I was reading David Bach’s book “The Automatic Millionaire” on the flight back home from our Philly/NY trip - except for some little excitement (for the wrong reasons) while reading his views on real estate, the book almost put me to sleep (sorry Bach fans). May be it’s not Bach’s fault here - there is a lot of stuff on personal finance (by various authors) that make me yawn with increasing frequency after a dozen pages or so.
Anyways, back to the point of interest. In one particular section in the book (titled “Six Reasons Why Homes Make Great Investments“), Bach starts painting a very rosy picture of investing in real estate. While some of the reasons are OK, I was not comfortable with the manner in which a couple of them were explained. For example, in reason #2, he starts with explaining the concept of leverage and then jumps to calculating returns on investment. Here, he tries to show how real estate investment can yield handsome returns by using the power of leverage. This is what comes next:
Let’s say you are buying a $250,000 home with a down payment of 20 percent. What this means is that you’re putting in $50,000 of your own money and borrowing the remaining $200,000 from a bank. Since you’ve put in only one fifth of the purchase price, you’ve got five to one leverage. Now let’s say the value of the house increases over the next five years to $300,000. Given that you’ve put in only $50,000, the $50,000 increase in value means you’ve effectively doubled your money. This is the power of leverage.
Am I being too critical or that just doesn’t sound right? That’s not telling the whole story. What about the payments that you have made every month over those five years, isn’t that a part of your investment? A quick calculation using a generic mortgage calculator shows that by the end of five years, a $200,000 mortgage (at a reasonable 6% rate of interest) would cost about $58,000 in interest alone (plus some amount of principal is paid back too ~ but let’s ignore that for the time being). Shouldn’t such costs be taken into account before making claims about doubling money? In fact, for this particular set of numbers, if you sell the house after five years, you would be making a handsome net loss.
If you are not yet convinced, here are some specific problems with David Bach’s argument:
- Let’s extend Bach’s calculation a little further. What if you put down only $25,000 instead of $50,000? With his calculation that would give a 200% rate or return. For $10,000 down payment that would be a 500% rate of return. Man..isn’t buying a house really profitable?! At this rate, Bach could easily tell you that if you don’t put anything down you get $50,000 on a $0 investment - now, I don’t think there are many people who could divide by zero (someone once mentioned to me that Chuck Norris can), but if Bach continues with this argument, he might as well perform the division and declare an “infinite rate of return” on investments.
- The doubling money argument totally ignores any kind of interest rates (his logic is applicable only when you borrow money at 0% interest rate and don’t make any payments for five years ~ and no one’s ever going to give that kind of a mortgage). For someone who is trying to explain potential gains using leverage, this isn’t a good sign. Profitable financial leverage cannot be explained without explaining the difference between the rate imposed on borrowed money and the rate of return that you get when you invest the borrowed money. For example, if you borrow $200,000 at the rate of 6% and invest it for a 4% rate of return, then it’s not a very wise way of using financial leverage ~ you will be losing money in such a deal (of course, there are complications like cash flow considerations - when you rent whole or part of your property, but we will ignore such issues for the time being - because Bach does not consider them either in his explanation).
Bach keeps up with this questionable math in the next paragraph:
Over the last five years, many homes have doubled in price. Think what this means in terms of leverage. If you invested $50,000 in a $250,000 home five years ago and it’s now worth $500,000, you’ve made $250,000 on a $50,000 investment. In investment circles, that’s called a five-bagger - an amazing 500% return on your money.
What does that “500% return on your money” sound like to you?
*cough* real estate agent *cough*