Tuesday, April 22, 2014

Own or rent? Thinking aloud about housing

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Note: I accidentally published this post early, then deleted it, then remade it. This is the correct post, but most RSS readers will also show the original, incomplete post just before this. Ignore it. Sorry!

Yesterday Catherine Rampell wrote about the strong preference Americans have for home ownership. Robert Shiller speaks of the "homeownership delusion." The more I think about housing, the stranger I think it is.

Owned housing provides a stream of housing services (which everyone needs), the nature of which can be exactly customized to the owner's preferences. A house is a large fixed asset with a low depreciation rate that is easily collateralized, allowing owners with equity to better smooth consumption or finance entrepreneurship. It sits on land, an asset with somewhat inelastic supply. Robust insurance markets exist for countering unexpected depreciation of the physical asset. Owning a house is like being able to pay rent with untaxed income. An owned house is a lifetime inventory of housing services; once paid for, this inventory allows owners to avoid large monthly living costs that can make retirement or job loss difficult and risky.

On the other hand, as a capital gains investment housing typically performs poorly compared to alternatives like stocks. Ownership imposes large adjustment costs on housing consumption. As a result, home owners are likely to often hold (and pay for) larger housing inventory than they need (e.g., owning a large home in anticipation of having a large family before said family arrives or after children leave the nest); in these situations, many people may be better off renting for extended periods. For most people, an owned house is a massively concentrated, highly leveraged, totally undiversified bet on one asset class (real estate) in one geographical region. It's a long-term bet on the local labor market and natural environment. It may be a long-term bet on the owner's job match or occupation. The home purchase includes a bundle of local amenities--school district, voting district, neighbors, public administration, commute, etc.--and the new owner is making a bet about the outlook for that bundle as well. In the past, owner-occupied housing may have been the only way for average people to gain exposure to the real estate asset class, but diversified real estate investment is now available to anyone with a Vanguard account.

In many personal finance books home ownership receives no attention in the context of optimal portfolio allocation, which I find very odd.

One pro-ownership argument I've seen made is that owned housing allows households to "lever up," which is true but a bit misleading. The housing investment is typically leveraged, and the collateral value is nontrivial (and much better than stocks), but a new home owner doesn't get leverage benefits compared to the renting alternative.* A mortgage allows one to buy a large inventory of housing services now but pay for it over time (albeit a time shorter than the duration of the service stream), while renting is just paying for those services at the time they are consumed. In some cases, the opportunity cost of owning is high as some of the money that would have gone toward mortgage payments could be invested elsewhere instead. Once the house is paid for, of course, the owner holds a lifetime inventory of housing services that can be consumed at (almost) no recurring cost; then the owner can devote a huge share of income to other investments. But observe that this strategy turns the Ayres and Nalebuff approach (book) on its head, concentrating portfolio risk in the short time period between house payoff and retirement.

All of these risks are diversifiable, but only for people with enough extra wealth to make hedging investments.

None of this is to say that buying a home is a bad decision. Occasionally I see people suggesting such. I'm simply arguing that the housing tenure decision is nontrivial. The standard norm that adults should buy a house as soon as they can save the down payment is probably inappropriate. Many people are probably financially better off renting. The right decision depends heavily on relative magnitudes of mortgage interest rates, ownership costs (e.g., property taxes and maintenance), rent, adjustment costs, returns to alternative assets, and time preferences. Spend some time with this excellent tool at NYT (be sure to fix some of the advanced settings, like investment returns). It doesn't take much experimentation to see the sensitivity of the tenure decision to parameterization. Of course, there are non-pecuniary benefits of owning, but in many cases these come at a significant financial cost.

Whether a person should rent or own depends on their circumstances, preferences, and assumptions about the future. I suspect that housing policy is made without accounting for the complex nature of the optimal decision. Maybe a lot of personal tenure decisions are as well.

UPDATE 30 April 2014: Josh Barro has a very nice video with MSNBC, here, in which he makes the argument for renting as the American dream. "Buy a home if you want to own a home, can afford a big down payment, and can afford to absorb the hit if house prices fall."

*I received a lot of push-back on this point in the comments. This is because I'm pushing the word "leverage" a bit too hard. Obviously I realize that a home allows people to use leverage; I mention its collateral value in several places in the post. When I say owning does not provide leverage benefits compared with renting, I am thinking in terms of the Ayres and Nalebuff lifecycle investing concept. This is the idea that leverage should be used to consume and invest now but pay for it later. Owning a home is basically the opposite of this, since it means you're prepaying your rent. You're paying now to consume and invest later. This reduces your ability to lengthen the time exposure of your investment portfolio, unless you think of the house itself as a capital gains investment portfolio (and history suggests that you shouldn't).

12 comments:

  1. Sorry, I do not get your point. A new home owner that borrows to buy does get leverage he/she would not get as a renter. No bank will lend you cheaply 3 to 4 years of your annual income to pile into any other type of assets.

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    1. Thanks for your comment, Henri. Of course I know that a house allows for borrowing, as I note elsewhere in the article. My argument is a bit more abstract and is targeted at a specific pro-ownership argument that I have seen. In a lifecycle context, there is a benefit to having access to leverage early so you can invest in things like stocks and gain exposure to aggregate risk over a long time period. At the extreme, this is the Ayres and Nalebuff "lifecycle investing" concept.

      A mortgage doesn't really help people do that, at least initially. Yes, you borrow money. But you do it to buy a durable consumption good that you could have rented instead. You're pre-paying a lot of rent, which is the opposite of leveraging for lifecycle investing. You gain less exposure to other investments early in life. From a lifecycle investing standpoint, it would be ideal if you could delay rent payments until death, rather than front loading them. This wouldn't matter if housing were a great capital gains investment, but it's not (or at least, it hasn't been historically, except for a few very short time periods). You effectively defer investment of other assets until after you've paid off the mortgage.

      Once it's paid off (or partly paid off), you can get HELOCs and maybe use those to satisfy lifecycle investing goals, but you're doing so later than otherwise. By renting instead, you can pay for housing services exactly when you get them and use your extra money for portfolio goals.

      I realize this is a minor point. I just think it's important to remember that leveraging to buy a house isn't like leveraging to buy stocks. A 30-year mortgage is just a way to pre-pay a lifetime worth of rent, albeit financed over 30 years. You still are paying for rent before you use it, which has an opportunity cost for your portfolio.

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    2. Sure, leveraging to buy a house isn't like leveraging to buy stocks, but my point is that most people simply cannot leverage to buy stocks, whereas retail banks will get out of their way to provide them with real estate leverage (because it gives them stable long-term customers for their fee-based businesses). Housing is thus often used as surrogate leverage, which I believe partly explains the strong herding behaviour one sees in housing markets.

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    3. Yes I know. I think you're missing my point, which is probably my fault. Housing is surrogate leverage for what? For leverage to be useful in investing, it should allow you to acquire financial assets now but pay for them later. Housing leverage lets you acquire a huge inventory of housing services now and pay for it over time, but you're still going to pay up before you need all the services. Renting lets you wait even longer to pay for the housing services! So unless you see the house purchase primarily as a financial asset (which you shouldn't, according to Shiller and others), the leverage isn't helping you invest better as compared with renting.

      Maybe what's causing confusion is my use of the word "leverage." Of course it's easier to borrow money to buy a house than to buy stocks. What I'm saying is that the leverage you use to buy a house doesn't give you the benefit of consuming now and paying later, since buying a house means prepaying lifetime rent. That's the opposite of consuming now and paying later--it's paying now and consuming later. Renting at least means consuming now and paying now, which makes it more "leveraged" than owning in the sense that it makes it easier to gain exposure to financial assets earlier.

      You're raising a semantic point, while I'm trying to make an economic one.

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    4. No Ryan, when you buy a house and get a mortgage, even assuming you put down all your savings, you buy the right to leverage later even when you have some savings. You can basically borrow 4 times the value of your house anytime you want to leverage, even if you have enough savings to pay your mortgage in full. The bank doesn't care that you don't NEED the mortgage, it will give you the money anyway.

      BTW aren't you forgetting the huge, nonsensical tax advantages in your cost-benefit? It makes generally no sense to rent if you can avoid it and if you plan to stay long enough to cover transaction costs.

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    5. Thanks for your comment. I know all of this. It is clear that I did not explain my argument very well. As you can see, I did mention that a house is great for collateral, particularly once you have a decent portion of it paid off. I thought I made it clear that I understand this (I mentioned it more than once, I think). It still doesn't produce the kind of leverage benefits I have in mind, particularly those associated with the Ayres lifecycle investing concept. The problem here is that we demand too much from the word "leverage", and I am using it in an unconventional way that is bothering people.

      I haven't forgotten the tax advantages. I considered getting into that but my post was getting too long already, and I figured everyone has already thought about that stuff. The very good NYT calculator I linked in the post can account for tax advantages. It still does not always deliver ownership as the dominant choice, though you are right that owning is often optimal for long time horizons. However, it is not "generally" true that owning always dominates renting. There are a lot of moving parts in the decision.

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  2. I think one of the stronger pro owning arguments is that it forces some savings that would otherwise be consumed. Many people would not invest the delta between renting and owning. Not a game changer, but a point worth mentioning.

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    1. That's a very good point, and I find it persuasive. "Behavioral reasons" to buy a home, as a forced saving mechanism.

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  3. Owning your own home versus renting is overall more economically efficient. Think of the old saying, no one ever washes a rental car (or trashes their own car). There is a difference in how an individual treats his/her own property versus a rental. The care in not breaking stuff, or the do it yourself repairs. Also the do it yourself, whether a lawn or other repairs, is not taxed and subject to the frictions that hired help is.
    There is a reason in any market rental tends to be much more common in the low end. Owned stuff will be nicer. Renting does not spending money on the custom touches that make a place home. Renters just do not spend the time, money or effort to improve a rental as homeowners do. In Europe where renter have almost property type rights, it is different.
    Also, one should be wary of comparing different financial investments with housing. Most lower end home owners, who really are the ones who might go either way, are not able to choice great investments, and would likely keep any money saved (to the extent not spent) in a savings account in the bank. At the higher end, because of the improvement and customization issue, they will always go ownership.
    The tax issues outside of the self help actually favor rental. While owners can deduct interest/taxes, owners of rental property get to deduct depreciation on very favorable terms.

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  4. I wonder whether there are too many variables like the country, region, the stage one's life etc. I had two experiences of buying a house, both in Melbourne Australia. The first time was in 1988, when I was 47. The rents seemed high and I bought a house for 105,000 with a down payment of 10 percent. The rates went up to 14.5 percent, it was difficult. The neighbourhood schools were bad, we experienced some racism but it was difficult to get out. Finally in 1992, I saved some money on a foreign trip and rented a house for myself and rented our house. After a few months rents did not come and I sold the house for 80,000. It was a bit of disaster. Finally in 1995, I bought a house again since I felt that I should own a house by the time I retired. This time the price was 150,000 and rates around 6 percent. It was bearable and by 2004, it was mostly paid off and I retired. We kept a bit of the loan so that we could borrow money if we wanted. Off and on we borrowed money on the house, once to buy a small business and sometimes to help the children to buy houses or other things. I never borrowed to invest in stocks. Now the house (mostly for the land) is worth over a million and I am comfortable with the superannuation I get. Without a house, it would not have been enough. Even the first place I bought is now worth around 500,000. So I generally advice our children to buy a house. But I am not sure about it since it may affect their mobility. I am not sure what to make off it. Certainly there were automatic savings since one had to pay mortgage. Other than that, there seem to be too many variables.

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