Guest Post: Housing is not a good investment
This is a guest post by Josh Snodgrass.
Housing is not a good investment, and it never was.
Our country has a special reverence for home ownership as a route to comfort and prosperity – and so provides subsidies and tax breaks. But, actually, housing is not nearly as good an investment as people think and it wasn’t so good historically, either. The big gains people earned from housing in the past were mostly the result of leverage, forced savings and inflation.
Many, white, middle-class American families have a story that goes something like this: They bought a home with a $10,000 down payment. While they raised their children there, the house grew in value to $250,000 which provided the funds to send their kids to college with something left over for their retirement.
This idyllic story led us to mythologize housing but it is just that, a myth. While the facts are true, the growth is a mis-perception. While things turned out well, the house was not that great an investment. Here is the full story.
The $10,000 down payment was only one-fifth of the total cost of a $50,000 home. So, instead of a 25-fold increase in value that they perceive, the price increased “only” 400%. Even 400% doesn’t seem bad, but considering that it took decades to earn, it wasn’t that great. Most financial investments we hold for decades grow to a multiple of their cost. The reason houses seem special is that they are the only asset we hold that long. Actually, the gain on houses typically just barely holds its own against inflation.
The key to turning a mediocre gain into a big one was the mortgage that they took out. If you only put up a fraction of the money but get all of the gain, you can multiply the returns earned. Wall Street loves this game and calls it leverage. But, it has a downside.If prices drop, you lose bigtime – as millions of families losing their houses to foreclosure these days are learning to their sorrow.
The mortgage was key to the myth in two other ways. In addition to the $10,000 the family put up when they bought the house, they may have paid a total of $100,000 on their mortgage, but since this was in relatively small monthly payments, it tends to be ignored when people do mental accounting on the investment.
The need to make monthly payments effectively required the family to save regularly – something we have trouble doing if we aren’t forced to do so. Saving regularly is a good thing. So the saving they had to do to pay the mortgage, more than the house, was what resulted in their having money for the kid’s college and retirement.
So, is this a good strategy after all? Not really. Buying a house on leverage is a risky investment. Home prices do go down, more often than we realize. And, with leverage, a 20% drop in price can wipe out all of the family savings.
In addition, home prices have been propped up by tax subsidies, low interest rates and the mythology. We cannot be sure their prices will even keep up with inflation in the future.
mathbabe 
Great. I would like to add the footnote (or a link in the text) about government creating ghettos when you have a chance. The others aren’t important. Historian Says Don’t ‘Sanitize’ How Our Government Created Ghettos | | | | | | | | | | | Historian Says Don’t ‘Sanitize’ How Our Government Creat…Richard Rothstein, who studies residential segregation in America, concludes: “Federal, state and local governments purposely created racial boundaries in these cit… | | | | View on http://www.npr.org | Preview by Yahoo | | | | |
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I said this was something many white middle class experienced.
Blacks experience was much worse, due to government discrimination.
http://www.npr.org/2015/05/14/406699264/historian-says-dont-sanitize-how-our-government-created-the-ghettos
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This analysis ignores imputed rent — yes, this is actually a phrase. Imputed rent is the money that you’re saving by not having to rent. In almost all localities, this amount is a significant fraction of the mortgage; sometimes it’s even more than 100% of the mortgage! (Speaking of which, property taxes and maintenance costs are also a significant fraction of the mortgage, but almost never exceed the imputed rent.) Imputed rent is tax-free, and property taxes are tax deductible (if you itemize), and these tax subsidies are also significant.
Although the outcome varies by location, my experience is that in most places home ownership is the profit-maximizing strategy after factoring in imputed rent, assuming that you own the home long enough to offset transaction costs (typically 3-5 years).
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Yes, it is oversimplified. it ignores imputed rent. Also taxes, maintenance and other costs.
I think the basic point that housing is not as sure a thing as perceived is valid. Also, you are basically saying that houses are typically good because of tax advantages — which are real but not what is being sold in public policy about housing.
You won’t find any politician saying “l;et’s subsidize housing because the rest of us should give homeowners a break.”
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Yes, housing is not as sure a thing as perceived. Shiller added a section to his book in 2005 on that. Timely, huh?
The tax advantages of homeownership, by contrast, are huge, especially for those with high incomes:
– the mortgage interest deduction is exempt from AMT
– the first $500k of capital gains on your house are exempt
– no tax on imputed rent less depreciation and maintenance
A traditional mortgage, moreover, is quite an instrument:
– it is callable (no prepayment penalty)
– it is salable (via explicit assignment, or wraparound)
– it is non-recourse (if you are underwater, walk away)
In 2005, even with those advantages, renting was a better bet because prices were so high and rents so reasonable. Today? It’s less clear, since both prices and rents are high, and since tax advantages carry political risk. You can’t ignore them in an analysis, though, any more than the safety inherent in a fixed-term, prepayable, non-recourse loan.
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But the proper comparison is between buying and renting. Can you do something on this?
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The problem with comparing renting and owning is that they are very different in risk. You can do a static analysis and I believe DJ is correct that in the typical median case, considering the tax subsidies, owning is better financially. But, there really is a lot of uncertainty about what the house will be worth when it is sold which is often lost in these comparisons.
If you never plan to sell it and are sure you will not lose your job or incur medical expenses causing you to default on your mortgage, that doesn’t matter. But, most people aren’t in that position.
Of course, a renter is also subject to risks — particularly the risk that rents will rise.
I’m not trying to say you should never own a home — I own my apartment. Just that it is not as sure an investment than is thought, and that we shouldn’t subsidize it as we do.
The main considerations in owning v renting are not strictly financial.
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P.S. I am not saying it isn’t worth going through the exercise of looking at the running costs of owning v renting. First of all, you should understand what you are getting into in terms of a commitment. And, if it doesn’t look attractive to own, home prices in that area may be vulnerable.
But that analysis is very dependent on the specific location and property.
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Even when a mortgage is paid off, homeowners have continuing significant payments of insurance, repairs, upkeep, property tax, utilities far greater than a renter… my eldest sister, in her 70s, found home-ownership a huge burden, and told me how LUCKY I was to be renting.
I think there are plenty of reasons for owning a house, but agree with Snodgrass, that great financial gain is NOT one of them, especially if you can invest the rent savings wisely.
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I think if you compare similar properties then there’s no way homeownership minus a mortgage costs more than renting. You can’t compare a big house to a small apartment; that’s obviously unequal. For two properties of the same size in the same location with the same usage, the cost of (for example) utilities must be identical — how can it not? The same holds for repairs, maintenance, and property tax. Now, you might argue that the landlord includes this cost in the rent, and that’s certainly possible; but the landlord is not (in the long run) going to be able to sustain losses indefinitely, which means that those costs (if included in the rent) must be less than the rent. The only valid point in favor of renting is that you don’t have to deal with the hassle of handling those expenses, but usually this convenience would cost a premium, rather than representing cost savings.
Insurance is an interesting exception. Rental dwelling policies typically cost MORE than standard homeowners insurance — around 10-25% more, depending on location. However, this insurance only covers the structure, not the belongings, so one saves a little money there, if the renter doesn’t care about his or her belongings. If you compare like for like policies (with equal coverage), then again the homeowner should save money. Even if the cost is included in the rent, it must still be passed on to the renter in some form, or else the landlord loses money.
An additional piece of insurance that renters need, but rarely ever get, is liability insurance. If the rental unit is damaged through the fault of the renter, the renter can get sued for the damage. Even if the rental unit is otherwise insured, the policy belongs to the landlord, not the renter, so the insurer can still sue the renter!
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Where I live the landlord does pick up various of the utility costs (granted it’s built into the rent), and even if I had an apt. the size of a house I still would NOT have a front & backyard to keep up which can be a major cost. I have no property taxes and insurance is waaay less than it would be for a house (I do have both liability & belongings insurance).
But another big factor, I don’t think specifically mentioned yet, is what I’ve seen so many friends going through in the last decade: needing to move, but unable to pay two mortgages — thus having to sell their house in a bad market before they can buy elsewhere — HUGE binding hassle! (even renting elsewhere, means two unaffordable monthly housing bills for many).
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I’m one of those people. I tried to sell my house in 2008 (just weeks before the Lehman Brothers collapse). After a few months of watching the value evaporate in front of us to the point of being under water, we rented it out. We still have the house. We’re still losing money on it, but at a more manageable level now.
Another thing people ignore in the rent vs. own calculation is the transaction cost of selling. I think people stay an average of only 7 years in a house. A 6 percent realtor fee is going to eat into whatever appreciation you can get in 7 years or less.
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Homeownership cost a lot more than renting in 2005.
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I specifically stipulated homeownership without a mortgage, since I was responding to a comment that began with “Even when a mortgage is paid off …”
It is extremely, extremely rare and unusual for a home without a mortgage to cost more than renting a comparable home (ignoring of course opportunity cost of not investing the equity elsewhere, which I am pretty sure was the intent of the comment to which I replied).
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I agree that there are a lot of financial downsides to owning a home, but in the end it is still worth it. I took a college level American History class as an adult and a particular question was eating at me “Why did Native Americans agree to trade their land away for frivolous trinkets?” The answer was that in their culture there was no concept of a human being able to “own land”, you may have birth rights to hunt in a certain area but you could not own it! The land and everything on it is owned by the earth! I was blown away by this answer and have always looked at things in a different perspective. But here is the deal, while homes will always be a money pit. the land on it is on is priceless, especially given population growth. But just like stock, you have to choose wisely which house to own.
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That is a small part of the answer. The real reason Native Americans agreed to the things they did is that they were forced to.
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It’s not quite like that. Early land treaties had stipulations built in where Native groups kept their rights to hunt and gather lands, as well as continue to pass through them. Colonists just didn’t care and largely refused to recognize them, and colonial courts generally followed suit. Even when colonial courts found in favor of Native peoples, there was the problem of enforcement.
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Sorry. I added a comment myself. So this one is redundant and unclear. Could you please delete it?
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As an investment, buying a house may only be advantageous because of the tax subsidies and the leverage. Fine, but buying a house is also pretty much the only leveraged investment normal people can make, so an analysis of a house as an investment should include the leverage (and the tax subsidies).
More importantly, while making a leveraged real estate bet is certainly risky, there are major risks associated with not buying a house too. By buying a house (with a fixed-rate mortgage), you’re locking in your housing costs over the long term (aside from property taxes), which protects you if rents in the area rise faster than your paycheck (which seems to happen a lot). If your home goes up in value and you have to move, that’s fine. If your home goes down in value but you don’t have to move, that’s fine too. If your home goes down in value and you do have to move, that’s where you do get screwed. But with renting, getting screwed is almost a sure thing.
Ending the mortgage tax subsidies and regulating rental housing could change things considerably in the future of course, but whether on not buying a house is a good “investment”, in many cases it is still (perhaps even more so now, given the low interest rates) a good decision.
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This is a really critical point–probably more important than the tax advantage. You simply can’t make a 4:1 leverage stock market investment the way you can with personal real estate.
Hedging out housing costs (imputed rent) is also really important and (in my experience) really challenging to model properly. It’s pretty well known that rents rise over time and you can factor that into a model as an assumption on the rent-vs-buy calculation, but rate-shocking the factor gets more tricky!
FoW
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Renting demands far less of your time. When I leave an apartment I vacuum the floor, wipe down the kitchen and bathroom surfaces, take my things and leave. When something needs to be fixed, I walk over to the office and report it—no Angie’s List or Googling required. The next morning a fix-it guy shows up at no charge.
Right now I am in the process of preparing the only two properties I’ve ever owned, to put on the market. Perhaps because my house is located in the desert, its patio roof was designed without drainage in mind. Whenever it rains, a waterfall forms on one side, with the water unfortunately running across the wooden eaves before falling to the ground. This eventually caused a roughly seven-foot section of the eaves to rot.
If I fix this myself it’s going to take at least a week of my time (I know how to hammer a nail, but it isn’t something I do every day). Contractors charge and arm and a leg for this type of repair. This is just one among several massively time-consuming (or expensive) property-preparation tasks that are currently on my plate.
During the past three years I DIY’d two major yard projects for the house: (1) completely replaced/upgraded the sprinkler system (two weeks), and (2) replaced the decorative rock—used in place of a lawn in the desert (one week). This type of activity is only mildly enjoyable to me…it isn’t something I’d choose to do if it weren’t badly needed.
I doubt I’ll ever own again, unless maybe it’s a “tiny house” (for anyone who has not heard of such things, I recommend Googling it). With hindsight, it doesn’t help that I gathered together the vast majority of my liquid assets to purchase my (unnecessary) two-bedroom condo—now worth 40% less than the purchase price—with a 65% down payment one month before Google went public…
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…and this is another really-important-and-difficult-to-model point. Renters definitely get an advantage in terms of both flexibility and not having to care about whether using draino is going to kill their plumbing over the next 5 years…
FoW
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Are there examples of houses that appreciate from $50K to $250K over the life of a mortgage? That seems huge (3% appreciation over 30 years gets you to $121K). I know nothing about this. I would have thought doubling in price was hitting the jackpot, but as you point out, you may not even break even due to mortgage interest, property tax, and upkeep if it merely gets up to $100K.
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There certainly are examples of that happening but I was somewhat overstating typical appreciation.
I was looking at a relatively inflationary period. A five-fold increase (400% appreciation) in 30 years is a 5.5% return. The average appreciation from 1960 to 2000 (ending in 2000 to exclude bubble) was 4.8% which would be a little better than 300% in 30 years (which mostly just compensated for inflation).
Past performance is no guarantee… The future could well be lower (or higher but I would bet on lower) for many reasons. And, whatever the national average is, any individual’s experience is likely to diverge from that quite a lot.
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First and foremost I don’t know anybody who thinks they paid $10,000 for a $50,000 dollar house. Everybody knows what they paid to the previous homeowner. The part they tend to forget is the portion paid to the lender in interest payments. The house cost me $50k and I sold it for $250k. is what people say when they should say the house cost $100k, $50k to the previous homeowner and $50k to Citibank.
Second, the reason people made money in housing was because interest rates and lending standards dropped. In 1990 my house cost me $125k plus 14% interest for 30 years. In 1997 the interest dropped to 7% when I refinanced. That was most definitely “found” money in my hands in the form of lower monthly payments. That “found” money fueled the stock market. And a boat. But mostly the stock market.
In 2002 or 2003 the housing market should have settled down but the Federal Gov allowed very low lending standards and mortgage companies were still able to sell very poor quality mortgages to pension funds in Detroit, and Greece and PR etc, because they were still seen as the sound investments they were before the standards were lowered. Eliot Spitzer tried to prosecute mortgage companies so we found out he had an affair. If he had not backed down we probably would have been told he was humping ponies or something.
Of course the pension fund manager was fifty years old and his mortgage had required a twenty percent down payment and monthlys could not be more than 25% of his income.
The idea that he was investing in a mortgage security that had been rated AAA by Moodys despite conatining NINJA loans ( No Income, No Job, No Assets) was probably a bit beyond the scope of his wildest nightmare. Plus the investment companies were still flat out lying to investors by saying that mortgages were guaranteed by the US Treasury, something that had not been true since the late 1970’s when Freddie and Fannie were privatized.
Hope that adds to the understanding,
Steven
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Agreed that investing with leverage can be risky, but it can greatly increase the upside of an investment (thats why Wall Street likes it). Its not something you should do with all of your money, but it can be a useful tool.
Real estate is essentially the only area in which regular people can make cheap leveraged investments.
The NYtimes has a great Rent vs. Buy calculator that takes into account the leverage you get from a mortgate, imputed rent, the relative growth of real estate prices vs. stocks, and lots of other things: http://www.nytimes.com/interactive/2014/upshot/buy-rent-calculator.html
You can see how the tradeoff works out under different assumptions about how these parameters will vary. But generally speaking, buying ends up winning if the horizon is long enough.
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Reblogged this on Alina's Blog.
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Sorry, Josh, I am not convinced. The first house I owned had a mortgage of 600/mo, no down pmt. My rent on a 1 br apt was 600/mo. I lived there for 19 years and sold for 165,000, with 34,000 left on the mortgage. With the proceeds I bought another property with cash. I am getting ready to sell again, and I will have at least 100,000 in equity when I do. I am retired and disabled, and I am getting one of those awesome Tiny Houses on wheels, and a small wooded acre to park it on when I am not traveling. I am not a rich person, and the property served as a much better investment for me than IRA or stocks, which have had some horrendous outcomes. It is possible that at the moment it is not something people can buy and flip for big bucks, but since my aim was not to be homeless, and still have control over my monthly outflow, it works perfectly for me.
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Yeah, it’s very hard to separate the investment and consumption aspects here, or the tangible benefits from the intangible ones. Most people are probably better off overall buying a house, but there’s a lot of psychology in that and other non-quantifiable factors (e.g. living in a school district where there isn’t much rental stock).
I think the first critical point that most buyers don’t get is that the long-term average unlevered real return on single-family homes is zero, and the variance by time period and geography is very high. So just from a basic finance perspective, you’re introducing a lot of extra risk into your outcome without a higher expected return.
The fact that houses are priced that way could in itself be taken as evidence that the structural benefits (e.g. mortgage tax break & non-callable, sometimes non-recourse 4x+ leverage) and intangible/emotional benefits must balance that out, not that I take that view exactly but it’s one rough way to look at it without getting into the weeds.
The second big thing is that people tend to overestimate how long they’ll stay in a house, so they mentally amortize commissions and other associated costs over too short a period.
But the most fascinating side of it to me is the feedback part, which is impossible to model — owning a house probably changes your psychology and behavior in lots of positive and negative ways. You’re less likely to take that job in another city that could have changed your whole career track, more likely to become a petty neighborhood NIMBYist, but on the positive side, more likely to form close relationships with your neighbors… etc etc etc.
In that sense it’s almost like having kids — not to the same extent of course, but you’re not quite the same person as a homeowner that you would have been otherwise, so straightforward comparisons are not as meaningful.
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