For many households the purchase of a home is the single largest investment
One rarely considers the amazing family barbeques in the backyard when buying shares in a company. However, these visions and other comforting experiences are often intertwined in the decision making process when purchasing a home. Beyond the emotional blind spots that one needs to factor when evaluating a purchase, is the fact that for many households the purchase of a home is the single largest investment.
While the rise in house prices over the last decade has garnered a lot of media attention, the risk profile of the investment is not as well understood. The investment risks embedded in owning real estate were well documented in a recent research paper published by Morningstar titled “The Home as a Risky Asset”. The authors outline three key aspects associated with owning a home that we believe are not well understood by the general population.
Three risks associated with owning a home
First, there are considerable risks associated with the fact the houses are illiquid assets, and require buyers to bear a high level of financial mortgage debt.
Secondly, there are significant transaction and maintenance costs that must be considered when evaluating a purchase. These costs, often lost in the assessment process, include insurance, property taxes, professional services and realtor commissions. The authors analyzed house prices index data from the U.S, Europe and Asia and concluded that the real returns, (after inflation) realized on house prices have likely been negative after considering all the costs of owning and selling a home.
Lastly, the authors identified select factors within the U.S housing market that have either generated stronger returns or less volatile returns. The key factors that led to higher returns were homes located in high-priced neighbourhoods, with warmer temperatures and a diverse racial population. In contrast houses in neighbourhoods with low housing turnover and with well- educated owners in the workforce experienced less volatile returns.
Proceed with caution if there are plans to sell within a few years
Ultimately the decision to purchase a home is unique compared to those considered when investing in stocks or bonds. That is because a home provides shelter and a number of other intangible benefits associated to your family life. However, we would caution against the temptation to make an investment in a home if there are plans to sell within a few years, due to high transaction costs and the illiquid nature of the asset. Also, it pays to do your homework to ensure the factors that have supported stronger house prices are reflected in your home in order to make for a pleasant and profitable investment.