Saturday, January 30, 2010

Buy a House? The "Best Leading Indicator" Says Yes!

I've owned three houses in my life.  They've all been terrible "investments", including the one I'm sitting in right now, and I haven't a clue when I'll sell it.

Think about a house as an investment.  Historically, residential real estate returns maybe two or three percent annually, after inflation.  That's actually not terrible, especially if you don't owe taxes on the sale.  But it will cost you at least five percent in various transaction costs.  We're not selling IBM shares, after all. While you own this "investment" you risk fast depreciation, (it burns down,) and slow depreciation, (the roof wears out.) Those are real dollars to keep the investment "working for you," as they say.

More abstractly, you severely limit your career.  You can't move cross country with this asset.  You also can't inexpensively change your child's school.  I know, you bought the house for the good schools.  That was ten years ago.  They had a great kindergarten!  The high school is full of hoodlums. 

Sure, you get to live there for free.  But, you tie up cash with a down payment.  You limit your flexibility to invest in other things.  You also buy too much of it because you perceive value that likely isn't there.  (Remember, that tax deductible interest holds for ANY investment, not just housing.)  Bottom line: renting probably works best for most people.

Wait, you say, I know lots of people, (like my parents!) who made a lot of money on their house.  First, they're thinking about their nominal returns, not their real returns.  Owning ANYTHING through the '70s and early '80s had huge nominal price appreciation.  The $0.10 Hershey bar of my childhood is the $1.25 for my kids.  It's still just a Hershey bar.

Second, they're forgetting that they leveraged themselves up five times with a mortgage.  As any banker will tell you, leverage works for anything when prices rise, not just real estate.

So, what's the leading indicator that says it's time to buy a house?  Insurance companies want to buy your house!  Insurance companies, in my experience, have pretty good long term investment track records.  They also understand real estate.  Life insurance companies built most of it in the first place.

How do I know they want to buy your house?  The business plans crawling from the woodwork.  Several start-up operations have formed to write insurance, or something like insurance, that protects you, the homeowner, from falling prices for your house.

Why do insurance companies want to take this risk?  Here's the cool part.  Property and casualty insurers have huge inflation risk.  When prices go up, their claims expenses go up.  For example, the Gecko gave you a low priced quote for auto insurance.  He estimated that your car that cost you $25k would cost $26k if you totaled it nine months later.  He carries the risk that it costs $27k.  Worse, the guy you hit sues you.  The Gecko knows (trust me!) what that's going to cost in legal bills over the next two years, unless inflation strikes hard, and your lawyer and his lawyer raise their prices.  You get the idea?

They need a way to hedge this risk.  Your fear of prices falling solves their problem!  You buy insurance, giving them more cash to invest, and pay future claims if inflation picks up.  But, if inflation picks up, they don't have to pay your claims.  This works the same way that banks hedge to reduce their cost of storing risk.


  1. Doesn't this just mean that insurance companies need to hedge against prices going down, not that it's a good time for me to buy a house? or are you saying i should buy a house and take out the insurance against prices going down?

  2. Or are you saying that I should buy a house now because insurance companies don't see prices falling any longer?

    And who says that they're right?

    And does that mean if I have a house, it's getting about time to sell?

  3. "Remember, that tax deductible interest holds for ANY investment, not just housing."

    Can you explain this?

    Otherwise, nice post especially the bit about nominal returns.

  4. A house is never an investment. This is an idea cooked up by mortgage salesmen in the 1970s to sell more mortgages. It's not an investment because there is no return.

    Housing prices go up and down. Sure, you can ride one of the up-waves and make a few bucks. But only if you sell in time. And if you are living in that house, it's hard to sell it from under yourself.

    Robert Schiller has done an interesting study of housing prices relative to wages going back to the 1600s (where records exist). His study found that houses go up in value about 1% per century. That's because housing prices are tied to wages: prices can go only as high as people can afford to pay. If they go higher, then after a while they will slide or snap back down again.

    And return = zero.

  5. I agree with robert, wholeheartedly.

    Anyone who buys a house because they think its an investment, should re-examine their values. Consider building a hut in a tree like Ewoks, the real entrepreneurs of our generation. For more financial consulting, feel free to email

  6. We are all clueing in why it is wiser to rent than to buy. I am interested in your motivations for buying three houses. There should have been a good reason. Money issue aside, is there a good reason to keep our own property despite the obvious risk?

  7. My husband & I bought our first house last fall, coincidentally the week we found out I was pregnant with our first child. We bought into the myth that being a home owner was somehow important, and with real estate prices bottoming out in our area we took the plunge. Since then we've regretted our decision. Not because there's anything wrong with our house, but because it's incredibly expensive to buy. Way too much money gets sucked into it each month... and because it's so much larger than our apartment we also felt like we had to buy furniture so that the place didn't feel so empty. We've been talking about the possibility of simply renting the next time around.

  8. There are also many downsides to renting. Tke this example, I was a renter and moved my family (including an 8 month old) across the country for a new job and rented a house with a 1 year lease. Four weeks after moving in, the landlords called and said, hey guess what, we are getting foreclosed on, you need to be out in a month or you might come home one day and find all your stuff on the front porch. Oh and that deposit you paid, sorry we won't be able to give it back since we don't have it anymore. I also lived in several rental houses that while I was living there the landlord decided to sell them - guess what gotta move and/or in one case they were willing to let us stay but the new landlord seems really slimy and we knew he would raise our rent once the current lease was up. So, I am now a homeowner and much more in control of my own destiny. For example, when a family member called and asked if they could move in with us for a few months, I didn't have to clear it with my landlord. I can have as many pets as I want (or is legal) without having to ask permission of a landlord. Lastly, my "rent" (Mortgage payment) is stable, no one will raise the rent on me! Plus I can paint rooms whatever color I want and not freak out when I spill something on the carpet beacsue it might after my ability to get my deposit yet. So, that's my argument for why you should buy a house YOU CAN AFFORD instead of renting. Our house is smaller than many our peers own but it's affordable. SO much so, that I have extra money to send my kid to private school if I really want (if the schools are or become bad)!

  9. I so agree with the previous commenter. There are many good reasons to buy a house instead of rent.

    The problem isn't buying a house, it's buying a house you can't afford with a mortgage you do not understand. I think the most important thing is to know your own priorities and do your homework. Don't let your agent and your lender sell you on something that is not actually going to work for your life and your financial situation.

  10. Interesting post. My GF and I have had our current house for 6 years. It has worked out well in that we did not really know what to expect in terms of "who" would be living here, and for how long. Her adult daughter moved out for three years, then ended up back here. Now, her son has moved out. It was nice to have a place for the "kids" to fall back on. That said, we talk often about downsizing and moving, and plan to do so regardless of who is still here. Guess it's off topic, but if we were renters, we would have had to make tough decisions about moving when there were just three in the house. I guess the benefit we received as owners was not needing to decide if we should move into a smaller apartment when the first kid moved out.

    The big decision will be when the other kid moves out. Too much space here, but don't want a new house around here either!

  11. [I need better response technology, sorry!]

    @Erik: yes, you are right. This is not about "now is a good time to buy a house". This is about insurance company risk taking. Generally speaking, I think owning real estate is a poorly thought out proposition.

    @Rob: I don't give investment advice;-)

    @anonymous(1): I don't give tax advice, but...investment interest, if the investment is taxable, generally is tax deductible. For example, margin loan interest is deductible.

    @Nancy: I basically agree, personal real estate is an investment, just a generally not very good one.

    @Isao: My wife and I consciously decide to make the bad "investment" because her work depends on our living in a particular place. Call it cost of doing business. Fortunately, we're in a position to absorb the expected loss.

    @Anonymous(2), Jess and Rory: Just because you can afford it doesn't make it a better investment! There are lots of lousy investments I can make that I can afford. They're still risky and low returning. Remember, I'm simply saying on average this isn't such a good idea, not that no one has success with their home ownership.

  12. After 30 years of home ownership of one house or another, my husband I and made the decision to sell our home and have since committed to being empty nest renters for life! What a relief! If we want to up and move to another part of the world, there is nothing holding us back but our current lease (way less scary then having to sell a house in a down market).

    And yes, there is the chance that our landlord will opt to sell, or get foreclosed upon, etc. and we'll have to move, but along with selling came a commitment to down-sizing, so that does not seem like a daunting task. I love the freedom that renting brings!

  13. My husband and I bought a house ~6 months ago. I was all for renting, but my husband changed my mind by pointing out that even if the value of the house doesn't go up and we "lose money" on this "investment," we will probably still save money compared to renting. We did all the math and found that if we stay for ~5 years, as we plan to, we could sell for ~25% less than we bought for and still break even as compared to renting (even including property taxes, homeowners insurance, closing costs, etc etc).
    You have to make a monthly payment either way, might as well have a chance to get some of it back.

  14. I've never quite bought into the whole buying a house concept. We've always rented. And like the fact that when something goes wrong with the place that the landlord comes out to fix it. And that if we need to move, we can. Also - we pay substantially less to rent than many of our friends pay to own.

    That extra money goes into retirement and emergency savings. If we want to paint, we can - we just have to paint make sure it's the original color again when we move. Still cheaper than buying. The tax break would be less than what we're saving in rent, and we get to be in a great location (6 blocks from the beach!) that we'd never be able to afford if we had to buy the place.

    I'm sure buying is a good idea for many people - a lot of people really like being homeowners. Including my parents and brothers - all very intelligent people. But we prefer flexibility, less responsibility, and fewer fixed (and unexpected!) expenses.

  15. Thanks for all the comments, as they continue to roll in. I'll add two of my own, in general response:

    First, I am certain there are many people for whom buying a house turns out to be a fine idea. I am equally certain there are many people for whom it will turn out to be a lousy idea. My hope is to direct people to think about (a) on average what they can expect to happen, and (b) how they'll be impacted in non-obvious ways that directly or indirectly impact their well being, and therefore costs.

    Second, an often overlooked concept when thinking about real estate purchases relates to people's opportunity costs of home ownership. What's the next best alternative, and what opportunities open up for you by not owning a home, and close for you by owning a home. Owning the home could be a "good" investment, but just maybe the investment you cannot make because you own the home would have been a "great" one!

  16. There are upsides to owning a house:
    (1)Frreedom to do more or less what one likes in terms not only of wall color but also of lifestyle choices. For example, environmental upgrades that not only accord with one's "green" philosophy of life but also do bring tax breaks.
    (2) When I bought my house the mortgage + principal was cheaper than renting. Still is. I have paid it off and now live "rent-free." (3) If one maintains a home office, a portion of the improvements made in the house can be written off for tax purposes. Which is a great plus if the property value goes up. (The advantages of deducting interest are a chimera compared to the advantage of having no debt whatsoever, regardless of the origin. It amazes me how many people feel good about carrying a mortgage becausee they think it gives them a tax advantage. It may do that, but it doesn't give any advantage in the big financial picture compared to having no interest to pay in the first place. One could get the same Schedule A deduction by giving that money to a charity of one's choice.)
    (4) Depending on one's location and also age and flexibility, the property can generate rental income. One might also rent out a room for extra income. In general, if one is feeling entrepreneurial, I think a house on a piece of property offers more leeway for developing an idea that one can do in one's own space or in the proverbial garage or in the yard.
    (4)One's house is a far cheaper source of credit than a credit card. Of course, one must use this credit line sensibly. But for the self-employed, a relatively low-interest-rate equity line can greatly help smooth out cash flow mismatches (when one must pay bills before one gets paid oneself). And that interest is deductible, unlike credit-card interest.

    That said, the downsides are loss of flexibility. Whether renting or buying, one must make a good financial decision and in the case of renting one must vet one's landlord/-lady carefully to avoid ongoing aggravations that might push one to buy a house just to get control of one's own life when the problem is in fact the landlord, not the concept of renting. Me, I would much rather take charge of caring for my property, choose my appliances (secondhand older ones are better than newer "upgrades" that a landlord will want to get higher rents for) than spend time on the phone begging a landlord to fix something, or get rid of noisy, inconsiderate tenants in the same building ruining my life!

  17. "A house is never an investment. This is an idea cooked up by mortgage salesmen in the 1970s to sell more mortgages. It's not an investment because there is no return."

    I agree, unless you buy one to rent it out and become a landlord, it won't give you any income.