April 9, 2019
Is buying a house better than renting? As a realtor, I am tempted to say “buy!” After all, this seems to be the conventional wisdom. For decades,we were told to buy as soon as we can because it is ‘a great investment.’ But as an economist, I will urge you to not blindly follow the common wisdom and instead take a more in-depth look at some of the most important factors.
So, is buying a house really a great investment?
In a way, this is a wrong question to ask for most people. We buy a house not only in the hopes of getting a nice return on our money but also to have a roof over our head. That is, in addition to investment we get consumption value out of this purchase.
Think of buying a car, for example. A car is a terrible investment vehicle (sorry, I couldn’t resist the pun). Does it mean you should never buy anew car? Well, financially, it often makes much better sense to drive an old heap of metal that can still take you from point A to point B. But who doesn’t lover rolling out of a dealership in a shiny new ride! So while a car is a lousy investment, it has a great consumption value. New cars are generally safer,more comfortable, and more fun.
Now, if you’re thinking of buying a house purely for investment purposes, you won’t get the best return for your money. According to Robert Shiller (yes, that Shiller… of the Case-Shiller index and a winner of the Nobel Prize in Economics), the return on investment in housing has been disappointing. He crunched some numbers and showed that over a long run stocks yielded greater returns than investments in real estate.
“Shark Tank” investor Kevin O’Leary says real estate is not great for investment because it’s illiquid and undiversified,while with stocks you can spread the risk over many sectors.
But let’s get away from abstract national-level figures that bunch together numbers from all over the country and instead take a closer look at the real estate in our own town of Jupiter (if you’re not familiar with Jupiter, check out Munara’s video tours).
For the sake of concreteness, I’ve analyzed sales data on all 4-bed/2-bath single-family homes in Egret Landing sold between 31 Aug 1998 and 31 Aug 2018(for a fresh fix of monthly real estate market report by neighborhood, check here). I found that in two decades, the average price of these homes went up from $248,462 to $564,071. Fantastic return, right? In percent, that’s about 6.35% per year.
However, after accounting for inflation, the (geometric – here is a quick primer) average return on investment in homes in Egret Landing, Jupiter,was 2.2% per year. Now it doesn’t look nearly as great but it’s not terrible either.
Then there is an often overlooked financial advantage of buying a home: essentially, it’s a forced savings plan. Richard Thaler, who won the Nobel Prize in Economics for showing how people aren’t as good at making smart choices (such as saving for retirement) as they think they are, says that automatic saving is a great way to make people save more. Btw, I recommend his books Misbehaving and Nudge. Fascinating reads!
Also keep in mind that owning a house comes with a few costs that renters don’t carry. Owners have to pay property taxes, association fees, buy insurance, make mortgage payments, and set some money aside for repairs and maintenance.
There are also transactions costs when buying and selling a house.
On the other hand, homeowners are protected from increases in rental rates (see chart below). And as for mortgage interest deduction, under the new tax law only about 4% of all taxpayers would claim this deduction, downfrom 21% (source).
There are also great benefits (as well as risks) of buying a house using leverage, which is how most people buy a house. Leverage is the use of borrowed funds, like mortgage, to finance a purchase. The main benefit is when home prices go up, as they usually do, a buyer’s net worth grows on both their original net worth (i.e. money down) and the borrowed funds. That’s right, you accumulate net worth on other people’s money!
For example, say you bought a house in Mallory Creek, Jupiter, three years ago for $500,000 with a down payment of 20%, or $100,000. Being a bit of a nerd, I crunched some numbers, and the median price of a 3-bedroom single-family home in Mallory Creek went up by 6.4% in the last three years. Thus, the value of your home went up by $32,000 ($500K x 0.064), and so you’ve made a whopping 32% return on your initial investment of $100,000. Had you used your down payment to buy a different property for $100,000 cash, at the same appreciation rate of 6.4% you’d have made only $6,400, not $32K.
However, there is a flip side of a leveraged purchase. If the market goes down by 6.4% (luckily, this doesn’t happen very often), your equity loss would be $32,000, as opposed to $6,400. If the drop in prices is deeper,you could end up owing more to the bank than your house is worth. This is how many people ended up ‘underwater’ during the Great Recession.
Finally, homeowners get to call their place ‘my home’ and customize it however they like, subject to neighborhood rules, of course, while renters have the convenience of not having to fix leaky faucets, replace appliances, and can pack up and move if they get a new job in a different state.
To sum up, you can (probably) do better financially if you view home buying as a form of investment and if you know how to work the stock market. However, for most people there are also huge emotional, life-style, and consumption benefits of owning a home.