Your House is Too Small, and I Think Your Smellovision is Broken

All that talk about home prices in the last post has made me hungry for data - And not just any data, mind you, but good ol' beefy data, data that will make you unbutton your pants and say to yourself,

"Wow. That's pretty meaty - And applicable, too!"

Watching your % Daily Value intake of beefy data? Not a problem, this data will reduce stress caused by losing money in a bad investment, and also get you laid. Before you exclaim, "Laid?" first allow me to kick your preconceived notions in the balls, then you can question me as much as you like.

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During a recent conversation about stocks and the returns on tax-free municipal bonds, my dad countered with a statement that the best investment that you could possibly make was buying a house. I didn't argue, as I thought it was common knowledge, especially according to Robert Kiyosaki, that if you bought a house, you're pretty much guaranteed a safe, well-performing investment.

First, I stumbled upon this graph, which is pretty incredible. Check it out.

This graph is based on the sales of standard existing homes, so the data is slightly different from the data I used, but not by much.

You can find U.S. historical median home prices all over the Internet. They're everywhere. Go ahead, try it. I'll wait here. Did you see anything about adjusting the prices you saw for square footage? Of course not, that's not what 'median home price' is. It's actually the price, regardless of square footage, that is less than one half of houses and greater than the other half.

As I mentioned in my last post, the median price for a house sold in 1968 was $120,341 after inflation. In nominal dollars, it was $20,100. So, you might know someone who said, "Man, I only paid $20,100 for this house. Back in my day, you could buy a gallon of gas for..." Be sure to reply in your most snotty voice, "Did you adjust that for inflation?"

Not only should you ask that question, but you should also ask what the square footage of their house is. If they paid around $20,000 there's a very good chance that they own a 1300 - 1500 sq. ft. house.

The median square footage for a home nowadays is almost twice what it was, at 2400 sq. ft. What's the median price? $231,502.

This means the price for a "regular" house in 2007 is $111,161 more than it was 40 years ago. Sure, but what everybody seems to ignore is that your median data comparisons are comparing two entirely different kinds of houses: Big uns and small uns. So what we need to do is compare the value of the same house over that time period:

So, the price per square foot of a house in 1968 was ($120,341 / 1400) = $85.96.

In 2007, it's (231,502 / 2400) = $96.46 per sq. ft.

So, a house you paid $20,100 ($14.36 per sq. ft.) for in 1968 is now worth $135,044 ($96.46 per sq. ft.)

Of course, $20,100 was a lot of money back then. After we adjust for inflation, $20,100 is the equivalent of $120,341 today. So, even adjusting for inflation, the house went up in value, but only by $14,703. (Also, this is pretty optimistic, as it's assuming you'll get median 2007 sq. ft. prices for a lower-than-median house.)

How good of an investment is this? Well, it comes out to about a 12.2% total return after 40 years.

So, if you bought a middle-of-the-road house at the middle-of-the-road price in 1968, you'd be able to sell it today and take the 12.2% percent after-inflation profit and, by the way, not pay any capital gains taxes if it was your primary residence. However, if it was an "investment property," you'd have to pay (currently) 15% of the sale price less purchase price difference in capital gains taxes. This would be 15% of the $111,161 in nominal profit, or $16,674.15 in taxes when you sell the house. So, after 40 years, your total benefit from the investment property would be a loss of $1,971. You're not going to know it, though, since you probably paid off the house 10 years before you sold it, and the windfall of $94,487 is going to seem like a lot of money for doing nothing but making payments into an "investment property." Oh, and I forgot to mention the fact that you probably financed the house at (in 1968) interest rates well above 10%. And one more thing: If you sold the house already, before the year 2000, you would have lost a huge portion of those nominal gains (see the graph I linked to, up top.)

So what does all this tell you? If you buy a house now, and if the American desire for larger houses and more money continues (which it will), by the year 2047, you'll own a 2400 sq. ft. house that is worth substantially less than the median house of 2047, which will probably be somethin' like $1.2 million and 4,300 square feet ($280 per sq. ft.). If these predictions are anywhere close (see sq. ft. historical percentage increases), who is going to want to pay $672,000 for a tiny little cottage that's barely big enough for their Smellovision, CyberFish Tank and 500 square foot refrigerators? Even if someone did buy your house, you'd lose money after inflation. You'd especially lose money after taxes, and REALLY lose money after 30 years of 6.5% fixed interest.

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"But if I don't buy a house, I won't have a house to live in!" -You

This is true. So what do you do?

Buy a smaller house today, invest the rest in bonds or, if you want my real advice, global ETFs (or even the U.S. S&P 500 tracking fund - Ticker: SPY). Actually, don't do that yet - rent for a couple of years, say, 2010, then start doin' it. I'll explain every bit of this timing advice in later posts, but for now, let's just make some assumptions:

Let's assume you're 27 years old, married, and making $90,000 a year in combined income before taxes and 401(k) contributions. Technically this means you could easily afford a $250,000 house if you follow the 35% percent-of-gross-income-spent-on-mortgage payments advice. After taxes, 401(k) contributions and loan payments, you'll have about $2,800 left for kids, food, heroin, etc. Also, according to the median home prices data that I just don't shut up about, you'll get a 2400 sq. ft. house.

The alternative? Buy a 1200 sq. ft. house now, then a 3000 sq. ft. house when the kids become old enough to demand their own rooms. Go ahead and ask. I know you're thinking it.

"Why?"

See! I knew you were thinking that! Here's why:

Cost of 1200 sq. ft. house now: $96.46 * 1200 = $115,742, AKA half the median home price of $231,502. This means your monthly payment is, essentially, halved also:

Monthly payment: about $1,250.

This leaves an extra $1,250 to invest... Where? Some place that pays more than 4% interest, like a BANK (One that actually pays interest, like ING or Scottrade Equity Accounts.)

So let's do the math for the first 10 years (while the kids are being birthed and growing up), then compare the results to "lifetime" options. I'll explain:

On one hand, you can buy a bigger house now, and pay $2,500 per month at a negative return (After financing, you will NOT get a positive return, especially in only 10 years.) But, for decency's sake, let's call it break-even for the first 10 years. At the end of 40 years, though, you will make some profit, if we assume some major housing booms from today's current levels and low inflation. Let's assume it's 12% - 15%, just like it was from 1968 to 2007. This is a pretty optimistic prediction, but let's get even crazier and pretend it will be 25%, or about 0.6% per year.

So, in this case, after ten years, you'll have a total gain of 6.2% AFTER inflation, on a $231,504 investment, or a gain of $15,500.

In the other case, you'll have a 6.2% gain on a smaller house (actually a little less considering our propensity to dislike smaller houses over time...), so let's say you get a 2% total return on your $115,742 house, or a gain of $2,314. But, if you found some good tax-free municipal bonds paying a good percentage return, you'd be able to invest that extra $1,250 every month and get returns (around 6%, minimum) for 10 years. Not only will you have $150,000 saved over 10 years into an investment account (municipal fund, in this case), but it will be worth $204,086 (compounded / dividends reinvested monthly), for a gain of $2,314 on the house and $54,086 on the invested cash, for a total gain of $56,400 before inflation. Assuming inflation is high (3%) every single year, your account will be worth 174,770 instead of 204,086, but that is not important for our first (after 10 years) calculation, as we're dealing entirely with "future prices."

But now it's 10 years later and your kids need more space! So, you sell your 1200 sq. ft. house, pay all the closing fees of, say, $4,000, and buy the biggest house you can afford. Let's be nuts and assume you're not divorced and your incomes haven't gone up, all the houses have increased in price by their historical yearly increase of 5.1% (adjusted for square footage increases and NOT for inflation), and the cost of the 2400 sq. ft. home is now $380,700. Since nothing has been adjusted for [expected] inflation, you've now got $118,056 from the sale of your 1200 sq. ft. house, less $4,000 in closing fees ($114,056) and $204,086 from your saving / investment account, for a total of $318,142 in cash at the end of your tenth year. So, at this point, how much of a house can you afford in order to break even (with scenario one)? Well, for the next 20 years, you will be paying $2,500 per month, as decided in our 30-year same-size house scenario, so that'll give you about $215,000 "worth of house" to buy (i.e. you can afford that much with those payments) at a 20-year loan, assuming interest rates are reasonably equivalent in ten years - around 6 or 7% - which I believe is something I've got strong evidence to support (Look for a future post about GDP damped oscillation, it'll be wild...). So, we end up converting our $1,250 savings into additional mortgage payments and throwing in the entire amount from the sale of the original house and the gains (+base) from the investment account in order to "break even," and the total amount comes to about $543,142. At the inflated predicted prices of $179.80 per square foot that we've already been using, this means you can buy a 3,021 sq. ft. house.

"What, 621 extra square feet for spending 10 years in a house that is half the size of a normal house?" -You, sounding more and more uninterested

Yes, but that's because you decided that your kids needed the 1,800 square foot difference between 1,200 and 3,021 in only 10 years (10 years after getting married, that is). Not only that, but by the very fact that you were beating yearly inflation by more than 3% and owning a house (albeit a smaller than normal house) means that, for every year you compound your savings, you end up with relatively more asset value than do homeowners that have their home as their sole investment. If, at any time during the 30 years we're looking at, you decide to "give up" and convert this asset value into the largest possible home, you'll always be able to afford a larger home than anyone else in your income group. We've done the math: If you only wait 10 years, you'll get an extra bedroom (621 sq. ft.). If you wait 20, it will be disproportionately more, maybe 1,500 sq. ft (I'm guessing).

This is the longest post yet, I think.

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So, you see the points here:

1. We keep hearing stats about the rising prices of homes, but these stats never seem to include the price per square foot, and they're almost never adjusted for inflation. If they were, we'd get some pretty boring statistics, as you can see for the majority of the years in the graph I linked to at the top of this post. Here it is again.

2. The majority of people who make "a killing" in real estate are the very vocal ones who got lucky enough to read Kiyosaki's dumb books before the most recent housing boom, or any localized rapid appreciation in prices (Like Phoenix over the past however many years). If you asked Kiyosaki, though, he'd say he's more about the cash flow, and not the investment. I propose he's right about that, but only in the best 20% or so of high-income rentable houses, and only in the best markets. For everything else, his flow gets eaten by inflation and wear and tear on the house by crappy renters.

3. If you can, live in a 1200 square foot house and feel good about it, like they did in the 1960s. Even if all your neighbors have 2400 sq. ft. houses and plenty of space for their overpriced furniture and decorations, let the requirements - not the greed - of your family determine your space, and you'll end up immensely richer in the end. Check out this article, it's awesome (fourth paragraph down).

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So, either buy a "median house" in a good market, or buy a cheap one anywhere you want. The problem with the first option would be in trying to predict where the market's headed. Read this article for inspiration:

Expected Return From Stocks In Next 5-10 Years
Thomas J. Chester
3 February 1997

(Notice the date the article was written and then read the first paragraph. Although he got the "going down at some point" right, he missed it by almost four years. For the record, the S&P has not been as low, not even once, in the past 10 years as it was in February of 1997. In fact, it is now about 83% higher, not including dividends! Holy cow, that's a spicy return on investment!)

P.S. I admit, this post is very long. So, if you want a summary, here it is: The home price data often used to calculate our future home values is misleading, so don't spend all your money on a big house when you're young, buy a utilitarian house first and invest the remainder. Then, when you absolutely need more space, buy as big a house as you want, and you'll end up with either more of a house or more cash on hand, or a little bit more of both, in the end. Actually, don't read this summary, it's too long for a summary. Go back and read the whole post.

P.P.S. As I promised at the beginning of this thing, this post will get you laid. All you have to do is repeat it, verbatim, to anyone, and they'll jump directly into your pants.