If you read those personal finance articles in magazines and newspapers, you've seen articles that tell you to exclude home equity from your projected net worth at retirement. Financial planners or the journalists who quote them say that homes make for relatively poor investments; and because you will still need a place to live after you retire, money tied up in a house won't add to your spending power.
Mortgage Secrets refutes these statements. Regardless of what the media report, homeownership and investment properties have helped more Americans build wealth than any other asset class. Yet, since the end of WWII, the media have missed the wealth-building power of property and instead have chosen to repeatedly warn of housing peaks and bubbles. Take this quick review of headline stories and so-called expert advice from the past 60 years.
♦ The prices of houses seem to have reached a plateau, and there is reasonable expectancy that prices will decline. (Time, December 1, 1947)
In the late 1940s, $8,000 to $10,000 seemed like an outrageous amount to pay for a house. In the late 1960s through the mid-1970s, $30,000 to $50,000 seemed well beyond anything reasonable. In the early 1980s, popular belief held that at $100,000, home prices in California could only go down. Today, similar comments about peaks, bubbles, and busts fill the press. But just as past voices now sound foolish, so too will current opinion as we look back from the future.
Can some home prices soften or decline in the short-run? Sure. They have done so before and will do so again. Local economies ebb and flow, but over periods of 5, 10, 20, or 30 years, well-selected properties will continue to register high-profit appreciation.2
Here's a simple example: You invest $10,000 in a $100,000 property. You finance your purchase with a 30-year, $90,000 mortgage at 7.75 percent. After eight years you will have paid down your mortgage balance to $81,585. With 4 percent a year appreciation for eight years, your property's value will have grown to $136,860. If we subtract the balance of $81,585 from this $136,860, you see that your original $10,000 investment has increased more than fivefold to $55,275. That result yields an after-tax annual rate of return of around 24 percent (see Table 10.1). During the early- to mid-2000s, lower rates of interest and higher rates of appreciation produced rates of return on invested cash that far exceeded 24 percent.
Depending on whose numbers you use, stocks have supposedly yielded average pretax returns of between 9 and 12 percent a year over the longer run. On an after-tax basis, a 10 percent a year return on stocks is considered very good. In fact, over the long term, fewer than 2 percent of professional
2 Potential homebuyers: For more extensive discussion of this issue, see Chapter 3, "Home Ownership: How to Make It Your Best Investment," in my book, The 106 Mistakes Homebuyers Make—and How to Avoid Them, 4th ed. (John Wiley & Sons, 2006).
Table 10.1 Property Appreciation Yields High Returns
Property purchase price Original Mortgage
Cash invested Eight Years Later
Market value @ 4% appreciation
Equity Growth Rate
136,860 81,585 $55,275
Annual growth rate of home equity = 24 percent. Proportionately increasing the down payment and purchase price would still yield a 24 percent rate of return.
fund managers have been able to consistently earn after-tax returns on stocks of more than 10 to 12 percent a year.
At the end of 1965 the Dow Jones Industrial Average (DJIA) stood at 969.26. At the start of 1982 this index of blue-chip companies actually stood lower, at 884.36. During this entire 16-year period, the DJIA closed no higher than 1051.70, and it fell to as low as 577.60 in 1974.
If you compare stock gains during the unprecedented market boom that ran from 1993 (DJIA at 3,500) to early 2000 (DJIA at 11,700), you'll find property wealth multiplying even faster. In the small college town of Gainesville, Florida, a home bought in 1993 for $100,000 could have been sold in 2000 for $150,000. Assuming a $10,000 down payment, that $50,000 gain in price returned a fivefold increase in investment—not counting mortgage paydown.
If instead, you had put $10,000 or $20,000 into a property in a boomtown such as Portland, Oregon; Austin, Texas; Boston; Seattle; San
Francisco; Park Cities, Utah; Denver or Boulder, Colorado; or Sarasota, Florida—or any one of dozens of other hot housing markets—you would have enjoyed a tenfold (or greater) increase in your original down payment investment, compared to the approximately threefold gain in the stock market.
You can reasonably expect your property investments to outperform the stock market. With a property you gain the benefits of leverage. You invest a 5, 10, or 20 percent down payment, yet you receive returns based on increases in the total value. That's why even a 4 percent annual rate of appreciation will nearly always outperform the price gains you might receive from stocks. And not only does property ownership present less risk than stocks, but stocks won't keep you dry when it rains or warm when the weather is freezing cold. Nor will they give you an amount of income (dividends) that comes close to the amount of income (rents) that an investment property can yield.
As you grow older, diversify your wealth into various types of investments. But don't naively accept the false idea that other investments will yield higher returns or lower risks than property. (For more historical investment results and explanations, see pegasusdialogues.com or garyweldred.com).
The financial planners dismiss housing as an investment not only because they claim (erroneously) that you can earn better returns in stocks, but also because your equity is illiquid. Wrong again. Equity lines of credit (HELOC), refinances, and reverse annuity (now called Homesaver) mortgages all provide tax-free money from your home.3
As your housing needs change, you may choose to downsize. Sell the higher-priced family home and move into a lower-priced empty-nester home. You and your spouse will pocket up to a $500,000 tax-free gain. In contrast, the IRS will tax the money you withdraw from your 401(k) and
3Mortgage Secrets discusses when and whether you should withdraw these monies later in this chapter.
other tax-deferred retirement accounts at your highest marginal ordinary income tax rates, even if a large part of those funds actually accrued through capital gains such as stock price appreciation.
Today, in addition to "stocks for the long run," financial planners preach the virtues of diversification. "Never put all of your eggs into one basket," they say. There's merit to this advice. But it doesn't apply to real estate in the way the stock enthusiasts think it does.
"Most experts argue—correctly, in my view"—writes Jonathan Clements of the Wall Street Journal, "that if you own your own home, you already have plenty of real estate exposure." And from Barron's Guide to Making Investment Decisions, the same Wall Street line: "We will argue that one's own home is probably enough exposure to the real estate market for the average individual investor. If you're thinking about buying [a home], please, at least consider the alternatives."
Why this hostility to real estate? According to the cliched critique, real estate fails the test of diversity. If you maintain your job, your home, and your property investments in the same community, you're placing too many eggs into one basket. If your employer, your industry, and your community slide into recession, your finances could take a triple hit.
In a know-nothing manner, this critique of property investment confuses the short run with the longer run. It also mistakenly assumes that housing prices yo-yo up and down like the prices of stocks and bonds. Yet, in most areas, in most times, property prices rarely slide down—and in those cases when a big down cycle does hit, rebounds nearly always occur within three to five years. In contrast, when stock prices hit down cycles, they can stay down for 10 to 20 years (e.g., 1907 to 1921, 1929 to 1953, 1966 to 1982).
Unless you develop short-term ownership strategies such as fix and flip, think of property as long-term wealth, not wealth that you check three times a day by tuning into Bloomberg reports. Sometimes local economies sag. Job growth falters. On occasion, homebuilders build too many houses, condos, and apartments. Unsold inventory gluts the market.
Nevertheless, these localized downturns rarely last for more than a few years. In fact, severe downturns such as occurred in California in the early to mid-1990s provide enormous opportunities to create home equity wealth by trading up. I know California homebuyers who, in 1993, bit the bullet and took a mild loss on their $200,000 home. They then bought a $400,000 home that had sold three years earlier for $550,000. Today, that house is worth $1.2 million; they've accumulated around $900,000 in equity, and their monthly payment (due to refinancing into lower interest rates) is only 15 percent higher than they were paying in 1990.
If you own stocks, you must diversify your holdings even if you invest for the long run. Stock prices and profit performance of even the best companies can plummet and remain down for decades. Name-brand highfliers of earlier eras can end up in bankruptcy. (To name just a few: Polaroid, Enron, United Airlines, World Com, U.S. Steel, Pan Am, and Pennsylvania Railroad.) Owning stocks of just one or several companies can expose you to financial ruin—especially when you plan to hold those stocks forever.
Property owners suffer no similar risk. Do you know of any decent property that would sell today for less than it sold for 5 or 10 years ago? Check the historical prices in so-called less-desirable neighborhoods. You will find that even these properties have appreciated. Certainly, individuals can let their properties run down, but I do not know of any neighborhoods in the United States where market values have declined from where they stood 10 years ago, unless the local job base (e.g., Detroit) has severely declined. Obviously, you should not invest in property that's located in a declining economic area, though you might speculate, if that suits your risk profile, and hope for a turnaround or revitalization.
Most retirees have gained greatly from the increased value of their property equity, but most of them haven't had to tap into it. Today's retirees still draw substantially from social security, company pensions, and, yes, the historically unprecedented bull run in stocks of the past two decades.
You, though, can't count on the same degree of income support from social security, pensions, or stocks. No one predicts huge increases in social security payments. Most companies have abandoned pensions. And who knows where stock prices might land 10, 20, or 30 years from now. Further, what will happen to stock prices when tens of millions of boomers try to liquidate their 401(k), 403(b)s, and IRAs to raise cash to pay for their living expenses?
In an uncertain world, one constant remains: If the United States continues to grow its population and its economy, housing values and rent levels will continue to go up. Unless you know that you can secure your finances in other ways, don't leave your equity gains to chance. Choose your properties and financing with a calculating eye on the future.
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