Housing: Don't Confuse An Expense With An Investment

(MoneyWatch)  We've had a couple of posts lately from Moneywatch writers debating the value of housing as an investment (Is Housing Still A Good Investment; Is Your House An Asset or A Liability). In my opinion, treating a house as an investment is the biggest mistake most people make in personal finance. That's why many people own houses they can't afford, and don't have sufficient financial assets to support themselves in retirement.

First and foremost, housing is a living expense. We have to pay some amount of money every month to live somewhere. Now, we will either pay it through renting a place or buying a place. But the amount spent on housing is a lifestyle expense. It's just like transportation. You have basic transportation costs to get around in life. You can either lease or buy a car, but the car is an expense, not an investment. And buying a $100,000 Mercedes isn't an investment; it's a lifestyle choice because you could have driven a used Kia or even taken the bus.

You might be thinking, "well a house is a lot different than a car, and that's not a valid comparison." Ah, but it is, because both assets are depreciating.

The house itself, the physical structure that you built or bought, is a depreciating asset, just like a car. It will age and fall apart over time unless you are constantly pumping money into it for maintenance. And the costs of maintenance and repair are expenses. Even when you pay off the mortgage, you will have costs to maintain, insure, and pay taxes on the value of that home. So the bigger the physical house, the more it will cost you to keep it. That's a fact.

By now you might be thinking, "but houses do go up in value, so how do you explain that?" Yes, they can as long as the region where you live is growing economically and you continue to maintain the home. If your region is growing, housing over the long term will roughly increase in price along with wage growth.

• By the way, if housing prices grew faster than wages over the long term, then no one could eventually afford a house as the annual mortgage payments would be more than the average worker's total annual salary.

In most parts of the country, that means a return from housing just slightly above inflation. That's not bad, but when you offset those price increases with the costs of maintaining the home, you usually end up putting more money into the house than you get out of it. See my prior post on housing: Is Your House an Asset or a Liability? That's not much of an investment.

OK, if houses depreciate and cost money to keep up, how come some people have made lots of money on their houses? Here's the answer: what really goes up in value is the land, not the house you built. Some people get lucky with houses and end up owning homes in parts of the country that experience big increases in land values. That's why the three most important things in real estate are location, location, location. It's the land that has the potential long term value, not the physical house.

So if you really want to turn your residential real estate into an investment opportunity, here's what to do:

• Buy the best piece of land you can in a region of the country that you predict will experience massive wage appreciation over the next 20 years.
• Build a tiny house on that land, just big enough for you to live in.
• Wait 20 years.
• Once land prices skyrocket because of the booming economy and huge wages, tear down that tiny house and sell the land for a fortune. Then go retire somewhere else where the land is cheaper and pocket the difference.

Could happen, but I wouldn't bet your retirement on it. What's more likely to happen is you buy a house in a part of the country that has average wage growth and you see average price increases that are fully offset by the amount of money you had to spend to maintain, insure and pay taxes on the house.

Bottom line. Houses are primarily a lifestyle expense. Necessary, but still an expense. Buy only what you can comfortably afford, and leave plenty of room in the budget to invest in financial assets that can support you in retirement.

Learn More: Want to learn about a simple way to manage your personal finances and prepare for retirement, investigate my new book Your Money Ratios: 8 Simple Tools For Financial Security, available in bookstores and at amazon.com The Wall Street Journal called the book "one of the best finance books to cross our desks this year." WSJ 12/19/09.