When I was in college, I had a girlfriend who was a lot of fun to be around. She was super cute and clever. Funny. Lots of laughter. Lots of energy. Full of life.
One day, I am driving her home when she asks me to make a quick detour. She said it would take a bit longer, but she really wanted to show me something. So, I followed her instructions, and we started up this small hill overlooking the valley where she lived.
We were soon in the midst of huge, "luxurious" McMansions. She started talking.
"I really like this one. And wait...especially THAT one. And...that one. But my favorite is the one coming up...it is...THAT one! I LOVE that one!"
It was right then, at that exact moment, that I had one of the greatest epiphanies of my entire life:
Whoa. Can't marry this one.
It's not just potential spouses that are into big houses. The entire industry is geared to selling up. Developers like big houses because they can make more money per lot. Banks like big houses because they charge an interest rate on the loan amount. Your real estate agent gets a bigger commission. Appliance manufacturers, cabinet makers, flooring companies, air conditioning and heating companies, even light bulb manufacturers all make more from larger houses.
Unfortunately, us buyers get suckered into the whole "bigger is better" idea, too. Even though it wreaks havoc with our retirement plans.
Here's how it typically goes: We sit down with our mortgage broker and talk numbers. The broker tells us about the 28/36 rule, asks about our income and debt levels, runs a few calcs and says, "you can afford to buy up to $500,000." (Or some such number.) And in a blink of an eye, that limit becomes our expectation.
Unfortunately, us buyers get suckered into the whole "bigger is better" idea, too. Even though it wreaks havoc with our retirement plans.
Here's how it typically goes: We sit down with our mortgage broker and talk numbers. The broker tells us about the 28/36 rule, asks about our income and debt levels, runs a few calcs and says, "you can afford to buy up to $500,000." (Or some such number.) And in a blink of an eye, that limit becomes our expectation.
So then we go out with our real estate agent and look at a few houses in our price range. And then, inexplicably, our agent takes us to a few houses above our price range. And we end up borrowing money from our parents because we just can't quite get what we're looking for without moving up in price.
(Kind of like the speed limit. It's a limit, but it becomes our expectation. And then...we add a bit more.)
It doesn't matter if our limit is $100,000 or $500,000 or $2,500,000. We see a house above our limit, and we want it. Above it, we covet, baby.
"Wait, hold on, there Deadweight. I'm not a moron. I didn't buy the nicest house I could afford because of some psychological trickery. And I didn't buy for status, either, if that's where you're headed. It's an investment, man. There's no real cost."
Yeah, Slash, I've heard that excuse before.
First of all, you can pretty much count on real estate to provide a lackluster return. People think the return is huge because they look at a house built say, in the fifties, and see that it is now worth 10x. But over that same time period, inflation went up by almost as much. In the long run, home prices barely outpace inflation. Yippee.
"Ha! Yer talking a national average. Some markets are red hot."
Well, I grew up in one of the absolute "hottest" markets in the country. The house was built in 1963. The current price estimate on Zillow suggests a compounded annual growth rate of 3.7%. Over that same time period, inflation ran at a compounded annual growth rate of 4.1%. So the price didn't even keep pace with inflation. Hot markets are like hot stocks - the hotness is often already priced in.
"That's a very specific example, Duckwalk. I'm sure I'm doin' much better."
You may be surprised. Try it yourself. Here's the formula:
Where:
CAGR = Compound Annual Growth Rate
SV = Starting Home Value (The price you paid)
EV = Ending Home Value (The estimated value today)
SY = Starting Year (The year in which you purchased your house)
EY = Ending Year (This year)
Once you're done calculating your house CAGR, use the same formula to figure out the inflation CAGR. Just replace your SV with something like $100 and use this inflation calculator to figure out the EV.
"Okay, Smartypants, give me just one second to figure this out..."
Take all the time you need...when Sunny gets blue...her eyes get gray and cloudy...then the rain begins to fall..pitter, patter...pitter, patter...
"Dude."
Sorry.
"...oh."
What did you come up with?
"Well, okay, it's not as big as I thought. But at least my house outpaced inflation. By about 1%. And..oh, hey! That's significant, right? You, yourself, once said that small differences in growth compound in a big way over time."
Yes, well, it would be a big impact, except your big, expensive home has a lot of annual expenses that scale with it. Maintenance and repair, landscaping, property taxes, mortgage insurance, home insurance, heating bills. All that can easily consume any advantage your home appreciation has over inflation. Besides, there is the opportunity cost. The historic real return of the stock market is more like 4-5%.
"Yes, but real estate is less risky than stocks. And you leverage real estate. That's what makes it a great investment! With leverage, my 1% real return becomes 4-5% real return - on par with stocks. Bam!"
Okay, first, you
could leverage to buy stock, too. (I definitely wouldn't advise it, but you could.) So let's not confuse things. Leverage isn't an investment. It's a tactic.
Second, real estate may be riskier than you think. It is very illiquid, prices can and do crash (remember 2008?), and with all the foreign money pouring in, we could see even greater volatility ahead.
And don't forget, if you do leverage, you aren't just magnifying the returns, you are also magnifying the risk. While home prices may not fluctuate as much as stock prices, by leveraging, you are significantly amplifying the volatility of your returns. (If you bought in 2008, you are painfully aware of this fact.)
Finally, your leverage dissipates over time as you pay back the principle. In the end, you have an outsized portion of your investments in a single asset, creating a highly non-diversified portfolio. That means you are assuming unnecessary and unrewarded risk.
(Although, my advice is to not consider your home as an investment in the first place. In which case, your portfolio may be balanced after all, but it is also a lot smaller than it would have been had you bought more modestly. Either way you look at it, big, expensive houses are not good for your early retirement plans.)
That's theoretically possible. But that's not what you are really doing. You didn't invest that borrowed money. You used it to buy a big ol' expensive house, remember?
Second, real estate may be riskier than you think. It is very illiquid, prices can and do crash (remember 2008?), and with all the foreign money pouring in, we could see even greater volatility ahead.
And don't forget, if you do leverage, you aren't just magnifying the returns, you are also magnifying the risk. While home prices may not fluctuate as much as stock prices, by leveraging, you are significantly amplifying the volatility of your returns. (If you bought in 2008, you are painfully aware of this fact.)
Finally, your leverage dissipates over time as you pay back the principle. In the end, you have an outsized portion of your investments in a single asset, creating a highly non-diversified portfolio. That means you are assuming unnecessary and unrewarded risk.
(Although, my advice is to not consider your home as an investment in the first place. In which case, your portfolio may be balanced after all, but it is also a lot smaller than it would have been had you bought more modestly. Either way you look at it, big, expensive houses are not good for your early retirement plans.)
"Okay, but what about the fact that interest rates are so low? I am borrowing cheap money and then investing at higher returns."
"So, what..don't buy a house? Ditch the American Dream?"
I'm not against home ownership. Just avoid the trap of buying as much as you can afford with the justification that the house is a great investment. It is not.
Your home purchase is an expense to be managed.
You know, even if these new, expensive McMansions make little financial sense, one really does have to admire their resplendent beauty: 1 2 3 4 5 6
I totally agree. My wife and I decided to purchase a smallish 900 sqft fixer-upper in a low income neighborhood, and then did the minimal amount of work ourselves to make it livable (less than $500). We pay less PITI than most people pay for a single bedroom apartment. This allows a lot more to go straight to our investments. Our biggest issue is that our neighbors still can't understand why we haven't repainted our house or landscaped our yard yet. We've tried explaining that housing is a liability and our goal is to minimize its expense.
ReplyDeleteNow, having said that, we do invest in rental real estate for a couple of reasons:
1) We buy smart, and our returns are better than the stock market (our lowest is 20% annually). And those returns are not dependent on housing prices going up or down.
2) We can add a lot of value to our investments via creativity and work (hard to do that with the stocks)
3) We genuinely enjoy the work, and hire people to do the parts we don't like. So yes, it's not as passive, but that's OK at this stage of our life.
Great articles! Keep them coming! :)
Okay, WOW. I think when it comes to home ownership, I just found myself a new hero. That's impressive, James.
DeleteTo be honest, I have purposely avoided discussing rental property in my blog because I don't know anything about it. My outsider's opinion, however, is that rental property is much more than an investment. It virtually constitutes a second job. To do it right, you have to be willing to put in the time and effort.
Unfortunately, I am way too lazy to learn the market, buy, sell, clean and update properties, deal with tenants, and make icky repairs. But I do admire anyone who is willing to do all that. And if you actually enjoy it? Fantastic - a hobby that makes you money. Doesn't get better than that.
Now, if only I could find some kind of role where I would get paid an obscene amount of money for doing absolutely nothing...
Oh, right. Congress.