Should you buy a home?
How to reason about real estate as a personal investment
For many of my friends and peers (and also many readers) buying a home will be the largest financial decision of their lives. For such an expensive purchase, it’s a surprisingly unexamined one. The desire to own your own home is so widely held that it is almost reflexive. But does it always make sense to buy?
Inside this issue:
Everyone is born short housing
Is a home a good investment?
Let the bank buy it for you
What does it mean to own property?
Should you buy a home?
Everyone is born short housing
To a first approximation, everyone reading this newsletter is alive. Congratulations! You have probably already noticed that one of the inconvenient little quirks about being alive is that you need somewhere to do it — ideally somewhere that isn’t full of other people being alive there already. Unfortunately, for a variety of (mostly bad) reasons we haven’t built enough homes in America, so finding somewhere to live is often pretty expensive. According to the Bureau of Labor Statistics (BLS) the typical American household spends ~1/3 of their annual budget on housing — roughly double the next largest category (transportation).
Conventional wisdom is that everyone should aspire to own their own home. The intuitive argument is obvious: renters are spending money, owners are investing in their own home equity. It obviously makes sense to plan such a significant life expense and experience carefully. You have to live somewhere. Does it make more sense to rent your home, or to buy it?
Is a home a good investment?
One part of the standard conventional wisdom that everyone should own their own home is the idea that real estate is a good investment. It is true that on average and over a long timeline property values tend to rise. According to the Federal Housing Finance Agency (FHFA) home prices in America have risen an average of ~4.5% / year since 1992. But that average also includes a five year bear market following the 2008 crash where prices fell as fast as -10.5% / year.1
You also can’t just buy a home in 1992, ignore it for 32 years and then expect to sell it in 2024 for a ~4x markup. Houses require a lot of repair and upkeep costs if you want to actually maintain the market price. Maintaining a property typically costs ~2% of the value of the property annually2 and property tax is approximately ~1%.3
That means the practical return on investment in American real estate over the last few decades has been around ~1.5% annually, with high volatility. By comparison, the S&P 500 returned an average of ~10.7% annually over that same period. Anyone who invested in stocks also didn’t have to list their home for months and pay for a real estate broker when they wanted to sell. In other words, real estate is mostly a terrible investment — at least when viewed in isolation.
It shouldn’t really surprise us that homes are bad investments: things are good investments when they are undervalued. But since most people prefer to own rather than rent it makes sense that the price of ownership is (on average) high. People who assume that owning property is a good financial strategy are either underestimating the true cost of owning property or they are underestimating the opportunity cost of not making other investments, or both.
Let the bank buy it for you
Of course, most people (at least in America) do not buy a house by paying for it all up front. The more typical arrangement is to take out a loan in the form of a mortgage and buy the house with debt. You end up paying more for the property overall but in exchange you pay more slowly. As long as your investments grow faster than the interest on your debt, a mortgage can lower the effective cost of ownership.
Mortgages let you own property without having to sell any of your other investments to pay for it. In other words, a mortgage magnifies your effective wealth by enabling you to "own" more assets than your total net worth. This is basically a form of margin (or leverage) trading, except that banks will offer much better terms for a loan against a house than brokers will offer for loans against a stock.
Banks do not offer mortgages out of generosity. What a bank is buying with a mortgage is greater certainty about the future — which means what banks are selling to you is risk. You get to own the property without having to pay for it — but you have to make all your future mortgage payments or you lose the property entirely. Intuitively, a mortgage reduces the opportunity cost of buying property but adds two new costs: debt interest and foreclosure risk.4
Since most people desire certainty about their future housing, committing to a future and selling that commitment to a bank can be a potentially agreeable tradeoff. A mortgage also typically allows people access to credit at a scale and cost that would be otherwise unavailable to them. Viewed this way you can think of a mortgage as a tool for harnessing future purchasing power in the present, allowing someone to live today in a home they will (eventually) be able to afford.
In a competitive market (which most real estate markets are) most buyers will need to use a mortgage to access their potential future wealth, rather than limiting themselves to buying using only their present wealth. The only other options are (a) buying a cheaper property than your economic peers or (b) waiting until your moment of peak lifetime wealth to make a purchase. For most people, most of the time, a mortgage will be the most practical option.
Banks are also not the only institutions with an interest in cultivating certainty about the future. Governments also usually prefer when citizens make a long term commitment to living in a certain place (and generating a certain amount of property tax revenue). That’s one of the reasons why many governments explicitly subsidize mortgages. In the US the government allows tax-paying households to deduct the interest paid on up to $750k worth of mortgage debt. Assuming you make enough taxable income (and if the bank gave you a mortgage you probably do) that means the first ~$750k worth of mortgage is reduced by whatever your effective tax rate is. You’re not so much paying interest as you are pre-paying taxes.
The existence of the mortgage interest tax break doesn’t make real estate an attractive investment — you are almost certainly better off investing your available wealth in a broad market index rather than levering up on a rapidly depreciating lottery ticket made of lumber and concrete. But the mortgage interest tax break does usually make buying a property with a mortgage more affordable than buying the same property with cash up front.
What does it mean to own property?
As I hope I’ve made clear above, the conventional wisdom that homes are good investments is just mistaken, even after accounting for things like mortgages and the mortgage interest tax break. The true cost of owning a home is a mix of obvious costs (down payment, mortgage payments, property tax) and non-obvious costs (upkeep/repair, foreclosure risk, opportunity cost of capital). The people who think owning a home is a good financial investment are underestimating one or more of the non-obvious costs. Renting is cheaper than buying.
It should not surprise us that renting is cheaper than buying, because buyers are both able to use debt to access their peak lifetime wealth and are heavily subsidized by the government. Renters have neither advantage. It also makes sense when you consider that for any property bought using a mortgage the bank could have bought that property and rented it out themselves instead. The very existence of a mortgage is evidence the bank thinks the buyer will end up paying them more (net risk) than a hypothetical renter would have. In practice most home buyers are paying a premium for the privilege of owning — pretty much the opposite of an ideal investment.
The financial case for owning your own home is extremely weak — but there are other arguments in favor of owning your own home. You might want to own your own property because it gives you greater freedom to customize it or greater emotional satisfaction to know that it belongs to you. You might get pride from maintaining or improving your property or you might view it as a family heirloom. Most importantly, owning your own property guarantees that you have somewhere to live!
More precisely, it grants you the right to live where you are. If you are renting your home the landlord can decide to raise the price, but if you are paying for a mortgage your terms are already locked in. In that sense, the premium you pay for owning a home includes the value of guaranteed access to living in that location. Depending on how you feel about your job/commute, local schools and other aspects of the neighborhood you might place a higher (or lower) premium on guaranteeing long term access. You might also just value stability for its own sake.
The ratio of the cost to rent a property vs own a similar property in a given community is a reflection of the premium that people in that community place on continuing to live there long term. So a college town will probably have higher rent prices and a quiet suburb with good public schools will probably have higher premium on ownership and (relatively) lower rents. In general, the more people want to live somewhere the more expensive it will be — but the longer they want to live there the more expensive buying will be, relative to renting.
This leads to a subtle and under-discussed value to owning your own property: it is a credible signal of both your wealth and your commitment to a particular community. That’s why owning property (especially expensive property) is generally viewed as high status: it can only be done by people who are both rich and have a strong affinity for that specific location. Owning property isn’t an efficient way of generating wealth, it’s an act of conspicuous consumption.
The property values in a neighborhood also tend to rise and fall together, which means people who have anchored their wealth to a home in a community have also anchored their wealth to each other.5 People who own homes on the same street have significantly more shared economic destiny than people who rent. As a result they are natural political allies — the political strength of homeowners is the reason the mortgage tax interest break exists in the first place.
Aligning yourself with the political and economic interests of a wealthy and well organized community might be expensive financially but viewed more holistically might be a very reasonable expense. Owning a home in America is a good rough-and-ready way of making sure the American government is looking out for your interests, especially at the local level. That’s pretty valuable, if you can afford it.
So, should you buy a home?
Maybe? Not as reflexively as conventional wisdom would suggest. I think it makes sense if you are confident in your future income, expect to live in your community for at least the next ten years and don’t mind paying a premium to guarantee stability in your future living situation.
A mortgage does not magically transform rent from an expense into an investment. The people who think renting is spending and owning is saving responsibly are just bad at math. Owning property is more like an expensive way to buy certainty about the future. Reasonable to want! But not something everyone needs.
You might have a different estimate for the growth potential of your particular market — but you should be suspicious of your ability to make those predictions. Even predicting the future of the American housing market as a whole is hard: real estate looked really good in 2007! It looked hopeless in 2011. Predicting narrower markets or shorter timeframes is even harder. Reasonable people are better off assuming they can’t.
The IRS allows rental property owners to deduct ~3.65% of the value of their building (excluding land) for maintenance expenses, and building values tend to range from ~30-80% of the total property value. That implies maintenance is ~1.1-2.9% of overall property value annually, simplified here to ~2% for clarity.
Property taxes in America range from 0.2-0.5% in some states up to 2-2.5% in others. There are also sometimes county and city taxes. ~1% is an extremely broad estimate.
People who borrow against one property to buy additional properties (like home flippers or real estate speculators) are often counting paper gains as guaranteed profit and neglecting to properly account for foreclosure risk. They are basically highly leveraged momentum traders who don’t know what "highly leveraged momentum trader" means.
The communities that form around shared property values are very similar in a lot of ways to the communities that form around NFT collections. They both exist primarily to promote myths and enforce norms explicitly organized around preserving the value of their mutual investments. And both can inspire a surprising degree of fanaticism.