On Housing, Part III – 7 Big Opportunities

By The Banker | Blog Posts, Personal Finance
1 Jun 2013
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House in HandAs I wrote before, housing is a combination of necessity, consumption, and investment.  To the extent a house is also an investment, we should be clear-eyed about the risks.

Despite the numerous risks of investing through home ownership – and acknowledging that it’s neither a slam dunk nor appropriate for everyone – I advocate long-term home ownership as an investment for a host of important reasons.  No other investment offers such an array of factors stacked in its favor.  The forced savings, tax-advantages, inflation-hedge characteristics, local specificity, and responsiveness to improvement all make home ownership the most important wealth creating vehicle widely available to the middle class.

Opportunities

I’ve listed in this post the 7 most important advantages of home ownership for personal wealth creation, in order of importance.

1. Forced savings – It turns out that for most people, voluntary savings is tough-to-impossible on a monthly basis.[1]  What seems to effectively generate a personal financial surplus each year are programs that ‘force’ savings — such as excessive income-tax withholding or automatic paycheck deductions for a 401K.

Monthly mortgage payments, which include a portion for paying down principal and therefore purchase small increments of home equity on a monthly basis, work in a similar fashion.  Most of us have a hard time accumulating a few hundred thousand dollars in investment equity.  But through the forced-savings method of paying down a mortgage every month for a period of 15 or 30 years, millions of people do manage it.

I can’t prove this, but I’d bet much of the ‘magic’ of wealth accumulation through home ownership can be attributed to this forced savings program.  The psychology of forced savings matters tremendously, probably more than any other factor.

Car and Monopoly house

2. Capital gains tax exemption – The mortgage interest tax deduction is what we think of when we think of tax-advantaged investing in our home, but I’d argue that the capital gains tax exemption for home owners overwhelms the mortgage interest tax deduction – when it comes to wealth creation.

An example here can illustrate my point.

Let’s say you bought your house for $200,000 15 years ago and just sold it for a gain.

Inflation on your home ran at 5% annually.  Using the compound interest formula we can calculate that your home sold for $415,785 today.

(This is because $415,785 = $200,000 * (1+5%)^ 15 )

As an investment, you now have a ‘capital gain’ of $215,785, the difference between your $200,000 purchase and your $415,785 sale.

Now let’s compare the $215,785 capital gain to other ways of making money through investments.

If you made $215,785 in capital gains, for example, by purchasing an IPO and flipping it soon after, you would owe taxes at your ordinary marginal income tax rate.  If you are the kind of highly compensated person who can access an IPO, with enough capital to make that kind of gain, you’re probably up at the 39.6% income tax rate and you might pay as much as $85,451 on your capital gains (39.6% of $215,785).

To take a more comparable investment scenario – if you held a stock investment for over a year – your capital gains tax rate drops to 20% in this scenario, and you would only owe $43,157 (because $43,157 = 20% of $215,785) on your stock investment, upon selling it.

Capital gains from your house in the example above, however, are completely exempt.  Meaning, zero taxes on your $215,785 gain.

Not only that, but as you roll your gains into a larger house, in many scenarios the gains on your next house also remain completely exempt from taxation.[2]  Most homeowners can continue to build home equity over a lifetime and a series of houses and never pay taxes on their capital gains.

No taxes.  This is amazing and awesome and a huge part of how middle class people accumulate tax-free wealth through home ownership.

The capital gains tax exemption gains on your house as an investment is a real cool money saver.

 

3. Mortgage interest deductibility – The tax deductibility of mortgage interest gets a lot of attention, and it’s worth acknowledging this important advantage of home ownership as an investment. I write this semi-grudgingly because my own opinion is that it’s an unfair tax break[3] and that it’s also overvalued[4] in the popular consciousness.[5]

But I’ll review the tax advantage anyway, using the same home mortgage example, as it’s still quite important.

Let’s assume you originally made a $40,000 down-payment on your $200,000 house 15 years ago, and took out a $160,000 mortgage at 6%. Over the course of the next 15 years – until sale – you would pay a total of $126,242 in mortgage interest.  Interest as a portion of mortgage payments declines annually from $9,546 the first year to $6,953 in the 15th year, with average annual mortgage interest payments of $8,416.

If you itemize your home mortgage interest on your taxes, at the highest 39.6% income tax rate, you’d save $49,992 (because $49,992 = 39.6% of $126,242 interest paid) in income taxes spread out over 15 years.  That’s probably the highest tax savings available under the scenario I created.

If you own your house for less time – let’s say 5 years, and you have a lower marginal income tax rate – let’s say 28% – you’d enjoy total tax savings over those 5 years of $13,001 on a total of $46,434 in mortgage interest.

In my example, a total of somewhere between $13K and $50K in tax savings on your investment sure helps.  If you have a mortgage larger than $160,000 and/or a higher interest rate and/or you own the home for a long period of time, the total tax savings will be even more significant than the example I give, which is also nice.  You can’t expect to save anything on any other investment loans – like a stock margin loan, so this mortgage interest tax break matters quite a bit.

dog and Monopoly house

4. Inflation-hedge – Gold bug investors think their shiny metal offers an appropriate inflation hedge for troubled financial times.[6]  Less well known is the fact that owning a home is a much better overall strategy, for a middle class person, to hedge against future inflation.

How does home ownership, with a mortgage, hedge against inflation?

In investment terms, the 20% down-payment on your home is equity,[7] which you finance with ‘debt,’ in the form of a mortgage.

There are two ways to use a little bit of compound interest math to see the advantage of a home and mortgage combination as an inflation hedge.  First I’ll focus on the nominal increase in home equity, and second I’ll focus on the real decrease in debt value.

Nominal increase in home equity

The value of your home – $200,000 in our example – should at least keep pace with inflation in the medium and long term.  If inflation ticks up from an ordinary 2% per year to a less comfortable 9% per year or worse, for example, you can reasonably expect your home, like other hard assets[8] will increase in price at a comparable rate.  If we suffered 10 years of regrettable 9% annual inflation – all else being equal – the price of your home will likely ‘appreciate’ in nominal terms at that rate, leading to an expected value at the end of ten years – calculated via the compound interest formula of course! – of $473,472.

(I got here because Future Value $473,472 = Present Value $200,000 * (1+inflation 9%) ^ 10yrs.)

But – and here’s the great thing about home ownership with a mortgage as an inflation hedge – your mortgage has a fixed value, starting at $160,000 and amortizing downward over the 10 years.  Assuming you paid the mortgage on time, your mortgage balance at the end of 10 years would be $134,030.

Your nominal[9] ‘home equity’ under the inflationary scenario of 10 years at 9% has increased to $339,442, which is the difference between $473,472 market value and $134,030 in remaining mortgage debt.

Under more moderate inflation – say 2% for 10 years – your nominal home equity would be only $109,768.  So in a way, you have a $229,673 higher ‘net worth’ after the higher inflationary period.

Of course the $229,673 higher net worth in nominal terms has less purchasing power in real terms than it did before inflation, but at least it has kept pace with inflation.  As a hedge, the increased net worth balances out the decreased purchasing power.

But, you may ask, aren’t there instances in which high rates of inflation cause such turmoil and chaos that the Peter Schiff and Ron Paul apocalyptic scenarios come true and my home price declines in value?  Shouldn’t I be buying guns, ammo, and canned goods as they seem to suggest, rather than depending on this ex-banker’s optimistic view of “house + mortgage = inflation hedge?”

Nope.  They’re wrong.  Houses can always go down in price for many reasons, but inflation isn’t one of them.  High inflation makes at least the nominal price of your house go up, kind of just by definition.  There is no reasonably probable alternative scenario in which anything but house price appreciation happens if we experience high inflation.

 

Real decrease in debt value

You can also conceive of your home-and-mortgage combination as an inflation hedge by flipping around the perspective and focusing on the decreased cost of your mortgage, in real terms, over the course of 10 years, under an inflationary scenario.

Using the same example of 9% compounding inflation, we can calculate the value of your future mortgage in adjusted purchasing power – also known as “Real” dollar – terms.

As I wrote above, at the end of 10 years of paying down your mortgage you can expect a remaining debt balance of $109,768.  But $109,768 after 10 years of relatively high 9% inflation no longer should be considered the same amount of debt.  You can apply the discounted cash flows formula to calculate how much $109,768, 10 years from now, will be worth in today’s terms.

Specifically your new mortgage balance after 10 years would be the equivalent of $46,367 in today’s dollar terms, or less than half of the nominal balance.

(I arrive at that number because Present Value $46,367 = Future Value $109,768 / (1+9% inflation) ^ 10years.)

What does it mean that your future mortgage balance of $109,768 is really worth $46,367 in today’s real dollars?  It means that the price of everything has increased in the future, including ideally and most importantly, the price of your labor.

In simplest terms, you can imagine that after 10 years of 9% inflation you’ll be earning more than twice what you earn today.  If your wages keep up with inflation, it will make the future $109,768 seem more like $46,367 seems today.  A sizeable amount still, but less than half as scary.[10]

If your wages do not increase commensurately with inflation, that is of course another big problem with inflation, and with earning a fixed income in general.  Anticipating inflation in the future is an argument for seeking to move from fixed income compensation to equity compensation, as I wrote about in my segments On Entrepreneurship.  The lifestyle of folks on a purely fixed income, like seniors on unadjusted social security and fixed pensions, would get ravaged by high inflation, making an inflation hedge like home ownership that much more important.

Gold Monopoly Game

5. 4-to-1 Leverage – Purchasing your $200,000 home with a $40,000 down payment and a $160,000 mortgage offers you, in financial terms, 4-to-1 ‘leverage,’ also known as the ratio between equity and debt.  For the average middle class person engaged in investing, banks and brokerage companies provide very little leverage.[11]

In many ways zero leverage is appropriate for the average investor, as leverage exaggerates investment returns, both up and down.  A review of financial history shows that leverage has a way of periodically punishing investors, and small-time investors are the least prepared for the catastrophic consequences of a systemic credit crunch.

For middle class folks fortunate enough to weather a few decades of home equity gains amplified by leverage, however, small nest eggs become meaningful accumulations of wealth through the magic of 4-to-1 leverage.

Yes, it increases your risk and the volatility of outcomes, especially in the short run.  If you can sustain a longer holding period, however, the debt helps you accumulate wealth.  And if you can use the debt responsibly – an acknowledged big ‘if’ – you can continue to access this home-equity-based leverage for other investment purposes.

 

6. Local knowledge is useful – Few middle class people can effectively apply local or personal knowledge to investing in securities.  We are all at an extraordinary information disadvantage when purchasing stocks, and even bonds.  Hundreds to tens of thousands of the smartest people in the world are – right now – following the same stocks we might buy as individuals, making moot most individual stock-picking efforts to find unrecognized value.[12]

When buying a house as an investment, however, specific local information can make us ‘experts,’ to some degree, in what we buy.  This local, personal knowledge helps even the playing field in a way not generally available in other investment areas.

Any home buyer can investigate or intuit neighborhood trends, school quality, demographic shifts and hidden aesthetic potential in homes.  As home buyers we become long-term value-investors in a way totally unavailable to most people in other investment spheres.

Who knows more about your home and neighborhood – you or Warren Buffett?  That’s right, kiddo!  In that one investment comparison at least, you shine.  Congratulations.

7. Home Improvement – ‘Activist Investing’ – I have what I like to call a ‘purple thumb’ when it comes to physical labor around the house – like swinging a hammer.[13]  Home improvement is not really an opportunity for me, without risking my concert pianist or surgical sub-specialty career.  (I have grandiose plans for my life as an ex-banker.)

But for many, home maintenance and improvement allow us to physically enhance our investments.  We can personally work on a low-value or under-valued asset and make it more valuable.  I think this is great.

When activist hedge fund investors like Bill Ackman or Carl Icahn purchase shares in a target company and then agitate to make that company more valuable for shareholders, they’re acting like home improvement guys with a different set of tools.  Most of us can’t bring our toolbox to a company board meeting.  I appreciate that housing makes ‘activist investing’ available to the everyman,[14] or at least anyone who can swing a hammer.  Just not me and my purple thumb.

 

Taken in combination, these seven factors greatly stack the investment aspect of home ownership in your favor.  Of course anyone can lose money owning a home – like any true investment, it’s risky – but most of us can accumulate long-term, real wealth through long-term home ownership.

Please see previous posts

On Housing I – Necessity, Consumption, and Investment

On Housing II – The Risks



[1] Approximately 50% of American households carry a credit card balance from month to month.  The average household credit card debt – as of this writing – is $15,956.  That’s a lot, I think.  Just to make the $15,956 entirely relatable to everyone, I mean, you could think of that as the equivalent of  7,978 $2 Powerball tickets, or conversely you could think: that’s 12% of the cost of your new 2014 Maserati Quattroporte!  I’m making the safe assumption that everyone reading this will be buying the 2014 Quattroporte, right?  Or is that a little off-topic?

[2] The fine print.  You should read the following with that weird sped-up-and-impossible-to-understand-technically-disclosure-but-not-really-audible voice you hear at the end of car dealership ads or Viagra commercials: “Individuals can exempt $250K of capital gains on their primary residence, and couples up to $500K.  You must have lived in your home for 2 of the previous 5 years, although not necessarily continuously.  If you do not have 2 years of prior residency you can claim an ‘unforeseen event’ at your place of employment to still qualify for the capital gains tax exemption.  If all goes well you can keep rolling forward tax free capital gains through a series of personal residences throughout your lifetime.”  Phew!

[3] Unfair because it’s a regressive tax: The 40% of households that do not own houses in the United States and can’t take advantage of the tax break correlate highly with lower-income households, making this a tax break for middle and upper income folks only.  In addition, the tax advantage increases the larger your mortgage and the higher your income tax bracket, making it even more regressive.  If that objection to a regressive tax makes me a pinko commie, fine, call me a pinko commie.  I can take it.

[4] One of the ways you know it’s overvalued is how often you’ll hear people justify a larger home or even a second home with the ‘I need the mortgage interest tax exemption.’  No, you don’t.  This is so backwards it deserves its own post, but I’ll let goofy finance guru Dave Ramsey address the issue concisely in this YouTube audio post.

[5] I don’t expect Congress will take away the mortgage interest tax exemption, as is sometimes considered, as it’s too popular with middle class voters and certain key sectors of the Financial Infotainment Industrial Complex.  But I think they should.  Would somebody please remind me in a little while to write a fuller post on the problem with the mortgage interest tax exemption?  Thanks!

[6] They’re wrong, but I’ll address that directly another time.

[7] My managing editor (aka wife) reminds me that using ‘equity’ in this context is not intuitive for all readers, including her.  In this context ‘equity’ is shorthand finance-guy lingo for ‘risky investment you own that could go up or down in value over time.’

[8] Traditionally thought of as real estate, and commodities like precious & industrial metals, or energy sources including oil & gas leases, and more recently expanded to include investments like timber rights, art, and collectibles.

[9] Again, managing editor (reader, I married her) reminds me to define my finance-guy lingo.  “Nominal” here refers to the idea that as the numbers get bigger due to inflation, they don’t indicate any increase in ‘Real’ terms of value.  If the price of everything in the world adjusts upward immediately by 10% in “Nominal” terms, nothing has actually become more valuable in “Real” terms.  Whenever the topic of inflation comes up, we have to start to quickly make “Nominal” and “Real” distinctions when talking about price and value.  I hope that helps.

[10] I’ve assumed for the sake of consistent comparisons the scenario of a 30-year, fixed rate, 6% mortgage of $160,000.  One variation of course is floating rate mortgages, in which monthly payments would rise due to higher interest rates.  The amortization of principal after 10 years would be roughly equivalent however, making the comparison still valid.  It really doesn’t change the fact that your future principal balance will be ‘half as costly’ in real dollar terms under that inflationary scenario.

[11] Since the reforms that followed The Crash of 1929, by law individual investors generally can only access a loan equal to 50% of their investment equity through their brokerage company.  This 0.5-to-1 leverage for stocks hardly compares to the 4-to-1 leverage of home ownership.

[12] I know this should go without saying but I can’t help myself:  Please remember that when prominent Financial Infotainment Industrial Complex clowns on CNBC pretend they have some deep insight and urge you to “buy it now” while honking an air horn and ringing a cowbell, it means that the professionals who do this for a living bought that stock long ago and are waiting to sell it to you.  Watching Jim Cramer does not give you an ‘edge’ when it comes to stock picking.  We should now collectively take a pause to weep bitter tears at everything this man represents.

 

[13] Once again, my managing editor intrudes: She would like Bankers Anonymous readers to know that when shit needs to get done around the house, she’s the one who owns the toolbox.  Fine, I will admit she is rather handy.

[14] Managing editor: “or everywoman.”  Gah!  Will you stop it please?

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