"The Little Book of Bulletproof Investing"
Your humble author Ben Stein was once considering buying a house on the Eastern Shore in Virginia. He decided to run the prospect past his pop, economist Herbert Stein:
Herbert: "Can you afford it?"
Ben: "I think I can buy it without putting myself in the neighborhood of poverty."
Herbert: "That's good, because that's a neighborhood you never want to be near."
Ben didn't buy the house. Our home is usually our single most significant asset. Yet the whole subject of housing is nettlesome, especially now that the value of residential real estate has fallen off the map, and is only beginning to claw its way back. Real estate was touted as the "safe" investment after the tech debacle of early 2000 through 2002, but something has gone very, very wrong. Houses became the subject of a speculative bubble and then the bursting of that bubble. First, our stock portfolios were wiped out, and then our houses (yes, even with the new Sub - Zero refrigerators and Viking stoves) were, too. Like everything else, the benefits of houses can be (and were) oversold. If only we had listened to Ben's dad....
Let's Cut to the Finish Line
Do buy your house. While it will turn into an investment over time, you should buy it as a place to live. The reason why housing is desirable as an investment is obscure: It is because when you own your home, in effect you pay the rent to yourself, but you don't have to pay tax on that (implied) rental income. The economic desirability of homeownership is primarily a byproduct of the tax code.
The economic desirability of homeownership is primarily a byproduct of the tax code. Get it? Imagine that you and your neighbor have identical homes in a subdivision. Instead of your owning the house you live in and his owning the house he lives in, you own his house and he owns your house. At the end of every month, he writes a rent check to you and you write an identical rent check to him. At this point, Uncle Sam reaches into both your pockets and taxes the rent as income. However, when you and your neighbor each own your own house, your living situation is unchanged, but Uncle Sam leaves you alone. This is not true in every country. It is one way the government subsidizes residential real estate in the United States, and you should take advantage of it. There are other government subsidies as well. Realtors always talk about the mortgage tax deduction -- the fact that your mortgage interest can be deducted from your taxable income. However, people who don't claim this deduction can still take the standard deduction, which is around $9,500, so the true mortgage deduction benefit for middle-income people is the annual amount of mortgage interest less $9,500, not the absolute amount of the mortgage interest versus no deduction at all.
Since the mortgage interest lowers every year on an amortization schedule, a crossover will come in the life of every mortgage when the standard deduction will be worth more. The government subsidizes the mortgage interest rate on home loans up to a certain size. These are the so-called "conforming" loans bought by Fannie Mae and Freddie Mac. The government will also overlook the first $250,000 of capital gains ($500,000 for couples) when you sell your house. The government affects the finances of home buying indirectly as well. Elementary and high school education are government monopolies paid for by your property taxes. If you plan to have children, you will be better off living in an area with a non-dysfunctional school system, if you can still find one (good luck!). This will eliminate the line item of private school tuition from your family's budget. The more children you have, the better a deal this is. A good public school system is an insurance policy protecting the value of your home. A
part from the government subsidies, a strong economic case can still be made for homeownership. Since most people cannot afford to pay cash for a house, they have to borrow money to buy one, so the home becomes a leveraged investment. For the price of 20 percent down, they get exposure to 100 percent of the house's value in the marketplace. Most of the time in most places, home price appreciation after inflation has been small according to Yale's Professor Robert Shiller: perhaps 0.4 percent per year. Long-term owners can find that they have almost doubled their money after inflation. In addition, the imputed rent gives you an annual return of about 6 to 8 percent, inflation-adjusted and tax-free. Homeownership amounts to a stealth form of enforced savings. Lenders take away people 's houses when the owners fail to pay their mortgages. Since people generally have equity in their homes that they do not want to lose, paying the mortgage becomes a marked priority. Even when they see a pretty new hat in the window at Bloomingdales, they pass on it and pay the mortgage instead. After 30 years of this monthly discipline, it turns out they own a significant asset.
Is Your House a Financial Asset?
People sometimes ponder whether a house should be considered an asset or an item of consumption. The answer mostly depends on the time scale and partly on your location. In the short run, a house is for consumption. If you have to sell it in a down market after having bought at the top, as many people are now doing, it will prove devastatingly expensive. If you hang in for the long haul, what was an item of consumption is alchemically transmuted into a major asset. It's true that you have to live somewhere, but after 30 years you may be ready to downsize to a smaller house, or move to a lower-cost area, or even to rent. Renting during retirement lets you remove the house from your estate and transfer the money into current consumption, where it may be badly needed. Real estate markets are local. On the coasts where palm trees grow, they are far more prone to a boom-and-bust cycle than Shiller's steady 0.4 percent increase that prevails in Minnesota or Arkansas. In hot markets, your returns will depend on your entry point. Buy during a crash, and your long-term returns should be handsome. Buy near the peak, when people are snatching up trophy properties for their trophy wives, and you may wait a long time before you see a positive return.
Regardless, real estate is a real asset, which means that it is protected from the ravages of inflation. This is another economic benefit of homeownership. If, heaven forfend, our country experiences another round of 1970s-style inflation, or worse, your home -- and that portion of your net worth -- should be protected (but there are no guarantees). Even if there were no economic benefits whatever to homeownership, there are such significant psychological benefits that many people would do so anyway. It frees you from the insanity of dealing with landlords. You can decorate it however you want. You can pound nails into the walls. You can make your home an extension of your personality, for good or for evil. This gives you a sense of control and peace of mind. According to the Federal Reserve's Survey of Consumer Finances, homeowners as a group are significantly richer than non-homeowners are, even when controlling for the usual suspects like age, gender, race, employment status, and so forth. In addition to the equity in their homes, homeowners have significantly more money in investment accounts, IRAs, 401(k)s, and so on. Perhaps renters never put down the kind of roots that are usually required to amass wealth. Perhaps homeowners as a group are more disciplined. Perhaps they just fit in better with the stream of things and so get ahead. There are undoubtedly many exceptions. Unfortunately, this does not mean that you can just give someone a cheap loan to buy a house and that will automatically make him rich, as we learned during the ongoing property collapse.
Housing Do's and Don'ts
DON'T own your home. That is, not if you are young and just starting out in your career. It is far more important to advance in your work than it is to own a house. You don't want the home to be an anchor holding you back. You also will want to pass on the opportunity if you are single and might marry someone who might not want to live in your home, or if there's any reason why you are likely to have to move within five years. Renting frees up money for current consumption that would otherwise be tied up in home equity.
DO start saving for your down payment as soon as you can. If you fit the home-owning profile, this should take priority over almost every other expenditure, on a par with your retirement savings, since essentially it is a form of retirement savings.
DON'T overpay for your home. Don't buy your home in the middle of the real estate equivalent of Shark Week on the Discovery Channel. When houses are selling with multiple offers over listing price within days of being listed, it's time to chill. Wait a couple of years and buy them after the crash.
DON'T make yourself "house-poor." You are house poor when your house owns you instead of the other way around. Remember that many of the expenses of owning a home are relentless, and the money tied up in the property is illiquid. Unless you have a comfortable margin of safety that allows you to put food on the table, you will sleep better if you rent.
DON'T take on a mortgage at a low "teaser" rate that resets to some higher rate later. When it comes to mortgages, as with all financial products, the less gimmicky, the better. You can count on any change in your mortgage rate later coming at exactly the wrong time and working against you. Don't assume for a moment that you will be able to roll your mortgage over, either. If you can't afford a house with (preferably) 20 percent down and a plain-vanilla, 30-year fixed-rate mortgage, you can't afford the house.
DO avoid redecorating insofar as possible. Once you are in the position of having to remodel or redecorate, your money will be devoured by builders, architects, carpenters, painters, and plumbers as if by a swarm of locusts. This trend is abetted by HGTV, the new gateway drug of the middle class. Your authors have often wondered about the rationale behind stainless-steel appliances. We never noticed that stains on refrigerators or dishwashers were a national problem. It seemed like a quick wipe with a sponge took care of most of them. We have the same puzzlement about countertops. Most will not receive such heavy use that it is essential to carve them out of granite slabs excavated from the same quarry the Romans used to build the Pantheon. Unlike nuclear waste disposal sites, the average kitchen need not be designed to endure thousands of years. Most kitchen countertops will not receive such heavy use that it is essential to carve them out of granite slabs excavated from the same quarry the Romans used to build the Pantheon.
DO rent rather than buy your vacation home, unless you plan to rent it out. Unless you have lots of surplus capital and are in love with a particular place that you want to return to often for long periods, the economics will generally pencil out in favor of renting. A hotel room is a form of short-term rental that lets you preserve a lot of other options for your money. P.S.: You will not be able to rent out your vacation home. By the time the unscrupulous management company has extracted its fees, and you have paid the maids and accounted for the thievery and scratched floors and stained sofas and broken appliances and paid yourself for the hours you spend on the phone dealing with every crisis du jour, it will not turn out to be the great investment the Realtor described. Meanwhile, all the renters clamoring to get in when you bought the property will have found a new and more exciting locale just up the road, leaving yours to sit empty month after month while your bills come due like clockwork.
DO be realistic about price when selling your home. The classic gambit is for a Realtor to tell you that your home is worth zillions in order to get your listing, and then come back in a month and tell you that you have to slice the price drastically since - surprise! - there is no interest at that price. There is, however, an element of truth to this process. The price of your home is set by the market, period. You may have paid $10 million for your pad in Malibu during the bubble, and then spent another two million fixing it up, but that does not mean the house is now worth a $12 million. If your TV series is canceled and you can't afford the mortgage, your house is worth only what buyers will pay for it today. That might be $6 million. Realtors do not set house prices; the market does. A house has no intrinsic monetary value apart from what someone is willing to pay to rent or own it.
DON'T trade in and out of houses frequently. Unless you are a Realtor yourself, you don't want to change homes very often. Despite the inroads made by the Internet in democratizing the real estate marketplace, transaction costs are high. A seller can spend 6 percent on commissions to a Realtor. Then there will be the costs of fixing up the house for the sale, and the months it sits on the market waiting to find a buyer. If you're a buyer, you will have inspections, fees, and closing costs on the mortgage. All in all, transaction costs in buying a home can verge on 10 percent if you are selling your old house at the same time. By comparison, you can sell a million dollars' worth of stock for $8 in one second with one mouse click. The people we know who have made money in residential real estate are people who bought their homes 25 years ago and woke up one day to realize they were rich.
Do's and Don'ts
• Do buy a home once you are ready to settle down.
• Don't buy into a red-hot real estate market.
• Don't buy so much home that you become "house poor."
• Don't use anything but a 30-year fixed-rate mortgage unless it is a 15-year fixed-rate mortgage.
• Do let movie stars own vacation homes; you are just visiting.
• Do be realistic about how much your house is worth when selling.
• Don't move frequently. Three moves equals one fire, as the proverb says.
Excerpted with permission of the publisher John Wiley & Sons, Inc. from The Little Book of Bulletproof Investing by Ben Stein and Phil DeMuth. Copyright (c) 2010 by Ben Stein and Phil DeMuth.