Over the weekend, Moom left a comment on 7 Ways to Kill Your Net Worth after observing a number of mainstream media articles touting the idea that real estate — your own home — is not a good investment.
Interesting how now that the housing market is stagnating or going down in many regions there are all these articles saying “don’t buy too much house” :)
Personally, I remember seeing this common advice when the market was booming. Although when exuberance was the general attitude towards the investment worthiness of real estate (including your own home), I also remember seeing more of the “buy as much house as humanly possible, it’s guaranteed” advice.
As if on cue, I found another article on the intelligence of renting rather than buying. First, a basic comparison:
Shares return 7% a year after inflation because that’s how fast companies tend to increase their profits. Houses have their own version of profits: rents. Tenant-occupied houses generate actual rents, while owner-occupied houses generate ones that are implied but no less real: the rents their owners don’t have to pay each year.
House prices and rents have been closely linked throughout history, with both increasing at the rate of inflation, or about 3% a year since 1900. A house, after all, is an ordinary good. It can’t think up ways to drive profits like a company’s managers can. Absent artificial boosts to demand, house prices will increase over long periods at the rate of inflation, for a real return of zero.
So on average, after inflation, shares of company stocks have returned 7%, while real estate has returned nothing over the past century plus. Real estate pundits get around this by ignoring everything up to World War II.
The average pundit, planner, lender or broker making the case for ownership doesn’t look at returns since 1890. Sometimes they reduce the matter to maxims about “building equity” and “paying yourself” instead of “throwing money down the drain.” If they do look at returns, they focus on recent ones. Those tell a different story.
Between World War II and 2000, house prices beat inflation by about 2 percentage points a year. (Stocks during that time beat inflation by their usual 7 percentage points a year.) Since 2000, houses have outpaced inflation by 6 percentage points a year. (Stocks have merely matched inflation.)
So what caused these post-war and 21st century surges?
- The government subsidized housing by relaxing borrowing standards in 1934, creating the ability to make down payments of “only” 20% and to stretch a loan for 30 years.
- When the stock market tanked in 2000, the government lowered interest rates very quickly, which caused frenzied house buying to take advantage of the low rates.
The author, Jack Hough, suggests that in order to keep up the housing returns of the past 20 years for the next 20, the government would need to relax housing standards even further. With the increase in foreclosures, that’s unlikely to happen. The author also believes that house prices probably won’t drop because owners aren’t likely to sell in down markets (like they do with stocks) and prefer to hold it out.
Here is the calculation that shows how renting and investing the difference you would normally pay for maintenance expenses pays off more than buying a house and paying for the incidental costs over 30 years ($700,000 on a $300,000 house according to the Wall Street Journal):
If you have $300,000 and a choice between spending it on a house or shares, you’ll pay $6,000 a year in incidentals if you buy the house or about $15,000 a year ($1,250 a month) in rent if you buy the shares. But the shares will return $21,000 a year after inflation while the house will return zero. (My numbers work out even better than these. I pay a smidgen less than $1,250 a month for rent, while house prices in my neighborhood are far higher than $300,000.)
In the second page of the article, the SmartMoney author refutes anticipated arguments, including:
- Homebuyers get tax breaks. (The tax breaks aren’t that good, investors get tax breaks, too, and most homeowners don’t or can’t take advantage of these tax breaks.)
- You seem to knock government housing subsidies, but they’ve helped many Americans afford homes. (The author says the subsidized also helped to raise prices, making housing not affordable for many in the middle class.)
- Houses are bigger than apartments. (You can find single-family houses to rent, not just traditional garden or tower apartments.)
- Are you saying I should sell my big house and rent an apartment instead? (No, the strong demand for housing keeps renting cheap.)
- Renting is for poor people. (It’s also for rich people. “Poor people rent modest apartments for lack of choice. Middle-income people buy houses. High-income people, presumably with a dose of financial savvy, often rent nice apartments instead of buying.”)
- You say houses return zero. But I’ve made a fortune on my house in recent years. (Recent performance is due to external forces that won’t be in play in the future and returns will revert to the mean — in line with inflation.)
- So you’re never going to buy a house? What about raising a family? (The author is 34 years old and engaged and hopes to rent for 10 more years. He thinks he’ll move into a bigger apartment when necessary.)
It’s been ingrained in our culture by the media that the “American Dream” is to own a piece of land and a house upon that property, and we’ve been led to believe it is a failsafe investment. I haven’t decided on my position in this debate, but I’m probably going to rent for at least another year to give me a chance to make decisions about where and when I want to “settle down” into a long-term relationship with a piece of property.
Updated March 19, 2012 and originally published May 7, 2007.