At that level of depreciation, Mr. Jones’s starting investment of $67,000, plus $20,250 he paid over five years to reduce the principal of his mortgage, erodes considerably from its total of $87,250, leaving him with $45,250 in reduced equity after five years.
In comparison, Mr. Smith’s original cash investment appreciates exactly the same as it would have during favourable market conditions. Although his cash investment and its appreciation on his overall rental accommodation cost are fully utilized and exhausted after five years, he lived in and enjoyed the rented unit of equal value and paid $13,920 less for his overall accommodation over five years.
The Effects on Mr. Smith of Unfavourable Market Conditions
An interesting situation could develop for Mr. Smith should the real estate market and economy turn for the worse. This would create more vacant condominium units, giving Mr. Smith a chance to rent the very same condominium for a lower price, perhaps $1,200 per month. Inflationary trends may drive interest rates up, giving his investments a higher yield. In this scenario, he likely ends up with a sizeable surplus after five years, rather than a very small shortfall.
The market conditions that could affect Mr. Jones adversely, as an owner, may work to the benefit of Mr. Smith, as a renter.
Who Fares Better After Five Years?
It is all about timing. If markets experience exceptionally favourable appreciation due to high demand and low interest rates, Mr. Jones ends up much better off than Mr. Smith. Overall prices may have gone up by as much as 30 per cent, as they did from 2000 to 2006.
SEE THE GRAPHIC ATTACHED TO THIS STORY: Financial breakdown during favourable market conditions.
But what if they had moved into their units in 1988? During the following five years, Mr. Jones likely would have lost about 30 per cent of the value of his unit due to depreciation caused by adverse market conditions. This would have wiped out his equity. The same can be said for the five-year period, starting in 2006, when real estate catastrophically lost as much as 50 per cent of its value in many U.S. cities.
SEE THE GRAPHIC ATTACHED TO THIS STORY: Financial breakdown during unfavourable market conditions.
As you can see in the above example, equity, in the short run, is not always based purely on paying off the principal of the mortgage. Equity is directly dependent on the property’s value, which is largely affected by prevailing market conditions. Buying into real estate for the short-term purpose of building equity is essentially gambling on the state of the economy, interest rates, and market conditions.
On May 11, 2011, the Web edition of the New York Times posted a very interesting analysis of buying vs. renting. According to the paper’s calculator, renting seems to be more advantageous for people who do not plan to stay in the same premises for more than four to five years, and buying is more advantageous for those who decide to stay for a longer period.
Investing vs. Renting: The Long-term Truth
Real estate market trends are influenced, not only by unemployment and interest rates, but also by demand, the cost of building materials and supplies, inflationary trends, and many other factors. These are complex market relationships. Even the best financial analysts do not have the precise answers when it comes to predicting market trends.
Things definitely tilt in a property owner’s favour over a longer period, regardless of the economy and periodical market swings. Owners of real estate properties gradually build up the benefit of equity as the principal of the mortgage debt is reduced and eventually paid off over time.
After about seven years, payments on the principal reduction of the mortgage become more prominent and, depending on the amortization period of the mortgage, the principal henceforth will be reduced more rapidly.
Depending on the amortization period, if the buyer hangs on for 15, 20, 25, or even 35 years, they will have accomplished the goal of living in their property while simultaneously lowering their mortgage debt and eventually paying it off.
Historically, real estate has appreciated in the range of 1.5 to 4 per cent per year except for periodic market corrections. Consumer wages were supposed to follow, but, unfortunately, this has not quite happened. Are consumer wages going to increase in the future to keep pace with overall inflationary real estate trends? Historically speaking, you should not be optimistic.