Why is home-buying typically considered an excellent long-term investment as well as an excellent hedge against inflation? Here’s a scenario:
§ One buys a house for $1,000,000 in 2012, putting down a down-payment of 20%: $200,000.
§ For 10 years, inflation runs at an average of 2.5% per year. For the sake of this scenario, we’ll assume inflation and appreciation are equal – obviously there are times when appreciation is higher or lower than inflation, but, generally speaking, home appreciation in San Francisco, over the longer term, generally runs significantly higher than inflation. (The median price for SF non-distressed houses basically tripled in the last 20 years – up about 200%, far above the rate of inflation.) But here we’ll assume appreciation and inflation are equal.
§ Ten years of inflation at 2.5% would bring the value of the house purchased for $1m in 2012 to about $1,280,000 in 2022, 28% higher, though in the dollars’ value at the time of purchase, its value has not really changed, it has only been affected by inflation.
Three issues pertain to the home as an investment and as hedge against inflation:
1. First of all, if you bought the home with a fixed rate loan, the number of dollars you’re using to pay off the loan each month stays the same, but it’s costing you less with each year of inflation. In 2022, ten years after buying, you’re paying off your loan with dollars that are worth less than 80 cents each in 2012 dollar value.
That’s sometimes a little hard to wrap one’s head around, but the following is much easier to understand.
2. The house price went up $280,000, 28%, $1,000,000 to $1,280,000, over the ten years. But you used leverage to purchase the home, and this is the key. On your cash investment (down-payment) of $200,000, you’ve received a return of $280,000, which equal a 140% return on investment. Even deducting inflation’s portion of the increase, over the ten years, you received over a 100% return on investment in 2012 dollars.
3. The reason why a home purchase is considered such a good hedge against inflation is that, due to the leverage aspect, the higher the inflation rate, the greater the real return on investment. While people’s bank savings are usually less valuable every year with significant inflation, your home down-payment investment is steeply increasing in value.
ü You had a home to live in for ten years.
ü If you purchased in 2011-2012, you got the lowest interest rates in history (which makes a huge difference in the ongoing cost of homeownership).
ü You were likely able to deduct your mortgage interest expense and property taxes on your tax returns. (Talk to your accountant.)
ü Selling in 2022, even after typical closing costs, and factoring in principal repayment of the loan, your net proceeds are well over $400,000 (against your $200k down-payment).
ü And that is without any appreciation above inflation: every 1% of additional appreciation per year would add a further 5% to your annual return on cash investment. In an appreciating market, such as we are in currently – values up 5-12% in the past 6 months in many San Francisco neighborhoods – this can add exponentially to your financial return.
ü There is a capital-gains exclusion for the first $250,000 of gain for a single person and $500,000 for a couple on the sale of a primary residence: you pay no capital gains taxes even though you doubled your investment. Unlike every other investment, your profit (up to the $250k/$500k limits) is tax free, free and clear.
One must review one’s specific financial circumstances and plans with an accountant. This scenario is for illustrative purposes only and no one knows the future. Market conditions can fluctuate dramatically and tax law is subject to change. All data above is from sources deemed reliable and calculations were performed in good faith, but this scenario may contain errors and is subject to revision.