Judging by the number of TV shows related to homes these days, it’s a logical to conclude just how interested people are in real estate. Do some channel surfing at night and you’ll find any number of programs dedicated to the process of evaluating and “investing” in real estate. Off the top of my head I can name “Rehab Addict”, “Property Brothers”, “Love it or List It”, “This Old House” (old school- on PBS) and I’m sure there are many others that I haven’t come across. I’m a believer in the old-fashioned concept of supply and demand so I think the reason these shows are broadcast is because there’s a demand for them- people like them. Some shows take the approach of “investing” in one’s own home while others focus on buying a downtrodden property with the intention of improving it, then “flipping it” for a higher price. But what I have never heard on any of these shows is just how the relationship of this substantial asset (usually leveraged) integrates to the rest of a family’s financial portfolio. This is a big oversight. In short, I believe it is critical to incorporate real estate, be it a personal residence, rental property or both, into any financial planning process given the substantial impact it can have on a family’s cash flow and balance sheet.
In Part 1 of my thoughts on real estate (see below), I will detail considerations around a family’s personal residence and the relationship to other financial assets. In part 2 (in the weeks to follow) I convey my thoughts on investing in rental real estate and some important implications. So on to Part 1…….
Part 1: Your Home is More Than Your Castle
As noted above, when most people think of investing or their financial plan it is usually within the construct of the “portfolio”. By most accounts, the concept of “the portfolio” usually pre-supposes some mix of stocks, bonds, mutual funds and other securities currently housed in various accounts. But the most underappreciated portion of a families “portfolio” doesn’t live in any of these accounts. The most underappreciated asset is usually the family residence. To me, a residence is yet another portion of families’ financial lives that needs to be factored into my holistic approach to financial planning, which my faithful readers (and clients) know goes way beyond stocks and bonds.
Before detailing some of the financial advantages and considerations on owning a home, let me preface my comments with a few qualifiers. First, owning a home is not for everyone. It must be properly sized to a family’s financial situation and a family must have the time and resources (i.e. cash flow) to dedicate to upkeep, improvements or even emergency expenses. Second, I don’t believe in speculating on a home to turn a quick buck- especially your residence. I think it’s fair to factor in a few percentage points of property value appreciation over a long period of time (especially after the massive bubble collapse) but as all realtors will tell you, all real estate is local so speculation is not my style. So I will not advise looking at a residence to make a bunch of money from flipping or speculating on real estate. The context of my thoughts are predicated on a family buying a home reasonably priced to their financial situation, with around 20% down payment and with the intention of occupying the home for the foreseeable future (at least 5 – 7 years).
In that context – the big advantages to owning a home are:
Taxes: Looking at tax policy as a proxy for how Uncle Sam tries to shape our behavior, it seems our federal government really wants us to own versus rent. The two main tax advantages are the deductions against income for and the (usually) tax free gain on the sale.
- Deductions to Income: As most people know, mortgage interest on all but the highest mortgages is fully deductible and has no phase-out for high earners. For a high-income family, this could be one of the few tax deductions actually available to them if they itemize their deductions. Unfortunately however, it is subject to the constraints of the onerous AMT (Alternative Minimum Tax). In addition, most taxpayers can also deduct the full amount of their real estate tax. Even outside the AMT, both these deductions could lose their effectiveness for high earners for other reasons. First, high earners are getting phased out of itemizing deductions in 2013 and beyond, assuming current tax code. Second, this deduction could be on the chopping block if broader tax reform seeks to “flatten rates” and “close loopholes”. Certainly, this is something I am keeping my eye on but for now, it is usually an advantage.
- Exclusion of Gain on Sale: When people sell their primary residence for a gain, a substantial exemption ceiling is in place that should make the gain tax free for most people. Married couples can exclude up to $500,000 of gain and individuals can exclude $250,000 of gain. What other asset can you purchase affords you that advantage? None that I can think of. Of course this does have some restrictions that must be adhered to (home was owned two of the last five years, home must have been personal residence for two of the last 5 years, etc.) but most families fit into these restrictions. Unfortunately it’s not all good news- a loss on a sale of a residence cannot be deducted for tax purposes.
In addition, the Fed continues to buy about $40 billion in mortgage backed securities per month, which again, being a believer in supply and demand tells me that demand for could be artificially high, effectively suppressing mortgage rates to our advantage (less so lately). Policies like these can get out of hand as one could argue that Fed policy and Federal lending regulations contributed to the real estate bubble of 5 years ago but that’s a topic for another discussion.
Inflation Hedge: (adapted from my prior blog: To Pay or Not to Pay? The Drama Around Paying Off a Mortgage): Leveraged real estate usually acts as an effective hedge against rapidly rising inflation. This is critical to balancing the total portfolio as I believe real estate acts as a decent buffer and offset to elevated inflation which typically has a negative impact on fixed income and sometimes equities. Again- this is why I consider real estate in the big picture of a family’s total portfolio (does the name “Net Worth Management” ring a bell?) So if a family has $50,000 of equity (20%) on a $250,000 house will usually see that house value increase with inflation on the $250,000 amount, not on the $50,000 amount. This means if inflation spikes to 7% per year, real estate as an asset class would theoretically move similarly. Assuming a home value would keep pace with inflation, this would mean:
$250,000 Home Value + 7% inflation / home value = $267,500 home value
Home Equity WAS: $250,000 Home Value – $200,000 Mortgage = $50,000 equity
Home Equity NOW: $267,500 Home Value – $200,000 Mortgage = $67,500 equity
Theoretical “gain” in equity = 35% (($67,500 – $50,000) / $50,000)
Of course “leverage” cuts both ways, as many people found out when they assumed home values would always go up before the real estate bubble burst in 2008 and 2009. So I caution families not to go all-in to real estate but the point is that your home needs to be factored into the inflation hedging portion of a portfolio (assuming no bubbles) as it can be effective in helping to offset a decline in bond and maybe stock values in a portfolio should high inflation rear its ugly head.
Personal Enjoyment: Finally, there are some value judgments that just don’t fit neatly into an Excel spreadsheet and I believe enjoyment of the family home is one of them. First and foremost, it’s tangible. I don’t know about you but to me, a new wood floor or landscaping or a new kitchen seems much more tangible than the bar graph in my monthly statement from Charles Schwab. Likewise, doing an ROI or IRR on adding a new deck for instance, usually won’t yield the practical return in dollars that we seek when we invest in a particular mix of securities. However, we CAN sit out on our deck and sip an adult beverage with our family and friends, which is tough to replicate with the Vanguard Total Market Index fund, despite all its merits. Said differently, I will not advise folks to view a home improvement as an “investment” that will be yield more dollars than the expense when it comes time to sell. This investment is almost never recouped and I caution families not to over-extend themselves with an upgraded home or a big home improvement project. Again, we need to be balanced across the entire portfolio of assets. That said, I think it is important to consider a home is one of the few asset classes that warrants consideration on the “non-financial” value that will be derived from the expense.