Published October 02, 2012
You may believe that a second home can be a great place to vacation and retire, that you can earn some equity over time and that it’s a good deal because property is a physical asset that can’t go away. While those statements may be true, it’s unlikely that buying a second home will be a very good financial move.
Here’s the unbiased reality: You may be able to earn some long-term wealth from a second home, but you probably would have earned a lot more wealth keeping your money in a well-diversified pool of financial assets or buying rental properties.
Cash out, no cash in
You see second homes, and land, have one very unappealing quality when you are looking to earn wealth: They don’t pay interest, dividends or net rental income. In fact, all they do is take money from your bank account for property taxes, insurance, maintenance, renovations, and, oh, that mortgage payment — all money going out the door, with no money coming in the door. So you are 100% speculating that the property will go up in value over time to compensate for all the negative cash flows that accumulate each year. And how are you covering those negative cash flows? You are taking money out your financial assets — stocks, bonds, mutual funds — to pay the bills that cause those negative cash flows.
And by the way, weren’t you earning interest and dividends on those financial assets? So you would have been earning 5-7% annual returns on a well-diversified pool of financial assets, but instead you are earning nothing — that’s termed the lost opportunity cost of capital.
Over the long term, all those negative cash flows and the lost opportunity to earn a rate of return on financial assets are really going to add up. If on a $100,000 property you spend $10,000 per year (inflated by CPI 3% per year) to carry that second home, with cumulative lost opportunity cost of capital, that could be $450,000 to $500,000 after 20 years that you would have had in financial assets. Of course if the value of the property goes up 8-9% per year for those two decades, so it’s worth $500,000, then you might just break even. Note: Housing appreciates about 3% per year over long periods of time.
So if you are buying a second home in hopes of earning wealth, you might earn it. But keep in mind that there probably are much better investments out there, and you should really think it through if you are simply hoping the value of the property will increase enough to provide a fair rate of return.
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Leonard Baron is America’s Real Estate Professor – his unbiased, neutral and inexpensive “Real Estate Ownership, Investment and Due Diligence 101” textbook teaches real estate buyers how to make smart and safe purchase decisions. He is a San Diego State University Lecturer, blogs at Zillow.com, and loves kicking the tires of a good piece of dirt! More at ProfessorBaron.com.