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Debunking My Real Estate Finance Professor’s Theory on Homeownership

Back in my MBA days at USC, the party line of my finance-savvy classmates was solidly against the housing market and homeownership in general.  Doubtless, this was fed by the considerable weight of the retrospective analysis being promulgated by our professors, some of whom have been intimately involved in real estate for 20-30 years.  The consensus view in 2008-2009 was certainly dismal at best and housing armageddon at worst.  However, I found myself, as usual, in the contrarian minority with the more long-term optimistic outlook about housing.  Incidentally, many female classmates quietly favored homeownership.

One of my professors, Robert Bridges, carried more weight than others as he was regularly involved in real estate development projects and had the rare perspective of an insider’s view.  His consistent message was that most recent (under 10 year old) real estate projects were ill-conceived and over-leveraged.  Certainly, his analysis of the historically low returns being generated was very compelling.  But, it’s the forecasts where we differed and that’s where it’s far more important to be correct, if you’re investing your own money.

He recommended that we avoid homeownership altogether (we were all at the brink of household formation).  His analysis in 2008 showed that it’s far cheaper to rent than own and you could get better financial returns by investing the savings with renting in the stock market.  While the situation has changed markedly since then, he’s sticking to his guns, as evidenced by this recent article he wrote for the Wall Street Journal: A Home is a Lousy Investment.

Rather than make the typical argument that houses are leveraged assets which should be expected to decline in value during a deleveraging cycle when credit is tight, he makes a considerable laundry list of housing’s limitations, i.e. the non-recourse nature of mortgages leads to moral hazard, the illiquidity of capital tied up in housing equity, and the non-economically productive nature of housing.  Instead of putting extra money into housing payments, he advocates saving for retirement.  When rents were significantly below mortgage payments, like during 2005-2007, that argument holds some water, since you could rent and theoretically save extra cash that earns a superior return on other investments.

But, now that rents are higher than mortgages, sometimes 30-40% higher in the Bay Area, then for those able to make a 5-10 year commitment, the regular payments of a fixed-rate, financed home purchase would certainly end up being cheaper.  In effect, whenever rent reaches parity with amortizing mortgage payments, you’re almost always better off owning as you’d be capturing some return of principal versus zero return with renting.  Since in the real world we need to pay to live somewhere (unless he really means we’re to live rent free in our parent’s garage or basement), it’s hard to see how the variable and rapidly increasing rents we’re currently seeing is a better financial choice than fixed mortgage payments.  In addition, this cash saving versus rent is augmented by the current preferential tax deductions for mortgage interest and property tax.  Then, the cash savings and tax refunds from homeowner deductions can be poured into other investments, further outpacing the rental option.

Another of his key arguments is that investments in homeownership yield lower returns than other investment categories.  While it’s patently obvious that there are almost always better investment returns available than what you have in your hands, what his comparison misses is the risk-adjustment needed.

Investments in the stock market have historically generated higher returns as stock equity is a higher risk investment with higher betas.  Investments in entrepreneurial ventures, while exciting and my passion in life, are also very high risk and not appropriate for most average investors.

By contrast, housing has historically been a very stable investment, even accounting for the recent unprecedented 30% fall over 4 years.  Similarly, by recent memory, stock markets can drop up to 70% in just months.  So, in the vein of Ben Graham and Warren Buffett, investment-minded buyers should invest in what they know, and nobody knows more about your house than you do.  Plus, it’s hard to put a price on the peace of mind knowing that you won’t need to suddenly move, which can happen as a renter if the owner needs to sell the house right away.

Michael Cheng