So let me ask you again, why do you want to buy this house?
Many people, even with genuine need of a dwelling, would offer their answer with this closing statement:
‘… and it seems like a good investment (or a good way to diversify, or a good way to grow my wealth in the long-term, etc.)’
If you intend to purchase the house as a pure investment, ask yourself the following three questions:
#1: What is your goal?
Unless you are in the business of real estate management or speculating on the housing market, most people expect making a return on a housing investment over a long period of time, so the asset becomes part of your wealth that may sustain you into retirement. If your goal is to grow your nest egg, you should view this investment as part of your overall portfolio and evaluate your risk tolerance and diversification accordingly.
#2: What are the risks you take?
For people in their 20s or 30s, I included, we generally have not accumulated enough wealth to justify putting a significant amount of net worth in a down payment while achieving diversification on our overall portfolio. If I have $100,000 in savings, and put $50,000 toward a down payment, that means 50% of my wealth is invested in one single object. You may be investing in a different asset class, but it does not help you achieve diversification- you are taking ‘unnecessary risk’.
Even if buying this house requires a relatively small portion of your net worth, you should still be aware that you run the risk of losing money from your investment: the property may depreciate in value or fail to generate income as you expected, which represents the true underlying risk that justifies the potential return. If taking this level of risk makes sense in light of your overall portfolio strategy, you can proceed to consider #3.
Of course, there is also credit risk if you require financing to purchase the house. Being able to make mortgage payments usually is buyer’s first concern, but it’s not the most important one when you make investment decisions. Nevertheless, you should be confident that your income source in the long run would cover mortgage payments.
#3: How big a return justifies the cost and risk?
As discussed in #2, buying this house may not be as risky as trading options, but it definitely comes with risk, especially if you are ‘leveraging,’ which means you borrow money (a mortgage) to make money (rent and future appreciation.) The return on investment is impacted by your down payment, the interest rate and the term/type of the mortgage, property tax rate, management cost, home price appreciation, rental income, and many more. Here is an online calculator that shows you the number educated “guess-timate” you need to obtain the return.
Does that return look appealing to you?
Let’s say your investment time frame is around 10 years. Instead of buying this property, you could have purchased a newly issued 10 year US Treasury Bond and hold it until maturity (if you believe the US government will pay its debt in 10 years), which guarantees 2.48% APR as of end of May 2014. That means in order for you to take any risk on this property, you need to make sure the expected return on investing in this house will be higher than investing in 10 year US Treasury Bond.
There are other investments other than US Treasury Bond that may give you higher returns with higher risk, just like this investment property. As you can see, it’s a matter of evaluating the return versus the risk you take. After just coming out of the subprime mortgage crisis, we all know now that house prices don’t always go up, and you don’t always find a renter. Picking one property to invest therefore requires you do the homework on the local market and the specific property so you understand the risks properly. This is made more difficult when you are overseas.
Still thinking about it? I would recommend seeking the assistance of an independent financial planner or real estate professional to gather objective data and help you calculate a realistic return and make the investment decision in light of your entire portfolio. Like many people say, it is your choice. Don’t feel pressured into doing it because you can and everyone does; and if you do, make sure you make calculated decisions and know what you are getting into.
Read Part I if you missed it.