Here’s evidence for the new consensus that homeownership is dumb: A pair of professors of finance say that in the vast majority of cases, Americans would have been better off renting rather than owning between 1978 and 2009.
“Homeowner expectations for price appreciation did not materialized [sic] on average, and given the expected opportunity cost renting was preferred to owning over 70% of the time between,” Eli Berach (East Carolina University) and Ken H. Johnson (Florida International University) write in a paper [pdf] for the University of Florida business college’s Financial Management Association International.
Counterintuitive as the finding may be to some, it is actually quite logical. Unless someone possesses the cash necessary to buy a residence, he or she will be renting one way or another. The choice is between renting the property directly or instead renting the capital necessary to buy the property. The amount of capital to be rented is a function of house prices, while the bulk of a mortgage payment is interest, which is the rental payment on this capital. After 2 years, the typical 30-year amortizing mortgage balance has been reduced by less than 3%. This means that a household that took out a $300,000 mortgage with a 5% interest rate to buy a home has only reduced its mortgage balance by $8,600 after two years despite spending nearly $39,000 in total over this period.
Housing advocates may respond by pointing out that at least the $8,600 in this scenario went towards home equity rather than simply being squandered on rent. But, as demonstrated in the Real Estate Economics article, the principal component of each mortgage payment – i.e. the portion of the mortgage payment that goes towards reducing the principal mortgage balance instead of interest – is an added expense renters don’t have. During the housing boom, the wealth created from housing was not principal amortization, but rather large price gains on a highly leveraged asset.
There’s an important nugget buried in that description of the principal payment as an “added expense renters don’t have.” Berach and Johnson explain that their conclusions assume the hypothetical renter is successfully investing the difference between rent payment and mortgage payment:
Thus, this piece does not seek to calculate the cost of ownership but rather to create a “horse race” between renting and owning by making a comparison between the value of an investment portfolio held by renters and the net selling proceeds collected by homeowners at the end of a holding period.
If I’m reading this thing correctly, that means the average renter would have to be doing at least a little better than 5.7 percent average annual return on investment. That’s a feasible goal, but for a regular person without an interest in Wall Street, it’s not as simple as advertised.
This is not to dispute the findings but to note that real estate’s tangibility is for many people one of its appeals. That appeal may be entirely misguided: The hassle of owning land (or worse, a condo) is arguably worse than the hassle of actively investing, where only paper money is at stake and you can get out at any time. But the simplicity of the investment is part of the value proposition for a real estate owner, as this 100-year-old birthday girl can attest:
Interestingly, Berach and Johnson say the real estate correction (or as I like to call it, the beginning of the real estate correction) has already reversed the conditions described in their own study and made housing an attractive investment again:
The lowest required appreciation rates for the U.S. are 3.72% and 4.35% when risk free and risk equal expected returns are used and are both associated with the second half of 2009. These observations imply that the current housing condition in the U.S. instigates the lowest price appreciation hurdle for homeowners since at least 1978.
In the course of criticizing government policies designed to encourage marginal households to get into real estate ownership, Economics21 concedes that “they provide an avenue towards wealth creation.” Presuming you’re not under water, it’s true that ownership at least provides an avenue toward wealth assembly, but even that advantage diminishes because government policies don’t encourage real estate ownership; they encourage the debt associated with real estate ownership.
I’ve been tracking the decline in equity portion (the percentage of their homes people own free and clear) for some time, but not as long as that portion – which was as high as 70 percent in the mid-1980s – has been declining. However, one microtrend I spotted back in March appears to have continued. The equity portion has continued to grow over the last year, after hitting a low around 41 percent. Americans now own 42.2 percent of their homes. (Data from Federal Reserve Flow of Funds reports.) It's a small change, but it could be a sign that in the face of relentless government efforts to get Americans to raise their own debt ceilings, Americans are beginning to say no. That's a more sure avenue to wealth creation than the get-rich-quick promises of either realtors or stock brokers.