“The major fortunes in America have been made in land.” - John D. Rockefeller
For generations, Americans have been taught that owning a home is one of, if not the best, investment they can make with their money. This philosophy was first popularized after the Great Depression under FDR’s New Deal which created government sponsored programs to make housing more affordable for Americans. The programs worked, and home ownership came to be considered the cornerstone of the “American Dream.” Generation after generation encouraged their offspring to buy houses and invest in real estate as a sure fire way to amass wealth. More and more people jumped onto the real estate bandwagon until the market became extremely frothy and speculative. As with all frothy markets throughout history, the bubble eventually popped in 2007 and the United States suffered a nationwide housing collapse for the first time since the Great Depression. Millions of Americans were “upside down” on their house leading to an extended period of defaults and foreclosures which we are still working through today.
Given this setup, one might think that homeownership has lost its place as the cornerstone of the American Dream. But according to a recent Gallup poll, Americans currently rank real estate as the best investment over stocks, gold, bonds, and savings accounts. Part of this is can be attributed to the recent bounce back in home prices, but that doesn’t explain the whole picture since stocks have had a tremendous rally from their 2008 lows and still rank behind real estate. Maybe another reason why real estate is back on top is because people gravitate toward its tangible nature and can understand the supply and demand forces that push prices. Another reason could simply be that they have been indoctrinated to believe that real estate, and specifically owning your own home, is the best investment. But is it really?
Economist and Yale professor Robert Shiller has dedicated a good amount of time to the study of real estate investing. He, along with fellow economist Karl Case, were responsible for developing the first set of nationwide indexes to track the value of homes in America. He also created an inflation adjusted index for US housing prices going back to 1890, which we’ve embedded below. Inflation adjusted simply means that all of the values shown on the chart are in today’s (2014) dollars. So a house that cost $150,000 today would have cost, in today’s dollars, roughly $125,000 50 years ago and $109,000 100 years ago. The change in real, inflation adjusted value of homes over the past 100 years has only been around 40% or roughly 0.33% per year.
Over that same 100 year time period, inflation has averaged just over 3.3% per year, so when we factor inflation back into the equation, the nominal increase in home prices has been around 3.7% annually. This type of return might be perfectly acceptable for some investors, but it is hardly the road to riches that many make it out to be. One might question whether the use of leverage (e.g. a mortgage) would change this analysis, since buying a home typically utilizes a large degree of leverage with a small equity position (down payment).
According to FRED, the average 30 year mortgage rate since they were first introduced back in the early 70’s is around 8.5%. The table to the right uses this average mortgage rate, the historical nominal home appreciation rate of 3.7% we calculated earlier, and a 10% down payment on a $250k house. The first set of numbers shows the value of the house and the payments made over the 30 year time horizon in nominal terms. In this scenario, the house has almost tripled in value after 30 years and is worth close to $750k. The reason most people think owning a home is such a good investment is because they forget how much they have paid in principal, interest, taxes, insurance, and maintenance over the life of the house and instead chose to concentrate on the fact that the house is worth so much more than what they bought it for “back in the day.” If we simply sum up all the payments that were made, ignoring taxes, insurance, and maintenance, we see that $650k was sunk into the $750k house, which isn’t bad but also isn’t a slam dunk from a return perspective. The problem with this analysis is that it ignores the impact of inflation since dollars paid out of pocket in 2014 are worth a lot more than dollars paid in 2044. The second set of numbers strips out the impact of inflation by looking at the value of the house and payments in today’s dollars. When viewed through this lens, the out of pocket expenses/payments exceed the value of the home after 30 years leading to a -33% inflation adjusted, total return.
One thing we left out of the above analysis is the tax benefit from paying on a mortgage since the interest is tax deductible. If we factor this in by assuming a fairly high marginal tax rate of 40% and bring the mortgage rate down to 4.5% to better reflect the current market environment, the numbers are a bit more favorable.
But even under the favorable assumptions, which again are ignoring taxes, interest, and maintenance, the internal rate of return (IRR) on the investment is less than 1% a year. That being said, at the end of the 30 years the homeowner in our example owns an asset free and clear that is worth roughly $280k in today’s dollars. The wealth in this example is more a function of a disciplined savings plan, making a monthly mortgage payment, than outsized returns on investment. As such, buying a house as a personal residence should be thought of as more of a savings vehicle than an investment vehicle.
There are obviously ways in which real estate can act as a fantastic investment for building wealth such as income producing rental properties, which we emphasize in our Diversification 2.0 portfolio construction. John D. Rockefeller knew a thing or two about amassing wealth and as the opening quote would indicate, he was a large proponent of owning real estate. The issue, and where the Gallup poll might be off, is when individuals think that their personal residence is a substitute for a well-diversified investment portfolio, which can not only match but greatly outpace inflation over time.
Author Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.
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