I just spent a few days at the beach in the Hamptons, New Yorkers’ favorite place to show off their tans and their real estate. To be precise, I was in Montauk, which is a little more laid back than the Hamptons, but has recently become the hottest beach location.

In the real estate status game, I get additional points for staying at a place that is not only south of the highway, but literally steps away from the beach. Unfortunately I don’t own this place, it was just a rental. At the end of my stay I dismantled the poles, folded up my tent, and sadly said goodbye to Hither Hills campground. I must say it was a very pleasant and liberating way to enjoy the beach.

Tent pitched on a field of grass My Hamptons manse boasts 6 foot ceilings and room for a queen size air mattress

This experience got me thinking about second homes. Does it make sense to own or should you rent? Would you be better off by renting your second home and choosing a separate investment that can maximize your returns? Being a real estate guy who has owned vacation homes, I was a little embarrassed to realize that I had never tackled the problem in the serious way that it deserves.

This 12 bedroom home in the Hamptons has a bowling alley, a rock-climbing wall, and a home theater with five screens. You can rent it for two weeks for $500,000 just like JayZ and Beyonce did. It’s not on the beach though.

Of course there are many reasons to own a home besides the potential return on investment. There is the comfort of having your favorite toys, books, and furniture waiting for you when you arrive, and the ease of getting away without a lot of advance planning. I merely want to address whether a second home is a good financial investment.

Let’s compare the two options. You can use a portion of your savings to buy a second home, or you can invest the same money in an investment property and rent your home. If you buy, you will incur the costs of ownership and you will also benefit from any appreciation in the home’s value. If you rent, the current return from your investment will help to offset the rental cost, and you may receive capital gains from appreciation of your investment property.

So, what’s the net effect of all this? The first trick is to honestly examine the cost of owning the home. It’s common to underestimate these expenses. Since it’s hard to find a house in the Hamptons for less than $1 million, let’s use a more reasonable example in New York’s scenic Hudson Valley.

Typical Second Home Expenses
Purchase Price $300,000
Mortgage Debt (66.7%) $200,000
Equity Invested $100,000
Mortgage Payment (P&I) $11,458
Interest Cost

(4.0% rate)

$8,000
Tax Benefit of Interest Deduction (35%) ($2,800)
Property Taxes $6,500
Insurance $1,500
Condo Fees $0
Maintenance,Repairs, Landscaping, Pool, etc. $7,200
Annual Cost to Own $19,800
Annual Price Appreciation (3.3%) ($10,000)
Net Cost to Own $9,800

The Annual Cost to Own is your net cost, after taking tax deductions into effect. Principal payments are not included in this because they are not really a cost – they are reducing your loan amount, and increasing the equity in your home.

These inputs may vary considerably depending on the location, condition and cost of your house, your tax situation, and other things. A few important assumptions and considerations include:

  1. Tax Benefit: Mortgage interest is deductible up to $1.1 million of total mortgage debt, for your primary and secondary residences combined. This analysis assumes that you are able to fully utilize the mortgage deduction, but if you have a large mortgage on your primary residence, you may not be able to take the full deduction on your second home.
  2. Property Taxes: These often go up when you buy a house, because the house is reassessed at the new purchase price. Make sure you calculate property taxes at the going forward rate, not last year’s rate.
  3. Maintenance and landscaping costs: They are often higher than expected. That beautiful English garden may cost you more than you realize, not to mention the putting green. Get bids from local service providers before you buy the house.

Now you know the annual cost to own your home, but how much will it appreciate? That of course, is highly dependent on the location of your home. Nationally, homes have appreciated at an annual rate of 3.3% for the last 25 years. A simple way to look at this is that your $300,000 home will appreciate by $10,000 a year, assuming the average growth rate. If you offset your annual expense of $19,800 with this gain, you end up with a net annual cost of $9,800.

Is 3.3% a realistic rate of appreciation? In the short run, many second home markets can appreciate more than this. But keep in mind that prices in many second home communities are much more volatile than the national average. When the economy goes south, owners may need to sell their weekend house to stay afloat. This makes it tough to come up with a reliable price projection so you may want to use a range of growth rates when you do your calculations.

The cost to rent a home comparable to the one in the example would be $2,000/month, or $24,000 for the year. Let’s say that you invested your $100,000 of equity at a total expected annualized return of 15%. This $15,000 of income offsets your rental cost, and you are left with a net cost of $9,000.

Let’s look at the alternative scenario, where you rent and invest.

Now, 15% may seem like an ambitious rate of return, and it clearly will require you to take some risk. The reason I am assuming 15% is that it is roughly the rate of return you should expect on a real estate fund that uses the same amount of leverage you would have on your second home. Since your purchase of a second home is a real estate investment, comparing it to a real estate fund is more fair than comparing to a bond fund, for example, which would produce lower returns but also entails less risk.

As a reference point, Blackstone has produced an average annualized net return of 17% on its 8 real estate funds, and many lesser known managers have produced higher returns than that. As they say in the disclaimer, “individual results may vary”. For example, returns on individual Blackstone funds have ranged from 11% to 40%.

Here’s the upshot. In this example, it’s practically a dead heat. Renting would be $800 per year cheaper than owning.

Comparison to Rent and Invest Strategy
Annual Cost to Rent $24,000
Income from Investment (15.0%) ($15,000)
Net Cost to Rent $9,000
Benefit to Rent vs. Own $800

Does that mean you should be indifferent between owning and renting? No – in many situations, one option could be significantly better. So here are some factors that can swing your decision:

Factors that Favor Owning
  1. You are buying in a strong market that is not overly dependent on second home buyers
  2. You are buying a house with relatively low property taxes and low maintenance requirements
  3. You love to talk about your beach house at cocktail parties
Factors that Favor Renting
  1. You can’t fully utilize the tax deduction
  2. You don’t use the house year-round, so you only need to rent for the season
  3. You prefer to talk about your amazing investments at cocktail parties

For me, the day will probably come again when I want to own a place where I can sleep in my own bed and invite friends and family on a moment’s notice. But for now, I’ll spend $35 a night to pitch my tent on the beach and invest the difference more productively.

Mitch Wasterlain
[email protected]

Originally Published on Physician on FIRE on September 15th, 2016, and on Barron's on September 22th, 2016.