Sunday, October 7, 2007

A house is NOT an investment

People often get caught up in prevailing myths which provide a basis of belief which leads them to make poor financial decsisions. One of the biggest myths is the idea that buying a house is an investment. The way we talk about things often dictates the decisions we make. Investing money always seems more prudent than simply buying. Often it is said that buying a house is an investment. Is this true? That of course depends on what we mean by investment.

I think the best definition of investing is using ones savings to buy an asset which will provide real future returns in excess of the invested capital.

For example buying a factory with which you will produce marketable products is an investment. Even if you borrow most of the capital, you can pay the interest payments with the operating cash flows. If it is a good investment, you will have profits left over which you can put into savings. Over the long term, it is likely that you can pay off the mortgage and collect these cash profits. After say 30 years, you will have paid off the loan so that you own the factory, the cash flows that were produced as well as the future cash flows that will come in the future. If the real value of these things are greater than the real value of the invested capital, you have made a profitable investment.

I will use the term real value to mean inflation adjusted value. We can compare dollar amounts at different times by discounting them by the risk free return.

Other examples of investments are buying stock in a company, buying CDs from a bank, buying an apartment building which is producing cash flows in excess of the mortgage payment interest rates.

So, what about buying a house? Well, we all need a place to live. Our main choices are renting an apartment or buying a house (or condo). A similar decision to this is choosing what to eat. We all need food but we seldom talk about investing in our food. We consider it a necessary purchase not an investment. Buying a house should be considered the same.

It is possible to think of buying houses as investing. For example, if you buy a house for the purpose of renting it out, it can be an investment. If the rental payments are large enough to pay for the mortgage and also build equity in the house, this can be an investment. However this shows that it is only possible to make housing an investment if mortgage payments to rent are a low enough ratio. In fact this is the best way to value the price of houses. The price to rent ratio is similar to the price to earnings ratio for a stock.

During times of a speculative housing mania, the price of houses will be increasing. People buy houses with borrowed money and hope to make money simply from the increase in house price. If the house price is increasing faster than the interest rate of the borrowed funds then it may be the case that the rent is below the required mortgage payment but the appreciation of the house makes up for this negative cashflow.

However, this situation is unstable and cannot last for long. Eventually the house price will stop appreciating at these high rates and may even start deceasing. These people with negative cashflow will have to sell. This wave of selling will lead to higher inventories of houses for sale which will lower prices further. This kind of "investing" is better thought of as speculation. The profits depend on price appreciation and not positive cashflow. It is no different than speculating on the prices of gold, currencies or pork bellies.

Whether or not such housing speculators make money depends on when they got into the game. People who started early may come out with a profit. Those who started late will come out with a loss.

The housing industry is constantly promoting the idea that buying a house is an investment when this usually is not true. When you are buying a house to live in, this is simply a purchase to satisfy your housing needs. It is the main alternative to renting and often makes sense for people. If the payments on a traditional 30-year fixed mortgage are comparable to the payments that you would pay to rent the same house, then buying is probably a good idea. That is because you are paying a similar amount and are building equity in the house.

The housing prices in Los Angeles these days are so high that buying a house can only be thought of as irrational. Prices are way above any amount that is justifiable by rental cash flows. You will pay more on a interest only mortgage than you would pay to rent the same place. With an interest only mortgage, you are building no equity in the house. The no-money-down, interest-only-loan, which was so common these past few years can be thought of as renting money to speculate with infinite leverage on house prices. Most people would never borrow $20K and then buy pork belly futures but they actually undertaking something even riskier when they use these interest-only motgage products to buy a house. They are not actually buying a house- i.e they don't build equity-they are merely speculating on rates of appreciation. The only benefit over renting is that you get to profit from any appreciation of the house. However in a climate of falling home prices, this can only be a negative. Plus you need to pay all of the expenses associated with buying such as taxes, repairs and insurance. In such an environment prices have to go down since there is practically no financial incentive to buy at current prices. People who got in late may forclose and these forclosed homes will add to the inventory driving prices down further.