Just like stocks, we can think of a home as a money machine, and estimate the cash coming out of the machine. The income a home generates is the rent a homeowner would otherwise have to pay a landlord. There are expenses, too. Homeowners make mortgage payments and pay property taxes, homeowner’s insurance, and maintenance expenses when a faucet drips and the walls need to be repainted. A home’s net income is the difference between the income and expenses. Since this net income is as real as the dividends from a stock portfolio, I call it the home dividend.
There are surely nonfinancial considerations that make renting and owning different. Renters might not like the pumpkin-orange walls the landlord picked out. Renters don’t get any financial benefit from remodeling a kitchen or landscaping a yard. Renters might have less privacy than homeowners. These are all arguments for why owning is better than renting and, to the extent they matter, home-dividend calculations underestimate the value of homeownership.
It is certainly not true that you can’t go wrong buying a home. The claim by a former Salomon Brothers director that “there is no bad time to buy” is embarrassingly silly. Everything has a price that is too low and a price that is too high. An apple is a bargain at a penny and too expensive at $100. The question here is whether the home dividend makes the price a bargain or a mistake.
All real estate is local, so we shouldn’t make nationwide generalizations like “there is no bad time to buy” or “the U.S. is in a real estate bubble.” Here is a real example from the height of there so-called real estate bubble. In the summer of 2005, a 3-bedroom, 3-bathroom, 1,917 square-foot house in Fishers, Indiana, was purchased for $135,000 with a 20 percent down payment ($27,000) and a 30-year mortgage. Fishers is an attractive Indianapolis suburb. The median family income is over $100,000 and Money magazine ranked Fishers among the top 50 places to live in the United States in 2005, 2006, 2008, 2010, and 2012.
In a book titled Houseonomics that I wrote with my wife, Margaret Hwang Smith, we estimated the home dividend for this house by making a list of the financial benefits and expenses from homeownership—the cash going in and the cash going out. Table 1 shows the estimated values for the first year.
The bottom line is a first-year home dividend of $5,622. After one year, the homeowners will have $5,622 more in their bank account than they would have if they were renting. Just like a stock portfolio that pays a $5,622 dividend, this $5,622 is their home dividend.
Is $5,622 a good return on their investment? As with stocks, we should compare the dividend with the size of the investment. When you buy a home, your investment is the cash you put up for the down payment and closing costs. Here, the down payment is $27,000. We’ll add $3,000 in closing costs to make it an even $30,000 investment. They invested $30,000, which they could otherwise have invested in stocks. The $5,622 first-year home dividend is a 19 percent after-tax rate of return on their investment! Where else could they invest $30,000 and get a $5,622 dividend the first year?
The home dividend will get bigger each year because rents will increase, but the mortgage payments won’t (if it is a fixed-rate mortgage). Let’s assume that rents, property taxes, insurance and maintenance all grow by 3 percent a year. The home dividend will be $5,942 in the second year, $8,843 in the tenth year, $13,471 in the twentieth year, and $19,478 in the thirtieth year. Then the mortgage payments stop. The home dividend jumps to $27,744 in the thirty-first year, and keeps on growing.
Just like stocks and bonds, we can calculate the present value of the home dividends and compare this intrinsic value to the $30,000 cost. Figure 1 shows the intrinsic values for after-tax required returns up to 30 percent. The break-even return is 23.8 percent. This home is an attractive investment for any after-tax required return below 23.8 percent.
For an after-tax required return of, say 10 percent, the present value of this $30,000 investment is $106,000. This is like buying a stock for $30 a share that is really worth $106. For an after-tax required return of 5 percent, it is like paying $30 for a stock worth $476. These are genuine $100 bills on the sidewalk.
As it turned out, home prices in the Indianapolis area have gone up about 1 percent a year since the summer of 2005. But that is just frosting on the cake. The cake itself is the tens of thousands of dollars in home dividends that the homebuyer earned during this period.