For many of our younger clients, the question of whether they can afford to buy a house is more pressing than the question of when they may be able to retire. We live in what is arguably one of the priciest real estate markets in the US, if not the world. The very amounts of money sloshing around our neighborhoods make this an emotionally charged topic, and as a result, one prone to emotional decisions and less-than-ideal outcomes.
So if you’re thinking about buying a house, here are four mistakes you’ll be wise to avoid.
Mistake #1: Thinking That Your House Is an Investment
Do you remember the old TV commercial for Certs that goes: “It’s a candy mint. It’s a breath mint. It’s two mints in one!” Well, a house you live in is just like that: It’s a purchase. It’s an investment. It’s two things in one! The first mistake to avoid is thinking that your home is a ‘pure’ investment. It is not – no matter what your realtor told you. Yes, there will be residual value, and perhaps even capital appreciation, but the essential nature of what you are doing when you buy a home is making the largest single consumption decision of your life.
Unlike a portfolio of marketable securities, your house actually costs you money. You can’t simply invest, review your holding occasionally, and cash in in twenty years’ time. Instead, you shell out hundreds of thousands – or even millions – of dollars, and then you really start to pay. You pay property taxes. You pay to insure the house, to maintain it, to heat it, and probably also to keep it clean, safe, and running properly. If there is empty space in it, you’ll pay to put things in it. And on and on it goes. If you add all the additional cash that you pour into your house over the years into its calculated cost, in most cases you’ll find that it wasn’t such a great investment after all. Most people, however, simply compare their initial cash outlay with their eventual sale price – ignoring everything in-between – and falsely conclude that they’ve made a killing. Yet if you consider an alternative scenario in which you use your initial cash to buy a broad basket of US stocks, and then automatically add the additional cash you would need to operate a house each and every year for 30 years to the portfolio, in the vast majority of cases your stock portfolio will be worth significantly more at the end of the period than the house you would have purchased.
At this point, many of you may be snickering. Your house in San Francisco or Los Altos or Menlo Park has, in fact, been its own mini IPO, and it’s made you rich, no matter the property taxes and PG&E bills. And you would be correct – in a way – but this is the exception that defines the rule, and I want to return to this later, because I’d like to offer a different perspective on this experience.
Mistake #2: Thinking Short-term About the Rent vs. Buy Decision
Even if you agree that your house may not be a great financial investment per se, you’re probably thinking that buying it was still better than paying rent. And I agree with that perspective, if you frame the analysis properly. Because the second big mistake that homebuyers make is not understanding how to do the rent-versus-buy analysis. Simply comparing current rents with current mortgage payments will give you the wrong answer.
How should you compare homeownership with a rental? Indeed, that is the trick, because you need to compare all the costs and risks of homeownership with the costs and risks of renting – and you need to do the comparison over your entire life. This lifetime view is essential because once your mortgage is paid off (hopefully just before your retire) the cost of homeownership decreases dramatically. This not only lowers your cash burn as a retiree, but it also substantially lowers your financial risk. In effect, owning a home is like having pre-payed much of your housing expense for the remainder of your life.
In a high-tax environment, this cost avoidance is worth twice as much as your capital appreciation on a dollar-for-dollar basis. It helps you maintain your accustomed lifestyle without having to risk dramatic rent increases. You can live well on less income, pay lower taxes, and control the cost of needs-based government services. I would argue that, for most people, the greatest benefit of owning a home is therefore not the potential for capital appreciation but rather the chance to limit one’s lifetime housing expense as well as to lower one’s financial risk in retirement.
Mistake #3: Thinking You Can’t Have Too Much House
When considering the lifetime financial benefits of owning a home, however, the third mistake people make is thinking that “if a little is good, more is better.” Unfortunately, you can have too much of a good thing when it comes to a house. As described above, buying a house is like deciding (roughly) how much to spend over your entire lifetime on housing. It can be more efficient than renting if you do it right – particularly over the long term – but owning a home is still a lifetime expense. As such, it needs to fit into your lifetime budget. If you ‘stretch’ so much to buy your home that you can’t afford to save for retirement as well, you may have to sell your house just to have enough cash to survive.
In fact, one strategy that some people opt into – or just stumble into – is just that. They like the idea of having a big, expensive house and figure that they’ll simply downsize in retirement and live off the proceeds. Yet while this strategy can work, it’s also extremely risky. Pulling it off successfully depends critically on the performance of an extremely undiversified investment portfolio (i.e., the house) as well as on the timing of the final transaction. If one of these elements doesn’t work out as planned, the strategy can easily fail. Moreover, having an oversized house relative to one’s current income means taking on too much mortgage risk. When the financial crisis of 2008-2009 struck, people discovered just how fickle a house-based retirement strategy can be.
Over the years we have done many, many house-purchase analyses for clients. We have found that for each client there is a unique ‘ideal purchase price band.’ In other words, there is a minimum amount of house that makes sense in order to minimize long-term housing costs and risks, but there is also a maximum amount of house above which the client actually stands to lose more than they gain. So making a smart house decision is “Goldilocks” kind of thing: you don’t want too little or too much, but just right.
Mistake #4: Assuming Future Returns Will Reflect Past Experience
I’d like to come back to the issue of IPO-like real estate returns in certain parts of the country – like the San Francisco Bay Area – over the past 50+ years. Yes, it does happen. And if you bought your house in Palo Alto in 1960 then you hit the jackpot. Good for you; you got lucky. This is like having decided to purchase a bunch of Microsoft stock in 1986 when it went public. You were in the right place at the right time. You could just as easily have bought one of the dozens of companies that has since folded or been acquired.
But you shouldn’t make the mistake of thinking that the kinds of returns the Bay Area has seen over the past half century are typical of houses in general or that even Bay Area real estate will necessarily continue at this pace forever. If you did buy that house in Palo Alto in 1960, you bought into a sleepy academic community surrounded by agricultural land. The fact that the next 50 years saw the area develop into the epicenter of world technology research and development is something that no one could have foreseen. In general, real estate soaks up excess wealth from the local economy it lives in. In a very real sense, therefore, it’s an option on the local economy. And while I agree that it’s difficult to image a scenario in which the Bay Area would fail to grow and prosper over the next 50 years, I would also suggest that the economic growth differential between the Bay Area and other US metro areas over the next 50 years is quite likely to be smaller than it was from 1960 – 2010.
If there is one thing that we experience over and over again in the investment world it is that past performance does not guarantee future returns. That is because the cost of an investment is inversely correlated with its long-term return potential. In other words, the things that made earlier investors rich are probably not the same things that will make new investors rich. They used to be undervalued, but they are no longer so; they are now fully valued. In order to earn outsized returns, you have to find an asset that is currently priced below its future intrinsic value. It seems to me that houses in the Bay Area are not such undiscovered assets.
So by all means buy a house as a prudent lifetime housing purchase, but be sure to have some cash left over to invest in assets that give you a good chance of building the wealth you’ll need to actually retire on.