Fresh Perspective On the Value of Home Ownership

When the topic of real estate comes up,everyone automatically starts to cringe.  It is not meant to be an offensive reaction, but is one that stems from the emotional connection most of us have with our house in conjunction with the thought of the stock market collapse of 2008.  Your house is your biggest investment that usually accounts for 20% to 35% of your monthly budget.  Because of loose regulations and lending standards, for some that percentage went up to almost 50% or 60% of their monthly take home pay.  During the time leading up to 2007 and 2008, housing pricing steadily increased and consumers took out equity within their dwelling to help finance their living standards.  Most people that own a home lost between, 30% to 50% of its value. Historically, housing has an annual appreciation of about 3%.  At that rate it would take 13 years to recover from a 30% loss, 18 years for a 40% loss, and 24 years for a 50% loss.  The effects of 2008 have forced individual consumers toreconsider the real purpose of a house.  

In this monthly blog I will explain why individuals should really think of their residence as a tax shield and a retirement planning tool as opposed to an ATM.  To explain my reasoning, I have included a table below (from the CFA institute) showing the classifications of various types of real estate categories along with their usual investors, sources of returns, and specific investment.

Type	Investors	Investment Traits	Sources of Return	Risks
Vacant Land	Speculators, Developers, investors	Passive, illiquid asset	demand, location, zoning policy	land doesn't increase in value, opportunity cost of capital being locked up
Apartment buildings	HNW individuals	significant debt, greater liquidity, income generating, potential appreciation in value, depreciation tax shield	market demand	active managerial oversight, more competition, high barriers to entry
Office Buildings	HNW individuals and other business entities/organizations	somewhat liquid, income generating, appreciation in value, depreciation tax shield	economic demands and tenants	active managerial oversight, competition, technology
Shopping malls	HNW individuals	low liquidity, location driven, moderate leverage	regional demographics and economic opportunities, active management	managerial oversight with high service, vacant units, malls
Hotels/Motels	HNW individuals and REITS	moderate liquidity, depreciation tax shield	location, tourist events/conferences	active management, competition, staff turnover, high utilization rate needed
Warehouse	Investors demanding cash flow	passive approach, moderate debt/liquidity, income generating, low lease cost, depreciation tax shield	commercial activity/strategic location	competition, outdated technology

What should be taken away from this table is that personal residence is not mentioned as an investment category within Real Estate. Why not? This is because your house is not, unless you have an income suite within your property.  Your personal residence cannot be sold tomorrow or in a week, which makes it an illiquid asset.  Besides rawland, every other category produces a cash payment.  Some of the advantages of real estate are:  tax benefits, the use of debt, control over property, diversification, a potential inflation hedge, and low volatility of returns. On the other hand, the disadvantages are: inability to split the investment, high information cost, commissions, operating/maintenance cost, location risk, and political risk (tax deductions).

So as an individual, how should you view your personal residence?  In my view, it should be a two-part type of investment.  Your residence should be a tax shield in the early years, and as retirement is closer it becomes a source of cash.  

Home ownership provides the household an opportunity to maximize on itemized deductions instead of using the standard deduction. For example, if an individual itemizes, they are able to deduct the following: medical/dental expenses, real estate taxes, mortgage interest, non-reimbursed business expenses, gifts to charity, and other miscellaneous expenses as allowed by the IRS. Using a slightly outdated IRS table (2010), the standard deductions were: $5,700 for single, $11,400 for married filing jointly, $8,400 for head of household, $5,700 married filing separately, and $11,400 for qualifying widow(er). On the other hand, a person owning a house that cost about $200,000 at an interest rate of 5%, the payment would be about $1,073.64 per month.  In the first year the homeowner would have paid $12,883.72 for housing of which $10,000.00 would be deductible interest.  If real estate taxes at 2% were factored in, that would be an additional $4,000 of tax-deductible expenses.  Just off housing along the household would receive more than the standard deduction without factoring in any other expenses.  This is a diminishing tax shield but because of amortization (the process of decreased accounting for, an amount over a period), your home provides a tax shield for almost at minimum the first 10 years. The only way the standard deduction is a viable option is if there are no housing expenses. So, what should be noted is that no other expenses were factored into this scenario.  Some investors have criticized home ownership as a waste of money.  Unless you can live somewhere rent-free or have housing expenses less than the standard deduction, once taxes are factored in, that argument becomes less visible.  Besides your home being a tax shield it does carry some sentimental value, and historically has been the root of a firm family foundation. 

As a family or individual gets closer to retirement a house can be a source of cash as you downsize your lifestyle. The gain (purchase price minus the loan value) on the sale of your housecan be used to purchase an annuity to be a source of additional income during a time in which you are living on a fixed income. For example if $100,000 from your housing gain was used to purchase a single level payment fixed rate annuity of 1.75%, the monthly payout would be about $513 according to the government Thrift Savings Plan website (www.tsp.gov).  In retirement ourearnings potential is minimized, but this extra income monthly could be used to offset medical expenses.  

I know this blog was a bit lengthy, but I wanted to ensure that I explained why your primary residence is not a traditional investment.  The benefit that should come out of homeownership should be in the form of a tax shield, retirement planning vehicle, or an emotional connection.  Multiple factors fueled the real estate bubble.  Ultimately, we saw one of those very prevalent factors—using a house as a proverbial ATM—prove to be a disastrous fad.  When irrational exuberance is rampant, a crash always happens. Such behavior forces all assets to exhibit a mathematical phenomenon called, mean reversion.