By: Dividend Sensei
During his administration US president George W. Bush was a big fan of what he called “an ownership society”. A big part of that was the idea that it was beneficial to promote as much US home ownership as possible. This is an idea that has long been shared by many politicians on both sides of the aisle. Which is why for decades the US government has enacted numerous policies designed to make purchasing a home available to more people. That includes setting up government government sponsored enterprises like Fannie Mae, Freddie Mac, and Ginnie Mae, which helped to popularize what’s known as government backed mortgage securities. These helped to ensure mortgages and created the modern residential mortgage backed securities or RMBS industry.
The way it works is that a bank or other financial company will fund a mortgage for a prospective home buyer. That mortgage, thanks to the backing of the US government, is then considered a low risk income producing asset class, usually with a 15 or 30 year fixed income stream. Mortgage originators can then securitize these loans by bundling them together in what’s called collateralized debt obligations or CDOs. Institutions such as pension funds, insurance companies, hedge funds, mutual funds, and other groups of investors buy them creating a way for mortgage originators to recoup much or all of the mortgage cost and thus increase the number of mortgages they can make.
Further fueling the rise of US home ownership has been preferential tax treatment in which home interest is full tax deductible for homes up to $750,000 bought after 2018 (it was $1 million before tax reform). These government incentives and initiatives to promote home ownership, while well intentioned, are also likely misguided. That’s because home ownership is far less beneficial than most people think. In fact there are three reasons why NOT buying a home can be one of the smartest things someone can do, and might in fact help you achieve their long-term goals of a prosperous retirement. Specifically renting instead of buying can result in a retirement portfolio that’s over $1 million larger.
Homes Have Historically Been A Terrible Investment
Thanks to strong home price appreciation in the early 2000s many people think that homes are a great investment. The logic seems simple enough. A growing population, combined with steady economic growth (society gets more affluent over time) and the fact that everyone needs a roof over their head means that home prices should go up over time right?
That’s true in absolute terms. And in certain periods homes can indeed make a good investment. For example between 1997 and 2006 the average return and inflation adjusted returns for homes was 9.7% and 7.1%, respectively. But keep in mind that housing prices, like most asset classes, experiences boom and bust cycles. In fact in the last few decades we’ve had four major housing crashes: 1972, 1978, 1984, and 2008.
And over the long-term the Case-Shiller Home Price Index shows that the rate of appreciation in home prices is actually far weaker than people think. For instance between 1928 and 2013 the annualized rate of home price increases was 3.7% or just 0.7% above the rate of inflation. Housing just barely managed to beat cash (short-term government bonds, savings accounts, and money market funds), and badly underperformed both bonds and stocks. These asset classes delivered 2.0% and 6.5% annualized inflation adjusted returns, respectively. And between 1890 and 2005 inflation adjusted housing prices appreciated at 1% per year while over the past century inflation adjusted housing prices have increased at 0.3% annualized vs the S&P 500’s 6.5%.
And keep in mind that these returns are only for home prices. In reality closing costs, real estate commissions, property taxes, and maintenance costs mean that it’s even harder to make a good return on your home. That’s because unlike commercial real estate (such as rental properties) your home doesn’t generate any income. Rather you have to constantly put more money in, on top of your mortgage payments (median amount is $462 per month according to the US Census Bureau).
This means that in order for a house to be a good investment several factors have to be true. First you need to be in a good housing market, preferably in a major city with thriving economy. Second you need to live in that home for a long time, so you can amortize the fixed costs more effectively (spread out closing costs, real estate commissions, and mortgage fees over time). According to the National Association of Realtors the average family changes homes every nine years (up from 6 years between 1985 and 2008). While nine years may seem like a long time remember that home prices can remain weak and underperform inflation for stretches lasting 10 years or more. Finally you need to get lucky, meaning buy when prices are relatively low and sell when they are near the top of the market. Remember that homes are illiquid assets meaning they can’t be readily be converted into cash. It usually takes several months to sell a home, which increases the risk of the market turning against you at the worst possible time.
In addition owning a home means that you are locked in one geographical area, which limits job flexibility. If the industry you work for faces a downturn and you lose your job than it’s much harder to move if you first have to sell your home (at whatever the market price may be at the time). But wait a second? What’s the alternative to buying? Renting? Buying a house builds up equity that you can borrow against, while renting doesn’t give you any benefits except a place to lay your head at night. Well yes and no. It turns out that for disciplined savers and investors renting can end up being a far preferable option to buying a house.