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Opportunity Cost of Owning a Home

by Ram Balakrishnan
November 7, 2007
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The buying-versus-renting debate has gone on forever because the answer depends on assumptions you make about the future, your local housing conditions, interest rates, your income tax rate, future tax rates, inflation, future interest rates etc. The latest in this series is a post by Millionaire Mommy Next Door (thanks to Four Pillars for referring this post), in which she shows how renting can be better than owning in her local market.

I don’t disagree with her numbers, except for the part about opportunity cost. First, let’s not kid ourselves and agree that there is an opportunity cost in owning a home. Home prices have been on a tear for the past five years or so but over the long term, the best homes can do is keep up with inflation. With equities, by contrast, you can expect to earn a real, inflation-adjusted return ranging from 4% to 6%. [Don’t shoot me because I’m just the messenger here. William Bernstein, for instance, figures future long-term real returns for large US stocks would be in the 3.5% range and small stocks in the 5% range.]

So, at first glance, a portfolio heavy in equities has a 6% real advantage over owning a home (we’ll assume the higher returns for equities). Not so fast, though. By owning a home, you save some money by not renting an equivalent place. In Millionaire Mommy’s own example, a home that sells for $300,000 and rents for $1,300 per month has annual costs of $9,000 and has a “yield” of 2.2%. What’s more this is a real yield, in the sense that future rents and ownership costs will keep pace with inflation as will the difference between them.

There is still one wrinkle to account for. The 6% real return from equities we assumed earlier is before taxes are paid. Let’s assume that taxes on capital gains remains at 20%. The real, after-tax return from an equities portfolio would be 4.8%.

Now, we are ready to make an apples-to-apples comparison. In Millionaire Mommy’s example, the opportunity cost of owning a home and not being in equities is 4.6% over the long-term (4.8% return for equities minus 2.2% real “yield” from housing plus 2% inflation), not the 10% she assumes in her example. Your local real estate market may also have a higher “housing yield”. In Ottawa, for example, a $300,000 house will rent for $1,600 per month and give you a net “yield” of 3.5% resulting in a 3.3% advantage for equities over housing. If you are pessimistic about future equity returns, use the 4% real return for equities and come up with an even smaller advantage.

The point of this post is not to show that owning a home is a financially superior decision. It probably isn’t in most scenarios and in most “normal” market conditions but the opportunity cost is most likely not as much as some are making it out to be. Still, compute your own opportunity cost of owning a home and see if it’s a reasonable expense in relation to your income. If not, you probably have too much house.

Related posts:

  1. Finding a Financial Advisor, Part 1
  2. Carnival of Debt Reduction # 19
  3. The Income Tax Cut is Better
  4. This and That
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