Home Ownership: Retirement Nest Egg?

January 15th, 2010

For years, conventional wisdom – no, let’s call it conventional thinking – held that owning your own home was the best investment you could make. As it happens, that belief was partly based on misunderstanding.

Now the market for residential real estate is in shambles throughout large sections of the country. Commercial real estate is not much better off. We are continually assured that prosperity is just around the corner, but every time we reach the corner we find that the data on prices or new construction have worsened. This must mean that home ownership is a lousy investment for retirement and the last thing anybody should consider is buying a house, right?

No, just the opposite.

Home Ownership as an Investment

We’re used to treating investment as a monetary purchase and viewing the return in money terms. In fact, the economic meaning of investment is an increase in productive capability through the creation of a capital good. The return on investment is the value of the productivity increase as a percentage of the investment cost. A house is a capital good because it provides a flow of such future services as shelter. Part of the return on investment is the subjective value or pleasure people receive from those services.

Compare home ownership to running a business. When a business buys a machine that improves its productivity, the value of the business rises. This makes sense because the business will earn more money in the future. The business’s return on investment can be divided into two parts – the increased profit resulting from the higher output it produces and the increase in the firm’s value. The increased profits are paid out to shareholders or reinvested in the firm. The increase in firm value is kept by the owners until they sell their shares.

Similarly, the home buyer’s annual return on investment has two parts. One part is the home’s increase in value from year to year. The other part of the rate of return is the subjective value derived from the services provided by the home; this is analogous to the business’s increase in current profits. The category called “imputed rental value of owner-occupied housing” in the national income accounts is economists’ attempt to put a money value on this subjective component.

Why the Conventional Thinking Is Wrong

The problem with the long-stated view that home ownership is the best investment is the way it is stated. The implication is that the house’s value should go up by more than the value of alternative investments. This is wrong. There is no reason to expect, for example, that home prices should go up by more than the rate of return on stocks or mutual funds. The equity rate of return includes both components noted above – current profit for the year concluded and the increase in the stock price over the year. The home’s value is only one component in its rate of return. Unfortunately, its use value – the value derived by its owners from using it over the course of the year – can’t be looked up in the newspaper or the Wall Street Journal the way a company dividend can. Rather than asking every household in America to express the satisfaction they get from using their house in monetary terms, the statisticians use the average rent paid for houses of equivalent size as a proxy.

What’s the Point?

If you think that a discussion of the true rate of return on home ownership is too esoteric to have any practical value, think again. Many is the married couple who become disgusted by the sluggish appreciation of their home’s value and then proceed to make wrong decisions based on an underestimation of its true value.

More specifically, this is an excellent time to ponder the value of home ownership as an asset in retirement. We’re used to listing the various financial assets associated with retirement – retirement plans like 401(k)s and IRAs, Social Security benefits, pensions, personal savings accounts and annuities – but real assets like a home often get lost in the shuffle. Even when they are included, it is seldom recognized that their rate of return can be evaluated, too.

Home Ownership as a Retirement Nest Egg

In retirement, you’re not working and not earning full-time income, so your assets have to provide the income you need to live. Once you realize that a home “throws off” income in the form of its services, you see its pertinence to the retirement planning process. Another way of looking at the situation is to consider the alternative to home ownership. You have to live somewhere; if you didn’t own a home, you’d rent. In other words, even when your home’s value doesn’t increase, you’re gaining by avoiding the cost of renting.

The four criteria by which we evaluate investments are growth, income, safety and liquidity. Home ownership rates quite well on three of these and only a little below par on the fourth. As we have seen, a home provides income just as surely as a bond or annuity does. While we’re in the midst of a rare catastrophic decline in home prices, the long-term trend of homes is upward. The underlying value of real estate must rise in the long run because its supply is severely limited. Thus, the level of safety is high in spite of today’s appearances. A retirement asset that can provide growth alongside income and security is highly valuable. The only sticking point is liquidity. Unlike money, a home is not divisible, so it can’t be sold in pieces. Sometimes a sale can take quite a while. These problems can be ameliorated by home-equity and reverse-mortgage loans, although those instruments carry their own problems and drawbacks.

All in all, considering that home ownership fulfills a vital need, it is a tremendous asset to retirement.

And Now?

Today’s circumstances are a once-in-a-lifetime combination of disaster and opportunity for home ownership. At first glance, the artificially-low interest rates might seem to represent a golden chance to purchase a home at a low interest rate. Aside from the fact that loans are harder to get and credit criteria have been tightened, there is widespread fear of taking on debt. This is probably well-founded.

However, nobody could argue with the idea of paying off an existing mortgage as quickly as possible. The avoided mortgage cost is almost certainly higher than current rates of return on alternative investments. A recession is the best time to get out from under debt. And securing ownership of the home going into retirement is apt to be one of the wisest planning moves you make.

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