Is your house a good investment as well as a home?

by HTG Investment Advisors

Owning a home is at the heart of the American Dream, whether that home is a log cabin, farmhouse or penthouse. It is the centerpiece of American financial well-being. Federal tax policy encourages home ownership through deductions and incentives. And the financial reality is that a home is the largest investment most people will ever make. For some, it will be the most profitable investment of their lifetime, but for others, home ownership will represent the loss of opportunity to pursue other more productive investment alternatives.

Nonetheless, for most people, the question isn’t whether to own a home, but rather what portion of personal assets to devote to home ownership.

With housing prices currently sliding, numerous articles have appeared questioning the future returns of residential real estate. Those articles also note that homeowners too often fail to fully consider the costs of home ownership, never preparing a complete P&L on their homes, and thereby overstating their profits.

In fairness, it is a complex financial and emotional job to calculate the return on a home. After totaling mortgage and property tax costs, owners need to tally the costs of renovations, purchased appliances, new cooling and heating systems, and carpeting replacement, not to mention painting inside and out. And, like it or not, a roof does not last forever. A good rule of thumb is that repair and long-term maintenance expenses cost 1% to 2% of the home’s value each year. Assuming a five-year holding period for a home, when real estate transaction and maintenance costs are taken into account, a home must appreciate by 3% per year just to break even.

Of course, recent history has lulled Americans into viewing real estate as the surest path to wealth. Real estate prices climbed steadily and dramatically upward for seven years through the first half of 2006. Now the tide has turned, and real estate inventories are rising while median new home prices fell 10.7% in the fourth quarter of 2006. This is a reminder that real estate is subject to market cycles, lest we forget the major residential real estate downturns of the early 1970s, 1980s and 1990s.

With aging baby boomers considering retirement, it is fair to ask how one should handle this single largest asset. To make this assessment, consider the relative long-term returns of residential real estate versus other investments. Fidelity Research Institute’s recent report on home values reports that the median new home price has, on average, appreciated 5.9% a year since 1963. Subtract the transaction and maintenance costs, and that appreciation rate drops to 3% or so each year, on average. Some areas have seen higher appreciation, such as in the Northeast, (6.9%/yr) and in the West (7.1%/yr). Yet when costs are netted out, the annual return drops to less than 5%, even on the two coasts. Compare that to the U.S. stock market average return of 11% annually and the CPI increase of 4.4% a year for the same time period.

Utilizing home equity for retirement income can be problematic. Factors to consider include:

 

• Unless you own multiple homes, your eggs are all in one basket. That is, one home in one neighborhood, in one region. Concentration of risks is seldom a good idea in a retirement portfolio.
  
• Gains on home equity growth are subject to tax once they reach the $250,000/person threshold.
  
• You’ll need to find a new home to meet your downsized needs. Replacement homes or condominiums may cost more than you imagine.
  
• Houses aren’t liquid. It can take longer to sell and costs can be higher than anticipated. In tight markets, sellers may find themselves making concessions to sell.

 

While many people believe that money invested in their homes is guaranteed to be a good financial investment, history does not support this conclusion. In fact, over-investment in one’s home may have a negative financial impact, preventing sufficient commitment to more diversified and lucrative investment alternatives.

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HTG Investment Advisors Inc
50 Locust Avenue
New Canaan, CT 06840
203-972-8262
203-966-4740(fax)