Your House is Your Home NOT Your Retirement Account

Professor Matthew Spiegel

December 26, 2005

You often hear that your house is your most important investment. Well, that may be but it is also likely to be your worst as well. From 1980 to 1999 housing returns were, on average, worse than even government bonds which themselves just kept ahead of inflation. (The curious can get additional details from the paper by William Goetzmann and Matthew Spiegel, "The Policy Implications of Portfolio Choice in Underserved Mortgage Markets," Low- Income Ownership, Joint Center for Housing Studies, Brookings Institution Press, Washington D.C.. Eds. Retsinas and Belsky, 2002.) Those of you living in areas that have seen housing values double or triple should keep this in mind before you trade up.

Why are Housing Returns So Poor?

In most of the U.S. undeveloped land is in abundant supply. Unless you live in New York, Boston, San Francisco, Los Angeles, or similar local a short drive will take you to a vacant lot on which you can build a house. Suppose that lot can be purchased for $20,000 and that it costs $80,000 for a professional build to put a house on it. In that case, in the long run, housing in your area will sell for about $100,000. The reason is simple. When prices go above $100,000 local builders will purchase land, build houses and sell them. They will continue to do so as long as new homes can be sold for more than $100,000. If prices fall below $100,000 the system works in reverse to some degree. Builders stop building. The current housing stock deteriorates and the supply of housing thus declines. Unless people are moving out of the area, eventually the supply will fall far enough that prices will return to their long run value of $100,000.

Anywhere there exists wide swaths of open land housing, in the long run, cannot sell for more than the price of vacant land plus the cost of construction. That means, in general, housing prices rise with construction costs; basically the rate of inflation. Not too surprisingly, this is what the data shows as having happened (in the long run) across most of the country.

There is one caveat to the above discussion; cities and other areas (such as lakefronts) without vacant land. When physical constraints prevent builders from putting up new homes prices can potentially rise faster then the cost of new construction for long periods of time. However, even in this case there remain two factors that help to keep prices from going up too fast. The first is that you can always change the housing stock to accommodate more people in the same area. Builders do this by converting single family homes to two family homes, and two family homes to townhouses and apartment buildings. What typically prevents this from occurring is the local zoning board. Anybody that already owns a home in an area where vacant land is in limited supply naturally wants to keep the population density down and thus their home’s value up. Generally, it works. The second drag on housing returns is the growth in local incomes. Before the typical house in your area can sell for a million dollars the typical family looking for a home actually has to be able to buy it. So unless area incomes shoot up (or mortgage rates collapse) it is difficult for housing returns to get too far in front of inflation.

How Big a House?

Even though housing prices tend to rise very slowly many in the real estate business still claim it is a good investment. Some just make this claim because they have a self interest in boosting real estate demand (home builders, real estate agents, and real estate lawyers to name a few). Others make this claim by including the rent you avoid paying when you own a house. Economists call this the “implicit rent” from ownership. Potentially, it can help boost real estate returns to seemingly respectable levels. Without going into whether or not including the savings from not renting really makes your house a good investment one thing is certain, buying a bigger house than you want as a way to boost your eventual retirement nest egg is a really bad idea. If you want a 3,000 square foot house and buy one that is 4,000 instead the value of the implicit rent on the extra 1,000 square feet is going to be very low. To see this, imagine you already own the 3,000 square foot house of your dreams. Along comes a rather odd opportunity to add (for free!) a 1,000 square foot addition. Alas, if you do add it you will need to rent it from the builder. How much would you be willing to pay each month for this addition? The answer to that question is value to you of the extra 1,000 square feet. For many people this personal implicit rent may very well be zero or close to it. After all we started with the premise that you were pretty happy with the original 3,000 square foot house. Thus, the 1,000 square feet of additional housing is likely to yield minimal additional joy. Basically, you should buy a house because living in it will make you happy. But you should not buy one that is even one square foot larger despite the local real estate vested interest’s spokesperson that “as everyone knows real estate is a great investment.” The fact is, it is not.

Your House and Your Portfolio

How a home fits into your investment portfolio depends on whether you currently have one or want to buy one. If you own one and if you are planning to invest in individual stocks you should avoid firms that are located in the same area as your house. The argument is similar to why you should avoid investing in your own employer. If the local economy does badly it is likely that so will the firms in your area (their poor performance may even be the cause of your area’s woes). When the local economy does badly so do area home prices. You can avoid “doubling down” on the same risk by simply avoiding companies in your area.

If you want to buy a home how to adjust your portfolio becomes somewhat tricky. Now you want your portfolio to help insure against a rise in local housing prices. To do that you might actually consider adding in stocks from a few local firms. If these firms do well so will the local economy. That in turn will raise housing prices. By allocating some of your portfolio to these firms you will insure that your ability to provide the necessary down payment will keep up with prices. However, be very careful. Do not put a very substantial fraction of your portfolio into stocks from local firms! Individual stocks are very volatile. It is possible that the firms you pick will do badly even if real estate does well. To pull this off without actually incurring more risk you will need to know how the stocks from firms in your local area have done relative to the real estate market. Most individuals will find that they need help from a really good advisor to pull this off. If you are unsure about whether your advisor has the necessary tools to help you out then just forget about everything in this paragraph. Instead, you are probably better off just putting your money into well diversified mutual funds.

If despite the caveats given above you still want to use your portfolio to help hedge out the risk that local real estate prices will rise before you buy a house it is time to seek out a top notch advisor. Fortunately, this problem makes it relatively easy to at least eliminate some of the under equipped advisors from the pool. If your advisor does not know what a covariance is and how to calculate it then he or she cannot provide the advice you are seeking. Alternatively, you can just contact www.alphainvestmentopportunities.com for help on this as they do know what a covariance is.