as a Portfolio Asset: A Life-Cycle Analysis
Bobby E. Waldrup, Seth C. Anderson, Sid Rosenberg,
2005 - In earlier decades, many individuals lived in more
modest homes and frequently stayed in these homes their entire
lives. With greater mobility and increased home ownership,
as well as increased access to financing alternatives, the
wealth consumed or created by personal housing decisions has
become more significant. Owners often view their homes as
a separate asset class apart from more conventional investment
vehicles such as stocks and bonds.
and Vincent Shea
debate surrounds the question of whether a home should be
considered a component of one’s investment portfolio.
Some argue that a home is frequently someone’s most
important investment because it provides healthy returns
via leverage, appreciation, tax deductibility of interest,
and an absence of capital gains upon sale. University of
Pennsylvania Professor Chris Mayer points out that one can
expect the equivalent of 10%–12% pretax return over
a typical seven- to 10-year timeframe. He attributes this
to 3%–5% in capital appreciation and the fact that
a homeowner does not have to pay rent.
however, contend that homes are a consumption item and may
not turn out to be a good investment. For example, New York
City financial planner Gary Schatsky argues that, unlike
other assets, selling the home to realize a profit is untenable,
and that homes in general are illiquid assets. Some planners
claim that home values can give people a false sense of
security and cause them to neglect sound financial-planning
strategies. Hence, many planners exclude one’s home
when calculating net worth.
Bonds, and Housing: Returns and Relationships
the 34-year period ending in 2002, the authors computed
the annual returns and return standard deviation for the
Standard & Poor’s 500 Index benchmark and found
annual returns to be 11%, with a standard deviation of 16%
1). For 10-year Treasury bonds, they found an annual
return of 8.2%, with a standard deviation of 7.8%. For
housing, they used existing single-family home prices over
the 34-year period and found an annual return of 6.3%, with
a standard deviation of 3.5%. (The authors acknowledge that
the use of repeat sales measures might more accurately reflect
an individual home’s appreciation rate, but chose
a broader index of price changes that reflects the national
upward trend as a more generic statistic.)
these asset classes have different mean returns and standard
deviations, a coefficient of variation (standard deviation
divided by mean return) was employed to compare riskiness
per unit of return among the asset classes. Exhibit
2 indicates that stock returns display a higher variability
per unit of return than do bonds or single-family home prices.
Perhaps as important, single-family homes have displayed
remarkable consistency in return variability over the last
diversification benefits of combining these asset classes
in a portfolio are a function of their return correlations.
Year-to-year returns for single-family homes display little
correlation with the returns of either stocks or bonds over
the 34-year period (–0.18 and –0.16, respectively).
Returns in single-family homes actually appear to track
changes in the inflation rate more closely than they track
the S&P 500 returns.
following sections use these historical relationships to
illustrate the impact of housing decisions at key points
in the life cycle. The three junctures are:
The decision to purchase a first home;
The decision to trade up in price; and
Decisions related to retirement.
Adults: Renting Versus Buying
a young couple, the Smiths, that are 30 years from retirement,
with an income resulting in a 33% combined marginal tax
bracket. This couple currently has a portfolio comprising
$15,700 in stocks and $15,700 in cash, with a current monthly
rent expense of $1,469 [estimated as an average PITI (principal,
interest, taxes, and insurance) and maintenance expenses
of a median-priced home]. The Smiths are considering purchasing
a median-priced home for $157,400 and financing it with
a 6% mortgage. (All examples assume a 6% mortgage rate,
3% inflation rate, and 4% carrying costs for a house.)
Smiths’ financial options are as follows: 1) to continue
renting (assuming a 3% inflation rate) and invest the entire
$31,400 in an S&P 500 index fund, or 2) to use the available
cash of $15,700 to initiate a home purchase and leave the
remaining $15,700 in stocks.
3 shows that the Smiths’ cumulative wealth impact
will be higher ($615,323 versus $27,034) over a 30-year
period under the home-purchase scenario. The wealth impact
assumes a 4% annual cost for taxes, insurance, and maintenance,
all of which grow at 3% annually. The
wealth impact can be attributed to several factors:
By purchasing a home, the Smiths have effectively frozen
their “consumable” cost of housing, thereby
stabilizing their payment stream to no longer increase
with inflation, in contrast to rental payments.
The Smiths’ investment in housing enjoys partial
tax deductibility throughout the period and some exemption
from capital gains at the end of the investment.
Although not explicitly illustrated, by reducing the overall
coefficient of variation of their wealth portfolio, the
Smiths may now be more willing to take greater risks in
their stock portfolio in order to achieve a greater long-term
Family: Status Quo Versus Moving Up
are three primary housing price subclasses: below-median
homes, median homes, and above-median homes. Exhibit
4 shows that while the average home price rose 2.45%
in 2002, median homes were projected to increase in price
by 2.33%, versus an increase of only 1.30% for high-priced
homes. The higher-priced homes were anticipated to increase
at roughly one half the rate of median-priced homes. The
Smiths’ choices and the ultimate importance of home
price changes can be considered accordingly.
the Smiths are midcareer professionals, in the 33% combined
marginal tax bracket. Their median-priced home, purchased
13 years ago, is currently valued at $157,400. They are
considering the financial implications of moving up to a
$315,000 house that would result in mortgage financing $238,083,
after subtracting an 8% selling cost and a down payment
of their accumulated equity, or continuing to live in their
present house. Under either scenario, the couple wishes
to pay off the house by age 62, their planned retirement
5 appears to show that their relocating would result
in a cumulative net wealth impact of $212,384, versus an
impact of $692,913 if they do not move. For the sake of
conservatism, assume that they invest the differences between
the two homes’ after-tax cash outflows in Treasury
bills. If the Smiths had employed any inflation-beating
alternate investment of this $480,304 difference, the gap
in wealth effect would widen substantially.
comparison assumes that the price appreciation rate of the
high-priced home equals that of a median-priced one. It
may be more appropriate to consider the impact of lower
price increases for more expensive homes (Exhibit
6). At a 5% rather than a 6% return, the wealth impact
of the high-price home falls to $91,130. When the rate of
price increase declines to 3%, the high-priced house wealth
impact is negative by $110,209.
Smiths’ initial decision to purchase a median-priced
home instead of renting produced a sound financial result.
When the Smiths considered the option of moving up, they
found that doubling the investment in their home does not
necessarily translate into doubling their investment gain.
Four reasons for this are:
The investment utility (the avoided rental cost) remains
relatively constant when moving up;
The high-priced home is in a fundamentally different market.
The percentage investment returns characterizing median-priced
homes may exceed the returns from higher-priced homes;
cumulative after-tax outflows are substantially larger
from moving up than from not doing so; and
a larger home extracts an opportunity cost in the form
of forgone investments due to higher cash outflows.
To Sell or To Stay?
consider now that the Smiths are approaching their planned
retirement age of 62. The current value of their home is
the median $157,400, and they have no remaining mortgage.
The three options they are currently considering are:
Selling the house, investing the proceeds in an annuity,
and moving into a rental unit;
a reverse mortgage on the house and continuing to live
Obtaining an 80% mortgage on the home and using the proceeds
to generate money for mortgage and living expenses.
the sell-and-rent scenario, the $157,400 price net of 8%
selling fees would yield $144,808, to be used for a joint-survivor
annuity. Given a joint life expectancy of 22 years, the
purchased annuity would generate $865 in monthly income,
which falls short of the Smiths’ $1,469 rental expense.
Assuming a rental increase of 3% annually, some selected
differences between rental expense and annuity revenue are
seen in Exhibit
7. A sell-and-rent scenario skews the out-of-pocket
cash flows to the later years of retirement, when such payments
may be more onerous, depending upon the Smiths’ other
financial assets. The growing discrepancy seen in years
1, 7, and 22 illustrates the impact of the geometrically
increased rate in rent, given an offsetting level annuity.
This scenario does not allow the Smiths to participate in
future home price increases, although maintenance, tax,
and insurance expenses are eliminated. Selling the home
eliminates any related estate tax issues. The cumulative
sum of negative cash flows is $333,339 for the sell-and-rent
people consider the Smiths’ second option, the reverse
mortgage, to be a last resort. Such a mortgage would yield
$474 income per month, which is short of the $525 monthly
expenses for taxes, insurance, and maintenance. Exhibit
7 shows the annual shortfall resulting from the higher expenses
for years 1, 7, and 22. Again, the out-of-pocket cash flows
are skewed toward the later years. The negative cash flows
total only $67,916, compared to $333,339 for the sell-and-rent
option. Note that the home appreciation of 3% annually results
in an approximate $23,000 net home value (market value less
accumulated reverse mortgage) after year 22, resulting in
a negative net worth impact of $44,940. If the Smiths’
remaining lives are relatively short, any residual home
equity will be included in their estate; should inflation
increase, their heirs would benefit from a higher home value.
Smiths’ last option is to take an 80% mortgage on
their house. Under
this plan, it is assumed that they could obtain a $125,920
loan on a 22-year mortgage with a $10,475 annual payment.
For simplicity’s sake, this option assumes equal mortgage
and a reinvestment rate of 6%, which initially generates
interest of $7,555, approximating the $7,800 standard deduction
threshold because it reduces the net cash outflow, thereby
making the option more appealing. In the later years of
the mortgage, the declining interest expense is less appealing.
It is assumed that the Smiths could invest the $125,920
at 6%, to yield $7,555 in the first year of the mortgage
and a declining amount each year thereafter, owing to the
excess of mortgage payments over the after-tax investment
returns. Exhibit 7 shows total cash outlay over the 22 years
for mortgage and home expenses of $386,803, with the largest
outlays occurring later in the mortgage life. After year
22, the value of the home is $301,595, which is $85,208
less than the total cash outlays over the period.
7 shows that the Smiths would experience a more severe effect
on the net wealth impact ($333,339) by selling and renting
than by using a reverse mortgage or an 80% mortgage. The
mortgage would generate taxable income for the retirees,
but would also subject them to some degree of investment
risk, depending upon the level of income sought. Any potential
negative inflation impact would be greatest under the sell-and-rent
scenario because of possible rent increases.
estate consequences differ, depending on the Smiths’
8). If they are short-lived, both the reverse mortgage
and the 80% mortgage will result in the home being included
in the estate. If they have long lives, the reverse mortgage
will largely deplete the home’s value, whereas the
80% mortgage will result in the home’s full value
being included in the estate. The reverse mortgage scenario
will yield mixed results in different inflation environments,
whereas the 80% mortgage choice will result in home appreciation,
which may benefit the Smiths’ heirs, but may possibly
result in higher estate taxes.
E. Waldrup, PhD, CPA, is an assistant professor of
Seth C. Anderson, PhD, is the Kip Professor
of Finance; Sid Rosenberg, PhD, is the William F. Sheffield
Professor of Real Estate; all in the department of accounting
and finance at the University of North Florida, Jacksonville,
Vincent Shea, CPA, is a PhD candidate at
Kent State University, Kent, Ohio.