A Home as an Investment

When we think about the American Dream, visions of prosperity and social mobility through hard work, smarts, and determination are often wrapped by a picket fence. For many, owning a home is the ultimate symbol of success. This makes sense because home ownership implies self-determination, a bedrock principle of American idealism.

But is owning a home right for everyone? And, more specifically to the financial planning world, is a home an investment like stocks and bonds, or something else entirely? Is it just shelter? Is it a safe asset or is it risky? What role does it play in your personal balance sheet as times goes by and debt turns into equity? How do you access the equity once it's there? How does owning rental real estate factor in? The list of planning questions is long.

Interestingly, the jury is still out on the core question of whether a home is an investment. Most planners and advisors agree that real estate can be an investment, but the type depends on one's perspective.

When people buy a home to enjoy living in they're not necessarily thinking about accumulating wealth by doing so. Over time, most of the wealth being accumulated happens by default due to inflation and the paying down of debt, which happens naturally with a fixed rate fully amortized mortgage. Some own second homes, either for vacation or perhaps due to inheritance. Sometimes these are rented, but they are often left vacant much of the time. About 3% of Americans are real estate "investors" who buy residential or commercial units and rent or "flip" them. Each of these folks would offer a different perspective on the home-as-investment question.

While most people buy a home to live in long-term, the average length of ownership is about eight years, according to RealtyTrac. This is higher than the historical average as homeowners are generally less mobile than before, for a variety of reasons. Whatever the ownership tenure or situation, the reality is that most homeowners have a substantial percentage of their net worth tied up in real estate. Is that a risky investment? The short answer is... it depends.

Along these lines David Blanchett, Head of Retirement Research at Morningstar Investment Management, researched this topic. Excerpts of a Q&A with him follows (emphasis mine). I have posted a link to this below and there's a short video of the Q&A as well...

Housing is the largest expense for the average American, and it's the largest tangible asset. So, it really does matter in terms of thinking about what is the right way to invest your portfolio and just think about your wealth holistically.

So, when you think about your portfolio, you don't usually live in your portfolio, right? You own a basket of stocks. Well, if you buy a home, it's two types of goods--an investment good because you can possibly realize a benefit from appreciation, but also it's a consumption good because it gives you a place to live for as long as you own the home for. And so, an important question is, does it makes sense financially? And I totally understand that for a lot of folks home ownership is more than just about the numbers. It's a very personal decision. It's very emotional. It does different things. But like all the researchers ask the question, how do you think about the home as an asset on a balance sheet? And what I find is that it can be one path to create wealth via kind of for savings but for a lot of folks maybe you look to rent first, and if you do buy, understand the risks there.

So, if you look at the return of homes both domestically and internationally, they increase by about 1% a year over inflation. So if inflation has been, let's say, 3%, homes will go up by about 4% a year. Now, there are some problems though with those numbers. I mean, one big problem with the metrics we use, the House Price Index, is that they are tied to resale value of homes. So, someone sells a home in 2011, it resells in 2016, what is the change in value? Well, a problem there is capital improvement. So, if I were buy a home and try to flip it, put all this money into it, you don't see those expenses in terms of the actual resale value. There's also things like insurance, ongoing maintenance, real estate taxes that really kind of drive that down. So, I think that when you factor in all the costs of owning a home, the realized return is often less than inflation or possibly even negative. So, a home is a very different asset than other things you may own.

So, if you own a portfolio of stocks, you could own literally thousands of individual securities. You got a very diversified portfolio. Well, if you own a home, you own one home in one place. So, when thinking about the risks of home ownership, people often talk about these kind of nationally diversified House Price Indexes like Case-Shiller. Well, again, those are indexes that track oftentimes thousands of homes that are all across the U.S. Well, again, you own one home in one place, and so the risk of an individual home in one area has annual standard deviation of about 12% and if you put that into kind of relative terms, a portfolio that's half stocks and half bonds, has that same level of risk. So, a home by itself is very risky. What compounds the risk is leverage. So, people often buy a home with a mortgage. If you put 20% down on a home, then you have effectively a 5 times leveraged asset with your equity. What that creates is an asset that's about as risky as a 3 times leveraged equity index. So, for a lot of younger households the home is hands down the riskiest asset.

Have questions? Ask me. I can help.

Video & article link: http://www.morningstar.com/cover/videocenter.aspx?id=766921

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