With interest rates projected to rise and inventory increasingly tight, the window for purchasing a second home at an affordable price may be starting to close.
Such sentiment has helped to fuel the recent boom in vacation property sales among affluent investors, many of whom are feeling flush on the heels of a six-year stock market rally. Demand is particularly high among baby boomers who are prepositioning for retirement.
“Last year’s impressive increase reflects long-term growth in the number of baby boomers moving closer to retirement and buying second homes to convert into their primary home in a few years,” said Lawrence Yun, chief economist for the National Association of Realtors (NAR).
Vacation home sales rose 57 percent last year over 2013, to 1.3 million properties, well above their most recent peak level in 2006, according to NAR. In fact, vacation home sales accounted for 21 percent of all real estate transactions last year, their highest market share since the survey was first conducted in 2003. NAR found in a survey that 85 percent of vacation buyers think now is a good time to purchase real estate.
Does it make sense to double down on real estate, especially in light of the interest-rate outlook and inventory dynamic?
Three main themes emerge when you consider a real estate investment properly.
1. Only buy a second home from a position of financial strength—gamblers need not apply.
Potential buyers should not consider the purchase of a second property if their job security is in question or it compromises financial goals that are higher on the list of priorities, said Diane Woodward, a certified financial planner with Oak Tree Wealth Management. “Is your own financial house in order?” she said. “Is your retirement in good shape? Are you able to keep up with college savings for your kids?”
Those considering the purchase of a second property should beef up their financial safety net, Woodward said, noting six months to a year’s worth of living expenses (that includes the new housing payment) in a liquid interest-bearing account is appropriate.
Banks have tightened their lending practices in the wake of the housing crisis, too, so buyers these days must have a stellar credit rating to qualify for the lowest rates and keep debt levels under control. Most lenders want your debt to be no more than 36 percent of your monthly pretax income, which includes both home payments.
Buyers should also come to the closing table with a 20 percent down payment to eliminate the monthly expense of private mortgage insurance—money that could be put to better use in the markets, Woodward said, where long-term returns are higher than real estate returns.
“What’s more important is what’s going on in your personal economy rather than the U.S. economy.”
“When I was working at traditional financial-planning firms, it was often the people with second homes who were having difficulties retiring early (or at all) because the cost to maintain two properties is so high,” said Sophia Bera, a certified financial planner and founder of Gen Y Planning.
Historically speaking, the median single-family home has appreciated 5.4 percent since 1968, while the S&P 500 index of blue-chip stocks has produced an annualized return of roughly 6.7 percent. (The value of vacation homes in more popular destinations may grow more quickly, so it’s important to research historical price appreciation in any market you are considering.)
Real estate can be a wise asset-allocation play—it’s an investment not correlated to stocks, but consider the following: The recommended allocation to real estate in an average investor’s portfolio is (or should be) a much smaller component of their asset allocation, whereas a second home is a disproportionately large, illiquid asset being added to the mix.
So if your motivation is price appreciation alone, you may be better served in the stock market, said Bera. And real estate is far less liquid than equities. In a financial pinch, you may not be able to sell your second home quickly at fair market value. In fact, it could take years.
2. Additional costs can add up and eat into the benefits of buying a second home.
Craig Venezia, author of “Buying a Second Home: Income, Getaway or Retirement,” estimates that insuring a vacation home that gets rented either in part or in full costs about 20 percent more than a primary residence.
Where rental properties are concerned, tax rules differ, marketing costs exists, and added medical and liability insurance coverage may be required. (If you rent your home for more than 14 days a year, you will need to report rental income and your state may require that you pay sales tax on that income. But you will be able to deduct rental expenses, including repairs.)
Those who plan to rent their property for added income should investigate potential return more aggressively. Is the opportunity to rent seasonal or year-round? Is the property close to local attractions, such as a beach or a lake, which makes your home more marketable? Do you need to hire a property manager? And how much can you reasonably expect to make in rental income, relative to similar properties?
Where vacation and rental homes are concerned, due diligence on owner communities is critical. Vacation homes are often built in communities with a homeowner’s association, which divvies up annual maintenance fees among its residents.
“If any of the homes in that community get foreclosed upon, that puts tremendous pressure on the other homeowners to pay those fees,” Woodward said. “Make sure that the community you’re buying into is in good financial shape.”
Lastly, be aware of the added costs associated with owning a second home. You may need to pay a handyman, for example, if you don’t live close enough to fix leaky pipes or leaf blow yourself, and flood insurance is often required for properties near the water.
“I am not a huge fan of buying second homes, but I am a big advocate of investment properties,” Bera said. “Usually people don’t use their second homes enough to justify the costs. It would be cheaper for them to rent a furnished apartment for a few months a year and then change locations if they decide to try a different country, city or apartment for a while.”
3. The value investment play may have already peaked, so scrutinize deal pricing closely.
With interest rates still historically low, buyers who can afford the costs of owning a rental property may be wise to act now before rates and prices head higher, Bera said.
Yet despite strong rental demand in many markets, investment-home sales have been less robust.
The sale of residential properties purchased primarily to produce rental income, or for potential price appreciation, declined in 2014 for the fourth straight year as rising home prices and fewer distressed properties coming onto the market have reduced the number of bargains available to turn into profitable rentals.
Even so, 68 percent of investment buyers surveyed by NAR indicated they are “very” or “somewhat likely” to buy another investment property in the next two years.
So the iron may be hot for buying a second home, but that doesn’t mean it’s right for you. Before you saddle yourself with another mortgage, make sure you factor in your other financial goals, research the market carefully, and crunch the numbers to be sure you can comfortably afford the costs.
“What’s more important is what’s going on in your personal economy rather than the U.S. economy,” Bera said.
—By Shelly Schwartz, special to CNBC.com