Is Housing Such a Bad Investment? Maybe Not...

One of the post-bubble conventional wisdom stories that has gotten a lot of traction is that housing is a bad investment and that consumers would do better to rent and invest in the stock market.  The problem is that it's wrong.

The prooftext for the idea that housing is a bad investment is a straightfoward comparison of the returns on stock market indices with those on housing market indices.  If one compares the return on the S&P500 index vs. the S&P/Case-Shiller Composite 10 index from the beginning of the Case-Shiller data (1987) to present, one sees that the S&P500 went up 630%, while the Case-Shiller went up only 197%.  Even if one uses an average return (averaging the monthly index values, relative to the starting value), S&P500 is 244%, while Case-Shiller is 98%.  Ergo housing is a bad investment compared to the stock market, right?

That's certainly what a bunch of smart people have argued. (I won't link or name names, but Google isn't coy.) There are two problems with this line of argument.

First, it fails to account for the leveraged nature of housing investment.  Most homes are purchased on leverage, and housing is the only leveraged investment broadly available to the middle class. When one factors in leverage, housing massively outperforms stock market mutual funds, making it a pretty sensible investment in most cases.   

Second, the simple return comparison fails to account for the indirect benefits of housing, such as school districts, commuting time, quality of life etc. I'm not going to try to quantify the indirect benefits, although some of them definitely translate into pecuniary terms (schooling, for example).

If you'll indulge me with some number play below the break, you'll see that the leverage point alone blows the "housing is a bad investment" argument out of the water. Leverage is not without its complications, though.  

Let's imagine that it's 1987.  You have $100.  You can invest in a mutual fund that tracks the S&P500 or you can invest in a house.  If you put your money in the mutual fund, you could sell it today for about $730.  There would be some small transaction costs involved-a fee for buying and selling and an annual fund manager's fee of a few basis points.  Let's say this all adds up to $5.  If so, your investment of $100 would have returned $725 over 27 years.  That's a 625% return.  

Let's say that instead you purchased a house in 1987.  You paid the entire $100 price in cash.  You sold the house today for $298.  The house purchase and sale also had some transaction costs.  Let's say those were 3% of the purchase price and 6% of the sale price, or about $21.  So your investment of $100 would have returned $277 over 27 years.  That's a 177% return.  Not nearly as good as the mutual fund. 

Now before I proceed further, I'm sure that some readers will be objecting:  you didn't include home maintenance and taxes.  And others will be pointing out that I didn't include an employer match for a 401(k) contribution.  

I don't think either are relevant to the analysis.  We're analyzing financial investments.  That means any costs related to the consumption value of the house--the imputed rents--should not figure into the calculation. I think it's reasonable to assume that imputed rents are basically the same as costs of financing plus costs of maintenance plus taxes.  Some may dicker with me, but I don't think it ends up materially affecting the analysis.  If I'm wrong, however, please show me why in the comments. 

As far as a 401(k) contribution match--that's not found money. To the extent an employer makes a match, it is in lieu of other compensation. There's a tax benefit to be sure, but there's also a home mortgage interest deduction that I'm not trying to figure in and not everyone can benefit from either of these factors, so I'm leaving them out of the analysis.  Plus, I don't really want to have to try and calculate the value of the tax benefits.  Again, if you think it's material, please show why. 

If the analysis ended here, it would be a no brainer not to buy a house as a financial investment. Yes, other non-financial or indirect pecuniary factors might change the calculus, but as a pure financial investment, buying the house is a bad move. 

Most Americans, however, don't pay for their homes in cash.  They borrow.  And leverage changes everything.  If we run the same numbers with 20% and 10% downpayments respectively, the returns on housing are $277 on $20 and $227 on $10.  That's a 1035% or a 2170% return respectively. When purchased on leverage, housing has WAY outperformed the stock market. 

If you want to run the figures just for the last five years, which have been an unbelievable bull market, the same story holds.  Same if you look at average returns.  When one accounts for leverage, housing is a MUCH better investment than the stock market. 

But wait--isn't this apples to oranges?  Stock can be purchased on margin too, no?  Yes, but mutual funds cannot be purchased on margin, and most stock market investment by consumers is through mutual funds.  Moreover, you can't get a margin loan at 80% or 90% LTV. 

Now leverage can be a blessing or a curse.  In a falling market, leverage is awful, as the last several years have shown.  But that's an exception, and a lot of mortgages are functionally non-recourse, so the put option from walking away functions as a loss limitation.  (None of this is to say that foreclosure is painless--quite the contrary, although a lot of the pain is non-pecuniary--but non-recourse status and things like bankruptcy have an insurance function that should not be ignored.) The bigger problem is that housing is an undiversified and unhedgeable investment, unlike a mutual fund.  So there are different risks in housing simply as a financial investment. But housing is the only leveraged investment available to most middle class Americans, and with stagnant real wages, it's probably the better bet than the stock market. 

Notice that none of this has considered the other benefits of housing:  property tenure rights (hedging against gentrification risk), pride of ownership, school districts, etc. All of those matter.  A LOT.  Obviously, like any investment, housing doesn't turn out to be a great bet for everyone.  But overall, when combined with the leverage point, housing is a really sensible investment for the American middle class.