It’s the season of holiday cheer and goodwill toward man. Forgive us for being a grinch, but it’s also time to burst the bubble surrounding everyone’s favorite investment myth.
People like to think their home, and residential real estate in general, is the best investment out there. While owning a home is usually a good investment, it may not be the best investment.
A myth that deserves to be debunked
How many times have people said to me that “real estate is the best investment out there” and “they’ve made much more money in their home or other real estate than in the stock market.”
I live in South Florida, so usually that pronouncement is followed by another, namely that “you can’t lose money in real estate in South Florida” and “the price of real estate will keep going up because they just can’t make more land.”
Ouch! Assumptions like that are misguided and can get you into investment trouble. Here’s why:
Which is the better investment? Stocks or homes?
Homes in general have been good investments. But as much as home prices have climbed, that growth has been eclipsed by the explosive returns on stocks.
Financial reporter Daniel de Visé in USA Today recently reviewed the main pros and cons of home ownership, including decades of data comparing home price appreciation (about 5.5% per year) with annual returns of the S&P 500 (averaging 10.4% per year). Not even close, folks.
Fuzzy math can make ‘real’ real estate returns harder to calculate
In addition, people’s perception of returns (e.g. how much money they have made) is often clouded by bad math. Owning a home involves recurring expenses, everything from mortgage interest payments, to HOA expenses, real estate taxes, periodic renovations, and lawn mowing and other maintenance. Those expenses help pay for a nice place for you to live, but may make your home a more expensive investment than you realize.
Diversification is usually the best approach
Of course, the best answer to the question of whether to own a home or stocks is that most people will want to own both. Stocks are an investment. A home is a place to live. A home is not intended to make money. It’s intended to give you a comfortable place to sleep, eat, raise your family, and keep warm. If it does go up in value, and helps you capture valuable tax benefits, more the better.
As with other investments, real estate cycles can work for you, or against you
Sometimes you’re lucky and home prices rise, especially if you own your home over a long period of time, but that’s not always the case (just ask those unlucky real estate investors who watched prices fall over 25% between 2007 and 2011).
Home prices are cyclical, just like stocks. Sometimes they rise, but other times they drop and you can lose money. The wisest course of action is to diversify your investments and have some of your net worth invested in stocks, bonds and other securities, and some invested in real estate, starting with your own home.
While we are on the subject, just how much of your net worth is in real estate?
One final note. When you are pulling together your Net Worth Statement (something you should do at least annually), you may find it helpful to calculate what percentage of your Net Worth is in real estate and what percentage stems from stocks, bonds and other securities. There’s no ‘right’ answer here, but having too much invested in real estate can be a red flag. Real estate tends to be highly illiquid (difficult or impossible to sell rapidly without making concessions on price). It is often leveraged with the use of borrowed money, and involves the ongoing commitment of new funds to cover expenses.
Bottom line: while owning a home or other real estate can be a valuable diversifier in your portfolio, it’s best to keep things in balance and not overdo it.