A Big House or More Equities?

April 06, 2006

Idle musings on the real estate and equities markets, how we invest and what we need to be taking care of.

It's not just Matt Hougan.  Practically everyone seems nervous about the current state of the real estate market.  And while Matt is looking for ways he might hedge his losses, waves of media coverage has been telling us that we are in the middle of a bubble.  Is it really true?  And if so, then what?  And while we're at it, is the stock market really all it's cracked up to be?  Enquiring minds…

I don't recall much of this conversation in early 2000, but the proximity of that tech bust and the ensuing bear market has many of us feeling twitchy about rapidly rising prices.  And for the homeowners among us, anyway, if it is a bubble, it's a bubble that we have a large percentage of or personal net assets locked into.

A wide array of financial (and mainstream) publications have been screaming about the plunge that is sure to come, with alarming magazine covers of houses falling off cliffs,  or floating around in bubbles.  Well, my home seems quite anchored (though I'll grant that I no longer live in San Francisco.  And here is the rub.  People will always need to LIVE in houses.  People don't need to live in the equities they buy.  This is the essential difference between real estate (much of it anyway) and equities.

So why does it matter that people live in houses?  Well, because everyone needs to have a home, the demand for housing will always rise and fall with the tides of the economy.  Intuitively (though I have heard some research that contradicts this) the housing market feels like it should be less volatile…certainly, for example, it seems highly unlikely that housing prices could plunge 50% within a couple of years.  Equities certainly could.

On the other hand, houses can't build cars or make shoes.  Like commodities there's no intrinsic growth in a house or land.  In fact the housing stock on your property should actually depreciate (in quality at least) over time.  Having your money in a balanced index fund taps into the innovation, energy and increased efficiencies that all of the entrepreneurs bring into the global economy and onto our stock markets.

But really, for my purposes today, all of that is somewhat beside the point.  What I want to do today is grab a bit of conventional wisdom by the horns and see if I can hold it steady or get flipped to the ground and trampled.  It wouldn't be the first time.  But I think it's a useful exercise, because it is our money.  And we'd like to feel assured we're on track on, well, reality's terms, not on conventional wisdom's.

Conventional wisdom says that over the long haul, investment in equities markets will outperform investment in fixed income instruments or…real estate.  Ibbotson actually has them at roughly equal returns (real estate and equities), and while most of us feel fairly certain that real estate won't be repeating it's gaudy recent returns anytime soon, not many of us are feeling like it's roll-out-the-barrels-time for equities, either. However, with real estate, there are some wildcards.   The most appreciated of these is the interest tax writeoff.   But my words for the day are 1) leverage and 2) compounding.

Let's even forget about the tax incentives (and they are LARGE - basically in the early years of your mortgage, the vast majority of you payments are in interest…and you get 1/3 of that money back…and you can of course invest that if you like).  For our purposes today, I've put together a VERY simple spreadsheet that shows that assuming (and it's a huge assumption), that real estate and equities performed similarly, at an annual return of 10% each (Ibbotson shows real estate at 11.1% and the DJIA at 10% from 1926 to 1996 according to a quick internet query), if you put $2,000 a month into the market, after 30 years, you'd have $3.42 million.  If you put the same $2,000 per month into a mortgage (here a nice mortgage calculator) that would get you about $340,000 worth of house today…which at 10% would expected to be worth nearly $6 million in 30 years.  And that does not even factor in the tax windfall you would enjoy along the way (though there's generally tax benefit in sheltered accounts on the equities side as well).

But you know what they say about past performance and future returns.  All that leverage you've had (by in effect having $340,000 generating returns from year 1 as opposed to the paltry $24,000 you managed to invest in the unleveraged equity account) won't get much done if, say the housing market only manages 5% a year (I wouldn't expect that we'll see the 20% a year over many years in the real estate market in my lifetime) - then all the sudden your house is only worth $1.5 million after 30 years. That feels intuitively right to me.  And give the market a possibly more realistic 8% return and you have $2.48 million in your equities account after 30 years. Open the spreadsheet and play around with the numbers if you'd like.

I guess the net conclusion is that the odds are, you're neither a fool nor a genius, whether you're renting or buying your home.  The KEY is, that one way or another you've GOT TO SAVE.   All that money you're saving on your mortgage by renting isn't doing you much good if you're not socking it away.  I know two kinds of people in Manhattan…those who sacrificed and bought (and are now - paper at least - millionaires) and those who didn't and aren't.  But this seems to me to have less to do with markets than planning and discipline.  Most people simply are not taking care of business when it comes to their personal finances.  Take care of yours.

It's like there's always one sucker at the poker table, and if you don't know who it is, it's you.  If you don't know what you'll need at retirement and have not calculated what you need to put away annually to get there, you are erring.  Without a plan, you won't be doing as well when you retire as you should.  No one is going to do it for you. It really does not take a lot…just get it done.

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