A collection of essays by Bill (website@ccjj.info) accompanied by feedback from his friends.

Sunday, February 21, 2010

Real Estate: Evils of the Owner-Occupied Paradigm

For many years, it has been the conventional wisdom in the United States that home ownership was the best investment strategy for the average person. Since 2006, we have seen real estate prices drop 32% nationwide and more severely than that in some areas, and along with that, we have seen a rash of foreclosures. The time is ripe to be rethinking our investment strategies.

US Home Prices Nationwide: 1994 - mid 2009
Reasons Why Buying the House You Live In Is Not a Good Idea

Diversification: One of the most important factors in an investment strategy should be diversification. You want a lot of little investments, of different types, so that if one investment goes sour, it doesn't wipe out your whole portfolio. You can't get much less diversified than a house -- not only is it a single investment, but if you start out with a 10% down payment, that house is 1000% of your portfolio! So if the house declines in value by 10%, you lose 100% of your initial investment.
Potential Debt: The traditional way to buy a house is on credit. You are investing with money that is not yours. That means that a small increase in the house's value will result in a large payoff for your initial investment. Many people experienced this prior to 2006, seeing huge increases in their net worth as their homes appreciated. It also means that a small decrease can leave you with negative net worth. In my book, having negative net worth is many times more bad than being rich is good. I prefer not to invest money I don't have, and follow an investment strategy where the worst case outcome is flat broke.
Pre-Bubble Mentality:
Prior to 2005, most people buying real estate believed it was a fundamental law of physics that real estate prices would always rise. When most people are thinking that way, it is called a bubble. It was a matter of time until the bubble burst.
Planning For Hard Times:
It really is a good idea to have sufficient savings to carry you through a couple of years of unemployment. Relying on credit to get you through tough times is risky -- banks respond to tough times by restricting credit. Furthermore, a computer glitch or identity theft can destroy your credit rating at any time. Generally, a mortgage payment is much higher than a rent payment for the same sized dwelling. And if you become unemployed for an extended period of time, you'll have no income to write off the mortgage interest against during that time.
When the economy goes badly, the banks are reluctant to extend credit, and are raising interest rates and lowering credit limits. If you rent your dwelling, then when hard times hit, you can easily move into more modest accomodations. If you own your dwelling, you probably can't move out of it and into a cheaper place without selling the old one -- a major hassle and a disaster in a down real estate market.

Industry Diversification:
If you work in an area dominated by a single industry, like Silicon Valley or Detroit or Manhattan, and you work in that single industry, real estate values in that area will fluctuate along with that industry. This means that if your industry takes a beating, you are liable to wind up long-term unemployed and needing money for relocation or retraining at the same time as the net equity in your house goes negative. Not a good position to be in.
Moving Becomes More of a Hassle:
When you move to a new place, many errands have to be taken care of, learn your way around the new city, find schools for your kids. Buying a house adds a huge decision with potentially disastrous consequences to the list of errands to be made when moving.
Too Many Constraints on a Single Decision:
A house you own has to satisfy too many requirements at once. It has to be appropriately located, the house itself has to be the kind of place you want to live in, and it has to be a very good investment. It is unlikely that you'll find a house that really meets all these requirements very well.
Prior to the Bubble Bursting

The government had an attitude that the more Americans owned their homes, the better. I remember in Bill Clinton's autobiography he spoke with pride about how the rate of home ownership increased during his presidency. This attitude is flawed -- many people are not cut out to be responsible home owners. And we have a great system for identifying who those people are, it's called the FICO credit score. People with lousy credit scores should not be given home loans, they are not responsible enough to handle it.

Another way to see if someone is going to be able to pay a mortgage is to demand a substantial down payment. If they can handle their money well enough to save up a down payment, that does a lot to demonstrate that they'll be responsible about paying back the mortgage. In addition, it provides a cushion, so that if the value of the house sinks by less than the down payment, the home owner still has positive equity in the house and is less likely to walk away from it or declare bankruptcy. But prior to the bubble bursting, many loans were being made with no down payment required.

Reasons For the Financial Crisis

Many people attribute the financial crisis to "too much greed". Baloney. A bank that isn't greedy is not a good bank. Greed is what drives the system.

The biggest issue that drove the financial crisis was that too many people, both home buyers and Wall Street investors, thought it was a fundamental law of physics that real estate prices would always rise forever. Home buyers took out many interest-only loans, a practice that makes no sense if you believe that real estate prices might fall. The financial system made loans to many people with poor credit or who otherwise showed signs of being likely to fail paying them back. The reason the financial system was willing to make these loans is that they felt it was guaranteed the value of the house would be greater than the outstanding value of the loan, even if no down payment was made, so that worst case, the value of the loan could always be recovered by foreclosure.
When real estate prices fell, all these deals fell apart. In some states, the homeowner was legally allowed to abandon their home loan if they let the bank take the house. As a result, when home prices fell, many homeowners whose houses were worth less than the outstanding loan walked away, a tactic called "rational foreclosure". With so many loans failing without sufficient collateral to cover the cost of the loan, the banks lost so much money that it caused a crisis.

The biggest mystery of this, to me, is why the people on Wall Street were so stupid. I can understand the homeowners being stupid, the guys on Wall Street had high IQ's and MBA's, and they just should have known better. One guess I have is that many of them did know better, but they were not investing their own money. The worst thing that could happen to them if there was a meltdown is they would lose their jobs in a down market. If this happened, they wouldn't be individually disgraced, since the industry as a whole went bad. And at the rate these guys were paid when times were good, they had plenty of resources with which to weather hard times.

What's Next?

Looking forward, I think people will not, within a generation, assume that owning the dwelling they live in is a sure-fire ticket to easy prosperity. Now that people know that real estate prices can go down, and down a lot, people will be much more careful about buying houses. People will buy houses because they really want to live in them for decades, and if their planning horizon is much shorter than that, they'll rent.
It could be a generation before real estate prices, in real terms, reach the highs of the summer of 2006. Several factors, which will not be repeated soon, contributed to housing values reaching those heights:

* People had not, within living memory, seen housing prices decline significantly on a nationwide basis.
* People were taking out interest-only loans, and loans with negative amortization.
* Mortgages were being extended to uncreditworthy people.
* Home loans were being made without requiring a down payment.

since none of these conditions are going to be repeated for decades, I anticipate that we will not see real estate prices reaching their 2006 peak again for decades.

How are we to invest for retirement from here on out? That's a good question. In the meltdown, all major asset classes -- real estate, stocks, bonds -- took a nosedive. People aren't going to feel safe investing in anything that's likely to deliver a good return. Hopefully people will at least diversify.

A mixture of stocks and bonds is naturally easier to diversify that a house. Even better, mutual funds or, better still, exchange-traded funds (ETF's) -- equity (stock) funds, and bond funds. Since each mutual fund spreads the money over a variety of investments, your portfolio is effectively even more diversified. Use equity funds for growth, and the bond funds for safety. And you don't have to go into debt to buy stocks and bonds.  Yes, if there's a recession, your bond funds will lose some (but probably not a lot of) value, and your equity funds will lose a lot of value, but your nest egg will always have positive worth.

One way to invest in real estate and avoid the problem of under diversification is to buy REIT's, which are funds that invests in real estate. This also avoids the hassle of having to maintain it, and also you can buy in small quantities.

Another reason people should be encouraged to invest in stocks and bonds rather than real estate is that investments in stocks and bonds help fund companies, which employ people and make stuff. Investment in real estate, for the most part, achieves no social good but rather just chases up the price of land.
I've heard the argument made that a purchase of stock only helps industry if you bought the stock directly in the IPO. This is wrong. As long as you own stock in a company, you have a relationship with that company. The shareholders can, at any time, choose to dissolve the company, sell the assetts of the company such as equipment, and return that money to the shareholders. Until they do that, they are continuing to invest in the company and their money is at work doing what the company does.


  1. While I agree with most of your analysis, I think you missed the main cause of the economy’s meltdown: the absence of reasonable regulation.

    1)The trigger was the collapse of the huge subprime mortgage market. That market should never have been allowed to flourish. A few years before the collapse, 52 state governments realized the danger and, collectively, petitioned the Bush administration to put the breaks on. They were refused.

    2) I would agree that it’s not the government’s responsibility to protect individuals from their own stupidity & greed. But, it is necessary for a government to protect the nation from destructive manipulation by clever & unscrupulous money managers (and any other group or individual whose operations threaten the nation, whether for politico/religious reasons -- e.g. jihad -- or just plain avarice).

    3)Institutions that invest in, buy & sell financial instruments of obscure or unfathomable value (e.g. hedge funds, credit default swaps) should be separated from those that provide the financial liquidity needed by business, industry & consumers. That way their failure hurts only their own investors and they need not be supported.

    4)Traditionally, home ownership has been promoted, not as a get-rich-quick investment, but for its security and its contribution to family and neighborhood stability.

    The current mess is a direct result of government not doing one of the jobs it should do: provide a stable secure financial environment for business. The mess is a direct result of Reaganonsense and its mantra, “government is the problem”.

  2. I don't agree that credit default swaps are such a shady thing. One way they can be used which is beneficial is to insure bonds against default. This is a perfectly sane use of them that banks, which buy a lot of bonds, should not be discouraged from employing.

    Regarding organizations that are "too big to fail", one response that I think would be appropriate that I haven't heard discussed in the press would be a tax on organizations that increases as the organization grows, such that at some point, before the organization becomes too big to fail, their after tax return on investment becomes so unfavorable that the organizations voluntarily choose to dismantle themselves into smaller units.

  3. Giddian, an interesting thing regarding regulation: I've been reading Adam Smith's "Wealth of Nations" (1200 pages) and he says an interesting thing about usury. Most of the time he is against government regulation, but they had usury laws at the time, and he felt they were a good thing. His rationale was that money loaned at lower interest rates is loaned to more responsible people, who make better employment of it. He would have been shocked to learn that today our credit cards routinely charge 29% interest.

    I disagree with Smith here. While laws capping interest rates would have made subprime loans illegal, the cap would have to have been so low that nearly all credit card interest rates would have been illegal, and I think our economy is better off for having credit cards.

    Also, the real estate bubble was not *ONLY* due to subprime loans. If it had not been for subprime loans, there still would have been a real estate bubble due to the fact that so many people were mesmerized by the conventional wisdom that real estate was a foolproof investment -- the bubble wouldn't have gotten as high without the subprime, but it would have been a bubble nonetheless.

  4. This blog entry was written in February 2010. That is currently over 3 years ago.

    I think my prediction is proving false. I expected that people would learn that real estate wasn't such a great way to invest, and choose (like myself) to rent while investing in other, more diversified, ways.

    Looking at what other people have been saying, I don't think the average Joe has learned a damn thing. To them, the mortgage meltdown was due to "greed" or "corruption on Wall Street". The people who bought houses they couldn't afford and got foreclosed upon are seen as innocent victims, not the irresponsible financial morons I see them as. According to the popular narrative, homeowners are responsible for nothing, Wall Street is responsible for everything. Most people have no idea what, exactly, Wall Street did wrong, but they're sure it was very immoral.

    Also, mortgage interest rates for people with good credit scores are unbelievably low. They can't get any lower. Someday they will rise, and when they do, real estate values will take a beating -- there is an inverse correlation between interest rates and real estate prices. So real estate is an especially bad investment when interest rates are low (meaning now).

  5. You have listed some of the cons of investing in the house you live in, but not so many pros. Such as..

    Tax treatment for owner occupied dwellings beats all other investments. In particular, the 500k exclusion on capital gains and mortgage interest deduction.

    Inefficient market. Unlike stocks, where you can buy a company for what the market believes it to be worth, you can buy a house for less than what the market thinks. You just need to wait for the right deal and negotiate.

    Leverage is actually a good thing. Real estate prices can go down sometimes, but mostly they go up. Over a long term period they have been shown to beat inflation by a percentage point or 2. 3-4% per year with a down payment of 10% translates to 30-40% year return on capital.

  6. Hi Nick,

    The absence of capital gains tax on a house should not be a big consideration. Capital gains on securities are taxed at a very low rate. The difference between "very low" and "nothing" should not be enough incentive to invest poorly.

    Your idea that you can get a house "below market value" is an illusion. If you buy a house for below the going rate, you have probably bought a house that everyone but you knows has something wrong with it.
    I could similarly argue that you can get stocks for less that their "market value" by timing your purchases to when the market is low. But that's an equally ridiculous argument. Less than 1% of the population, if anyone, can judge when the market is high or low, or how the market is going to play out short term.

    Your last point was that historically, real estate values have risen a rate of 3% above inflation. Inflation has been around 2%, so that's a 5% non-inflation-adjusted return. Stocks, historically if you include dividends as well as capital gains yield about 10%. Furthermore, the 10% yield of the stock market, unlike the 5% yield of real estate, is indefinitely sustainable.

    Let me explain that. Companies exist to make money for their shareholders. There is no reason to expect them to not continue to be able to do that at the same rate that we have seen historically (10%) indefinitely.

    At some point real estate, on the other hand, will reach a point where homeowners taking out interest-only mortgages (which are hardly different in terms of monthly payment from a 30-year mortgage) will be paying such a large share of their income on the mortgage that they just can't afford to pay any more. After that, real estate prices can only rise as fast as per-capita GDP in the neighborhood, which won't rise anywhere near 10% per annum.

    Your argument about a 30% return when ridiculously leveraged is a VERY poor argument. If you similarly borrowed 9 times your net worth and invested in it the stock market, along with your net worth, the 1000% concentration in your portfolio would have an expected return of 100% per annum. If you borrowed 99 times your net worth, you'd get a 1000% per annum return. It's just an absurd way to compare.

    As I made clear in the piece, it's REALLY unwise to make a highly leveraged investment in something, like real estate, that might tank.