Among the many surprises that the Covid pandemic brought into our lives was a split-second decision by thousands of U.S. households not only to uproot themselves and relocate to far flung areas of the country but to make the biggest purchase decision of their lives and buy a house. We’re still in the midst of the pandemic, but reports are already arriving of buyer’s remorse and people feeling “house poor” despite the historically low mortgage rates.
For anyone else considering a house purchase now, what questions should you ask to try to avoid a similar fate? The answer depends on whether you view a house more as an investment asset or as a consumption asset. There’s a world of difference with all the other important purchase questions, depending on how you answer this first one.
An investment asset is one that an investor holds in hopes of earning income or capital gain. Examples include stocks, bonds, and many types of real estate. Dividends, interest payments, and price appreciation are the reasons that investors part with their money to purchase these kinds of assets.
A consumption asset is one that’s held primarily for use and enjoyment - your car, a set of golf clubs, or a musical instrument, for example. The primary purpose for buying these assets isn’t to make money, it’s personal reward and fun, or to solve a problem such as how you’ll get to work.
While it’s true that many assets can have dual characteristics - a vintage saxophone may appreciate in value; a company stock can be entertaining when its price is rising - one of the easiest ways to make a poor decision is to prioritize both financial reward and personal enjoyment when making a purchase. The feelings that help us figure out whether a consumption asset will provide the most satisfaction are often unhelpful and even counterproductive when evaluating the best risk-reward profile of an investment asset.
In fact, a proven way to ensure that an asset evades proper due diligence is to call it a “hybrid asset,” one that is “part investment, part expense.” This is the path to rationalization, since it’s easy to conclude that we can buy anything we want if we’ll be making money off of it. It’s also the path to undue influence by self-interested parties who see the look of desire in our eyes and are happy to help us purchase what we want, since they’ll be making money on the transaction, too.
If you cannot control your emotions, you cannot control your money.
- Warren Buffett
Before walking down that path, it’s best to pause and consider what your purchase decision would be if you knew that the property was going to be purely an expense and never make you any money? Alternately, what would you look for in a property if you were buying it purely as an investment?
House As Consumption Asset
If your house were simply another line-item expense on your cash flow statement, like groceries or entertainment, how large of a mortgage would you be willing to assume? A mortgage looks a lot different, depending on whether it’s “leverage” used to earn a higher investment return, or simply a tool to borrow money today that you’ll have to pay back with tomorrow’s earnings.
Pulling income forward from your future self for a purchase today can be a useful tradeoff if you have a stable job and a pretty good sense that your future self won’t mind having less to spend. But when things don’t work as smoothly, the debt can cause trouble.
During the financial crisis more than a decade ago, a client who had bought a million-dollar home in San Francisco suffered a business failure and needed to relocate to Los Angeles to find new employment. At the time, the value of his home declined twenty-percent, which meant he owed more to the mortgage lender than the house was worth. It took him nearly half a year to get the lender’s approval to do a “short sale” of the house and pay back the lender with additional cash from savings.
If you assume your house will never appreciate in value, how will you feel about the ongoing cost to own it? A lot of the imagined satisfaction of owning a home rather than renting is attributed to the idea that once you pay off the mortgage, the house is yours free and clear. This might have been true when we were still living in caves, but in today’s world, there are some expenses that are required to be paid for as long as you own the house - the so-called “carrying costs” of property taxes, insurance, and maintenance.
Each of these expenses tends to surprise new homeowners. Sometimes they forget that their property taxes will be higher than the tax history on the house if they bought at today’s higher prices. Property insurance tends to cost more than expected, and premiums have been skyrocketing in many parts of the country due to increased climate risks from floods and fire. With parts and labor in short supply these days, maintenance costs are rising as well.
Plus, as one client put it, “Around here, a repair usually turns into a renovation.” Home improvements tend to come hand in glove even with newly constructed homes. After the initial excitement of having a place of your own subsides, it’s rare for owners to avoid thinking about how they might enjoy the house just a little bit more if they had more storage space, or upgraded countertops, or new lighting.
For many people, being able to design and implement the home of their dreams is a pleasure. But will you be okay with the financial trade offs involved - say, getting a new deck for the barbecue rather than taking a foreign vacation next year?
If you expect that your house will be more of a “money pit” than an “engine of wealth creation,” how will you feel about the time required to own and maintain it? Even if you can pay someone to mow the yard and do the housekeeping, there’s almost always something that needs attention with a house.
How we spend our days is, of course, how we spend our lives.
- Annie Dillard
For some people, if they see a detail that needs attention, a small improvement they might make, it’s a fun project to address. For them, owning a home is a hobby as much as anything. Will this be the case for you, or are there other interests you might rather pursue?
Finally, the time required to own a home includes your commute and all the time the house location requires you to spend running errands and taking care of the activities of daily living. A lot of people are balking today at going back to the office, having realized how much better life is without an hour drive each way to get to their jobs.
Why didn’t they realize this before, or, if they did, why were they willing to accept a long commute? Perhaps because they were thinking of the house more as an investment.
House As Investment Asset
If you view your house as a good investment, arguably none of the questions above matter. Who cares about property taxes and a commute if owning a home helps you accumulate wealth?
Making a good investment, though, involves a different set of questions - questions about risks and return and about opportunity costs. The question isn’t simply “how much did you earn?” but “how much risk did you take in order to earn that return?”
A commercial real estate investor often compares several potential purchase opportunities at once, considering the tradeoffs and the likelihood of the income stream or appreciation playing out as expected. The analysis focuses as much or more on what other people - potential tenants or future buyers - might think about the building, since the investor will need these parties in order to generate an income stream from rents or appreciation.
By contrast, the typical approach to buying a house is for the buyer to think only about what they value, not the preferences and needs of future purchasers. The general sentiment seems to be, Hey, if house prices always go up, somebody will be around to buy it from me.
However, as the chart below demonstrates, house prices don’t always go up.
US Home Prices 1890-Present
Source: Robert Shiller
What jumps out is how jagged house prices have become over the past couple of decades compared to before. Economists have offered lots of explanations - excess global supplies of cash; changing lending standards; etc. - but whatever the case, it’s easy to see that a good investment return on a house is anything but guaranteed.
The economic conditions for housing are always evolving and affecting how people perceive houses as an investment. What an investor ultimately earns from a house depends in large part on what’s happening economically at the time they want or need to sell.
Sellers during the pandemic have practically been able to mint money, with houses routinely selling at hundreds of thousands of dollars over asking price. But one client’s home declined over forty percent during the financial crisis of 2008 and 2009, and she felt fortunate to have a second chance at selling it a number of years later.
In addition, with houses, a lot of determinants of pricing depend on what’s happening locally - in the city or town where it’s located, in the neighborhood, or even on the street itself. How might changing commute patterns affect the neighborhood? How might local housing policies affect future housing supply? What kinds of demographic trends might affect prices?
Today, as always, the prospect for future house prices is unpredictable. What happens if rock-bottom mortgage rates begin to rise? What will be the effect of businesses and families relocating to new areas in the coming years?
The nature of the housing market itself appears to be changing, with new types of institutional buyers such as private equity investors having entered to compete with individual buyers. Yet the changing conditions have meant that even these sophisticated buyers with tons of analytical firepower have found the terrain difficult to navigate. Last month, Zillow stunned the market “when it said that it [was] no longer buying homes and [would] lay off a quarter of its roughly 8,000-person workforce,” writing off nearly half a billion dollars on the value of the homes that it previously purchased.
If residential housing offers good expected returns going forward, it is undoubtedly because there are plenty of risks attached to it.
Good financial planning is all about evaluating competing priorities and trade-offs, but it’s difficult to do this with a house purchase if you pretend that there are only benefits and no costs. Going through the thought exercise of evaluating a potential purchase as either a consumption asset or an investment asset can help you take the time required to make the best decision possible.