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Should We Rent Instead?

Should We Rent Instead?

April 08, 2021

Robert Shiller is an economist at Yale University and is regarded as a leading expert on housing. His analysis concludes that real estate generally keeps pace with inflation but seldom offers any return above1. Returns look even less appealing after accounting for repairs, maintenance, transaction fees, annual property taxes, insurance, and other hidden costs.

The obvious question is why the returns from home ownership have been so shockingly poor. The answer becomes apparent when comparing the characteristics of an asset to an investment.

The difference between the two is that an asset is a store of value, while an investment also has the potential to generate value over time. Precious metals, art, collectibles, fancy wines, and cars are all examples of a store of value. An asset’s value changes over time solely from the demand to own it and the supply available.

For instance, a piece of art hanging on a wall does no more or less than silver coins sitting in a safe. If society over time views the painting to be worth more than it was in the past, then the owner may be able to sell it for a profit.

An investment is more than a store of value because its intended purpose is to generate a return in the form of either income or quantifiable growth. Bonds are investments because they pay income, and stocks are investments because companies that grow tend to see earnings rise. Those earnings can then be reinvested back into the business or paid out in the form of dividends or share buybacks.

Here’s why some assets should never be classified as investments. The chart below compares the performance of the Wilshire 5000 Total Market Full Cap Index (purple line), which is an equity index comprised of most publicly traded stocks in the U.S., to the spot price for gold (gold line).

All it takes is a quick glance to accuse gold of being a terrible investment when compared to the broader stock market. However, it’s an unfair comparison because this shiny pet rock suffers from the same limitations as a home.

Gold generates no income, requires expensive storage and insurance costs, cannot compound over time, etc. Since gold does not possess the characteristics of a real investment, it should not be expected to perform like one.

Similarly, homes do not create and sell innovative products or buy rivals to grow market share. They also rarely generate cash flow, and when they do, the cash received from renting that spare bedroom rarely pays the mortgage. Hence, it is equally inappropriate to classify homes with stocks, bonds, and other investments.

Only a select few real estate examples possess the required attributes. Landlords generating monthly rental income above their costs, and restoration experts that repair properties and sell them for a profit can certainly claim to own investments. The rest are just assets. 

The Bottom Line

There is an old saying that where there’s thunder there’s lightning, but the opposite is not always the case. Just because lightning rips across the sky does not guarantee thunder is right behind.

The same applies to assets and investments. Investments can be classified as assets, but not all assets are investments. Investors can get themselves into trouble when they are unable to distinguish between the two, and admittedly, it’s not always easy.

There is also a compelling case to own both assets and investments together. For example, after years of renting, my wife and I finally purchased our very first apartment back in 2015. Given the data above, it’s justifiable to ask why we would want to lock up capital in a 

down payment, spend cash periodically for maintenance, and waste weekends on tasks that I truly despise, only to achieve a rate of return that may not exceed inflation.

The answer lies in what we hope to gain through home ownership. Assets often carry “intangible” value that cannot be seen, touched, or quantified. Within this context, we made the largest purchase of our lives for reasons that had nothing to do with investing. We wanted to pick our own paint colors, customize a kitchen to suit our needs, and take a few years off from moving (few tortures in this known universe are more painful than moving between apartments in New York City).

There’s no question that there was an economic component to our decision to buy. We certainly hope to earn a profit, and home ownership provides us a number of financial advantages. For example, we can write off the mortgage interest and avoid annual rent hikes in a city where prices seem to rise every fifteen minutes.

We also were very careful to buy an apartment in a neighborhood that has historically maintained is value. Leverage works both ways, so we did not want to put ourselves in a situation that would pose an outsized risk to our down payment.

However, since our apartment is not part of our investment portfolio, we maintain realistic expectations that it will not be a major contributor to a safe and comfortable retirement years down the road.

The bottom line is that a home is an asset and likely a great place to create memories while raising a family, but it should not be treated as an investment.


Sources

1 Robert Shiller, Irrational Exuberance: https://www.amazon.com/Irrational-Exuberance-Revised-Expanded-Third/dp/0691173125/


Disclosures

This material has been prepared for informational purposes only and should not be construed as a solicitation to effect, or attempt to effect, either transactions in securities or the rendering of personalized investment advice. This material is not intended to provide, and should not be relied on for tax, legal, investment, accounting, or other financial advice. You should consult your own tax, legal, financial, and accounting advisors before engaging in any transaction. Asset allocation and diversification do not guarantee a profit or protect against a loss. All references to potential future developments or outcomes are strictly the views and opinions of Richard W. Paul & Associates and in no way promise, guarantee, or seek to predict with any certainty what may or may not occur in various economies and investment markets. Past performance is not necessarily indicative of future performance.