FOOL ON THE HILL
Housing vs. Stocks

Burned by the market in the short term, many investors think residential real estate is a better place for their money. Over the long term, they have been wrong. Invest in stocks for long-term growth, but choose your home as carefully as you do any investment. That's because for most people, a home will be something like their personal bank.

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By Tom Jacobs (TMF Tom9)
April 4, 2002

Two-thirds of U.S. households own their own homes. According to The Economist, that London-based bastion of world business news and dry wit, American homeowners have seen 9% appreciation on average in the last year. That's the largest inflation-adjusted annual increase on record, and even the lower The Wall Street Journal's figures of 9.2% for 2000 and 6.9% for 2001 are pretty nifty. With U.S. stock portfolios off $4 trillion and home equity up $1.2 trillion since the start of 2000, some U.S. investors sensibly ask, should we take money out of stocks and put it into real estate?

Before answering, please note that we at The Motley Fool are not real estate experts. In buying our own homes, we rely on friends, family, and our Home Center and Buying or Selling a Home discussion board. But we do think we've studied investing, and research says that common stocks on average have outperformed all other asset classes -- gold, bonds, diamonds, housing, Pez dispensers -- for rolling periods of 20 years or more since the 1920s. We recognize that doesn't help if you have a shorter holding period, and the past doesn't predict the future, but it does tell a story: Stocks beat houses. 

The Economist agrees. In its March 28, 2002 issue, it started a regular survey of housing prices in 13 countries, beginning with annual data starting in 1980. The results were that U.S. residential real estate from 1980-2001 returned a nominal 158% and a real (inflation-adjusted) 20%. That's a nominal compound annual growth rate (CAGR) of 5.11% and real of -- gulp! -- 0.87%. Let's line this up with the S&P 500 over the same period:

1980-2001     Housing  S&P 500 (w/o div.)
Total return 185.00% 961.40%
CAGR 5.11% 11.09%

These averages strongly suggest that investors would have been far better off investing in stocks than housing for the last 21 years, and that's not even allowing that we buy houses sort of "on margin" -- paying huge amounts of interest on loans for years.

But does it really make any sense to compare the two as investment vehicles? Yes. While the numbers indicate we shouldn't invest in our house expecting to beat the market averages, we should buy a house as carefully as we choose a stock, because it is likely to end up being at least as important a part of our overall financial well-being.

Houses aren't like stocks
Broadly speaking, houses are not like stocks. Most people don't buy them as investments. People buy houses because they believe that it is better to pay huge amounts of tax-deductible mortgage interest to own an asset that may appreciate -- however little -- rather than pay rent. Houses are not as liquid as stocks. They can be somewhat liquid -- consider the Seattle market in the late 1980s -- but they can also be illiquid, as in any Plains state county that's losing population.

Also, real estate is not about national averages. What you buy depends entirely on local factors, and price varies by city, neighborhood, block, and, of course, the actual property itself. Most of us can't live just anywhere, limited by proximity to our jobs and neighborhood affordability. We just don't have the same choice and information about housing that we do about stocks -- though online real estate sources now give us ways to find price comparison information on our own.

Houses are like stocks
But it can be very helpful to think about houses as stocks, too. Just as it usually isn't a good idea to buy stocks with money you absolutely need within five years, you shouldn't buy a house unless you plan to live in it for five years or more. The shorter the holding period, the more maintenance and transfer costs (a 6% average real estate sales commission plus transfer taxes) and property taxes cut into the relatively low appreciation. I've read that homeowners have an average seven-year holding period. That's good.

When you buy a house, as when you buy a share of a business, you want to maximize its revenue and minimize its cost. You should look for houses always with an eye to resale. Is it the highest priced house in the  neighborhood, an unusual design, too small or too large for most buyers? Unless you really enjoy it, you want a house that requires low maintenance and that either won't require a lot of major work or will appreciate in line with any rehab that you do.

As with stocks, it's also best not to fall in love with a house, despite the real estate industry's sales efforts. Even though each of us derives significantly more satisfaction from the roof over our heads than from our investment portfolio, we should be at least as hard-headed when buying a house as a stock. This is because in the U.S., housing represents 25% of household wealth and we use our homes for financial purposes far more actively throughout our lives than we do our stock portfolios, which are more likely geared towards retirement. 

With a home equity line of credit, we have a ready-made emergency fund. When we use the home equity, we can take deductions for interest payments, and it may make sense to use this equity at different times for education, home improvement, and the like, though not for current consumption. At retirement, we can sell the house, exclude $250,000 in capital gains from taxes ($500,000 for married couples), and downsize, increasing our retirement funds. 

So is there a housing bubble?
Given that our homes represent such a large proportion of our wealth, we are concerned about headlines that suggest we may be in a housing price bubble. No one wants to end up like Japan, with 11 years of housing price declines down to half 1990 levels, or like  poor-performing Germany and Canada.

The Economist's March 28 issue provides the major arguments for and against, relying in part on research from Robert Shiller, author of Irrational Exuberance. Housing prices have risen because national income has increased and houses have gotten bigger. That appreciation will slow if and when interest rates increase. The U.S. has generally done well this recession because there has not been an oversupply of housing and because personal incomes kept increasing despite the slowdown. The most comforting statistic? The ratio of housing price to income in the U.S. is still below its 1988 peak and far lower than the ratios in the Netherlands, Ireland, or Spain. There's certainly pain in markets like San Francisco, with recent price drops, but the factors affecting housing prices in the short term -- interest rates, supply and demand -- will matter less the longer your holding period. Just as with well-selected stocks.   

Buy a home that you want to live in for a while, and look at it with the same hard-headedness you do when buying a stock. It's going to be a large part of your financial plan as you go through life.  

Tom Jacobs (TMF Tom9) is glad to have a roof over his head. To see his stock holdings, view his profile, and check out The Motley Fool's disclosure policy.