Your home is most probably your most valuable asset – outstripping the value of your ISA savings and most people’s pension portfolios. But the risks of investing in real estate are generally poorly understood.
There are significant homeownership risks driven largely by the illiquid nature of owning a single home. The risk of homeownership in the US is approximately double that of house price index investing such as the S&P Case-Shiller Home Price Indices, with an annual standard deviation of 12%, which is approximately equivalent to the historical volatility of a portfolio invested in 60% stocks and 40% government bonds.
While the return on house price indexes has exceeded inflation historically, the actual real return realised by homeowners, after considering the various costs associated owning and selling a home, has likely been negative in real terms.
Renting is often a better option for many households, especially those households with lower incomes and shorter expected periods of time in each property. Home price, county unemployment rate, housing turnover, home size, and even average annual temperature, differ by region and are strongly related to the returns, volatility and market risk of homeownership.
Many households may use this factor information to better approximate the risk of their homes. Overall, the impact of owning a home is likely to vary significantly by household, based on the unique risks associated with the home, household wealth, and other non-financial household assets.
The Home as a Risky Asset
The total value of global real estate is approximately $217 trillion, according to London-based real estate services provider Savills. This is more than the value of other common financial assets, such as equities at around $62 trillion or bonds at around $122 trillion, combined.
Residential real estate – a home – is a unique asset for households since it is both an investment and consumption good. A home is an investment good such that it allows the household to accumulate equity over the duration of homeownership, and it is a consumption good since it provides shelter. When assessing the value of homeownership, it is important to understand both aspects. We should consider both the risks associated with owning a home and the best financial option to provide shelter such as buying versus renting.
Unlike stock portfolios, which can easily be diversified through the purchase of other stocks or some type of collective investment vehicle such as a fund or ETF, a homeowner is subject to significant idiosyncratic risk that cannot be easily diversified away. While a homeowner can insure against types of risk, such as fire or theft, most location-specific risk is virtually impossible to hedge away given the relatively illiquid market of homes today.
The Value of Homeownership
The income stream that owners could save from buying a home instead of renting is commonly termed “imputed rent.” Despite the potential benefits of renting, homeownership is generally encouraged versus renting by national governments. The main economic argument for subsidising homeownership is that ownership may give rise to positive spill-overs for society, such as wealth accumulation, better outcomes for children, community engagement, etc., although the evidence of these benefits is mixed.
Countries use a variety of methods to encourage homeownership, such as tax policies; allowing the deduction of mortgage interest costs is common, and interventions in the financial markets such as a government guarantee in the housing finance market.
There are pronounced differences in homeownership across different countries, peaking in Romania at 96.6% and bottoming at 43.8% in Switzerland. At 64%, the U.S. homeownership rate is relatively low compared to other developed nations. Most countries in the OECD have seen an increase in homeownership over the past few decades, although the underlying factors driving the changes vary.
Household characteristics and ageing – since older people are more likely to be homeowners, explain a significant amount of changes.
Most individuals who purchase a home typically use a mortgage, since relatively few homeowners have the necessary savings to purchase the home outright. Mortgage features also vary significantly by region, with government interventions often playing a significant role. While fixed rates on mortgages are most common, there are some countries such as the UK that have predominately floating-rate mortgages. Mortgage terms vary from as low as 10 years in the Netherlands to 30 years in the U.S. and Denmark
Most countries require some type of down payment, typically in the range of 5%-30% of the value of the home. Additionally, while there is generally no penalty for early repayment a mortgage in the U.S., the lenders in some countries such as in Germany, the UK and Japan may be entitled to compensation for lost income.
No Portfolio is an Island: The Impact of the Home
When building portfolios, investment professionals and financial planners often focus entirely on the available set of investible assets for the financial portfolio, such as stocks and bonds. In reality, the financial assets are only one of many assets owned by the client, and considering the risks of the other assets can be an essential aspect to building truly efficient portfolios when viewed from a total wealth perspective.
When thinking about the impact of the home on a portfolio, the first decision is whether to purchase a home at all. Our analysis suggests many households are likely better off renting, especially those who are likely to be in the home for less than six years and those on lower incomes.
However, to realise the potential benefit of renting, the household must be disciplined and be willing to save the difference between renting and owning. It is worth noting that while the other potential benefits associated with owning a home may outweigh the investment considerations it is important be aware of the additional potential costs associated with purchasing a home so that the household can plan accordingly.
If an individual decides to purchase a home, the key risk to consider is the idiosyncratic risk associated with that home. The risks associated with owning a single home are very different than those for a diversified portfolio of homes such as residential or commercial property fund. While many people consider houses to be a safe investment, the historical volatility of individual homes has been approximately double that of city-specific home price indexes. This level of volatility has historically been associated with a portfolio that is 60% stocks and 40% government bonds. Therefore, a home is hardly a risk-free asset.
