Economic Review of Home Ownership

I have always had in interest in how things work and why certain recommendations are made. I recently got curious about the profitability of home ownership and resell value, so I undertook some research to ascertain what the research community had to say on the subject.

First, it is very hard to get economic information on a local level; most of the information that is compiled looks at national trends and large regional differences. Second, access to information is quite limited; the research articles are not accessible to the general public and I had to rely on my University credentials to gain access to the information. This poses a barrier to information for interested consumers to make fully informed decisions. Third, the research has a hard time controlling for all the variables and assessing the full picture. In an effort to provide a full picture of home ownership as a driver of wealth I will rely on the information gleaned from several articles in an attempt to clarify the boundaries of wealth building.

I suppose many of us have been told that home ownership is the path to wealth and that we should buy a house as soon as possible. The rationale given is that your monthly payments go toward decreasing the principal owned on the house and thus constitute equity. The second aspect of home ownership is that land appreciates over time and when you sell you will not only receive the equity you have paid into the house, but also the difference in cost from the selling price to the purchase price. In this way you will have acquired 'wealth'.

What has always struck me about this is the cost of ownership. When you purchase a house you have additional costs that you have to consider above the cost of renting. These costs include insurance, mortgage insurance, interest, taxes, home improvements and equipment or appliances. While you can deduct interest and taxes on your income taxes the other payments need to be rolled into the total cost of ownership when considering home ownership as a wealth builder. When you go to sell your home, these incremental costs need to added to the initial purchase price along with the closing and realtor fees in order to truly determine if home ownership is a profitable endeavor.

When deciding to purchase a home, think with the end in mind: how desirable will your house be when you decide to sell? There are two types of home buyers; consumers and investors. Consumers buy a home in as desirable a neighborhood as they can afford without considering ownership implications and resell value. Investors, on the other hand, view home ownership as a means to an end and buy ever increasing houses over a period of time to ultimately end up in a highly desirable neighborhood. As they buy and sell they look to buy in areas that will appreciate over time to maximize their resell value, whereas consumers purchase homes that they want to live in without considering resale value. Those that follow an investor mind set build more wealth and see more money at resale over consumers. The main risk is predicting what will be a desirable neighborhood when the home goes up for resale. The desirability of a location is what drives the underlying appreciation of the housing asset.

For homeowners that buy a house and subsequently undertake remodeling projects to increase home value, they also need to be wary of what projects they choose to do. The idea that a remodel will increase home value above the cost of the remodel is not a guarantee. If the remodel is not in line with other houses in the community then the value will not be realized. For example, if no other house in the neighborhood granite counter tops then putting in granite may not make sense for that particular market. Once again, think with the end in mind. If a remodel is meant to improve your experience in your house then by all means do it to maximize your enjoyment, but go into it knowing that it might not increase your home value. When you go to resell it is important to determine what your remodel recoup ratio is to determine profitability: the cost of remodels added to the purchase price compared to the sale price. Achieving a ratio of 1 (100% return) is very unlikely. As with all things, there are external factors that determine this ratio, what is the cost of construction (materials and labor), what is the cost of new housing and what is the market doing. Remodeling can provide a return close to, or above 1, if the cost of construction is low and the market is strong at resell. Those two factors allow a housing remodel to achieve profitability.

So far we have seen that it is possible to earn a profit at resell, but it is not a guarantee, so the other question is how does home ownership compare to renting and investing as a means of wealth creation? One study compared these over  series of 30 years from 1970-1999 in 10 year increments. The author compared home ownership appreciation (sales price minus purchase price) to renting and investing the difference in cost of home ownership to renting into a stock and bond portfolio. After 10 years, the house was sold and the portfolio was sold and the incremental value was compared to each other. For 1/3 of the time, home ownership was preferable to renting and investing for wealth, 1/3 of the time renting and investing was preferable to home ownership and 1/3 of the time it was impossible to tell. The identified factors that led to wealth were as follows: market timing of home purchase and resale (buy low sell high) and interest rates. If a home buyer was lucky to buy a home when the market was low and sell when the market was high they would achieve greater profitability. If they bought when the market was up then this limited profitability. There are a couple of limitations that need to be addressed though: 1. The resell value only looked at resell to purchase and did not consider remodeling costs 2. the stock and bond portfolio was not specified, so the asset allocation was unknown. 3. The assets were sold after 10 years thus limiting continued compounding earning potential that is proven to be a builder of wealth.

Our final article looked at home ownership as a builder of wealth, specific to minorities. Once again, the results are mixed: home ownership was preferable since it provided a forced savings mechanism both in saving for a down payment and in the monthly pay down of principal. Ownership wealth is also dependent on the resale value which is dependent on location and market cycles. In order to modify the risk of market fluctuations, time lived in the home is a factor. Length of time will flatten the risk profile, with 8 years being the cutoff time to both pay equity and build wealth. Once again, total wealth is dependent on market conditions at time of resale.  Wealth is only realized if ownership is maintained, those that lose their house, lose their wealth. On the other hand, for renters to achieve wealth they must invest money into an investment account. Failure to invest provides no opportunity for wealth.

Conclusions:

• If you choose to purchase a home, look at it as an investment and make a decision with the future resale in mind. Highly desirable areas provide greater appreciation and wealth, but this is also a risk, predicting future desirability is not an easy task.
• Wealth via home ownership is somewhat a matter of luck in that you maximize wealth if the home is purchased when the market is down and sold when the area is desirable and the market is high. This risk is somewhat modified by length of time in the home prior to resale, preferably 8 years or more.
• The method of wealth for home ownership is made by saving for a down payment and then building equity over time prior to resell.
• It is possible to achieve wealth with renting, but money must be invested into the stock market. Failure to do this provides no chance for wealth creation.
• Undertaking remodeling projects to boost resale value is uncertain and is dependent upon the cost of construction and market forces including local comparable houses and the appreciation of the local market in general.

Overall, it appears that to a certain extent, luck is involved when looking to build wealth with a home, you are dependent on the market conditions at both purchase and resale, as well as the borrowing environment as a whole. In order to truly create wealth and earn a profit with a home sale a full cost of ownership picture needs to be considered that adds the incremental cost of ownership to the purchase price, remodeling costs, maintenance and closing costs. It is also advised to invest money for both home owners and renters to take advantage of wealth accumulation over time. To the old real estate caveat location, location, location needs to be added market timing, market timing, market timing. Only an ideal combination of location with low purchase price and high sale price leads to wealth maximization via home ownership.

The water is a bit murky when it comes to home ownership and resale as a sure thing. The best we can do is to make wise decisions based on all the available information and to incrementally invest money.

It may be that we need to rethink home ownership as a profit building mechanism and change our view to one of a savings account. In this light, we can change our thought processes from home ownership being a way to build wealth and look at it as a way to build up a cash cushion that is realized at resale, regardless of how profitable the endeavor was.

References:
Choi, H., Hong, H., & Scheinkman, J. (2014). Speculating on home improvements. Journal of Financial Economics, 111. 609-624.
Haavio, M., & Kauppi, H. (2013). Buying a home with a resale value: Location, location, location. Scandinavian Journal of Economics, 115(4). 1046-1083.
Herbert, C., McCune, D., & Sanchez-Moyano, R. (2013). Is homeownership still an effective means of building wealth for low-income and minority households? Joint Center for Housing Studies, Homeownership built to last: Lessons from the housing crisis on sustaining homeownership for low-income and minority families-a national symposium, September 2013.
Rappaport, J. (2010). The effectiveness of homeownership in building household wealth. Economic Review, Fourth quarter 2010. 35-65.

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