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Investing in a House of Cards

Michael Reid, CFA
July 2, 2019
Investing in a House of CardsIt’s long been said that home ownership is the escalator to wealth in this country. But with residential home prices continuing to advance well beyond the high water mark set prior to the Great Recession, both existing homeowners and prospective new home buyers may be starting to wonder if the escalator more closely resembles the stairway to heaven they're hoping for, or the conveyor belt to oblivion they fear.  I wanted to know too.

The Good, The Bad, & The Ugly

Viewed from the perspective of financial planning, home ownership is a big deal. For most of us, the purchase of a home will be the single largest purchase decision in our financial life. Unfortunately, unless we get incredibly lucky with respect to market timing, it probably won’t be the best investment decision we’ll ever make. That’s because the S & P Case-Shiller index that tracks this data shows home prices barely eke out positive returns after being adjusted for inflation. If you find that unsettling... wait, it gets worse. What’s left out of the index data that tracks home prices is the "negative yield" required to maintain your housing investment.

Negative yield stems from costs like:

  1. Property taxes
  2. Mortgage interest
  3. Insurance
  4. Home maintenance
  5. Repairs & renovations
  6. Home decorating

When these cash flows are factored into the total cost of home ownership, the return on investment calculus can turn from merely uninspiring to downright ugly in the blink of an eye. Moreover, there is additional data suggesting home buyers are not only willing to look beyond lackluster price return data, they are actually doubling down and making progressively larger commitments to housing.

According to a report the U.S. Census Bureau issued in 2015, the median home size in this country increased by more than 1,000 sq. ft since 1973 and there’s no sign of that trend abating. Add to that equation data that shows decelerating rates of household formation in the U.S. and it’s reasonable to wonder if housing prices are careening towards some kind of demographic cliff where demand is overwhelmed by supply and price plummets.

It’s Complicated

So what’s going on here? Is it possible millions of Americans are caught up in some crazy mass delusion that systematically hinders rational economic thinking? It seems unlikely, but that really doesn’t become evident until a simple rule is applied: Stop thinking about your house as an investment.

Unlike stocks, bonds, mutual funds, or CDs that are clearly held for pure investment purposes, home ownership fuses a primary human need (shelter) with consumption preferences and a somewhat eclectic assortment of cash flow characteristics. After all, we all have to live somewhere. What initially may seem like a simple rent vs. own decision often transforms into a tangled knot of personal finance, raw emotion, and accidental geography determined by where you happen to find employment. In this context, it’s nearly impossible to segregate investment decisions from lifestyle choices. Stop trying.

Whenever I travel for business, I have to think about the kind of temporary accommodations that will be necessary for that trip. Sometimes I want to stay at the conference center where I can catch an elevator to the meeting rooms, walk to a nice restaurant to entertain colleagues, and have room to spread out to relax in the evening. Other times I just want overnight accommodations at the airport hotel to avoid a bleary red-eye flight back home. Space, luxury, convenience, and location can all be had…for a price. It’s all a matter of need, amenities, and circumstance. In the realm of housing one thing is certain: needs, circumstances, and amenity preferences vary considerably from one person to the next.

Like staying in a hotel every night for the rest of your life, “rent” is not just an expense you pay to someone else, it is the part of your housing budget that gets consumed. That expense is a constant variable whether you own the hotel or are just leasing a room night to night. It never goes away. Not when you are starting your first job, not when you get married, not when you are raising kids, not when you are downsizing, not when you require skilled nursing care. Not ever.

Figuring out how much “rent” you’re going to need to pay and over what time horizon can't be a simple “set it and forget it” type decision. It’s nuanced and it’s variable in ways that are often difficult to predict with any degree of certainty. In short, it’s complicated.

As financial planners, we often find ourselves addressing issues that have little to do with “maximizing” return on investment. More frequently, we are asked to determine whether or not the run rate on a given set of expenditures is sustainable and whether or not a sufficient margin of safety exists to withstand an unexpected turn of events.

Time Horizon Matters

When it comes to housing expense tied to home ownership, one thing we do know for certain: Switching costs are high. Real estate commissions, closing costs, moving expense, and taxes: the magnitude of these line items are more or less calibrated to size of property or the popularity of its location. Since all these costs need to be supported by current income or accumulated savings, it’s not surprising that more established households are better able to absorb the costs of moving.

In this context and regardless of wealth, many people rationally decide that entering into a short-term lease or apartment living offers the ability to purchase flexibility and mobility options to move to where jobs are located. A reliable and growing stream of income from employment opportunities translates directly into a diminished need to purchase flexibility. This means the likelihood of circumstances where switching costs become a forced event recedes and the ability to enter longer term housing arrangements (like ownership) is elevated.

So why is it that home ownership has traditionally come to be regarded as the escalator to wealth by so many Americans? While there are undoubtedly multiple explanations, I’ll hazard to guess it’s largely a historic relic with a kernel of truth buried deep under layers of semi-outdated information. I think it harkens back to a day where home ownership meant freedom from the predatory housing conditions that victimized large numbers of first generation immigrants clustered in tenements and the working poor ensnared in company-owned housing. I think stable and affordable housing is not so much an escalator as it is the third rung (after education/training and stable employment) on the ladder towards economic prosperity and financial independence.

As for that unsettling “house of cards” feeling we may be experiencing with housing prices at or near record highs? While it would be positively reckless to conclude it’s just a false alarm that can safely be ignored, it also shouldn't be taken as a harbinger that a collapse is imminent. Like asset prices of all kinds, values respond to a variety of economic conditions and it pays to maintain a watchful eye. Just be sure when the wind picks up, your housing cards are anchored down so you aren’t required to sell into a passing storm.

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Michael Reid, CFA is Managing Director and a Partner at Exchange Capital Management who does not gamble but still finds it useful to count cards. The opinions expressed in this article are his own.