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Should I Buy a House?
Low Mortgage Rate - Real Estate Return - Inflation - Bubble - Bearish
Hello, I am Nicolas Bustamante. I’m an entrepreneur and I write about building successful startups.
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It's almost impossible to go out with friends nowadays without having a conversation about buying a home. The discussion has barely even started before you hear stories about mortgage rates drop and extraordinary profits made in a matter of months. So, should I go along with the herd and buy a house? Well, not so fast...
Housing market returns are terrible. Between 1948 and 2004, the real increase in value in the U.S. real estate market was less than 1% a year. In the meantime, the S&P500 inflation-adjusted returns with dividend reinvested were 8% per year. That is to say that if you have bought a $1m home in 1948, it will be worth, on average today, taking inflation into account, $1 745 809,82. The same investment in the S&P500 will be worth $74,426,964.60. In his paper, A Long Run House Price Index: The Herengracht Index Piet M. A. Eichholtz studied the buildings' price on the Herengracht in Amsterdam for 345 years. Between 1628 and 1973, the real property values, adjusted for inflation, went up a mere 0.2 percent per year, a rate even worse than the worst savings account option. Same perspective for the house prices in France or in Paris where J. Friggit has been aggregating data since 1200!
The evidence shows low average rates of real appreciation of most homes and that consumer prices rise at the same rate as home prices. It offers no capital gains for long-term investors. However, this real estate market has been experiencing a boom since George W. Bush vowed to expand homeownership. His political stand, the fair lending, and affordable housing policy, the Federal Reserve cutting interest rates to almost zero, and financial subprime engineering led to a real estate price boom. In other words, this cocktail created the classic irrational exuberance that Robert Schiller wrote about in his book that predicted the 2008 crisis.
For one of the rare times in history, home real estate prices rose fast from 2000 until the collapse of the housing bubble of 2008. Interestingly, the current low-interest rates are fueling yet another bubble in which the Home Price Index, adjusted for inflation, rose by 45% from 2012 to 2020. That is a fast rise for a sector that lagged for centuries. Robert Schiller noted that "That is a remarkable record, considering that the United States is grappling with the coronavirus pandemic, a major recession, and social upheaval." It is shocking that the housing market is rising faster than the disposable income growth. The Nobel Prize, Robert Schiller, created the S&P/CoreLogic/Case-Shiller National Home Price Index to track home real estate prices. It shows that the CSNHP has gained 6% per year on average since 2012, whereas the net rental income has barely kept up with inflation. The result is that home prices are overvalued like they were in the spring of 2005, nine months before the crash. Homes' values are more expensive than the stock market today when you compare the CAPE for U.S. housing versus the S&P500 CAPE. As the saying goes for value investors, if you buy high, returns will be low or negative.
Real estate crashes do happen, as we saw in the U.S. in 2008. It happened in China, Canada, the U.K., and Spain. In short, it's happened everywhere. So much for the saying that "real estate only goes up." The problem with a real estate crisis is that it takes a long time to recover. Citing Schiller again: "for a home buyer in 2005, who put up life savings for a 10 percent or 20 percent down payment, the price decline amounted to a devastating loss by 2012. If they had been able to hold on until now, their real home value would probably be mostly restored, but no one would want that 15-year experience again." Real estate's cycle is particular because skyrocketing prices lead to the creation of more buildings, and when the crisis comes, there is a large inventory of new buildings pushing the price to even lower levels. For example, it takes more time for the real estate market to adjust and way more time to recover from a crisis than equities.
For most people, their home investment represents a large part of their net worth. From a diversification perspective, it's a catastrophe. It's not even a diversified investment in different real estate assets, it's one asset in one location. This means it is also a bad move in terms of optionality. If crime rises in your neighborhood, the school closes, or if you have a good job opportunity elsewhere, it's tough to move. If a crisis happens at this location, an investor can lose a lot of their net worth and wait up to 15 years to recover. But for most investors, there will be no recovery because of leverage.
Most real estate investments are made with borrowed capital to multiply the investor's buying power. Leverage consequently multiplies the downside risk if the investment doesn't work out. In the case of real estate, investors are highly leveraged because they have more debt than equity. Today's attractive rates encourage investors to borrow large sums of capital to buy costly homes. But a cheap mortgage is a trap that leads to buying an overvalued asset. In case of a downturn, investors will continue to reimburse the amount they have borrowed while the house's value is potentially half of what it was. Adding to that, if the investor loses his job, there is no way he will be able to keep paying the mortgage. The investor will be forced to sell and lose a large part of their net worth or, even worse, face bankruptcy because of the high financial leverage.
One of the harsh things with real estate is taxation. In most countries, there is a property tax on the value of real estate. The tax burden is real because if your home price rises, so will your property tax (even if your net income stays the same). Worse, in a world where capital is very mobile, governments tend to increase the taxation on illiquid assets such as real estate. Better take taxes into the equation because they can dramatically reduce returns. Talking about hidden costs, real estate faces depreciation, and investors need to pay for the house to keep up the value. It's not that different from a business, but it's often forgotten. All of that can eat up the investor's return and take a lot of time.
Finally, the last reason I'm not bullish on buying a home is the opportunity cost. I have stated earlier the difference in returns between the real estate market and the S&P500. Over a lifetime, the difference is staggering. I have read a funny story that says if Donald Trump had sold all his real estate in 1982, retired, and put all his money in the S&P500, he will be twice as rich. I like Warren Buffet's advice: "When I got married, we did have about $10,000 starting off, and I told Susie, I said, Now, you know, there's two choices, it's up to you. We can either buy a house, which will use up all my capital and clean me out, and it'll be like a carpenter who's had his tools taken away for him. "Or you can let me work on this and someday, who knows, maybe I'll even buy a little bit larger house than would otherwise be the case." So she was very understanding on that point. And we waited until 1956. We got married in 1952. And I decided to buy a house when it was about -- when the down payment was about 10% or so of my net worth because I really felt I wanted to use the capital for other purposes."
Today, I won't capitulate and buy a house. When everyone is greedy and hypnotized by short-term profit, I will remain skeptical, fearful, risk avert, and prudent. Today's prices in the housing market are high and even higher than the already expensive valuation of the S&P500. If you believe the pendulum will swing back to the long-term average return, then it's not the right time to borrow a large sum of money over 30 years for a house. If one day real estate is cheap, the down payment is less than 10% of my net worth, and I know I want to spend 30 years in a location, I might consider such an asset.
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