Traditional advice has always been to buy a home to “lock in” your housing costs. Over the past 30 years inflation has increased rents considerably, and those that took out a mortgage did well as inflation eroded the cost of the money they borrowed. We have discussed how alternatively you can choose to invest in diversified investments and rent a home instead. Generally the other investments return more than the house does per year, but you cannot borrow and use leverage on stocks and bonds like you can on a house. It is the access to cheap leverage when buying a home that makes people see it as the best investment.
Leverage goes both Ways
For a long time it seemed as if leverage could only be a good thing in terms of homes. in 1999 with stocks we saw how using margin could be disastrous, yet with owning a home as long as you made the payment you could still enjoy its use. Then in 2008 the myth that housing never goes down was busted. What is amazing is how fast housing has rocketed back up to where it was and even higher than the last crash. People seem to believe that housing could never go down again. If housing only goes up, then yes taking out a large mortgage employing max leverage will probably be a boon to your finance. I just don’t see how anyone can truly believe that. Whenever someone says an investment can’t lose, or is guaranteed, it is usually time to run to the hills.
Current Price Psychology
I think as humans we get used to current prices. For instance if eggs are $4 a dozen at the grocery store for 2 years and then then jump to $5 we get upset and angry, but then again get used to the new price level until it goes to $6. With housing in 2007 we all laughed that prices are just going to keep going up and that we will need 50 year mortgages to be able to purchase one in the future. When the prices fell through the floor and homes were listed for half of what they were a lot of people were afraid and thought that houses could just keep going lower. The point is the price is just what it happens to be. We cannot know if it is over priced, under priced, or fairly priced. Sure within any market we can determine that a potential purchase is a better value than the next property, but compared to what prices could be 10-20 years in the future we have no idea if its a good buy today. Okay so what is my point with all of this? It is that depending on where you live could happen to be a place where real estate growth and prosperity will be there for years to come, or your city could fall into a decline like the once great Detroit did. The answer is you don’t know, but neither does anyone else. It’s all a guess. It is a speculation. Speculations can be very rewarding, but can also be disastrous. Great investors do not speculate, they invest.
Buying a house vs a diversified Portfolio
Now that we have determined that buying a house is a speculative investment let’s compare your options. A) Buy a home with all of your savings put into the down payment. B) Rent a home and put all of your savings into a set of diversified investments. The key difference here is in choice A a mortgage is being used to essentially lever the value of the home 5x. Whereas with B the diversified portfolio is not using leverage.
In situation A you have employed tremendous leverage and are completely non diversified. In situation B you are well diversified, but are not employing leverage of any kind. Here is who would come out ahead in different scenarios:
- Home Prices and Rents skyrocket: Choice A would clearly benefit as the leverage amplifies the gains if they choose to sell the home, or the income saved not paying higher rent increases
- Home Price Tank: Choice B clearly would benefit as the diversified investments would be better insulated to the home price decline. Choice A would be wiped out.
- Home prices stay flat or moderately rise: In this case choice A will likely not make much money even with the leverage as they are continuing to spend on maintenance and upkeep of the properly. If they choose to sell the home they will lose a lot of the proceeds to commissions. Choice B will likely fair better even without the leverage , because the diversified investments are more likely to make a better return than the home.
*Due to the nature of the 5x leverage on the home this would mean that portfolio B would need to return 5x the percentage yield to be equal. Under scenario 1 it is unlikely B would gain enough. But under 2 and 3 B would be far superior. We have no guarantees that stocks, bonds, and commodities will perform better than housing, but by being diversified the probability is that it will be a safer return.
Take away: If you use high leverage then you will make a lot of money if the investment goes up, but will get crushed if it goes down. To me this is speculation at its finest. Rolling the dice.
How you can have your cake and eat it Too
Let’s revisit the above scenarios again, but this time throw in an extra variable “below market rent.” It is generally assumed that if you buy the home you have locked in your housing costs, but if you rent you are at risk to indefinite rent increases. What is not talked about is that if you buy the house you will also have indefinite repair bills, and if you are a renter with good credit and pay on time you likely will see minimal rent increases.
It is not likely that you will initially be able to get a rental that is substantially below current market rates. However, if you stay for a few years and are a quality tenant many smart landlords realize they do not want to lose you and are happy to not raise the rent, or make smaller increases than they normally would. If you can feel out one of these situations, or move around until you are in one of them you can greatly benefit. If you are in a below market rent situation you get all the “financial” benefits of owning the home. You have your rent “locked in” and you don’t have to pay for the maintenance. Best of all you didn’t have to tie up your savings in a downpayment, so this money is growing in your other investments. Let me repeat that: You get below market rent without tying up any or your money or taking on any financial risk!
If home prices stay flat or go down you come out way ahead. If home prices greatly go up and your landlord eventually raises your rent this is okay for a brief period of time. All the years before this happened you have saved the difference and invested the money that has been growing. As time continues if you stay or find another rental you could again find yourself below market again. You don’t need to be below market for 30 years in a row to be as good as owning a home. I believe that renting at current market rent and having diversified investments beats housing by itself in scenario 2 and 3 above. In situation 1 where housing goes up huge due to the leverage the homeowner wins. But if you can get a few years of below market rent mixed in, then even under scenario 1 you should do okay. Therefore, speculating that buying the home will be a windfall has more downside than upside risk. You could still do great, but don’t expect to.
Non financial Considerations
Another reason people tend to buy a home has nothing to do with the financial aspects. It is more for the stability, not having a bad landlord, being able to customize it and most likely it is more exciting. I know looking at the MLS and the glossy flyers are enticing. I think people may end up buying just because there are better properties more easily visible. There are a lot of nice rentals available, but the landlords don’t want to spend money to advertise them and they don’t get the exposure they should.
When homes are listed for sale with a real estate agent they have high quality professional photos, staged open houses, and public record information and disclosure reports available. These are all great things to have access to when deciding where to live. I think this could change as Trulia and other major sites are starting to feature rental listings now. If these same tools, and marketing are brought to rentals there may be higher demand and people may feel less pull to owning.
Another fun factor to think about when renting is the cost of remodelling. HGTV has been a phenomenon and many home owners spend thousands of dollars to update and improve their homes constantly. This money is never factored into the equation when deciding to buy or rent. It is usually well we can get a mortgage for $2,300 on this place and throw $65,000 into it to upgrade it.
If you had rented the place, when you decide you are tired of the decor, or want something newer, you simply wait until your lease is up and move to another rental that has the features you want. You likely will pay more, but your diversified investments have been providing income the whole time you have been living there as well.
Again if you do want to buy a place, just be aware of the costs to maintain it, to sell it if you want to move, and the lack of diversity if it is the majority of your money. If you already have a strong balanced portfolio and want to use a small less than 20% of your total assets to purchase a home that you plan to stay in for a long time, then I think that is not overly risky.
The Fear of Missing Out is something that I and many humans struggle with. If you perceive the majority of people are doing something and it works well for them, then you easily feel that you should be doing it too. As with leverage this can go both ways as something that is beneficial vs detrimental. In regards to housing when it is rising it seems that you hear constantly about how rich your friends and other contacts are getting from it and you may feel “left behind.” There is no quick fix to this, you just have to believe that you made your decision to buy or not buy something for reasons that were sound, and that the current results do not change that. In regards to housing we just need to remember that it is a speculative investment. It could easily go down just as well as it goes up.