The Value of Debt: How to Manage Both Sides of a Balance Sheet to Maximize Wealth by Thomas J. Anderson

Author:Thomas J. Anderson [Anderson, Thomas J.]
Language: eng
Format: azw3
Publisher: Wiley
Published: 2013-08-27T16:00:00+00:00

Purchasing a Second Home: Pluses and Minuses

In Chapter 3, when discussing how to determine your optimal debt ratio, we discussed at some length the question of whether your primary residence should be included in your optimal debt ratio. We concluded that for some people, there’s no question that their primary residence should be free and clear—with no debt on it—as this is emotionally important to them. However, as a way to add desirable debt into your overall financial equation, the purchase of a second home may prove very promising.

Before considering how you might go about purchasing a second home, let’s start by reviewing some of the disadvantages of owning a second home and whether you might want to just rent a vacation home instead. That is, before even beginning to look for a second home for vacation or investment or adding in good debt to the mix, you want to be well aware of the expenses and other factors typically associated with owning a second home. Let’s go through these one by one.

Depreciation

To begin with, homes have multiple expenses associated with them that are often not fully factored into the cost of ownership and the likely rate of return on the property, starting with depreciation. If you were to build a new house and leave it in the middle of a cornfield for 50 years, and then you came back and visited it, there’d be no part of the property that you would still be able to use. You’d essentially have to replace everything—the house would need a new roof, new windows, new carpeting, new appliances, new bathrooms, and so on. With a 50-year time horizon, this implies a 2 percent annual depreciation on the house just to maintain it and keep it exactly the same; if you assume a 30-year period, then that means approximately a 3 percent yearly depreciation cost.

It is important to apply this to the value of the building and not the land. So let’s say that you have a lot worth $100,000 and you have a $1 million property on that lot for a total value of $1.1 million. In this example it is reasonable to assume that you will have somewhere between $20,000 and $30,000 a year of maintenance expenses just to keep the building in the same condition. Alternatively, if you have a $5 million property with $2 million of structure and $3 million of lot, then your depreciation may run closer to $60,000 per year (3% × $2 million). Separating the land value from the building value is particularly important in areas with high land values (coasts and cities) and less important where the land value is less than 30 percent of the value of the property.

Clearly these expenses won’t be evenly distributed. With respect to new construction, the first two years tend to be expenses that are more related to finishing work versus maintenance. Years 3–10 tend to not have as much maintenance, but homeowners tend to underestimate the deferred maintenance that is building up.

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