There are lots of reasons why you may want to own a home: privacy, stability, prestige, worth, etc. If your reason however for wanting to own a home is to turn your money into more money, a home purchase may not be the best investment you can make.
It is almost a financial tradition to buy your own home as soon as you can, we hear it from our parents, it is further iterated by certain personal finance experts and we watch our peers do it. But is this really a good idea or is it just a fad?
Is buying a house a good investment?
No doubt, a house could be an investment vehicle as it can help investors move money from the present to the future, with a very likely increase in the value of their money, but is it a good investment? To answer this, we must place it side by side with other investment options considering some factors for better contrast.
1. Interest rate
Except some strategies are employed, a typical house will only increase in value by a percentage of 3 per annum. Other conventional investment options, stocks and bonds, has shown to increase by 10% and 5% respectively per annum.
Some may argue that while the appreciation rate may be very modest, it is certain and consistent as it is less volatile than other financial assets. While this might be true in some sense, it is also important to point out that there is a tendency for home value to depreciate just like in the housing bubble that lasted 6 years from 2006 – although very unlikely. Moreover, in terms of consistency in rate of appreciation, insurance and maintenance costs of homes tend to counter the very modest 3% return and turn the whole activity into a zero-sum game. Other investment options that have been considered – stocks, bonds or even treasury bills – don’t charge for insurance nor do they need maintenance of any sort.
More so, 3% return is very little to hedge against inflation in Nigeria as the inflation rate hovers around 12%.
Diversification of one’s portfolio is very key in investing. What this really means is investing across different companies in different industries. This protects you from any shock – idiosyncratic and systemic – and also makes you available to participate in any spectacular gain in any industry or company.
Investing in a home goes against this iconic investment strategy. Houses cost a good lot and buying one would mean laying aside a preponderant part of your wealth for a single investment. This exposes you to an inordinate amount of risk as whatever affects the house or the housing market, in general, would be disastrous to your finances. Taking the money and spreading it across many industries puts you in a better spot.
Illiquid Investments are securities or assets that cannot be easily sold or exchanged for cash. Real estate which includes houses falls squarely into this category.
It is a usual occurrence for some assets in an investor’s portfolio to by a great measure outperform some others. For fairly liquid assets like stocks, the investor has a lot of options in situations like this. He could quickly take the proceeds of the high performing assets to buy more of the low performing stocks at a low price.
When sensitive news that would affect an industry is released, an investor can also make decisions in real-time in response to that news. This is rarely the case with real estate. The time taken to liquidate illiquid assets creates a lag that could hinder the flexibility of an investor’s decision.
When is buying a house a good investment?
There are many strategies we could employ to circumvent the very low 3% interest rates of real estate and realize an even better return. More so, owning a house could have certain other advantages over other asset classes.
There are two basic ways we could commercialize a house: renting and flipping.
Renting a house involves buying or building a house and then renting out the spaces while flipping a house involves building a house or buying a house at much less than its market value, rehabilitating it and then quickly reselling at a high price.
Both have advantages and disadvantages but in terms of returns precisely, flipping might be a better option.
Let’s say there are two investors seeking to invest in real estate, the first investor buys a house at N50 million and decides to rent out the building which has let’s say 6 units at N250,000 per year per unit, which will add up to about N1.5 million passive income yearly, in this situation, it will take the investor roughly 33 years to even break even, i.e make the N50 million in returns, before even compounding profits and about 20 years if he rents the units in the house at an outrageous price of N400,000 per year. This is without considering vacancy costs – periods where some units lie dormant without any paying tenant due to recent evacuation or any other factors.
If the other investor buys a financially distressed substandard house and applies the 70% rule which states that an investor should pay no more than 70% of the after-repair value (ARV) of a property minus the repairs needed. The ARV is what a home is worth after it is fully repaired.
In that case, a house that needs a repair of about N8 million to come to an after-repair value (AVR) of about N50 million would be bought by an investor at a price of N26 million. The investor makes a profit of over N15 million naira (N50 million – [N26 million + N8 million]) almost immediately. This would take the first investor more than 50 years to accumulate with legal and managerial hassles he would be faced with as a landlord.
2. Forced Savings.
Though we have spoken extensively on how money used in building or buying a house would have been better of if invested in stocks and other asset classes with better returns, most people are not very good at keeping cash aside for investment. Building or buying a house then can be a way of persuading such persons to invest or save their money in an illiquid form.
More so, the illiquidity of real estate which has disadvantages that have been considered also has an advantageous side as it mitigates excessive spending in people with reckless tendencies. While one can easily exchange stock for cash to satisfy a need or want in a matter of minutes, it isn’t feasible with real estate.
3. Fundamental analysis.
If your core intent is to profit off real estate, then you must carry out certain fundamental analysis before buying or developing one.
The cost of real estate is not as important as the rate of appreciation. Half a plot of land that costs N2 million where development is booming may be worth more than 2 plots of land that cost a million naira in a village with no signs of development.
Just like have been mentioned, the housing and real estate market sees about 3% growth rate but there are conditions that can cause a real estate investment to disobey this rate and see a booming growth of even 100%. Development.
A house bought in an area where major constructions and projects like stadiums, airports, etc are going on could see a spectacular rate of return because of very obvious reasons – development attracts population and population growth is proportional to rate appreciation.
If profit is your major objective make sure to carry out your fundamental analysis and figure out areas with a higher possibility of development.
The African Irrationality
Most Africans especially Nigerians make some decisions as building a house in their hometowns where almost no one lives and then paying rent in the cities. This is a financial irrationality and might be prompted by such factors as social proof, tradition, quest for importance, etc.
Building a house for such reason might not be the best financial decision if you’re in a wealth-building period as you would suffer both the disadvantages of owning a house (maintenance and repairs) and also that of paying rent. You can of course tow this path when you have achieved a certain level of financial freedom and not before.
Should I buy/build a house?
Real estate development might be a lousy performer when it comes to returns on investment (i.e if the strategies discussed above are not put in place) however, owning your own house has several other benefits that may not have anything to do with profit.
If you want a stable environment for your family, privacy, security, self-worth and esteem, then building your own house may be the best bet but if you are after profit, then you might reconsider or better still put in place the strategies already discussed.
Moreover, it is financial wisdom to buy/build with your profit, not with your capital. Your assets should pay for your house, not your life savings.
Source : Nairametrics