The Home Equity Illusion

For many Americans, the equity in their home is the single greatest asset, often dwarfing their investment assets. But this is an illusion fostered by the high leverage involved in home buying, not because it’s such a great deal to invest in a home.

In light of that, home ownership is not necessarily a step you need (or want) to take to build financial success.

A Pew Research Center poll from 2011, likely still true today, finds that 81% still believe a home is the best long-term investment. Yet at the same time, research by Yale’s Robert Shiller, an authority on housing who called the real estate bust that started in 2007, shows that is not so: After adjusting for inflation, housing prices did not appreciate since the 1890s (over a century ago), aside from some temporary swings up and down. And unfortunately, we are still working off the very notable swing upwards in the last 10 years.

How can we reconcile current public opinion and 120 years of investment history? Even the safest of government bonds historically provided some real return premium over inflation.

The key is that the personal residence is one of the only assets that most Americans buy, with leverage. In other words, we borrow money to buy the asset. In this country, we've institutionalized this process. How many people do you know who have ever bought a house and paid 100% of the price in cash? A full-cash purchase for someone's first home is a true rarity.

So imagine you have $50,000, and can choose from three investments when inflation is expected to be 3%. You can buy either: a stock with an expected annual return of 10% (which is 7% after inflation), a bond projected to earn 5% (2% after inflation) or a residence that grows 3% in value (no appreciation above inflation). The highest anticipated return is from the stocks, and the lowest is from the home. (Of course, stocks are more volatile and risky, but for now we're assuming very long-term investing where we can ride out the short-term bumps.)

But let's look at how this purchase would likely go in today's world. A $50,000 investment in stocks means you allocate $50,000 for the purchase; a $50,000 investment in bonds, also $50,000. However, a $50,000 contribution toward a home buys only a portion of the asset: It’s a 20% down payment on a $250,000 house. The rest of the purchase price is from a mortgage.

So what happens now? The stocks earn 10%, growing to $55,000. The bonds earn 5%, growing to $52,500. The whole house grows 3%, rising in value to $257,500, and after subtracting the borrowed $200,000, the equity in the home is $57,500.

Lo and behold! Thanks to the benefit of 5:1 leverage with a 20% down payment, you turn a $50,000 investment into $57,500, which is a whopping 15% return on the investment, outperforming stocks and bonds. And of course, for much of the past two decades, down payments were even lower than 20%, and consequently the leverage – and returns on investment – were even higher.

But the bottom line is that the real reason the personal residence becomes a wealth-builder is not because this form of real estate investing generates high returns. It's simply because it's an investment we buy with a huge amount of leverage, such that even a mediocre return that can't beat inflation turns into a tremendous increase on the dollars actually invested out of pocket.

The problem with the approach – as has become so apparent in recent years – is that leverage cuts both ways. While it may magnify the upside when times are good, it also creates the risk of significant losses when house prices go the other way.

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Michael Kitces, MSFS, MTAX, CFP, CLU, ChFC, is a partner and the director of research for Pinnacle Advisory Group, a private wealth management firm located in Columbia, Md., that oversees approximately $1 billion of client assets, and Pinnacle Advisor Solutions, a firm that provides outsourced investment management services for financial advisors. He is the publisher of the e-newsletter The Kitces Report and the blog Nerd’s Eye View through his website Kitces is also one of the 2010 recipients of the Financial Planning Association’s “Heart of Financial Planning” awards for his dedication to advancing the financial planning profession. Follow Kitces on Twitter at  @MichaelKitces .
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