This means every year, he would have been able to invest an additional ($88,365.46 + $74,062 – $850 rent/month x 36 months) / 3 = $43,942.49. This will be a total of $156,827.47 invested. How does this do in the markets?
|Year||Starting Balance||Savings||Portfolio RIO||Gain/Loss||Ending Balance|
At the end of 2014, this $156,827.47 has now grown to $185,423.27, a gain of $28,595.80, or 18.2%!
That is 4.64X he made on a house.
When we started doing this little investigation of ours, we were expecting that housing would suck, but not to this extent. Even we are floored by how bad these numbers look. Remember, this is a time period where both housing AND a 60/40 portfolio appreciated at about the same rate! An investor during this period would have made over $95k by putting their money into simple, low-cost, Index-hugging ETFs. A homeowner on a mortgage got robbed blind.
THIS is why most people will never accumulate wealth. Not because you are being irresponsible with your money, but because as a homeowner there are so many hands in your pockets bleeding you dry that you will never EVER get ahead. And everyone who robbed you can never be charged for any crime, because everything they did was 100% legal.
So no. No, leverage is not your friend.
Has anyone else been burned by this? Chime in in the comments.
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