Why homes aren’t investments, cont.

By Felix Salmon
December 9, 2009
this, in defense of housing-as-an-investment:

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Do you ever get the feeling that you must be right about something just on the strength of how ludicrous people sound when they argue against you? Take this, in defense of housing-as-an-investment:

Say you live in a neighborhood that you believe is going to clean up, crime will go down, housing stock will improve, and rent is going to go from $500 a month now to $1,000 in three years and then grow at 8% a year perpetually…

And say that you’re right, and say that no one else is as perspicacious as you are, which means that houses in that neighborhood are still cheap. Then yay, you’ve just found a gold mine!

Except, beware confirmation bias. “Housing markets are extremely local; block by block even. It’s much easier to spot a trend that others haven’t, and have local knowledge that others don’t, when the relevant market is your neighborhood,” continues Adam Ozimek.

I’ve got many friends who bought houses in London or NYC, saw both rents and property prices saw, and ended up making mark-to-market profits often exceeding their total lifetime earnings. That’s a good sign of a bubble, but at the time it seems like a sign of farsighted and insightful investment prowess. The point is that either property prices in general go up, or else they go down. Real estate is pretty much never a good investment in a down market, no matter how granular and detailed your local knowledge is. Meanwhile, in an up market, it doesn’t matter much either. Yes, that gentrifying neighborhood is going up in value. But so’s the old-money neighborhood a mile away, and so’s everything else in a 20-mile radius.

Remember that it’s sometimes not a good idea to buy a house even if your total monthly payments are lower than what you would be paying in rent on the same place. If prices fall, rents can fall too: just ask any landlord in New York City. And while the renters next door are happily renegotiating their lease so they pay $300 a month less than they were paying last year, you’re stuck with the same fixed mortgage for the next 30 years. If only you’d held off buying, your monthlies would be lower while renting, and you could buy now, if you were so inclined, at a lower price. Price the option: if you’re renting, you always have the option to buy. If you already own, you don’t.

Ozimek has other arguments, too, including the novel one that house investments are inherently leveraged while other investments aren’t. Well, yes, exactly. What that means is that a house can make you bankrupt in the way that other investments can’t: you can lose more money than you invested. And then there’s the bit about the “covariance with the rest of your portfolio”. OK, I’ll grant you that one: if the value of your home (not your downpayment) is somewhere in the region of 5% to 10% of your net worth, then congratulations, you’re very rich, and you can go ahead and buy what you like. For 99% of us, buying a home means putting our overall portfolio massively overweight real estate. And the only real way to justify that is precisely because a home is not an investment.

Ozimek finishes his argument with this rather bizarre rhetorical flourish:

A housing investment is more like buying a small business than it is like a security investment. In fact, it is buying a small business; the business is being your own landlord. Being a landlord is more likely to be a profitable venture if you have reliable renters who you can trust. As a landlord, you’re the best renter you could ever want, which makes being your own landlord less risky than being someone elses landlord. This is because being your own landlord solves the principal agent problem inherent in the rental relationship; the owner/renter interests are exactly aligned.

Huh? Living in your own home is like renting that home to yourself? Well, you are making rent-like payments to someone else — they’re called mortgage interest payments, and they’re going to the bank. Only in this case, if you find yourself in a situation where you can’t continue to make those payments, you can’t just move somewhere cheaper: instead you’re liable to end up losing all your money and your credit rating.

In any case, as a landlord, the best renter you could ever want is a renter who reliably pays more than your mortgage, and whose rent payments go up every year — maybe even by 8%! But there’s a problem here: even if the rental value of your property does go up a lot, you don’t reap the benefit of that unless and until you sell the house or move out and rent it to a second-best renter while looking for somewhere else to live yourself.

When unemployment is high, there’s a premium on mobility and the ability to go where the jobs are. Houses, by contrast, tend to tie people to one spot. And what happens if your neighborhood goes in the opposite direction to the one you’d hoped for, with crime increasing and all those overextended boutiques and coffee shops moving out? Try asking anybody who owns a home in Detroit whether houses are a good investment.

In my experience, most people who buy a home do so primarily for psychological reasons. They’re not bad reasons, necessarily, they just don’t make a lot of financial sense. People who insist that their home is an investment tend to be people who would have bought anyway, but who are just casting around for good-sounding reasons to justify their actions. They should just be happy that they have what they want.

Update: Ozimek replies.

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Comments
24 comments so far

Hi Felix, do you have any thoughts on good sources of information for people who are considering buying a house? It may not be a good investment, but there is still a difference between a poor investment and a disastrous investment.

Posted by JonHocut | Report as abusive

@JonHocut –

A.
The an excellent indicator of a good deal is if you can get a 30 year fixed mortgage (with 20% down) that is cheaper than the equivalent rent you would pay for comparables.

B.
Another excellent indicator of a good deal is if the ratio of (price)/(1 year of rent on comparables) is in the range of 12 or less.

One more factor:
The same house may or may not be a good deal depending on the buyer. Specifically, what kind of interest rate can the buyer can get? What may be a good buy for someone facing 5% fixed interest may not be such a good buy for someone looking at 7.5%.

The other factor is to avoid buying more house than you need. A 5 BR for a family of six? Sure, if you can afford it! A 5 BR for a family of 2? Waste of resources and money!

Posted by DanHess | Report as abusive

Felix –

Homeownership is a terrific pseudoinvestment. The best pseudoinvestment most people will ever make. If done properly, it will chain people into a forced-savings regimen that will leave them much better off financially than they would otherwise be. It will also chain them into the kind of routine existence that is good for their financial health.

There is a reason homeownership is the foundation for much of the wealth in this country.

Posted by DanHess | Report as abusive

Ha!

More renter self-confirmation claptrap!

Posted by davew | Report as abusive

Mmm, I kind of agree with the sentiment – houses are not a easy route to riches, which is what people in Britain believe(d) – but I can’t quite agree. When you buy a house, a bit like buying a washing machine, you are paying now for a stream of consumption later. Which is an investment. Contrast with watching a movie.

The problem with that simplistic argument is of course most people can’t afford to buy a house, so borrow against it. But that isn’t necessarily wrong, again look at how people (traditionally) bought washing machines.

This sounds a bit irrelevant, but it comes to my main point which is houses are great pension assets. Shelter is about the only aspect of consumption you can reliably be sure you will want when retired, and furthermore can stockpile in advance. It’s like tin baked beans, but much nicer. Thus insofar as you know 20% of your income in retirement will go on housing services, to save reliably for that now is a good thing.

[As I said otherwise I agree with you. I'm not sure about this 'option to buy' though if you are renting. Doesn't an option have a fixed strike price?]

Posted by mjturner | Report as abusive

It’s “soar” not “saw” just FYI. Although right now they are more likely to “saw” in half, IMHO.

Felix is right that it is a highly levered bet that you are making and hence the chance of bankruptcy is considerably more than zero.
However, you can significantly mitigate that risk by building in a substantial “rainy day fund” in case you are made redundant for example, 24 months of mortgage payments should be enough…

However, to claim you are a 30 year bear on property is a strange call.
Also, don’t forget the convenience and tax efficiency of saving by paying off the capital in your mortgage. Most morons taking this option don’t even realise they are saving and actually compare principal+interest payments with renting in their affordability calculations giving even further margin for safety.

Posted by TinyTim1 | Report as abusive

[Quote] Price the option: if you’re renting, you always have the option to buy. If you already own, you don’t. [/quote]
So owners don’t have the option to sell and rent? In practice they don’t, but that’s an argument in favor of home-ownership.

Posted by Mr.Do | Report as abusive

I think homeowning is pretty much a wash financially. As noted above, it’s consumption– but, in addition, your home is an asset, so mortgage debt is some combination of good debt (borrow to control an asset whose value is likely to increase in the long term) and bad debt (borrow for consumption).

Posted by MattF | Report as abusive

Most of us do not buy a house, we buy a loan, a 15 or 30 year loan. We don’t own, we owe. There is a write-off with the interest, but most of us are not in the right tax bracket to take full advantage of it. There is upkeep and upgrades that must be done and the costs involved to do them. When you add it all up, we probably paid more than we would ever get back when we sold. Having rented and owed at the same time for a twelve year run, I liked the rental the best. It came with a super who did everything. All I had to do was concentrate on making money to pay for everything. Just before the bubble burst, we sold the house for triple what we had bought it for. I didn’t want to sell it but I knew; you sell high. That house gave me a certain serenity, not security, that looking at a computer screened portfolio can never give. I know in my head that portfolio makes more cents. But in my heart, sitting on the deck of that house on weekends and summertime made more sense.

Posted by beachpaul | Report as abusive

Gentrification advocates are some of the most obnoxious people around. But really, old habits die hard and financial illiterates have a strong pro-homeownership bias.

See :
http://worthwhile.typepad.com/worthwhile _canadian_initi/2009/12/reflections-on-t eaching-very-basic-finance-to-first-year -economics-students.html

Posted by lemarin | Report as abusive

davew, I own my home.

I would love to see a rental property, apartment, condo, home, whatever, that sees its rent go from $500 to $1000 over the next 3 years. The 8%/yr increase implies inflation at 8%. In that case, your fixed-rate mortgage is more of an inflation hedge than anything else. If your interest rate is lower than inflation than your real interest rate is negative.

Matt is correct that housing is a combination consumption/investment.

FWIW, my mortgage payment, PITI, is less than what we’d pay to rent a comparable unit, not even accounting for paying in equity and tax savings. If your PITI is going to be well above rent, you really need to crunch the numbers.

Posted by winstongator | Report as abusive

small note regarding this discussion:

The etymology of mortgage is “death pledge”

Posted by falconium | Report as abusive

I am quite certain that for those who have enough cash to buy a home outright, and who have reasonable locational stability, ownership is best.

As a renter, you are earning someone a profit: your rent must include a return above the cost of the landlord’s capital and expenses. To use Ozimek’s analogy, that ‘profit’ might as well flow to you.

Add to that the fact that you get to bank part of the mortgage payment and payments can be made to never ever increase, and it is better to buy most of the time, if you can get a large downpayment and therefore a good fixed rate.

There are those who wonder if we could be looking at a long-term market like Japan has seen, but there could hardly be a worse analogy. In a country facing demographic collapse (Japan) real estate prices must go into secular decline. Even though Japanese population hasn’t crashed yet, new household formation has long been in steep decline. In a growing country such as the US, the opposite is true (long term of course! We still have an overhang to work through.)

Posted by DanHess | Report as abusive

How bad is Japanese real estate? Just think: They face a permanent overhang of homes that they will never be able to work through, ever, because of their demographic problems.

Posted by DanHess | Report as abusive

Thoughts on this conversation. A house can make you money when you sell it. A house can also make you money if you rent it. Unfortunately, there is not a discussion on why people like my grandmother used to buy houses: Ownership so you don’t have to pay rent to someone else. Money you don’t have to pay in rent is money you don’t have to earn just to survive. A home that is paid off effectively provides passive income equivalent to the rent you’d have to pay for equivalent shelter. I have experienced some lean periods in my life, living off of ramen noodles and buying clothes at Goodwill. It does not cost very much to survive in this country if you don’t have to worry about shelter. Once your house is paid off, life is cheap.

Posted by SSC | Report as abusive

Homeownership is the ilusive American Dream! I think is a ripoff invented by the bankers to enslave the working and middle class. 30 plus years of paying interest. Oh!… but his is a capitalist society. The government should issue housing loans with minimal interests or credits against taxation. Crazy? I hated to see my mortgage statement. I paid 600 a month, 567 went to interest ad 27 to principal. Took chapter 7 and got rid of it!

Posted by dconcept1 | Report as abusive

This question should be looked at from a different angle, and in relation to my biggest question about the housing bubble – why the geographic dependence? My theory is the prevalence of property speculators/investors/vacation home buyers – whatever you want to call them. They ‘invested’ where property looked to be the best ‘investment’ – FL, CA, NV, AZ, and then ski type places in Idaho & Utah (look at some of the smaller failed banks in those regions). What drove a lot of this was the lax enforcement of tougher loan standards for non-owner occupied homes. People were buying 2nd, 3rd, 5th homes with 0-10% down. Then using pay-option arms giving a pay rate of 2%, when for a 2nd+ prop should have been in the 8% ballpark. Add 20% appreciation to your first ‘investment’, you can cash out and triple down!

The areas that were seen as the best ‘investments’ turned out to be the worst places to invest. This fact alone should sound alarm for those advocating housing as an investment.

Posted by winstongator | Report as abusive

It’d be very helpful if you could define what you mean by ‘investment’ – I think that’s missing from the discussion. I watched a successful lawyer in Italy rent his entire life, and when he retired he had to rely on his daughter to support him because he could no long afford the rent – his happy-go-lucky lifestyle meant he’d never really put away enough and his pension couldn’t cover medical costs.

I think this is a case of the ‘commitment device’ principle of a home. It’s hard enough to convince 30-40 year olds that putting money into a pension is a good idea. But convincing them to buy a house seems easier.

Posted by nicfulton | Report as abusive

Felix, have you ever thought about running the numbers behind home purchases before jumping to conclusions that they are a bad investment?

Lets take for instance the situation of a person who makes $50,000 per year and buys an $100,000 home in an inner ring suburb and puts his standard 20% down.

In year one, this tax-payer will receive an $8000 first time home-buyer tax credit, will receive a $4700 mortgage interest tax deduction, and right around $2500 more for property tax deduction. Because of the tax-payer’s income, he’s in the 25% tax bracket and will have an $1,800 reduction in his income tax liability. Over the course of a 30 year mortgage, the tax-payer will have paid $92,000 in interest and $75,000 in real-estate taxes, these would translate into a tax-benefit of $41,000 over 30 years for the tax-payer.

Additionally, if we have a particularly prudent tax-payer, he will purchase his car with a HELOC instead of financing as an Auto-Loan. Lets say he buys a reasonable Honda Civic and finances $15000 of it. Over 5 years, the tax-payer will pay $2800 in interest on the loan. Since it’s a HELOC instead of an Auto loan, the interest is deductible, and tax-payer will realize a $700 benefit. He’ll buy three civics over thirty years for a net benefit of $2,100. Purchases like this are made regardless of the method financed.

Now, finance your dental work or medical bills with a HELOC instead of CareCredit, pay for your child’s college tuition (and double dip deductions), etc. and you can see how the benefits add up. But for purposes of this, lets leave it simple. You Receive a 30 year benefit of $43,800 from tax-benefits that a renter would not have. Additionally, assuming that home value grew at the CPI of 2% annually, the tax-payer has a $170,000 asset.

Typically, a homeowner spends 10-15% more buying a home than a comparable renter (because of maintenance, taxes, insurance, etc). This homeowner is paying $900 per month for mortgage, insurance, taxes, water/sewer and routine maintenance. Lets give Felix the benefit of the doubt and we’ll assume a renter pays 25% less for that home and has a first year rent of $675 per month that increases 2% with the CPI.

At the end of 30 years, the renter would pay $4600 more over 30 years than the home-owner.

Even if we again give you the benefit of the doubt, and assume rent never goes up, and that the renters will invest their money and return 5% average on it over 30 years, they’ll end up with $170-$180k. This is still substantially less than the net assets of the home-owner (whose assets do not reflect investment). If the homeowner invests at the same rate, the asset value shoots up just short of $300k. To match that, the renter needs an 8-9% average return.

Is a home an investment? Only to the extent that you take the time to effectively utilize it.

Posted by johnathontaylor | Report as abusive

Johnathon, I laughed out loud at the idea of a $100,00 home in an inner-ring suburb. Redo your example for a major non-sunbelt city, take into account the desire to live in a good school district, and your math falls apart. But if I want to live in Boone, Iowa, I’m sure this can be a fine investment.

Posted by Anonymous | Report as abusive

I can’t read the entire thread, and suspect these points may already have been made. No one should buy a house mainly to make money. There are better and more direct ways. But people should buy a house if they can expect not to lose money. (Here, the mortgage interest deduction helps mightily). Buying a house, and living in it for a while, attaches you to a community, and invests you in it, in a way nothing else does. Having a community of people with equity in their community is a social good. It’s a good reason for (relatively minor) financial incentives for home ownership.

Posted by Matthoboken | Report as abusive

A point that seems to be largely ignored by the “rent promoters” is that outside of major metropolitan areas where housing prices are very high, it’s simply cheaper to buy a house than rent one. I live outside Houston and pay $750 a month to rent a house that is only worth $56,000. My rent is significantly cheaper than the going rate of $800 for a 2 BR apartment or $1000+ for a house because I know the home’s owner and the home is in fairly severe disrepair (cracked walls, leaky pipes, etc). However, if I had purchased this home on a 30-year loan, I’d be paying less than the $750 a month I am now.

The only reason I’m renting is that I just moved to the area and didn’t have time to look for a home to purchase before my transfer went through. In this area, it’s just much cheaper to buy than to rent.

Posted by Anonymous | Report as abusive

In support of Johnathon, new home construction in the Tulsa area is around $77-$86 per square foot (I paid $72 a couple of years ago for an ’04 build – I negotiate pretty good). A 3 bdrm home build in ’63 would run around $80k in a medium neighborhood. The Houston area is even less expensive. Additionally, the pay in Tulsa is pretty good, the unemployment rate is low, and the crime index is likewise low. Google these things if you doubt me. I used to live in Los Angeles and the weather is great; however, the weather where I live has its benefits, too (e.g. lots of green due to higher rainfall).

I don’t know why people continue to overpay for housing in areas such as the Los Angeles. I used to think there was more opportunity, but that seems to be a myth given the current rate of unemployment out there.

Posted by SSC | Report as abusive
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