How buying a home is gambling

By Felix Salmon
December 11, 2009
Ryan Avent adjudicates the homes-as-investments debate, and comes to a positively Solomonic conclusion:

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Ryan Avent adjudicates the homes-as-investments debate, and comes to a positively Solomonic conclusion:

Sure, it’s fine to think of homes as investments, so long as the kind of investment you have in mind is the highly risky sort you wouldn’t recommend to anyone who didn’t have the ample knowledge and financial cushion you’d expect to see in a successful entrepreneur. And that does not describe most potential homeowners.

I think that both Adam Ozimek and I might well agree with that. Here’s Ozimek’s latest:

I agree with Felix that buying a house is not a certain investment; you can lose your money and your home. Obviously in the past few years many people have, and that’s terrible. Where I disagree, is with his contention that since the outcome is so bad, the potential investment returns are never worth it, and you should stick with other investments which don’t have the added downside of homelessness…

Why can the potential cost of losing your money and your home be worth it for the consumption or psychological benefits, but not for benefit of potential financial returns?

The problem here is that no one ever buys a house with their eyes that wide open, fully cognizant that they are taking a calculated risk in which they know full well that there’s a non-trivial probability that the consequences of their “investment” will be foreclosure, bankruptcy, and homelessness. Investments don’t work like that: if you’ve laboriously saved up enough money to scrape together a downpayment on a home, that’s money you’re not going to gamble. The number of people genuinely comfortable with taking that kind of downside risk is basically zero, as it should be. (Remember that most homeowners have families to support: they’re not just gambling their own livelihood, but that of their family too.)

So yes, Adam, I do feel comfortable giving this much investment advice: no potential investment returns are worth it if the downside is that there’s a good chance that you’ll end up financially devastated. That’s not sensible diversification: it’s putting all your eggs into a basket that you have essentially no control over. Avent is right that buying a home is a bit like starting a small business, but the big difference is that the value of a small business comes in large part down to the owner. Whereas in the property market, the owner can only affect value at the margin.

If you have essentially no control over the outcome of your investment, and you have no way to exit that investment if it starts to go bad, then you’re a gambler. And as Avent says, that does not describe most potential homeowners.

Update: Konczal also weighs in, and reckons that buying a house is basically the same as buying a hedge fund with a 2-and-66 fee structure.


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How does losing ownership of a house force people into homelessness? Aren’t they really being forced into renting, which is where they would have been anyway? I’m not saying it isn’t terrible to lose all the money you’ve put into a home. But I am tired of all the people talking about the horrors of having to go back to being renters like all the unwashed masses.

Posted by JonHocut | Report as abusive

When buying a primary residence, the investment value should never be the primary decision criteria. If it were, you would always choose the biggest house you could afford, to maximize your investment returns. You are still ‘consuming’ your whole home, even if you are not using it. You minimize wasted consumption costs by buying a home well suited to what you are actually going to use the home for. This matches well with many who had the worst investment returns in this recent market – buying more home than they needed.

Even Ozimek pretty much acknowledges the fact that residential RE’s main investment advantages are inflation hedges (through FRMs) and leverage. If you look at areas outside RE that invest like that, it’s pretty much hedge funds.

Doesn’t Buffett have an idea about controlling the outcome of your investment by paying careful attention to how much you pay for it, especially relative to its cashflow (comparable rent)? Your control over your return in a real estate investment has a lot to do with how much you pay for the property, which will correlate with property value cycles.

Posted by winstongator | Report as abusive

most mortgage loans are non-recourse so you can return the house if you can’t make the payments. painful, but it wouldn’t cause bankruptcy on its own.

Posted by q_is_too_short | Report as abusive

> the fact that residential RE’s main investment advantages are inflation hedges (through FRMs) and leverage. If you look at areas outside RE that invest like that, it’s pretty much hedge funds.

uh, no. a house is a capital intensive investment that pays cash flows over time. in a financial it’s the same as a factory you might build and then rent to someone to produce things, or a pipeline (again, you build it and rent it out), or a forest, or a farm, or anything of the sort. the fact the nominal value increases with inflation (or the size of the economy) whereas the payments do not is always taken into account when you value ANYTHING.

the economics is the same whether you live in it or rent it out. how can these two cases be different?

the proper measure would be return on equity. is felix salmon or mike konzcal doing this calculation? no…. but this is business 101.

Posted by q_is_too_short | Report as abusive

I hadn’t been following closely; it kind of mystified me that you might really think housing isn’t an investment. It now looks to me like you’ve defined “investment” with stocks as the archetype. Housing is obviously an investment, though it may be valuable not to emphasize that point in your head as you buy; like any investment, it has risk, and unlike stocks, it’s not liquid.

Rortybomb manages to count only appreciation as the return from this investment, when there is a current return as well, i.e. the rent you would otherwise have paid, net of maintenance costs and property taxes and the like. Excluding imputed rent from the returns to owning a home in order to argue that it’s a really terrible investment is comparable to excluding imputed rent from the returns to owning a home to argue that renting is “throwing your money away”; it’s wrong both times. Living in a home really is valuable; in fact, it’s the only reason houses are worthwhile. You shouldn’t expect it to be free.

Posted by dWj | Report as abusive

Oh, I forgot one of the big points I wanted to make, which was leverage. Leverage is one of the places people get into trouble with investments, and not least home investing.

Ken Lay had almost all of his wealth in Enron stock, and someone suggested he diversify, so he borrowed against the Enron stock to buy other investments. This obviously — well, I think it’s obvious — doesn’t solve the problem. Now he has all of his wealth in Enron stock, and another half of his wealth in the other investments. Not good. Similarly, if you’re 30 +/- 5 years old and think buying a home is just something you do, there’s a very, very good chance that the home you’re buying is more than all of your wealth. The fact that you were able to borrow much of the payment not only doesn’t change that, but is the only reason that’s possible.

Which also gets to the diversification issue. As you note, you can’t diversify an investment in your own home, because it’s indivisible and is a large portion of your net wealth (for almost everyone), even if you’re 60 and have paid off the mortgage. Just as liquidity is not a defining characteristic of an “investment”, neither is the ability to hedge or diversify it. (If you think otherwise, you may well be spending too much time around traders.)

Posted by dWj | Report as abusive

In the places where housing has been a terrible investment, really the places at the root of the financial crisis, fully amortized non-teaser interest payments on homes were FAR more expensive than renting comparable homes – 2 to 3X. If your payment is less than your cost to rent, and you put a small value on the ability to move without paying 6% comission and possibly have to pay for your home while you live somewhere else, then it is an easy decision. For people during the bubble, this was not the debate they were having.

Homes that you can rent and be cash-flow positive are good investments, but lots of people looked at RE as an investment just by owning. A home that you ‘own’ but has no one living in it is a liability.

People are looking at return on equity, and the idea that if you reduce equity to 0, any return gives an infinite RoE. Negative returns also do more damage the lower your equity.

The whole argument should take a step back to individuals and whether they should or should not buy a particular home, whether to live there, vacation, or rent it out. If you look at particular cases, especially taking cases where you know the outcomes (bought in 2005, FC’d in 2008, etc) you can find elements to help people make better decisions. Lots of people made terrible homebuying decisions thinking homes were always great investments, and the consequences of those decisions are widespread well beyond just those individual buyers.

Posted by winstongator | Report as abusive

What excites people about real-estate investing is capital apprecitaion, not cash-flow. Can I sell today for more than I paid, or sell tomorrow for more than I might pay today. The flip side is what scares people most – will I be able to sell my house for what I paid for it. When you see a home on a block sell in June 2009 for 15% less than it sold for new in 2002, you have to think twice about buying a home on that block for 50% more than its 2002 new price. Real block, with real percentages. Better for analysis than hypothetical rent doubling over the next 3 years.

It is the bubble areas that had the most ‘investors’ (better to call them specuvestors), and where people today are most concerned about whether a possible purchase is a good investment or not.

Posted by winstongator | Report as abusive

JonHocut, the point is that at least when the rental market is tight, landlords are very happy to refuse to rent to people with bad credit. And getting foreclosed upon does devastate your credit.

I’m not advocating Robert Kiyosaki, but, he did mention in one of his books that you should not look at your personal residence as an investment. You should primarily view it as a place to live.

Of course, you should be smart in your decision-making process when you obtain a home. You don’t want to lose money.

But, if more people looked at as a place to live, many more people would have bought smaller, lower-cost homes and they may have been able to keep up the lower payments. That’s what I did.

I and my wife have been unemployed multiple times in the past few years (beginning before the financial crisis). We have not been late on any debt payments because the payments are low and reasonable.

Posted by kingdavidlives | Report as abusive