Your House is not an Investment

December 6, 2013



When I was first starting out, there was a frequently perpetuated myth that "your house is the most important investment you will ever make." If that turns out to be true for you, then you have made some mistakes along the way, missing out on investments (US stocks) that provide extremely good returns over long periods of time. The thinking was based upon the faulty premise that "houses always go up in value". Some people still think of the downturn in real estate as a blip. They think that the previously espoused "wisdom" of significant future home price appreciation will still hold over long periods. However, based on what we know to be true today, it seems likely that this will not be the case.

Home price appreciation above the rate of inflation occurred because of strong population growth, and an ever increasing appetite for higher overall levels of debt, longer loan terms, and higher LTV ratios. The measures may have also been ignoring the fact that homes were getting bigger and nicer as the "average home price" was going up above the rate of inflation. But we will ignore that part for now and focus on the population growth and borrowing trends.

First of all, there was a baby boom in this country after WWII. People needed bigger homes during that period to accommodate all of those children. Of course, as the children grew up, they needed homes as well. All of this meant increased demand for homes. But today, the rate of US population growth is as low as it's ever been. So is the birth rate. I've seen people predicting another baby boom. However, until that happens, it would be quite speculative to bank on a high rate of growth in the U.S. population. What was happening in the past to drive real estate prices higher is no longer happening. Baby boomers kept buying bigger houses, second houses, etc. all the way through the last boom. The oldest baby boomers are now 68. Now, they are or will be soon hitting the age during which one of three things start happening 1) Downsizing 2) Assisted living facilities 3) Death. Combine that with the fact that the majority of baby boomers have less than $100,000 saved for retirement, and what you get is a poor long term outlook for residential real estate. In other words, I'm guessing all of this will cause more than a few houses to come onto the market over the next 10-15 years.

But this is only one part of the equation. The other big part is the borrowing trends seen in this country over the last 80 years or so. As I understand it, mortgage loans started off in the 1930s with 5 year terms and 50% LTV ratios. Those numbers peaked in 2006-2008, at 30-40 year terms and 105% LTV ratios. Of course home prices will rise significantly as credit becomes more and more available, people's appetites for taking on mortgage debt grow, loan terms are lengthened, and interest rates are kept artificially low. Those trends have all peaked. I think they will all reverse somewhat in the future, but it's hard to predict government intervention. What we can say though, is that even if they don't reverse, but instead remain the same, they already capped out. The change in those factors which drove price appreciation is done. Over. Finished. You can't go any higher than 40 year loan terms and 105% LTV ratios. You can't go much lower than where interest rates have been the last few years. There is nowhere left for those factors to run, at least nowhere that will drive future appreciation.

It just doesn't make much sense to me to view a primary residence as an investment. Investments should pay you money and increase in value well above any cost that you may incur while holding them. Homes require a good bit of work and expense to repair, maintain, and update over the years. They also cost you money in the form of property taxes and insurance. Even at today's interest rates, if you take out a 30 year mortgage loan to pay for one, you most likely won't recoup the cost of your "investment" by the time you hit retirement age... and you'll still need somewhere to live until you die. Owning a home is not a bad thing at all. But if it's investments you're interested in, you need to look elsewhere.

I should note that there are two major exceptions to the view that home prices should be expected to rise with the rate of inflation, and therefore never viewed as an investment (for owner occupied homes):

1) Extremely strong fundamentals in a specific area. Stronger than average population and/or income growth in a specific area could lead to stronger than average appreciation in prices for that area. However, in regard to existing homes, new development could easily offset strong population and income growth in the long run. So, counting on those factors for strong appreciation in home prices is still dubious. There is also a strong tendency to believe that our own future is abnormally bright. Survey after survey taken at the height of the real estate boom showed that most people thought a crash was coming, but they didn't think their specific area would be materially affected.

2) Sweat equity. Sweat equity is the very real phenomenon of creating wealth by making significant improvements to a home. When I say sweat equity, I don't mean the owner has to do all of the physical work (though it helps if you can). Investors can buy homes well below market value, pay contractors to do all of the work, and still realize a significant profit. That's because they have taken on risk, done a good bit of work, and added value above costs. If you buy a house, make repairs and renovations, live in it for a while, then sell or rent it and continue the process, it could very well help your chances of retiring early, comfortably, or both. However, it does require a lot of hard work, and a good bit of risk. Even after mitigating risks through knowledge and experience, there are still going to be unforeseen issues and costs at times.

So, if the myth about primary residences as an investment was not already dispelled in your mind, hopefully it is now. Even though they generally hold value, and the value can fluctuate up as well as down, houses are not investments. They cost money - a lot of money. They fill a need in our lives. In terms of a national average, they should be expected to hold their value, and possibly rise with the rate of inflation going forward. Therefore, a primary home purchase should be based on your needs, in light of what you can afford, never as an "investment". Americans really should consider buying a home based on a significant (at least 10%) down payment and a 10 year mortgage. Extending yourself with excess debt in order to capitalize on potential future appreciation is, shall we say, less than wise.

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UPDATE: 2/7/2014 I continue to think about this article from time to time. One question I've asked myself is whether the use of a reverse mortgage (or the potential for using one) turns a primary residence into an investment. I think the answer is that it doesn't. A primary residence is a significant asset that holds value in real terms. What a reverse mortgage does is allow you to tap into at least some of that value while you are still using the asset. Just because you can tap into some of the accumulated value does not mean that you have turned a profit in real terms, or that there is any rational expectation of being able to turn a profit in the future. I also want to note that while I think we should consider making significant down payments and taking out 10 year mortgages, I fully understand the arguments in favor of buying even when you have no down payment. Buying a house that is more than double your annual income, using a longer loan term, and a lesser down payment all means greater risk in the case of job loss, but it could also still work out really well if you never have those storms. Suffice it to say, if I had everything to do over again, I would have turned my 10% down payment into a 20% down payment by buying a house that was about half of what I payed for my second house. I would have probably done a 10 year loan term as well. But my situation was different at that time. I had more options. Right now, the only way my family would be able to buy a home would be with no money down, but the monthly payment would be less than what we pay to rent if we get a nice deal. So, I definitely understand the appeal of buying under that scenario too.

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