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August 23, 2018

Is a Hot Dog a Sandwich? (Part 1)

Is your home an investment?

Some say yes.

Some say no.

I say:

• It is an investment

• Not a great investment

• But for a lot of people, the best investment

Let’s unpack.

A House Is a Terrible Investment

A house has a very high cost of carry. Unless you buy a new house, you are probably going to spend up to 1% of the value of the house on maintenance every year. Stuff breaks. Pipes burst, roofs leak, and occasionally the whole thing burns down.

Gold, held in a vault in London, will not burn down. It costs a little bit to store gold in a vault in London, but it costs a lot more to maintain your house. I live by the ocean, so the maintenance is relentless—constant leaks, and we had to fork up for a new deck last year (not to mention the hurricanes).

Why this is important: ideally, you would like your investments to yield something. A bond could yield 4%. The average stock yields 2%, about what T-bills yield. Your house essentially yields -1%, unless you rent it out.

You have to pay to insure it, you have to pay the property taxes, and you have to pay for all the other crap. This doesn’t include the mortgage, and you probably can’t deduct any of this stuff on your taxes following the implementation of tax reform.

Ordinarily, you wouldn’t characterize something that costs you money as a good investment.

But house prices go up over time, right? Well, as we learned ten years ago, they can also go down. Sure, over a 40-year time horizon, I feel pretty comfortable that the price of my house will go up, even if only because of inflation. But the dynamics of the US housing market have changed dramatically in the last 20 years. We’ve had one big national bubble, and now we have some very pronounced regional bubbles.

People should stop thinking about their house as a trade and start thinking about it as a place to live. Throughout most of US history, that is what it was and nothing more.

And besides, most people simply can’t time when they buy a house. Most people buy a house under duress—they are forced to make a purchase because they move to a new state for a new job, they have an addition to the family, and so on.

It’s not like stocks, where you can reasonably try to buy low and sell high. Everyone needs to live somewhere, and it’s either buy or rent.

Renting gets a bad rap—the “I’m just flushing all that money down the toilet” argument. Yes, but if you buy a house, it is possible you will flush even more money down the toilet. There are times when it mathematically makes sense to rent… and there are times when it makes sense to rent even when it doesn’t make sense mathematically.

The Math of Leverage

If people realized how risky buying a house was, they would puke down their shirt.

Let’s take the example from a couple of weeks ago—my first house purchase.

(Foreword to this section: most people here are already conversant with the arithmetic, but let me go through it for everyone else’s benefit.)

The condo we bought was about $179,000.

Our down payment was about $40,000.

We sold it for $300,000.

So we made $121,000… off a $40,000 investment.

That’s a return of a bit over 300%.

If we had paid cash for the condo, it would have been about a 60% return. Still terrific, but nowhere near as eye-popping.

If you can make 300% in two years, you can lose it, too. Let’s say we bought our condo for $175,000 and sold it for $135,000.

Our equity would have been wiped out—we would have walked away with nothing. A 100% loss.

If you can make 300% on something or lose 100% on it, I would not characterize that as a safe or boring investment.

And of course, if prices decline even more, then you have to pay to get out of the house. And if you don’t have the cash, then you are dunzo.

I lost money on one house, during the financial crisis. It was my primary residence. I sold it in 2010 at a 20% loss. But I had plenty of equity because I had been prepaying the s--- out of it during the seven years I owned the house (more on prepaying later), so I didn’t have to pay to leave.

It’s kind of B.S. that people now have to think about market conditions when they buy or sell a home. I suppose that was always true, but it is truer than ever these days. A house should be a boring investment. You should dutifully make your payments and own it and never think about the fluctuations in price. I place the blame directly on the Federal Reserve.

Leverage is a sword that cuts both ways. This is the case in the capital markets, but it is especially the case in houses.

A House Is a Great Investment

The single most important financial innovation of the last 100 years is the 30-year fixed rate mortgage.

Most people suck at saving. No matter how many times they read The Millionaire Next Door, they simply cannot do it.

The 30-year fixed rate mortgage is a forced savings program. With each monthly payment, you amortize (pay down) a little bit of the principal. And over time, you build equity. It happens slowly at first, and then picks up speed. Before long, you own 30, 40, or 50% of your house.

If you make prepayments, otherwise known as curtailments, you dramatically shorten the duration of the mortgage. It doesn’t take much. Prepay just a little bit of it, and knock years off the mortgage. I am a big advocate of prepaying your mortgage, under certain circumstances (which we will talk about next week).

As we have said before, the interest that you pay is wholly unproductive, and you want to minimize it as much as possible. If you don’t prepay your mortgage at all, you will end up making hundreds of thousands of dollars of interest payments.

Building equity in your home is super important. Real-life example: Myrtle Beach is full of people from places like Queens, NY who sold their homes for $800,000-$900,000 after paying the house off over the course of 30 years, and having no other savings. They sell their house, receive cash, move south, pay $300,000 for a house, and live off the rest.

Let me be clear: these people often have no other savings apart from the equity in their homes. And they are living well in retirement.

Magic.

I am saddened when I hear of people doing things like cash-out refinancings or HELOCs. I know people who have made payments on their homes for twenty years and have zero equity. They literally have nothing to show for it. They would have been better off renting. Never tap the equity—not even as a last resort.

The Renting Heuristic

Not everyone should buy a home. You should rent instead of buy, if:

1. You would suck at taking care of a house.

2. You don’t have a cushion if things go wrong.

3. You are irresponsible.

4. Your rental payments are lower than a mortgage payment on an after-tax basis (incl. property taxes and insurance) for a dwelling of comparable size.

5. You think houses are overpriced (see 4).

There is a stigma to renting, like, you’re not a responsible adult if you rent. Actually, renting might mean that you’re even more of a responsible adult, instead of financially tomahawking yourself just to own a home.

Full disclosure: I have owned a home since I was 24 years old and I have not rented since. But I would rent if it made sense. If I packed up and moved to Manhattan Beach tomorrow, I would rent.

Buying a home takes away your flexibility. You become immobile. If you are forced to live somewhere else, you have to play this game where you’re buying one house the same time you’re trying to sell the other, and maybe one transaction is contingent on the other, or you get a bridge loan, or whatever. It is super complicated. The only time it’s easy is if you’re paying cash, and that doesn’t apply to most people. Flexibility is massively underrated.

Tune in next time as we go deeper into residential real estate.

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Jared Dillian
Editor, The 10th Man

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