“Is buying a home a good investment?” This is one of the most common questions we get in our business. That’s not surprising, since a home is most people’s largest single asset, and so many of our clients live in the hot San Francisco Bay Area real estate market, where price appreciation has been in the double digits for several years. The answer to this question is rarely simple, but in most cases, buying a home is a good investment because of the intangibles—joy, stability, pride—it provides to its owner. However, it’s important to maintain grounded financial expectations, whatever you decide to do.
Since the S&P CoreLogic Case-Shiller San Francisco Home Price Index began tracking in 1987, Bay Area home prices have increased by about 5% per year, a little higher than the 3% inflation rate of home prices nationally from 1890 through 1990. In recent years, regional price increases have been high, largely due to the demand fueled by growth in local technology firms. But even with higher-than-average growth rates, the investment in homeownership is not what it appears to be on the surface. Property taxes, insurance, maintenance costs and improvements reduce the return on your investment.
Whether or not the Bay Area continues to outpace the national real estate market, the mathematical reality is that the long-term returns of home ownership can’t compete with the 9.5% annualized return that stocks have delivered since 1928. But the risk of investing in a diversified basket of stocks and bonds is very different than that of housing. While the prices of stocks are more volatile, your stock and bond portfolio will never flood, burn down, or grow black mold.
So why does housing seem like it provides great financial returns, if the evidence suggests otherwise? There are three main reasons.
- People have “recency bias”—the tendency to put more weight on recent experience. The double-digit increases of the last few years are top of mind, while more sober markets seem like a distant memory.
- The “magic of compounding” makes even meager rates of return translate into large numbers. Our parents may proudly tell us that they bought their home for $150,000 thirty years ago, and could sell it for $1,500,000 now. But if you assume a 5% sale commission, 1% annual property taxes, another 1% in annual upkeep, and $100,000 in improvements, the annual return is just under 4%.
- Much of the equity we build in our homes is the result of the disciplined savings imposed on us by our mortgages. Paying off one’s mortgage forces homeowners to “pay yourself first” – savings that might otherwise be spent on consumption. Some people argue that borrowing more can significantly juice housing returns, but that’s only true if you are lucky enough to lock in a mortgage rate that is lower than the rate of home price appreciation. Otherwise, borrowing more reduces the long-term return of home ownership.
There may also be other indirect financial benefits created by the stability and personal satisfaction that homeownership creates, and the moving costs and disruption that it helps avoid.
The bottom line is that purchasing a home as a primary residence is generally a wise decision, but should not be pursued as an investment or substitute for a diversified savings portfolio. The financial return is typically not as good, and there are risks, costs, and work associated with being a homeowner. Buying more house than you need is not a good financial investment. The best returns of homeownership are the satisfaction and stability of owning a home. From a purely financial risk-and-return point of view, a diversified portfolio is the way to go.
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