There is a single word that has been all around the advice from real estate and that is location. This common phrase has persisted over the years and is still widely used by real estate agents today when helping potential homeowners find the right home. The whole notion, however, might be based on the faulty premise that buying a house is a good investment.
Let us start with a look at current housing investment returns. The S&P CoreLogic Case-Shiller National Home Price Index increased to 6.2% in September, beating many estimates and the previous month’s 5.9%. In the 20-city index, home prices increased in all cities for September and posted an annual gain of 6.2%. As home equity is the largest asset for most Americans, far outpacing average investable assets for most people, the 6.2% annual return should be welcome news. The higher than expected home price increases have been boosted by low unemployment, low home inventory, and historically low interest rates. Compared to the stock market, however, housing is providing substantially lower returns. Both the S&P and the Dow have provided annual returns in 2017 of over 18%.
While the stock market might represent a better short term return, most people would list their home as a safer asset than market investments. Most investors recognize that the stock market is volatile and can be risky. Returns for market investments need to be higher than safer assets due in part to their higher volatility and risk. So, if the home is a safe asset, it might still be a good investment. Unfortunately, the home is also not a safe investment.
While the overall housing market might be safer and less volatile than market investments, an individual home is far riskier than the overall housing market. Individual homeownership has some serious drawbacks, like location risk and illiquidity. A single home is not very liquid, as it can take months to sell. Additionally, the old mantra “location, location, location” also poses a risk to homeownership. If you live in an area with one major employer and that employer goes out of business, it could decimate your home price. In a lot of ways, buying one home is like holding all of your investment assets in one company stock. Of course, locations in some areas of the country see tremendous growth, like San Francisco, but others, like Detroit, see tremendous losses.
The risk of single homeownership has an annual standard deviation of roughly 12%, which is close to the standard deviation of a traditional investment portfolio of 60 percent stocks and 40 percent bonds. This means that a home is not significantly safer than most investment portfolios, and it provides a substantially lower investment return. Historically, home equity mostly just keeps pace with inflation and provides no real return. According to Professor Robert Shiller, one of the leading experts on housing prices in the United States, the real inflation-corrected prices of homes showed almost no change from 1890 to 1990, and showed losses in the 2000s.
Individual housing tends to be a risky investment with poor returns, but it does appreciate over time, leaving many people to believe it was a good investment. So then, armed with the knowledge that the home is not a great investment, the next question to answer is whether you should buy a home or rent. A number of studies show that many people would increase their wealth faster if they rented and invested the money into higher return investments that they would otherwise put as a down payment on a home or pay for a mortgage. Another factor to consider is the length of time you expect to be in the home. There is a significant amount of research showing that especially if you plan on being in the home for less than 5 years, you are better off renting and investing the money you don’t spend on housing.