By Wealth Foundations

Most compare the current house value with the purchase price …

Like me, you probably often hear long term home owners making statements such as:

“I bought this place in 1982 for $200,000 and it has to be worth $2 million now.”

The suggestion is that the home has been a fantastic investment and reinforces a widely held view that you just can’t go wrong with property.

The real estate sections of newspapers, when reporting on recent house sales, also like to refer to the last traded price. In Sydney, at least, if this last sale occurred longer than twenty years ago the increase in value will almost certainly appear impressive.

But, other than deluding people regarding the investment merits of owning their own home, what is the point of comparing current value with purchase price? It certainly does not allow you to calculate a true economic return on holding the property to compare with alternative investments that could have been made at the time of purchase. And it says nothing about what will happen in the future.

… the reality is more complicated and less positive

To understand why comparing the most recent sale price of a home with its last traded value is of dubious worth, let’s examine a recent report from “The Sydney Morning Herald” of 17 March 2012. It describes how Mandalong House in Mosman “sold snappily last week for $18 million”. It goes on to state that the owners “have renovated Mandalong House twice since buying it for $3,375,000 in 1989”.

The easily impressed reader probably thinks an over $14 million profit has been made! The little more numerate might calculate a greater than five times return on the initial outlay over 23 years. Both would possibly conclude that Mandalong House had been an astute investment for its owners.

A more analytical reader, that knows something about the time value of money, would want to calculate a compound annual growth rate (“CAGR”) before making such a judgement. Simply dividing the sale price by the last traded price implies a CAGR of about 7.5% a year over the 23 year period. Now this doesn’t appear as impressive.

But again, it is not the actual return on the property nor do we have a basis for a valid comparison with, for example, the share market. To calculate the property’s true return, we also need to allow for:

- the cash outflows associated with the two renovations plus any other capital expenditure;

- the costs of buying and selling;

- the ongoing holding and maintenance costs that a renter of the property would not bear; and

- the benefit of the notional rental return received by the owners.

Their combined effect could dramatically impact the result.

To compare this correctly calculated return with that of the share market, the appropriate benchmark is the Australian All Ordinaries Accumulation Index that allows for reinvestment of dividends paid.

Based on a number of assumptions, we estimate the actual return on the Mosman property was somewhere between 7.5-8.5% p.a. for the 23 year period. The comparative share market return (before any costs and allowance for franking credits) was 9.1% p.a. implying a $3.375 million investment made in February 1989 with all dividends re-invested would have grown to about $25 million by February 2012.

Now provided the property was the owners’ principal residence, its return was tax free. The share market return on the same initial investment, unless held in superannuation environment, would have been reduced to some extent by tax. But regardless of this finessing for tax, we expect most would be surprised that at least on a pre-tax basis the Australian share market almost certainly outperformed this particular prime Mosman residence over the past 23 years.

Your home is a lifestyle asset, not an investment

There is a lot of puffery in real estate reporting. Unlike the share market, where prices and returns are very transparent, it is impossible for real estate agents and reporting journalists to calculate the true economic return on each house sold. The reality is they don’t have the relevant data.

But as a proxy for return, their alternative focus on the difference between the most recent sale price and last traded price is misleading, at best. It plays on most people’s lack of an intuitive understanding of the time value of money and compounding. It also supports the real estate industry’s message that buying a home has been a great “investment” in the past and, by implication, will be in the future.

The reality is that much of the difference between current value and last traded prices often reflects spending on improvements rather the underlying performance of the overall property market that is primarily driven by changes in land values. The property that has recently sold may be vastly different to that when it was purchased many years ago – it’s an apples and oranges comparison.

Our advice is to view both home purchase and sale primarily as “lifestyle” rather than “investment” decisions, much like the purchase of a motor vehicle. Succumbing to the real estate industry hype and confusing the two leads to poor decision-making and, inevitably, an overconcentration of wealth in a highly illiquid asset.

As an end note, an increase in the value of a residence from $200,000 in 1982 to $2 million over a thirty year period to now represents a return of 8.0% p.a. Over the thirty years to end April 2012, the Australian share market grew by 11.9% p.a. On a pre-tax basis, and with dividends reinvested, $200,000 invested in the share market index at end April 1982 would have grown to $5.9 million by end April 2012.

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Wealth Foundations (ABN 36 121 535 993) is a licensed Australian financial services firm (AFS Licence No. 317369). The material contained in this article is for general purposes only and should not be used as a substitute for personal financial advice. This article does not take into account your specific objectives, financial situation or needs. No person should act or refrain from acting solely on the basis of this material. Before making a financial planning or investment decision, you should consider if it is appropriate for your circumstances. You should read and understand any relevant Product Disclosure Statements or any other associated documentation relevant to your individual situation.