Dumping Stocks for Land? That May Be a Big Mistake
From the 31 July WSJ>
If you want mediocre investment results, sometimes there's no place like home.
No, I am not going to argue there is a bubble in housing prices. My contention: Even if property prices behave themselves, returns are likely to be lackluster for the folks who are dumping stocks and snapping up real estate instead.
For proof, consider three of today's favorite real-estate strategies.
Doubling Down: Thinking of moving money out of stocks and into a vacation home? Take a moment to ponder a few numbers.
For the past 27 years, home prices have outpaced inflation by just one percentage point a year. But that doesn't mean real estate is a lousy investment. After all, homes provide shelter. How valuable is that? When you rent out a house, you might collect annual rent equal to 8% of a home's value.
That's a pretty nice return on your money -- if you receive the rent in cash. The problem is, people often end up using their vacation homes themselves. They are still getting value out of the property, but this value isn't of the cash variety.
To be sure, these folks could still score decent gains, thanks to the leverage involved. If you put down $20,000 on a $200,000 house and the price climbs 10% to $220,000, your home equity doubles to $40,000. But be warned: Leverage can cut both ways. Indeed, it would take a drop of just 10% to wipe out your $20,000 down payment.
Karl Case, an economics professor at Wellesley College in Massachusetts, doesn't think real-estate prices are about to collapse. Nonetheless, he cautions that "buying a large, leveraged asset at a time of uncertainty is not without risk. You wouldn't go into the stock market and leverage your money 10 times."
Still tempted to buy a second home? Pick your property carefully. "If you're going to invest in vacation homes, you want to invest where the supply is relatively fixed," says Chris Mayer, a real-estate professor at the University of Pennsylvania's Wharton School in Philadelphia. "You don't want to invest in an area where it's easy to put up cookie-cutter condominiums."
In other words, it may make sense to purchase a vacation home in a well-established seaside town. But you probably wouldn't want to buy a house next to a ski resort where there's plenty of room to build new homes.
Landing a Big One: Instead of buying a second place, you could stick with a single residence, but use your stock-market money to trade up to a bigger home.
A good idea? That depends partly on what happens to real-estate prices. If you sell your $200,000 home and buy a $400,000 house, you will clearly rack up bigger dollar gains if home prices continue to climb. Let's say real-estate prices jump 20%. A $200,000 home will rise to $240,000, but a $400,000 house will balloon to $480,000.
But there is a cost to all this. Home prices could turn against you. You will also have to fork over more in mortgage interest, maintenance costs and property taxes. For instance, annual maintenance costs might come to 2% of your home's value. That would mean a manageable $4,000 a year on your old $200,000 house, but a much stiffer $8,000 for your new $400,000 home.
In addition, if you trade up, there's the cost of selling your current home and buying the bigger one. "The roundtrip cost, including moving costs, mortgage-application costs and brokers' fees, is upwards of 10%" of your old home's value, Prof. Mayer says.
If you really enjoy the larger house, all this is worthwhile. But if you are trading up simply because you think it is a good investment, you are likely making a big mistake.
Why? Remember, for homeowners, the biggest gain comes not from home-price appreciation, but from the rent they avoid paying. If you live in a house that's bigger than you really need or want, it's like paying an unnecessarily large amount of rent.
Similar logic holds for home improvements. By all means expand or renovate your house, if you will get pleasure commensurate with the dollars spent. But don't kid yourself that you are making an investment. When you sell your home, you are unlikely to recoup the full cost of your home improvements.
Repaying the Piper: Don't want the hassle of a bigger house or a second home? You could follow the lead of other disillusioned stock investors and use your savings to make extra-principal payments on your mortgage.
Reducing mortgage debt can be a smart strategy. But don't think of it as an investment in real estate. If you own a $200,000 house, you have $200,000 in real-estate exposure, no matter what the size of your mortgage.
Instead, paying down a mortgage is really akin to buying bonds, but with a subtle difference. You don't earn interest. Instead, when you make an extra-principal payment, what you do is reduce the amount of interest you have to pay.
Suppose your mortgage rate is 7%. That is the interest cost you avoid by making extra-principal payments, and thus that's your pretax rate of return. Seem like a healthy gain? Over the long haul, you will likely fare better by funding almost any sort of retirement account or by buying stocks in a taxable account.
But what if the alternative is to purchase, say, government bonds or certificates of deposit in a taxable account? In that case, you should clock a higher rate of return by paying down your mortgage.
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