It is difficult to think of a financial topic that is surrounded with more emotionalism and misinformation than home ownership. It’s understandable. The family home, where you raise your children and create memories, means far more to us emotionally than stocks and bonds in an investment portfolio. But given that the home is one of the largest, if not the largest financial asset on the balance sheet of most households, it is critical to step back and take a dispassionate and rational look at housing and the role it plays in our financial lives.
I’ll open with my first (and only) home buying experience. My wife and I met in 1999, got married in 2003, and lived in an apartment in San Francisco. We chose to rent, because we knew that we would soon have children, and move out of the city within a few years. We committed to saving as much as we could for an eventual down payment. By 2006, we had 2 young children, and our once spacious apartment was feeling increasingly cramped. I tangibly felt how personal life events were dictating my need to buy a house, and not any rational investment considerations. Our timing was unlucky, with the bay area real estate market, already strong for many years, beginning to really surge. Just as we started the search process, housing inventory became nonexistant, bidding wars were the norm, and prices were rising dramatically. By early 2007, I distinctly remember the pervasive psychology surrounding housing at the time. Many thought the market was crazy, but no one I talked to, literally no one, thought it would-or could-go down. Even friends and family who had been advising us to wait were now saying we just had to get in, or risk getting priced out.
Totally worn down by the process, we finally found a great home, probably 20% above our original budget, and purchased it in the spring of 2007. We put 35% down, and as someone who never had debt, took on what seemed to me an ominously large mortgage. Additionally, as a young couple in a very expensive market, the home represented an uncomfortably large percentage of our net worth. Upon moving in, my reaction was part relief that the whole thing was over, coupled with a sense of dread and almost immediate buyer’s remorse.
We all know what happened next. The real estate peaked just prior to our purchase and began its dramatic fall. I remember thinking sometime in 2009, that we likely had negative equity in the home. After saving and scrimping for over a decade, our equity was more than wiped out in less than 2 years. While we had no intention of selling the home, it was a sobering and disconcerting time. Now over a decade later, we still live in the home, our kids our growing up in it, and we have created many memories. And after a pronounced recovery in real estate values, we likely have a profit in it. But that personal experience, coupled with my career financially advising others has given me a few perspectives.
My experience reminds me of a quote from Warren Buffett: “If you’ve been playing poker for half an hour and you still don’t know who the patsy is, you’re the patsy.” Though I considered myself fairly financially astute, about housing I was clearly uninformed and naive. Everyone involved in the industry and the process is incentivized to overstate the benefits of home ownership and to get transactions done. When it came to fundamental questions of what should I buy, rather than what could I buy, to understanding where we stood in the real estate cycle, to long-term real estate returns, I was in the woods. What I needed was an impartial advisor who understood my financial condition and by goals, and could provide advice accordingly.
Some simple observations and thoughts:
Residential real estate is highly cyclical, and it’s long-term real returns are poor: Despite the rosy projections the real estate industry promotes, residential real estate has historically been a poor investment. The inflation-adjusted annual returns on US housing over the last hundred years is below 1%. However, when you net that number against interest costs (net of tax breaks), repairs and maintenance expense, property taxes, and significant transaction costs, the actual returns on real estate are likely flat to slightly negative. These low returns come with unfortunate side-effect of high cyclicality. That cyclicality, when combined with large amounts of mortgage debt, can be a potent combination. Yes, you can make dramatic short-term returns, but you can also get wiped out. Think about the financial impact of investing a huge proportion of your net worth in an asset that shows nominal or negative long-term returns.
Your returns are dictated by when you buy and when you sell your house, and you don’t make those decisions for investment reasons: Most of us don’t make home purchase and sale decisions based on rational investment merits that exist at the time, but based on your life track and events. You don’t buy your home because the market has just crashed and you like the risk-adjusted return projections. You buy because you just got married, or had a child, or had a third child- factors completely disconnected from what the real estate market is doing. Conversely, you don’t typically sell when you think prices are reaching peak euphoria. Rather, you sell when you retire, or when you get transferred, or when your kids leave the house. If you get lucky and lived in California in the early 1980s, had kids and bought a house, and are now retiring-your life path conspired to create a great financial outcome for you. Don’t assume it always work this way. Does it make sense to have so much of your net worth tied up in an illiquid asset that you don’t really have control of the timing of buying and selling?
Give thought to how much you want to invest in your house, and at the expense of other priorities: A 2014 study by CLSA looked at the spending habits of middle-class families in a dozen Asian countries. These families spent, on average, 16% of their income on housing/transportation. In the US, that number is three times that, at 50%. Bear in mind that the size of the typical new house built in the US today has increased nearly 60% since the early 1980s (1700 square feet to 2,700). Where did these Asian families prioritize their spending? 15% of total income was spent on supplemental education, or tutoring, for their children. In the US that number is a paltry 2%. We can spend our money how we chose, but it has been my experience that we are most happy with our financial decisions when they truly align with our values. Generally speaking, the people I know with the smallest allocation to personal real estate, in relation to their net worth, tend to be the most satisfied with their finances. That may not be the case with you, but you should reflect on it.
Don’t buy the forced savings argument: A popular argument in favor of homeownership is that it forces people to save money, which they wouldn’t otherwise have had the discipline to do on their own. You pay a high cost for having that discipline imposed on you by a mortgage. In most cases, buying a more modest home, and working with an advisor who can hold you accountable to save whatever you would have spent on a bigger mortgage, and investing that money in assets that generate far superior real returns to housing (think stocks and their 6-8% annual real returns) results in superior financial outcomes.
Work with an advisor who thinks about your financial life holistically, including home ownership, and not just the assets he manages for you. The right advisor can help you to develop an understanding of housing cycles, valuation trends, recent changes in housing related tax policy, return projections, and mortgage and interest rate considerations. Equally important is to couple these asset class factors with the client’s unique financial considerations such as personal goals, values and objectives, to help determine how to fit home ownership more optimally into their financial life.
Ryan P. Dolan
ryanpdolan@dolanpartners.com