Financial Planning for Businesses

Your Home Is Not An Investment

In my tireless search to find other smart and savvy (not to mention financially literate) individuals on the Internet, I came across an absolutely brilliant article about home ownership on Yahoo’s real estate pages.

Personally, I have never been very big on owning a home. The idea has crossed my mind several times, and there have been a couple of houses that I’ve actually liked and could see myself living in (they were all tri-level homes with large, open floor plans). However, most of the time, I find myself thinking “wow, that’s an expensive pile of wood (or brick, or stone, etc.)”.

Whenever I have mentioned this to a Realtor, or to a homeowner who discovered that I prefer leasing to purchasing, the immediate (and I do mean immediate) response is usually one of defensiveness followed by offensiveness.

The defense, as it were, is the Realtor’s insistence that homes are investments. The home owner’s defensiveness is often a justification as to why they are willing to spend so much money on the home plus the cost of taxes and maintenance.

The offense is that I am apparently wasting my money on lease payments and that 30 or 40 years from now (provided I don’t find a home that takes my breath away), all I’ll have left are a bunch of receipts, while the home owner will have all that equity in their home. Perhaps I’ll address that issue of “wasted lease payments” in another post, but at this point, I think I need to address some key facts that may not be entirely obvious to the general public.

First, owner-occupied homes are not investments. By “investment” I mean savings that are used to finance future production. I cannot overstate this: above all, one of the essential aspects for an investment is that your savings must be financing some productive endeavor. Something must be produced using your savings. Additionally, the profits, in the form of income or appreciation, will be a sign that your investment is profitable.

Does an owner-occupied home pass the sniff test when it comes to the term “investment”? The fundamental question to ask yourself is: “what does an owner-occupied home produce?”. On this issue alone, I think it fails. But, we can also look at the appreciation and income aspects of investments.

First, the house itself depreciates. It does not appreciate. I’ve mentioned it before in older blog posts, but electrical wires fray, plumbing leaks, and roofs sag. You need to maintain a house and that’s all you can really do with it. The land, I think, may hold its value, but determining demand in real terms is pretty difficult which makes determining its appreciation difficult.

Prior to WWII there was no inherent demand for home ownership. The government literally created an artificial market for it in 1934 with the creation of the Federal Housing Authority, or FHA. You’ve probably heard of FHA loans-the clue is in the name.  

The FHA is also the reason why people started buying more homes. Prior to 1934, borrowers had to cough up 40% of the price for their new home and usually only financed a house for 15 years. The free market in housing kept a housing “boom” from ever happening and kept home valuations in check. Once the free market was destroyed in housing, valuations began to climb, and banks were incentivized to extend loan terms to 20 years, and then 30 years. Because the FHA was insuring mortgages, lenders could come up with incredibly creative loan schemes to attract new home buyers.

The second major boom in housing started, of course, in 2000, when the government once again loosened lending standards and really started encouraging banks to lend to more and more people, regardless of whether they had earned a home loan or not. By 2003, the federal funds rate was dropped to 1%, and we have seen the chaos that has ensued from that little maneuver.

Finally, the most interesting aspect of treating a home as an investment is that its “real return” after inflation is about 0.4% per year, and the only reason the housing market has had it so good is because of the government creating an artificial market for demand in housing. Land, has an excellent history of preserving or holding its value, but its not so good at actually becoming more valuable (in real terms). As for the house that sits on the land:

Jack Hough points out,

A house, after all, is an ordinary good. It can’t think up ways to drive profits like a company’s managers can. Absent artificial boosts to demand, house prices will increase at the rate of inflation over long time periods for a real return of zero.

He’s right on the money. Businesses generate profits by creating and selling values. Unless you own investment properties that generate rents, a home doesn’t make money, it just costs money (in terms of mortgage interest, taxes, and maintenance that eat into your equity appreciation).

Does this mean you should never own a home? Gosh no. Just like people who own cars, or motor bikes, or travel the world every 6 months, or buy time shares-it’s fun and it provides something meaningful to a person’s life. If an individual wants to buy a home, I say buy it. But, do it with the understanding that you are buying a commodity. You don’t expect to be able to make a profit on selling your ipod 20 years from now. Don’t expect to do it with your home. Instead, ideally, you would hope to preserve the value of your home (in real terms) for however long you own it.

June 11th, 2010 | by David | No Comments

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