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Is Housing Such a Bad Investment? Maybe Not...

posted by Adam Levitin

One of the post-bubble conventional wisdom stories that has gotten a lot of traction is that housing is a bad investment and that consumers would do better to rent and invest in the stock market.  The problem is that it's wrong.

The prooftext for the idea that housing is a bad investment is a straightfoward comparison of the returns on stock market indices with those on housing market indices.  If one compares the return on the S&P500 index vs. the S&P/Case-Shiller Composite 10 index from the beginning of the Case-Shiller data (1987) to present, one sees that the S&P500 went up 630%, while the Case-Shiller went up only 197%.  Even if one uses an average return (averaging the monthly index values, relative to the starting value), S&P500 is 244%, while Case-Shiller is 98%.  Ergo housing is a bad investment compared to the stock market, right?

That's certainly what a bunch of smart people have argued. (I won't link or name names, but Google isn't coy.) There are two problems with this line of argument.

First, it fails to account for the leveraged nature of housing investment.  Most homes are purchased on leverage, and housing is the only leveraged investment broadly available to the middle class. When one factors in leverage, housing massively outperforms stock market mutual funds, making it a pretty sensible investment in most cases.   

Second, the simple return comparison fails to account for the indirect benefits of housing, such as school districts, commuting time, quality of life etc. I'm not going to try to quantify the indirect benefits, although some of them definitely translate into pecuniary terms (schooling, for example).

If you'll indulge me with some number play below the break, you'll see that the leverage point alone blows the "housing is a bad investment" argument out of the water. Leverage is not without its complications, though.  

Let's imagine that it's 1987.  You have $100.  You can invest in a mutual fund that tracks the S&P500 or you can invest in a house.  If you put your money in the mutual fund, you could sell it today for about $730.  There would be some small transaction costs involved-a fee for buying and selling and an annual fund manager's fee of a few basis points.  Let's say this all adds up to $5.  If so, your investment of $100 would have returned $725 over 27 years.  That's a 625% return.  

Let's say that instead you purchased a house in 1987.  You paid the entire $100 price in cash.  You sold the house today for $298.  The house purchase and sale also had some transaction costs.  Let's say those were 3% of the purchase price and 6% of the sale price, or about $21.  So your investment of $100 would have returned $277 over 27 years.  That's a 177% return.  Not nearly as good as the mutual fund. 

Now before I proceed further, I'm sure that some readers will be objecting:  you didn't include home maintenance and taxes.  And others will be pointing out that I didn't include an employer match for a 401(k) contribution.  

I don't think either are relevant to the analysis.  We're analyzing financial investments.  That means any costs related to the consumption value of the house--the imputed rents--should not figure into the calculation. I think it's reasonable to assume that imputed rents are basically the same as costs of financing plus costs of maintenance plus taxes.  Some may dicker with me, but I don't think it ends up materially affecting the analysis.  If I'm wrong, however, please show me why in the comments. 

As far as a 401(k) contribution match--that's not found money. To the extent an employer makes a match, it is in lieu of other compensation. There's a tax benefit to be sure, but there's also a home mortgage interest deduction that I'm not trying to figure in and not everyone can benefit from either of these factors, so I'm leaving them out of the analysis.  Plus, I don't really want to have to try and calculate the value of the tax benefits.  Again, if you think it's material, please show why. 

If the analysis ended here, it would be a no brainer not to buy a house as a financial investment. Yes, other non-financial or indirect pecuniary factors might change the calculus, but as a pure financial investment, buying the house is a bad move. 

Most Americans, however, don't pay for their homes in cash.  They borrow.  And leverage changes everything.  If we run the same numbers with 20% and 10% downpayments respectively, the returns on housing are $277 on $20 and $227 on $10.  That's a 1035% or a 2170% return respectively. When purchased on leverage, housing has WAY outperformed the stock market. 

If you want to run the figures just for the last five years, which have been an unbelievable bull market, the same story holds.  Same if you look at average returns.  When one accounts for leverage, housing is a MUCH better investment than the stock market. 

But wait--isn't this apples to oranges?  Stock can be purchased on margin too, no?  Yes, but mutual funds cannot be purchased on margin, and most stock market investment by consumers is through mutual funds.  Moreover, you can't get a margin loan at 80% or 90% LTV. 

Now leverage can be a blessing or a curse.  In a falling market, leverage is awful, as the last several years have shown.  But that's an exception, and a lot of mortgages are functionally non-recourse, so the put option from walking away functions as a loss limitation.  (None of this is to say that foreclosure is painless--quite the contrary, although a lot of the pain is non-pecuniary--but non-recourse status and things like bankruptcy have an insurance function that should not be ignored.) The bigger problem is that housing is an undiversified and unhedgeable investment, unlike a mutual fund.  So there are different risks in housing simply as a financial investment. But housing is the only leveraged investment available to most middle class Americans, and with stagnant real wages, it's probably the better bet than the stock market. 

Notice that none of this has considered the other benefits of housing:  property tenure rights (hedging against gentrification risk), pride of ownership, school districts, etc. All of those matter.  A LOT.  Obviously, like any investment, housing doesn't turn out to be a great bet for everyone.  But overall, when combined with the leverage point, housing is a really sensible investment for the American middle class.  

Comments

It's hard to take seriously any analysis of housing as an investment without taking into account that housing produces income.

If we go back to your example and posit a price to rent ratio 20, your $100 house is going to produce $5 a year in rental income. Over the 27 years of our example, the house produces $135, bringing our return to 312%.

But wait, we also forgot about inflation. If we assume that rental income tracks roughly with housing price, the house is now renting for about $15 a year. Calculating the full ROI is more work than I'm willing to do for this blog comment, but you get the idea.

Of course if you live in your house, as most of us do, you're not getting this money in your pocket. But the imputed rental income is replacing money you would otherwise have to pay out in rent.

In reality the rent/buy/invest calculations are pretty complex, if done properly. But simply comparing the S&P to Case-Schiller is just silly.

I'm already getting taken to the woodshed (as I anticipated) for this post. So let me start addressing points in the comments and mailed to me directly.

I was trying to set this up as mutual fund + renting vs. homeownership. But it could be more complex. There's also renting + homeownership as an investment.

1. Imputed rents and dividends. Housing prices should reflect imputed rents, no? Similarly shouldn't stock prices reflect expectations of future dividends? If so, I don't think they need to be separately addressed. Dividends on the mutual fund investment make an apples-to-oranges tax comparison, so let's make this easy and assume that the mutual fund is a 401(k), so that all taxes are deferred to the end.

2. Carrying costs. To the extent that mortgage + maintenance + taxes + insurance = rental costs, then carrying costs can be excluded from the analysis. They aren't always equal, of course, but for equivalent properties, they should be very close, with the mortgage costs being a bit higher to reflect the put options (refi and walk-away) in the mortgage.

Don't forget reinvested dividends. The S&P500 total return index is up ~1200% since 1987.

Why are you comparing a leveraged investment in real estate to an unleveraged investment in the markets?

A stock investor can lever up to 75%. The comparison should use typical rates of available leverage. It should also take into account the debt service, which for securities accounts is an order of magnitude below RE loan rates.

And it should take into account imputed income and dividends (which compound, unlike imputed RE income).

It would be shocking if the stock account isn't generating many, many times the return of the RE investment.

(Actually if you want to be really clever you'd figure out what degree of leverage in the S&P matched the risk of an 80% leveraged RE investment, but no need to get that sophisticated...)

If you don't want to do this calculation, e-mail me and I may well do it -- it sounds like a bit of fun.

Amos,

I think Adam has the better of the leveraging argument. He is comparing the average Joe's decision to invest in the stock market or a house. To make a fair comparison, you have to look at how Joe would make the investment. It is very likely that Joe would use a mortgage to buy a house, but would not borrow to buy stocks.

Now, if you were talking about the average Donald (Trump) or Warren (Buffet), it would likely be a different calculation altogether. That is why Donald and Warrent go the stock market way, while Joe should buy a house.

@ Amos:

I think it's fair to compare unleveraged to leveraged here, as most people don't buy stock directly. They buy mutual funds. You can't buy a mutual fund on margin, although you can post it as margin for stock purchases.

Also, the maximum leverage for a stock purchase is 50%, not 75%. 75% is the maintenance margin allowed by Reg T, but initial margin is capped at 50%.

Another reason why it isn't fair to demand that a leveraged home purchase be compared to stock investments on margin is that there really isn't such a thing as a margin call on a residential home. The homeowner can choose to keep making payments on an underwater loan. The margin stock investor doesn't get to make that choice. So, the increased potential returns on margin stock come with a much higher level of risk.

Ummm... No. That's just wrong.

We evaluate investments in terms of both return and risk. If you compare an unlevereaged investment to a leveraged one in a generally rising market, the leveraged one is unfairly juiced.

The appropriate comparison is to purchase of an index fund. While the *fund* can't leverage it's holdings, the investor can leverage his investment in the fund.

As for margin calls-is that a joke? A margin call in the RE market is when rental value falls below debt service.

If Adam wants to ignore issues like imputed rental income and tax effects, fine, but do so fairly. Otherwise we just replicate the rationale behind what may be a g-d awful, malicious even, meme about how ordinary people should invest.

@ Amos:

The apples-to-oranges nature of the investment decision is the point. Housing is virtually the only leveraged investment option available to most Americans. That's part of what makes it attractive. Unleveraged home purchases are generally a poor investment relative to unleveraged stock purchases. But the fact that most people buy their homes on leverage and buy their stock via unleveraged mutual funds changes the balance. That's what makes housing attractive.

Not following your other points:

How does one leverage an investment in an index fund? Neither the *fund* nor the *investor* are leveraged. The fund is equity investment only, while the investor cannot buy a mutual fund on margin. (The fund can provide margin to *other* leveraged investments, however.)

There are no margin calls in RE, which reduces the risk of the leverage. Even if a house is underwater, the homeowner can keep the house by continuing to make payments on the mortgage. This lets the homeowner essentially retain a call option on the underwater house, being able to keep any future appreciation. Not the case with stocks, where a margin call is a liquidation event.

I think what you are arguing is that the average Joe is better off making an undiversified, high variance investment (leveraged real estate) versus a diversified, comparatively low variance investment (unleveraged stock market) because there's a chance of hitting a home run. This strikes me as rather aggressive. If you were advising someone today about how to invest their nest egg, would you advise them to take all their savings, borrow to the hilt, and buy a single commercial real estate property, or would you advise them to invest in stock market index funds? The home aspect is irrelevant to the financial question.

Adam, you can buy the SPY ETF with the same leverage as any other stock, I'm pretty sure. And as marmico points out, you HAVE to include dividends, since they are a very significant component of stock market returns.

ETF are different that traditional mutual funds. When you purchase a share of a traditional mutual fund it is considered a new issue, and therefore not margin eligible. With an ETF, you are buying the shares not from the fund, but from someone else on through the exchange, so it's not a new issue, so it's marginable. ETF are still relatively small compared with traditional mutual funds, and their cost structures are different.

Regarding dividends, the expected future dividends should be reflected in the stock price, just as expected future imputed rents are in the home price. And not all stocks pay dividends--a company can retain earnings and the gain will all be reflected in the share price. That's why I'm comfortable using just purchase/sale prices for both.

@Douglas Levene,

I appreciate the stark way you tee up the issue: a leveraged RE investment vs. an unleveraged stock investment. That said, I don't think that's quite fair. First, most consumers cannot make a leveraged CRE investment. It's not really on their menu. Second, CRE has risks that residential does not, namely property vacancy, and local CRE markets are sometimes more volatile than housing markets.
Third, I haven't run the numbers on CRE. (One can, but the time series is much shorter).
Fourth, when one adds in the non-investment aspects of a residential real estate, the risks are more palatable.

This makes absolutely no sense from a total dollar standpoint. In order to purchase a 200k home today over the course of a 30 year note, the purchaser must pay a total of approximately 345,000 in principal and interest at a 4% rate (resulting in a $955/month payment), which I discount 20% from a 5% rate in order to offset the approximate benefit of the mortgage interest deduction. Add to that approximately $4,000 per year in property taxes (at least), for 30 years and you have paid $465,000.00. Add to that probably no less than $40,000 in maintenance and you've now paid over $500,000 for a $200,000 home. In other words, just to recoup your "investment" you'd have to sell the home for no less than $500,000 just to break even. Furthermore, you would still have an effective rent of 333/month at the end of the payments for paying the property taxes.

On the other hand, if you could rent for $700/month (which is very doable in my neck of the woods), and take the $250/month difference between home and rent payment, and invest it and make a measley 5%, you would have paid rent out of only $252,000 during the 30 year period, but the annuity of $250/month would have a future value of $218,000.00, which would then be giving you $908/month at the end of 30 years (or paying for the rent and providing extra income. Furthermore, with the benefits of renting, you usually paid nothing for maintenance, and in many cases, you also might not have had to pay for a utility bill or two.

Given the difference, renting/investing allows you to pay the rent out of your investment in the future, while you will still pay some sort of rent (a/k/a - property taxes) for the home that must come out of current income. Furthermore, given that the renter wasn't paying the additional 333/month in property taxes, and could likely save maybe no less than 250/month on utilities/maintenance, the lost opportunity cost of investing that additional money into retirement is staggering. An additional 583/month in additional savings plowed into that same investment earning 5% per month would have a future value of $508,000 at the end of the 30 year period.

So, the homeowner pays out $500,000 for his investment, and has to hope that he can recoup all that money he paid out. He also has no additional annuity like the renter does.

The renter, on the other hand, pays less overall, saves on utilities, maintenance, and property taxes, and if he plows those savings into a safe investment, ends up with over $700,000 in retirement funds at the end ... laughing all the way to the bank. This is why it's better to rent and invest.

@ Brian Rookard: your whole analysis is premised on rental costs being MUCH less than homeownership costs. It's often very hard to find equivalent rental/ownership options. But for the same property, the costs should be very similar, with the rental costs being slightly lower to account for inferior property tenure. Taxes and maintenance (and possibly utilities) are baked into the rental cost. So if you're paying $700/month for rental, it's not going to be for a property that is anywhere close to equivalent to one with a $950/month mortgage payment. In essence, what you're saying is, live in a less nice place (which might still be plenty nice) and invest the savings in the stock market. That's a fair strategy, but that's a choice of consuming less housing and more pure financial investment, not a choice between two alternative financial investments with identical housing consumption.

Adam, whether or not dividends are reflected in the stock price is completely irrelevant. The point is that in order to calculate the historical return of an investment in the S&P 500, historical dividends MUST be included. The standard S&P 500 index does not include these, hence you have to either use the S&P 500 total return index (which does), or account for them yourself.

Your calculation makes about as little sense as saying that the return of a 10y treasury note is zero, since you invest 100 and get back 100, and the 100 "already reflects the value of the coupons".

The rationale for ignoring imputed rents, btw, is not that they are reflected in the purchase price of the house, but that you are assuming that the carrying cost of the house (financing + maintenance) is equal to the imputed rent.

i.e. for the stock investment, you get dividends, you have to pay actual rent for housing.

For the house, you pay financing, you pay actual maintenance.

If you assume that the rent you would pay if investing in the stock market equals the financing and maintenance you would pay if buying a house, you can ignore that bit for both.

Adam: You say "Housing is virtually the only leveraged investment option available to most Americans. That's part of what makes it attractive. . . . How does one leverage an investment in an index fund? Neither the *fund* nor the *investor* are leveraged."

Others have explained how you buy an index fund on leverage. But either way, that isn't the point. We want to compare the risk and returns of exposure to the stock market to the risk and returns of exposure to the RE market. Index funds are convenient way to do the math, not the exclusive vehicle for taking on the risk.

Its absolutely not true that consumers don't have access to margin, but can borrow to buy homes. The consumer can take the cash that would otherwise go into their down payment, and put it into a brokerage account. Then they have access to margin.

Your point that leverage is what makes housing attractive is just the well-established CAPM principle that returns correlate with risk. Which means the RE investor is taking on more risk. A comparison to financial instruments should be a comparison of risk-to-reward ratios (e.g., Sharpe ratios or the like), to see which risk is better priced.

And, again, RE *does* have margin calls. When the imputed (or actual) rental value of the RE falls below debt maintenance, that's a margin call. If the homeowner is *living* in the home, then its an *imputed* margin call, just like they have *imputed* rental income. But you're excluding these from your analysis -- which is why its apples-to-oranges.

Your analysis also excludes part of the effect of compounding. Stock dividends get (usually automatically) reinvested. For RE, what happens when the imputed rental income exceeds carrying cost (I think equating them is mistaken, but I'm playing along)? In a rising real estate market, imputed income *must* be higher than carrying cost after a few years, since the financing interest rate doesn't change. And either way, you can't reinvest imputed income!

Its true that someone who invested in RE in the 70s or 80s did well, and that seems to be what misleads people about RE. They would have done even better with stocks, but anyone who began saving in the 70s or 80s did spectacularly well regardless of what asset class or mix they chose because asset prices were skyrocketing for decades. (With very few exceptions, a la Enron.)

One more point -- as a matter of basic economics, how could real estate go up faster than the economy as a whole? If its because the population is increasing, well, if the population is generally increasing faster than the economy, then we're in continual severe recession or depression. Moreover, the quantity of real estate isn't fixed. We create more real estate all the time -- by building upwards, and by building highways.

Will you now concede the point? :-)

Amos, while I generally agree with what you're saying, I'm not sure I get the "margin call" bit. If the value of the house drops below the debt that has to be repaid, that's a loss, but it's not a margin call. You won't have to put up new equity unless and until you want to refinance the house. i.e. if you take out a 10y interest-only mortgage on your property, you can face a "margin call", but only at the end of the 10y. This is very different from the stock market, where you can face a margin call at any time of any day. On the flip side, of course, it's generally difficult to re-lever your house if its value goes up (unless HELOC loans are back in vogue), while that's very easy in the stock market.

Nivedita: To see that it really is a margin call, imagine that the income is *not* imputed, and that instead the property is being rented to a third party.

When the rental value of the home falls below debt service, the owner has to put in cash each month out-of-pocket. Whether you call that "equity" or something else really doesn't matter, its economically the same thing.

We agree *that* is equivalent to a margin call, right?

Switching from actual to imputed rent, the margin call is still there, its just imputed.

I think what you're referring to, is that the rate on leased property doesn't change month-to-month with the housing market. That's true, but when we're imputing rent, that complexity disappears -- we impute an amount at the then-current market rate.

With me now?

As for re-levering and de-levering, you're pointing out that RE is far less liquid and has higher transaction costs than the capital markets. But Adam is assuming those issues away :)

Amos, yes you do have to put in some equity each month, but the difference is that this is not the amount by which the value of the house's rental income stream has dropped. i.e. if the rental income and financing cost are both about 5% per year and the rental income drops 20%, you only have to come up with another 1% each year of equity. If this had been a stock, you'd have to put in 10% more equity to compensate for the 20% drop in value ($50 of equity for $100 of stock -> $30 of equity for $80 of stock -> have to put in $10 to maintain leverage at 2x). It's much easier to come up with 1% per year than 10% in a day.

Ok, so you've agreed with me that it's a margin call :)

Your new position is that its a *smaller* margin call. But it isn't.

First, if there's a 20% drop in stock price, there's no margin call. A consumer can margin up to 50%, but they don't get a call until their equity drops to 33%.

So let's make it a 40% drop.

Second, a price drop after margin call has a greater impact on the RE investor. Assume both start with $100 cash (5x leverage on the house, 2x on the stock). After a 40% drop, the RE investor has a loss of $210 (he's underwater). The stock investor's loss is only $80.

Third, when the price goes back up, that becomes additional equity that facilitates additional borrowing by the stock investor. For the RE investor, its imputed income that doesn't compound.

Just for testing, I tried a simple monte carlo, assuming that annual returns average 6% with a standard deviation of 20%.

After 19 years, the stock investor's return averaged **20x** the RE investor's return.

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