There is a kernel of truth in the widely held belief that the home is the ‘best investment’ that most people make (of course, assuming that all housing-related expenses fit comfortably within a household budget). We know that it is not due to the usual claims (”this house is worth twice what we paid”) because it conveniently omits to take mortgage interest, maintenance, closing costs and other expenses that come with owning a home into account. But home ownership mostly works out okay due to the following reasons:
Disciplined Investing: Homeowners usually put into practice the discipline that equity investors should be following in owning stocks: they invest periodically by slowly building equity with each mortgage payment; they own for the long-term by buying a home and living in it for years; they save more even though, at least initially, owning will cost more than renting because they find a way to spend less on other things. In short, owning a home is probably the ‘best investment’ for most people, even though superior returns can be had from stocks, simply due to better investing behaviour.
Tax-Free ‘Dividends’: The biggest return from owning a home is in the form of a ‘dividend’ - the rent that would have to be paid if the home is not owned. As I noted in an earlier post, such ‘dividends’ can be significant and even better it is tax-free. In the example cited in the post, the ‘dividend’ yield from owning a home is 4.7%, which doesn’t sound all that much until you realize that it is after tax.
Low Returns from Stocks: There is a key difference between how much equities have returned in the past and how much an average investor actually earned by owning stocks. Studies such as those by DALBAR has consistently shown that investor returns have been much less than market returns because of performance chasing, expenses, turnover and taxes. In most cases, the shortfall is quite stunning and shows that the average equity investor would have been better off investing in bonds (thanks to Larry MacDonald for pointing this out). When actual returns obtained from owning a superior asset class is so poor, it isn’t surprising that for most people, their home turns out to be the ‘best investment’.
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27 responses so far ↓
1 brad // Mar 25, 2008 at 7:38 pm
A more subtle benefit to home ownership is that if you invest in energy efficiency improvements (which you’re more likely to do if you own your home than if you rent), you can get really great returns, as high as 40 percent after tax on some improvements. Check out this U.S. government lab comparison of the return on investments from energy efficiency improvements; it’s dated now (the stock market figures are from the 1990s), but the ROI numbers for efficiency improvements haven’t changed all that much since then:
http://hes.lbl.gov/hes/profitable.html
And of course if you plow the savings from your reduced utility bills into investments or even a high-yield savings account, your returns are even greater.
2 Canadian Capitalist // Mar 25, 2008 at 7:47 pm
Brad: Thanks for the link. I guess it is a great idea for a post and some of the improvements mentioned are worth checking out (duct sealing, for instance).
3 Michael James // Mar 25, 2008 at 10:12 pm
I knew that holders of stock mutual funds lagged the index badly, but the Dalbar study seems incredible! The average investor lags the S&P by 9.5% per year? Wow!
I would have thought that holders of actively-managed bond funds would have lagged the corresponding index as well. Do you know what Larry MacDonald was comparing when he said that holders of equity mutual funds would have been better off investing in bonds? Is this an apples-to-apples comparison of mutual fund investors, or is it comparing equity mutual fund investors to bond index investors?
4 thickenmywallet // Mar 25, 2008 at 10:27 pm
I don’t disagree with you about the need for shelter which is your own. However, I would separate those defending home ownership from those who think of real estate as the “best” investment vehicle. I do not consider owning my house to be an “investment”. It is my shelter; the fact I can build equity in it is a bonus to me- it is a last resort asset. The value of owning your own castle, financially and emotionally, cannot be understated. Call me old fashioned but a home is a home and not an investment.
Outside of the principal residence context, the return on real estate is lesser than popular perception. A U.S. Census survey taken in 2000 of over 16,000 landlords found that only 41.4% reported they made a profit with an astounding 15.7% not knowing whether they made a profit! One could conclude that perhaps people are equally unsuccessful investing in real estate as stocks (or, at the very least, people need to track their cash flow better).
I suspect the baby is being thrown out with the bathwater in the rush to jump on the anti-real estate bandwagon but, framed contextually, I would agree with you to own your own shelter but would be leery to extend that argument to real estate is a great investment and, after this subprime hiccup is over, mountains of gold will rain down on real estate owners anew.
5 FinancialJungle.com // Mar 25, 2008 at 11:45 pm
I can understand your point-of-view on home versus investment. I’m going to present my view, and would appreciate your feedback:
I would go as far as distinguishing shelter from ownership. A shelter is not an investment, but a necessity as you need a roof over your head.
However home ownership, IMHO, is part investment and part luxury. It’s an investment because your equity and cash-flow improve over time. It’s also a piece of luxury as it unleashes a sense of pride, which is not that different from owning a Ferrari if you’re into cars.
A “castle” is in the eye of the beholder. My stock portfolio is paying rents on my Downtown Vancouver condo, so from my point-of-view, my portfolio is my castle, and I most definitely would count my castle as investment. If your castle (home ownership) is paying your rents, shouldn’t that be an investment as well?
One can draw a lot of parallels from other examples. To start with, a shelter is a necessity, but ownership is an investment. Milk is a necessity, but Saputo is an investment. Gasoline is a necessity, but PetroCanada is an investment. Grocery is a necessity, but Loblaws is an investment. A vacation is a luxury, but Carnival is an investment. An IPod is a luxury, but Apple is an investment. Smoking is a luxury, but Altria is an investment.
Sorry for the mental accounting, but the idea is that home ownership satisfies both financial and emotional needs as much as an investment portfolio does. I’m still a little fuzzy why home ownership isn’t an investment.
Unfortunately, this is one of these personal finance debates that are purely philosophical. I.e. it won’t make any of us richer regardless of the outcome.
CC - I think you summed it up well with, “owning a home is probably the best investment for most people, even though superior returns can be had from stocks, simply due to *better investing behaviour*.” This applies to investment style as well: ETF, value, growth, dividend, daytrading, etc.
6 Canadian Capitalist // Mar 26, 2008 at 6:45 am
Michael: I believe the DALBAR study compared how stock funds performed relative to the index. They then looked at the results of the average investor further broken down into no-load funds and those that sold through an advisor. They also did a study on bond investors and found that they lagged the index badly as well. Also, DALBAR isn’t the only study that looked at the actual returns experienced by average investors. John Bogle had an entire chapter in his “Little book” and funnily even indexed investors lagged the index due to performance chasing. The book is loaned out, so I can’t quote Bogle’s figures.
I’ll have to dig out Larry’s post because I don’t think he said equity investors would be better off in bonds; his post was in the context of paying down the mortgage as opposed to contributing to a RRSP.
Thicken: I agree with your view; the post deals with personal residence and not rental real estate. Also, a home is first and foremost a shelter, not an investment in a strict sense.
FJ: Personally, I don’t consider a personal residence as an investment because lifestyle factors (”part luxury” in your comment) are mixed up. It’s not just pride - it may be proximity to schools or work, the layout of the kitchen, the curb appeal or whatever rather than strictly financial motives. That said, I agree with you that this is a “I say tomato…” debate. I also agree with your comment about ETF, value, growth, dividend but not so sure about daytrading!
7 Al // Mar 26, 2008 at 8:36 am
One value of home ownership is that it provides a hedge against inflation. Say for instance we se some late 70s/early 80s style high inflation. Rents are going to move up at the same rate (there will probably be a lag, but they’ll catch up). The purchase price of the house is fixed so isn’t affected by inflation, though taxes, insurance and maintenance will be.
Of course if interest rates are up to fight inflation and its time to renew your mortgage….
8 Michael James // Mar 26, 2008 at 8:59 am
CC: This part of your discussion has been timely for me because I did a little thought experiment of my own on market timing. I’ll post about that tomorrow.
It would be interesting to know whether the Dalbar study said anything about how investors who bought and held (if there were any) performed.
I’ve read some of Bogle’s writings before about underperformance due to market timing. But, I don’t remember how much he said they inderperform. The 9.5% figure from the Dalbar study is huge.
9 Four Pillars // Mar 26, 2008 at 9:17 am
MJ - I’ve made this comment before here, but I am skeptical of the Dalbar study - nobody seems to know any of the details of the research they did and since they seem to be sponsored by some sort of financial advisor group then the numbers are quite biased in my opinion.
That said, I wish there were more studies like this - ie from academic institutions since it is an interesting question.
Mike
10 Michael James // Mar 26, 2008 at 10:15 am
Mike: I didn’t want to say it without seeing the details of the study, but I guess I’m skeptical of the 9.5% figure as well. I can think of a few different ways to calculate such a figure based on raw data, and they would give very different results.
11 Canadian Capitalist // Mar 26, 2008 at 10:21 am
Mike: But DALBAR isn’t the only study that points to significant under performance by the average investor. Also, the DALBAR study is periodically updated and shows that there isn’t much difference in results between broker-sold funds and direct market funds. Don’t quote me on this but I seem to recall Bogle saying that the average investor past under performance is around 5%.
12 Four Pillars // Mar 26, 2008 at 11:04 am
CC - that’s true - I think the wealthy boomer talked about a study recently…
I guess I have hard time believing that the average investor is that bad.
MJ - I’m no data or stats expert but I too would really like to see how they worked out their figures.
13 Joseph // Mar 26, 2008 at 11:10 am
To say that one receives a dividend in saving rent when owning a home, is like saying that one receives a dividend in saving mortage payments, taxes, maintenance, etc. when renting.
14 The Patch » Blog Archive » Real Estate Investing? // Mar 26, 2008 at 11:28 am
[...] For another point of view, here’s In Defence of Home Ownership [...]
15 Tony Danza // Mar 26, 2008 at 11:34 am
Al, funny you mention the early 80’s inflation. My house fell ~40% in value 18 months after I bought it in 1980 wiping out my down payment and then some, so much for hedging inflation huh? It took more than 20 years to get back to the inflation adjusted price that I paid.
CC, I agree with RE being a good “investment” for the average joe/jane IF the fundamentals make sense, otherwise it can be one of the worst “investments” you’ll ever make. By fundamentals I mean the cost of servicing the debt and maintenance on the house is somewhere around what it would cost to rent the same house. With interest rates at their lowest levels in a generation(s?) and Canadian real estate prices at a multi decade high I would say right now real estate is an extremely risky “investment”.
16 FinancialJungle // Mar 26, 2008 at 11:58 am
Comment I left at ThickenMyWallet’s blog:
End point bias can drastically alter the compounded appreciation of real estate. Vancouverites, who bought homes at the market top in 1980, had to wait 26 years just to recover their inflation-adjusted principal back. The lucky ones who bought 5 years ago have already doubled their money.
A real estate investor once told me “you make money on the day you buy.” Financially speaking, buying a house is like buying stocks. The more attractive the entry price is, the better the return.
17 Canadian Capitalist // Mar 26, 2008 at 12:26 pm
Joseph: That’s an argument for the “In defence of Renting” post
Though I didn’t mention it in this post, owning a home free and clear is a huge step to retirement precisely because of these ‘dividends’ because shelter costs drop dramatically. Of course, in the initial years, the ‘dividends’ are negative, so another way of thing about owning would be paying the cost of renting upfront.
Tony: Excellent point that can’t be stressed enough. Especially considering that buying a home involves taking on a massive leverage. Comparing ownership costs to renting and judging it to be ‘reasonable’ would be one way of not overpaying. First-time buyers might find it better to rent for another year or two but unfortunately, human nature being what it is, we tend to be greedy when we should be fearful (just like stocks).
18 Tony Danza // Mar 26, 2008 at 12:44 pm
“human nature being what it is, we tend to be greedy when we should be fearful (just like stocks).”
It’s a hard habit to break, one that I’m still occasionally [often:)] guilty of.
19 telly // Mar 26, 2008 at 1:04 pm
FJ said: “Financially speaking, buying a house is like buying stocks. The more attractive the entry price is, the better the return.”
Oddly enough, just like we (investors) do regularly in the stock market (buy high sell low), we tend to behave similarly with respect to real estate, despite the fact that we know, financially, it’s not the best move.
20 Michael James // Mar 26, 2008 at 7:30 pm
CC and Mike:
I find the 5% figure much more believable than 9.5%. Every attempt I’ve made at analyzing market timing indicates that you’d lose money trying to do it, but 9.5% is a little much, especially considering that the 9.5% applied to the average mutual fund investor rather than just the ones who attempted market timing.
21 WhereDoesAllMyMoneyGo // Mar 26, 2008 at 10:55 pm
I can see how the gross underperformance can occur. I remember meeting someone who showed me his statements going back 20 years with no overall gains - but constant switching in and out of funds.
Most of the funds he had would’ve given him decent returns if he had just sat on his hands from beginning to end (in any of them).
22 Four Pillars // Mar 26, 2008 at 10:56 pm
Telly - I think the fear of “getting left behind” is very strong in a rising real estate market. To be honest I don’t know that I would be able to resist…
Michael - yes, 5% is definitely more reasonable than 9.5%.
23 Pam // Mar 30, 2008 at 7:03 pm
How do you make the leap to home ownership from low-cost apartment renting?
Currently my fiance and I (we are 26 and 23 respectively) rent a 900 square foot 2 bed, 1 bath apartment in Ottawa for $1000 a month including parking. We make $135k in gross income combined. We are currently in closing on a $330k, 4 bed 3 bath house with property taxes of $4k a year and utility costs estimated at $250 a month (we’ve hopefully estimated high there - currently we only pay about $33 a month for hydro, and our building management takes care of water). The bank pre-approved us for $450k (and actually told us we could easily get more) and we decided to go with about 75% to 80% of that number as our “real” affordability.
We plan on putting in ultra high efficiency water heater, furnace, windows and buying high efficiency appliances, but the fact remains that we need to purchase about $10k worth of appliances (we have a toaster and a microwave, and that’s it!) right away, and then add these high efficiency upgrades over the next few years. Buying this home will be a huge dent to our savings. We will need to drain our savings & RRSPs (through the homebuyer’s program) and still will likely go about $5k to $10k into debt, maybe more.
The reason we went with such a large “starter” home is that we want to stay there the rest of our lives and never spend money on moving costs or real estate agent fees again.
I feel like in 40 years this will pay off, but it is quite daunting to go from $0 of debt and $20k in savings between the two of us to literally hundreds of thousands of dollars in debt and NO savings. Obviously we’ve already worked the numbers and we KNOW that we can do this without changing our lifestyle but it’s still a bit of a leap from seeing the numbers on paper to actually coming to grips with it in reality. Does anyone have any tips?
24 Pam // Mar 30, 2008 at 7:29 pm
Oh and let’s not forget all of the other up-front sunk costs like land transfer tax (as first time buyers we do get $2k refunded but still!) lawyers, home inspection etc etc etc!
It’s just madness, I’ve never spent so much money in my life.
25 Canadian Capitalist // Mar 30, 2008 at 10:17 pm
Pam: Just my opinion, but you are likely to be ok considering that you’ve paid less than 2.5 times your income for your home. But yes, home ownership is a very expensive proposition in the initial years but once it’s paid off, it is a huge step toward retirement. Good luck!
26 Rob in Madrid // Apr 1, 2008 at 2:10 pm
Generally speaking for most people buying a reasonably priced house is a smart move. Where it’s a tougher call is as with Pam where house prices have really outshoot rents as is the case (still) in many parts of the US. For example I’ve seen stories where people spend upwards of 50,000 a year mortgage upkeep and taxes to live in the “right” area.
If you really want an in depth look at it go here
Rent vs Buy the hidden cost of buying
It’s a long post and the comments not surprisingly are even longer. It was also written before house prices went south in America.
the biggest problem is people underestmate the cost of home ownership.
27 Hanks Weekly Hangouts #24 (April 5, 2008) | My Investing Blog // Apr 5, 2008 at 4:02 am
[...] CanadianCapitalist defends the home ownership stance against the evil renters [...]
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