The best reasons to own a home are not financial. Buying a house gives you the prospect of a permanent physical and emotional centerpiece for your life, a place to store a treasure trove of memories with your family. Immediately, you can customize somewhere in the world and make it your very own. Knowing you’ll be around for a while, you can invest time and energy in your local community. And when you come to own your home outright, you are well on your way to powerful independence - the ability to do what you want and live your life without worrying about having to make the next payment. The promise of homeownership is captured in a single word: stability.
From a broad social perspective, real estate analyst Alex Avery reports the feeling that “home ownership helps create a productive and disciplined society. Owning a home makes people more likely to work hard, stay employed, abide by the laws of the land, and generally behave in a predictable and manageable way.” As a conservative, I can’t help but note that home ownership is correlated with better politics - do conservatives just wind up buying homes, or is there something to the responsibility of ownership that causes homeowners to become more conservative?
Renting simply may not provide what you’re looking for in a place to live. Partially because there is such a widespread and profound preference for ownership, there just are a lot less single family housing options to rent, especially outside an urban area. If your growing family needs a certain number of bedrooms, perhaps a backyard, especially in the right school district, your rental options shrink.
Figure 1. You may not be able to rent a place with a spacious basement for a man cave with all your gadgets.
But just because the best reasons to own a home are not financial does not mean you should forget finances! In a moment, we will go over how you can pursue homeownership from the strongest financial position, but first let’s talk generally about some reasons why home ownership can make financial sense.
The best financial reason to buy a house is that diligent and disciplined saving over many years is a proven difficulty for most people and, even if the typical house doesn’t have a fabulous return on investment, paying off a mortgage and retiring with house equity is better than having spent every dime you ever made. As we discussed in our last correspondence, on average and over the long term, buying a house has not been as lucrative as investing in the stock market. But people are far more likely to make absolutely sure they pay their mortgage than make absolutely sure they set aside savings every month to invest. Similarly, if the relevant market takes a nosedive, people are far more likely to fearfully sell their liquid stocks than their illiquid home. Profitable stock market investing takes fortitude that many find they don’t have.
Figure 2. Another great financial reason to buy a house is if, in telling your wife about the financial wonders of renting, she threatens to divorce you. Say “yes, dear” and immediately save 50% of your net worth!
Noting that stock returns typically beat housing returns or even that real housing returns have averaged out at 0% over time is not, however, to argue that no one has ever made real money on housing - plenty have. But any homebuyer should be very aware of the concentrated risk, especially in that debt supercharges returns and losses. So if you put down 10% of the purchase price, an increase of 4% of the value of the home “translates to a 40-percent rate of return on equity” (minus transaction costs and any other costs you accumulated along the way). But likewise if your home loses 1% of its value, you lose 10% of your original investment. And if your home loses 10% of its value, you lose 100% of your original investment. Because of leverage, a small gain in your neck of the woods can translate to a great personal gain - but debt endangers the stability at the heart of homeownership.
Because so many people want to buy a home, the U.S. government tries to make home ownership easier (ironically thereby driving up the price of housing). Before the 2017 tax reform, most people saw this when they deducted their mortgage payments from their taxes - now the general exemption is high enough that many people no longer specifically deduct but they still might benefit from a capped exemption on the capital gains tax. Relatedly, if you own your home outright, the imputed rent you pay yourself can be more valuable than a bond yield or stock dividend because it’s tax free. State governments also get in on the action with an array of policies ranging from reducing property taxes for veterans to shielding homes from creditors.
Figure 3. Irony alert: the government also may provide tax breaks to get you into a house in order to make it easier to find and tax you.
Lesser known but more significant is that the U.S. government creates the market for 30 year mortgages, which would never otherwise make sense amidst the unpredictable inflation of a fiat currency (in other countries, you might get an offer for 7 years.) As a result of this government intervention, you can arrange for a long-time fixed rate and either benefit from refinancing when interest rates drop or from inflation that erodes the real value of the debt. Because rent tends to be adjusted for inflation, the government’s irresponsible management of money combined with its mortgage subsidy may make a mortgage more financially attractive over a longer time horizon. But note that maintenance costs keep up with inflation.
You might also consider that the market is generally efficient and that landlords are not stupid: they are looking to make a profit. By purchasing your own home rather than renting, you capture that profit for yourself - but only by assuming their risks. While this is true in theory, it’s extremely difficult to see and treat your home as a landlord would, especially if you’re not already in the real estate industry. I personally know several homeowners who justified a remodel on the basis that “it would pay for itself” - and then it didn’t. To reiterate the point of our last correspondence, such an outcome is actually fine so long as homeowners understand remodels as a luxury to enjoy rather than an investment with a good return.
Figure 4. “With these 12 foot ceilings, we might just be able to put in a hoop - and then, wow, we could resell this house to an NBA player!”
Given all we have discussed, how should someone aspiring to wealth think about housing?
The plain secret is consistently living below your means. The classic problem of being penny wise and pound foolish is epitomized in the family that clips coupons without managing housing costs: you need to attack the big expenses first. If you’re concerned about wealth, when you do buy, do not try to maximize your house with whatever you’ve got in the bank, try to maximize what you can get in the bank with your choice of home. Personal finance columnist Gregory Karp suggests that a rule of thumb is that housing should consume less than 1/3 of your after-tax take-home pay. Thrift guru Vicki Robin asks: why not less? How many hours are you working to pay for a place that you enjoy for only so many of the hours that remain? Beware that in the last several decades the typical American has been getting more house for less family - and average happiness has not gone up.
Remarkably, in a survey of American millionaires, the “large majority” of whom were self-made, Dr. Thomas Stanley found that most “buy homes only after they have accumulated wealth, and only after they have a well-established, predictable cash flow.” Stanley advises: “never borrow long-term with the prospects of short-term income.” He reports that of those with a net worth between 1 and 2.5 million dollars, the average value of their homes was $220,796. While that implies that the most aggressive positioning is about 22% of net worth, as people got richer, the percentage that they put into their personal residence declined, such that the average person worth more than $20 million had a home worth about $1 million (or only 5% of their net worth). The rich are not house poor.
Warren Buffett was once asked at the Berkshire annual shareholder meeting about when one should buy a house and, after reporting his consternation early in his marriage about tying up such significant capital he could be putting to use in the marketplace, said he came around to it, with his wife’s insistence, when the down-payment (in the 1950s probably 20% of the value of the home) was less than 10% of their net worth. So, following the Buffett rule, if the average home price in 2022 is about $350,000, that would imply that your net worth ought to be $700,000 before you buy. A probably more generous (and therefore dangerous) rule of thumb is that you should not buy a home worth more than 3x your gross annual income, meaning the buyer of the average home should be making about $117,000 annually (and certainly should have six months of living expenses left over in cash as a reserve). Stanley, based on his interviews with millionaires who insisted that you must only buy a house that is ‘easily affordable’ offered this thought experiment to run: “assume that within a year of your purchase, your total annual realized income is cut in half. How long would you be able to make mortgage and related payments given your reduced income? Go the next step and assume that your investments also decline in value by 50 percent. Could you still make ends meet for at least five years? If the answer is no, then the home you wish to purchase is not easily affordable!”
When you’re in striking distance of getting a house, get intimately familiar with your local marketplace and understand what houses generally go for both in terms of rent and sales both presently and historically. Plan for contingencies and avoid having a date that you must buy by. If you want to get into ownership faster, consider buying a duplex, taking on roommates/renters, or figuring out some way for the property to produce income to change the calculus. Continuously run the numbers on expected return to rent versus own for your particular finances, the local real estate scene, and the general environment for interest and investment - Khan Academy explains how to do so in a spreadsheet or various sites like the New York Times have fairly simple calculators. For a very simple calculation, James Dahle, a blogger for high-income investors, suggests you “multiply your prospective principal and interest payment on a 30-year mortgage by 1.8. If renting a comparable home is much less than that figure, there is a very good chance you will be better off renting unless you are in the home for a very long time.” The investment adviser William Bernstein suggests:
“A good rule of thumb is never, ever pay more than 15 years fair rental value for any residence. This computes out to a 6.7% (1/15th) gross rental dividend, or 3.7% after taxes, insurance, and maintenance… The figure I keep in mind when house shopping is 150: the number of months in 12.5 years. After hearing a realtor's spiel, I will ask, ‘So, what would this house reasonably rent for?’ If the number seems right, multiply it by 150; this will give you an excellent idea of the home's fair market value, above which you are better off renting.”
If you are contemplating owning your own home outright, you might consider whether the equivalent value in the stock market might throw off enough dividends (or a safe enough withdrawal rate) to afford rent to live similarly.
Look for a house you can live in for a long time. Recall that transaction costs for houses are significant and the more frequently you move, the worse for your bottom line. In the early years of a mortgage, you’re paying mostly interest on your debt, so the longer you wait, the more likely you can benefit from either inflation or refinancing. And more time also hopefully smooths over any short term dips in the real estate market so that you at least come out without a loss. Dahle argues that the numbers generally only start to make sense at the 5 year mark, but the longer the better. Stanley reported in his survey that more than 1 in 5 millionaires had been in their present house for 25 years or more and a majority had been there for more than 10. Buffett lived in that first house he ever purchased for more than six decades thereafter.
Figure 5. In 1965, 90 year old French widow Jeanne Calment sold her condo to an attorney on the condition that she be able to occupy the home and receive a monthly stipend until her death. 30 years later, the attorney was dead but she was still alive and living off the payments from his family. By the time she died as the world’s oldest person at 122, Calment had received in cash many times the value of the condo, making her an unexpectedly savvy real estate deal maker. Her longevity secret? A diet rich in olive oil.
In an ideal world, you’d wait for a buyers’ market - but when one is going to occur next is almost impossible to predict. Counterintuitively, the ideal time to buy a house is when interest rates are high: the monthly payment is scaring off so many other buyers that sellers have to lower their prices. If you’re in a position to offer cash, then it’s all upside for you. But even if you have to get a mortgage, again, you can either benefit from increasing inflation or refinance when interest rates subside. Most significantly, according to Alex Avery, “Lower interest rates put upward pressure on house prices, but not on rents.” Simultaneously: beware a sellers’ market - if the average home is moving in 3 days after listing without inspection above asking price, very strongly consider renting.
You can also try to find your own distressed part of the marketplace: more than a third of decamillionaires picked up their home in a foreclosure, estate sale, or out of someone else’s divorce proceeding. Stanley reports that millionaire bargain hunters often shop off-market, keenly reading the obituary page and befriending bankruptcy attorneys to sniff out opportunities, sometimes just sending deeply discounted unsolicited offers to see what sticks. An alternative tactic would be to think about what popular things are not important to you - for example, if you’re not sending your kid to public school, you can probably buy cheaper in a worse school district. If you don’t believe in ghosts, that haunted house looks cheap! If your fifth floor condo doesn’t have an elevator, hey, free gym! But bear in mind that embracing the unpopular for a discount now will affect your exit.
Most millionaires buy quality in anticipation of a sale. What is “quality”? Stanley reports homes in “excellent condition, nicely decorated, well situated on a quality lot, and located in a fine neighborhood with good public schools.” But note that housing is always declining in value because it gets older and falls apart. Instead, real estate appreciation beyond inflation tends to come from land scarcity and use scarcity. Some economists argue that the latter is the biggest driver of all: what exactly does the government allow you to do on your land? If demand sustains or increases but new houses can’t be built cheaply and easily, the price of your house will go up. Personally, I am not inclined toward government overregulation - but how much there is should factor into your exit calculations.
Avery puts his own spin on classic financial advice: “the newest, biggest, shiniest, and most expensive house on the street has more of its value contained in the house, rather than the land, than any other house on the street. That means that more of the investment made in that house will go down in value than it will for any other house on the street.” Just beware that owning the worst home on the block is a recipe for more financial success but less personal happiness. Avery advises: “If you’re going to buy a home, figure out how much the land you are buying represents as a percentage of the purchase price so you can get a sense of long-term return potential. If the financial performance of your housing is a top priority, try to maximize the value of the land in your purchase.” To calculate, “figure out land value by looking for nearby homes on similar-sized lots that were recently sold and subsequently torn down. The difference between that price and what a homebuyer pays for a nearby home is what they are paying for the building. And that is the consumption portion of the purchase price.” Avery insists: “home buying needs to be seen for what it really is: an investment in land plus consumption of the glamorous building that has been erected on that piece of land.”
Figure 6. Or, as one friend puts it, “don’t think that you can make money on 2x4s”
An obviously great house will spend less time on the open market so you need to know about it first and be prepared to jump on it. Stanley advises that you find an outstanding, proven real estate agent (very likely not a personal friend) and tell them that you are in no hurry but you are a serious buyer for the right house - and that you want to see quality houses within your parameters as soon as possible, ideally even before they go to market. But be careful! Remember that your real estate agent is always incentivized to see you buy bigger. Do not get bamboozled into buying blind or acting so fast that you’re sloppy. You need to be familiar enough with the marketplace in advance, perhaps scouting for months, so that you’re truly comfortable that your offer is capturing the value of the house. Stanley reports that the vast majority of millionaires have never paid the initial asking price of a home and are prepared to walk away from a deal at any time that doesn’t make sense. About half will even open with a deeply discounted offer. Again, because this is perhaps the biggest purchase you’ll make, prepare! I may review it another time, but the best negotiating book I’ve read is Never Split the Difference and is well worth digging into before you start making offers.
That’s basically it: always live below your means and pay special attention to the major expense that is housing. When you’re ready to buy a house, get very familiar with the market, run the numbers, get the best price you can, and then be prepared to stay there for a long time.
Figure 7. Click here to acquire the Millionaire Mind (7/10). Stanley’s books are not the best written but they are insightful. Just beware that they were written around the year 2000 and so dollar figures may require an inflation translation or a percentage of net worth substitute - I would love to see an update. I also have some questions about whether his methodology for finding millionaires resulted in a representative sample, but his housing section also includes analysis of more extensive IRS data. His most profound finding, covered in the Millionaire Next Door, is that there is a significant difference between having a high income and being wealthy: what you have left over. To that end, most people overconsume housing and risk not being wealthy.
Figure 8. Click here to acquire the Wealthy Renter (8/10) - the title obviously suggests that renting is a real live option, but he does not insist it is always the best choice and has advice about how to make sure if you buy, how to buy with finances in mind.
PS. For the already wealthy, a warning and a comment:
The warning: unless you’re a professional homebuilder, you are unlikely to save money building your own home. Stanley suggests that if you are nevertheless determined to do so, have an attorney and an accountant go over all the details with your contractor in advance. Notably, wealthy attorneys are the least likely profession to have custom homes, partially because they know the exact value of their hours and partially because they see what happens when things go wrong. You have to honestly weigh the trade-offs between ultimately having exactly what you want v. the large amount of time, energy, and attention it will take to get there. And, of course, if you build a truly unique home that fully expresses yourself, it might not express anyone else - it will be a challenge to build and to sell.
The comment: from a purely financial perspective, the best place to buy a house might be abroad. Along with foreign-situated gold, it is good insurance against local deep risk. And, as Tyler Cowen argues,
“due to globalization, returns on equities are increasingly correlated across countries, which makes diversification harder to achieve. That is less true with real estate markets, which depend more on local conditions. So buying real estate in different countries, if you are in a financial position to do so, is a good way to diversify, in some ways better than equities.”