In asset allocation, real estate is considered an alternative investment class that should be part of every healthy portfolio. However, a common question is whether or not your home should count toward this asset class in your portfolio. Before we answer that question specifically, let’s explore a few things about your home as an investment.
At its core, to be defined as an investment, you must invest money in expectation of interest, profit, income, or appreciation in value. When you purchase a home you are trading money in the form of a down payment for equity in the value of the home. You are trading money for ownership in an asset. That asset — your house, condo, or townhouse — can go up in value and be sold in the future at a profit. In the most basic sense of the word, your home can be considered an investment.
Your home is a place where you live. It is four walls and a roof over your head. Even if you are able to sell your home for a great profit, you still have to have a place to live — this alone should disqualify your home as an investment.
If you truly looked at your home as an investment, you would sell it once it meet a certain predefine criteria. Would you sell your house today if it went up 25% in value? Would you leave behind the great neighbors and close commute you currently enjoy? And with other homes in your area also going up in value, you may not really be getting that much additional value because you still need some place to live.
If your home was truly an investment you could sell it without it greatly impacting your life — just like selling stocks.
When you are looking at things like asset allocation and overall risk, should your home enter the equation? First, let’s talk about what counts. Your home likely has a mortgage associated with it. It is both an asset and a liability. So I think what counts should be your equity in the home, i.e., the difference between the current home value minus what you still owe.
And if you have negative equity (e.g., you owe more than the house is worth), the difference should be counted as a negative bond allocation.
Now let’s talk specifically about primary residence versus rental property
When you first buy the home the impact to your net worth is practically zero because you put money down (an asset), got a mortgage (a liability), and some equity in a property (an asset). But when you’re looking at things like asset allocation, should your home count?
I think the best way to deal with this is to frame it as a question: Would you sell your home if this portion of your portfolio increased dramatically to keep it in line with your asset allocation goals? Most people would say absolutely not because they see their property as a place to live, not an asset that should be bought and sold to stay in line with portfolio expectations.
So the short answer is NO — don’t count your primary residence in your portfolio asset allocation.
The story is a bit different if you own rental property. Rental property in its most basic form is not a place for you to live. You want renters living there, paying rent, paying off the mortgage, and generating rental income for you. At its core, rental property is in an investment. As such, it should be factored into your portfolio.
If you only want a 10% exposure to real estate and your rental property currently makes up 10% of your portfolio, you shouldn’t go invest additional funds into other real estate investments (such as REIT mutual funds). That would throw your portfolio out of whack and give you too much exposure to that asset class.
Even if you considered your home an investment asset, it turns out it is a pretty bad one when you compare it against other investments.
Over a long period of time your home will go up in value, but not because it is a superior investment. Home prices have risen gradually over decades dues to inflation. Granted, there are spikes where home prices go crazy (as we saw a few years ago), but these are anomalies that eventually come crashing back down to the historical averages.
Buy on Margin
When you trade stocks, you have the option of borrowing money from the broker to buy shares. In general, this is not a good idea because the cost of margin is very hard to overcome. When you buy a home, you almost always have to borrow money (unless you have a pile of cash sitting around). On a 30 year mortgage you will practically buy the house twice with all of the interest you pay over the life of the mortgage.
When you buy shares in a mutual fund you are charged a fee based on the amount of money you have invested with the fund, i.e., the expense ratio. The average cost across all mutual funds is around 1% per year. When you buy a home your “expense ratio” is significantly higher.
You have maintenance costs that you have to pay, e.g., your roof will need replacing, the water heater will go out, and the air conditioner will need recharging. These costs are all your responsibility and can really add up. On top of maintainance, you have other annual fees that typically include property tax, home insurance, and home owner association fee.
All of these expenses do add up and can easily cost you more than 1% per year.
High Trading Fee and Low Liquidity
When you deal with other asset classes, you only have to worry about the trade commission and the bid-ask spread. These expenses are miniscule compare to what it takes to buy and sell a home. Also it takes months to buy and sell a home, compare to the few minutes it takes to buy and sell stocks.
If you decide to buy $10,000 worth of a single company’s stock you can almost always be able to sell off that investment through the massive stock exchanges. Your home is not a liquid investment like a stock. If you buy a home and decide you want to sell, you have to wait for the right buyer to come along. You can’t sell your house on a whim like you can your stocks or mutual fund investments. When it does sell, you have 6% realtor commissions (usually) to pay, plus other closing costs. It’s a tough asset to sell and the transaction costs are massive.
Not counting the annual property tax you have to pay, the one main advantage of a house is its tax efficiency. Compare to other investments that are subject to capital gains tax, the capital gains on your home sale could be tax free. This alone can make up for many of the deficiencies listed above.
Moreover, your home has several tax advantages over other investments:
One reason why real estate is a good alternative investment is because its ability to hedge against inflation. Your home is a hard asset that requires raw material to build and the land it sits on is limited in quantity, both of these factors ensure that your home with at least keep up with the rate of inflation over the long-term.
Moreover, your mortgage is a hedge against inflation. When you take out a mortgage, you pay the same amount over the course of 30 years. At the long-term inflation rate average of 3.43%, this means that you are effectively paying about 10% less every 3-4 years. If you are paying $1,000 a month mortgage payment today, in 10 years, it is the equivalent of $740 in today’s dollars; and in 30 years, it is the equivalent of $380. This works especially well with today’s mortgage rates where the rates are approaching the long-term inflation rate average.
So, what do you think? Do you count your home as part of your investment portfolio?
Photo by Images of Money.
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