How should people view a house within their personal portfolio? For many North American households, their residence is their most important asset. As a result, it is a very important factor to take into account when planning for retirement. In this article, I explain how I prefer to view a house within a personal portfolio. (Throughout this article, I will use the term house, but the logic applies to condos as well.)
This article is generic, and is going to be read by an international audience. As such, I do not attempt to give advice whether buying a house is a good or bad idea for a particular individual. Additionally, my logic is based on conditions that may be particular for Canada and the United States; some factors I discuss do not apply in other regions.
The analysis framework is aimed at people who are a long way from retirement. Such people have a great deal of uncertainty in their financial planning due to the uncertainty about their future employment income, and their choice of where they live is driven by the location of their employer. A retiree has less ability to recover from a bad decision, but they should have more flexibility in choosing where to live.
Finally, in order to keep this article from getting too long, I will not cover the macroeconomic impact of the micro decisions people have been making about housing. But I feel that most households do not analyse their housing decisions the way I do here, and this represents one negative factor that hangs over the North American economies.
Housing: Asset Or Liability?
The key principle to keep in mind about housing is that it is very different than financial assets. Housing is an asset that loses money every year, up until the house is sold. (In the lingo of fixed income, it’s a negative carry asset.) Generally speaking, the larger the value of the house, the bigger the cost of owning it. And this is not even counting the financing cost; houses are typically purchased using mortgages, whereas few retail investors use debt financing to purchase other financial assets. The mortgage size (and interest costs) will increase in line with the value of the house.
Typically, the increase in home value is based on increasing home size (keeping other factors like the neighbourhood or age of the home comparable). As a result, there are four main factors that lead to housing costs increasing with the value of the home:
- Property taxes are proportional to the value of the home throughout most of North America. (As an aside, there are differences how property taxes generally are handled between Canada and the United States. American municipalities tend to keep the property tax rate fixed, so that the tax take rises and falls with the housing cycle. Conversely, Canadian municipalities decide what level of tax they want to extract, and then adjust the tax rate to hit the revenue target. This makes Canadian municipalities a much better credit risk, although this may be a small consolation to taxpayers.)
- Heating and cooling costs are typically increase as the home size gets larger. (This may be less of an issue in more temperate parts of the world.)
- The bigger the house, the more stuff you can (and probably will) squeeze into it. Stuff costs money.
- Maintenance costs will rise based on home size. This is an important factor to keep in mind for aging wood-framed houses, which is the standard Canadian home construction method.
A larger home also entails more home maintenance, which is an increased drain on what may be the most precious resource for working households – their time. Less free time entails monetary costs to compensate (eating out, paying for home maintenance services, the “need” for expensive vacations to reduce stress levels, and less time for part-time work).
If your financial plan is to live your life in a home you own, a more expensive home will generate increased negative cash flows throughout your life. This meets the definition of increasing a liability, not holding a larger asset. Plus, you have to sell other assets that generate income, and/or borrow, for the privilege of holding the liability. The only time the increased value of a home will increase the cash flows that you receive is when you sell the thing – but even then, your transaction costs will probably also increase (particularly in Canada). If you do die a homeowner, your estate will be larger if you have a more valuable home. But that is based on the assumption that you had enough financial assets to cover your spending when you were alive in order to leave an estate.
I have not forgotten that “you need to live somewhere”. Owning a home eliminates the need for paying rent, and home ownership was historically relatively cost effective, as long you did not need the flexibility of being able relocate. (As many have discovered in the United States in this cycle, being locked into a home can cost you potential jobs.) But when doing the rent versus buy decision, the real comparison is not necessarily for renting the same sized residence as you want to buy; the comparison is for a sensibly priced rental unit, which may be much smaller. If you are renting, you should not be accumulating piles of material goods, as you will have to move the junk repeatedly. You only need to rent a large house if you have already locked yourself into the treadmill of accumulating a lot of stuff that you need to pay to keep somewhere.
In summary, your residence is not really a portfolio asset; it is a lifestyle decision like deciding which automobile to drive (or not). Housing expenses have to be held under control within a budget, allowing you to accumulate financial assets that actually pay you to hold them.
Rental Housing As An Investment
Without the particular details of the individual situation, I cannot really say how to view housing that you rent to others is a good or bad portfolio asset. Property investment has probably generated a lot of rich individuals, but that is not necessarily because housing is a great asset. It is the only asset that retail investors routinely buy with leverage, and the magic of Other People’s Money magnifies returns - and losses. It is also an operating business that is relatively easy to manage; you mainly just need to deal with renters and maintenance. Returns on operating businesses should be better than the returns on assets you hold passively, although it represents a loss of time (which as I noted above, is a very crucial resource if you are working).
Things to keep in mind are liquidity and diversification. You have to have a liquidity buffer to allow you to hold on the assets in a period of interrupted cash flows (vacancy or losing your job). As for diversification, it is a basic principle of personal finance to avoid “putting all your eggs in one basket”. If you own only a small number of rental units, even slightly bad luck could generate a horrible occupancy rate – having a larger number of units increases the odds of having a an occupancy rate near the average. Having a properly diversified portfolio along with rental housing is difficult to achieve, unless your portfolio is relatively large.
But in addition to portfolio diversification, you need to factor in diversification versus the risk to your overall financial plans.
- For most working age people, their largest source of cash flows comes from their employment. Having a large real estate asset could create a toxic correlation with your employment risks.House prices often soften in recessions, when you are statistically most likely to lose your job.
- If you work in a profession related to real estate, your job outlook could crater at the same time as your home value. (This career correlation hit technology employees who invested in IT stocks during the 1990’s tech bubble.)
- North American one-employer small town property values can collapse if that employer shuts down the business.
Mortgages: A Short Position In Bonds
To use financial market lingo, a mortgage is a short position in bonds. In other words, a negative bond position. Given that bond yields are currently very low in absolute terms, this may not be that bad a thing. But this can be problematic if rates are at more typical levels. Bond values increase during recessions, which are bad times (on average) for households’ cash flows. This creates an unwanted correlation between your financial net worth and the job market. This is probably not too big a deal; U.S. mortgages can often be refinanced, and Canadian mortgage durations are very short. But it is something to be kept in mind when looking at your total portfolio, as many household’s mortgages are larger than their holdings of financial assets.
Housing As An Inflation Hedge
Housing is typically viewed as an effective inflation hedge. This appears extremely useful, as there are few assets that are cost-effective inflation assets (see my comment on equities as an inflation hedge here). This is most important for retirees, as they need to control their expenses, and they will not have wages that presumably rise with inflation.
But for people a long way from retirement, most of the advantage given by inflation is the result of the fact that they probably have a large mortgage (a short bond position). Your negative cash flows created by the house will be increasing with inflation. Since your payoff from selling the house is far in the future, the increase in the future house value from inflation may be swamped by the fact that long-term interest rates will probably be higher (i.e., the discounted value of the house proceeds may be lower if inflation rises). Therefore, if you are young, upsizing your house may be counterproductive financially if you are attempting to hedge inflation.
Now that I’ve scared everybody, Happy Halloween (and have a good weekend)!
(c) Brian Romanchuk 2013