In previous posts I have advocated investing in a home as a way to build wealth. Renting for long periods is generally a bad idea because you are not taking advantage of a U.S. tax code that incentivizes home ownership, and you are not building wealth in the form of home equity.
Now I want to expand on the topic of home ownership. When I talk to people about their investment in their home, I often hear a lot of misconceptions, so I will address some of these. People tend to be very emotional about their home, which clouds their judgment, and so they neglect to apply the principles of basic investing. So I will outline a rational, clearheaded way to think about your investment in your home.
First, while investing in a home is usually smarter than renting, a home is not a great investment compared to many other types of investments, such as a diversified portfolio of stocks and bonds. Much of the benefit of a home is that you get to live in and enjoy it (i.e., consumption). If you were considering whether or not to add a large amount of investment into your home by either doing a major renovation or moving and upsizing, you shouldn’t do it for the investment return. More home always equals more expenses, in the form of property taxes, utilities, maintenance, insurance, etc., so purely as an investment, it is not the best place to put your extra money, unless you just want to pay down your existing mortgage. Renovate or upsize to enjoy your new space, but not as a smart investment.
Real estate values move in very pronounced cycles. When the real estate market rises rapidly, as it did in 2002 – 2006, people tend to get much too giddy about their newfound wealth. And then when it crashes, such as happened in 2007, people become much too sad. In terms of its performance as an investment, real estate should be viewed as every other investment: you don’t make or lose any money until you sell. And the key to making a good return on your home is to buy low and sell high, if possible. So let’s explore this in more detail.
When you buy your first house or condo, from a pure investment perspective, it would be best if you could buy when the market is somewhat beaten down, or at least not at a frothy high. This is “buying low.” When you move up into a larger and more expensive home, as most people do once or more during their lifetime, it would again be great if the market were weak, since you are adding to your investment, and again you want to buy low.
When you get older, and if you should choose to downsize, you would like the market to be relatively strong, because now you are now beginning the process of disinvesting in (“liquidating”) your home, and you want to sell high.
What happens in the real estate market at any time in between these initial purchase/upsizing and downsizing points is completely irrelevant to your investment return on your home.
I talk to people all the time who have lived in their home for 20 years, and who plan to live in it for probably 20 more, and who are terribly depressed about a “down” real estate market. What difference does it make? The only thing that matters is what the market was like when you bought and what it will be like when you sell. People who plan to live in their home for decades were much too happy in 2006 and much too sad in 2007.
I also talk to people who would like to move, but don’t because the market is down. Their reasoning is often irrational: they don’t want to sell their home for less than they paid for it, less than they think it is worth, or less than it would have sold for in a recent up market. This is logical if they are downsizing, since this is a disinvestment, or liquidating, point. However, if they are planning to buy a somewhat more expensive house, it is actually a great time to sell and move from an investment standpoint, since they will be adding to their investment at a time when prices are low. So even if they will be getting less for their existing home than they would like, it will be more than made up for by the lower price on the larger investment in the new house. This is a win. They wish they could have sold their existing home at the market high, and bought their new home at the current market low, but it is just that, wishful thinking, and not reality.
It is also important to realize that for many people the investment in their home is not liquidated until they die, since they never downsize, at least not in terms of dollar investment. They either stay in the same house until they pass away, or they move into a smaller, but just as expensive home, such as a condo downtown or a townhouse in a neighborhood with a pool and golf course. So the liquidating event never happens in their lifetime and they never reap the windfall. Having a large financial investment in a home can still afford you financial strength during your lifetime, in that you can borrow against it with a home equity loan or line of credit, but unless you downsize before you die, you are really just building wealth for your heirs, and not yourself. When you are planning financially for retirement, if it is unlikely you will downsize your home significantly, make sure you don’t plan to spend home equity that is never actually liquidated.
I hope this discussion helps you make more logical decisions in regards to your home, and to experience fewer unnecessary episodes of mania and depression. Enjoy your home, but be levelheaded about it as an investment. You will be happier, and build real, rather than imagined, wealth.