How To “Lie” With Personal Finance – Part 2 (Homeownership Edition)

Remember the blog post from a few months ago, How To “Lie” With Personal Finance? I got a fresh set of four new “lies” today! Again, just for the record, that other post and today’s post should be understood as a way to spot the lies and misunderstandings in the personal finance world, not a manual to manufacture those lies. Of course!

This one is about the rent vs. homeownership debate. Is homeownership a wise financial decision? I’m not going to answer this question here. It’s a calculation that’s highly dependent on personal factors. I lean toward homeownership over renting but that’s because of our idiosyncratic personal preferences – our ideal early retirement lifestyle involves having a stable home base in a good school district. For us personally, the monetary side of homeownership has also worked out pretty well (“My best investment ever: Homeownership?!”) and I like to hedge against Sequence Risk in early retirement by taking a small chunk of our net worth – just under 10% – and “investing” it in an asset that lowers our mandatory expenses because we don’t have to pay rent. But I can certainly see how some other folks, whether retired or not, would prefer to rent. I certainly don’t want to talk anyone out of renting. But on the web, you sometimes read pretty nonsensical arguments against homeownership. And just for balance, there’s also a prominent lie in favor of homeownership. This is going to be interesting; let’s take a look…

1: Confusing Price Returns and Total Returns

James Altucher is an entrepreneur, crypto expert and TV/internet celebrity. A few months ago, he wrote a blog post Don’t Buy A Home and here’s the quote you’ll find often as an argument against homeownership brought forward by the “radical renters:”

“The Case-Shiller Housing Price Index has returned 3.7% between 1928 and 2013. The stock market has returned an annualized 9.5%.” Source: James Altucher’s “Don’t Buy A Home!”

5.8% extra return for equities? Who wants to own a home then? But there is a flaw in this logic! Unfortunately, too many personal finance experts and even highly competent and respected FIRE bloggers/podcasters have fallen victim to this same fallacy. What’s wrong with this calculation? How do I even start picking apart this lunacy? I like to add a little bit of humor to help bring home my point. To this end, let’s look at the following totally fictional(!) conversation. And to make sure, these are totally fictional personal finance bloggers and all similarities with actual living people would be perfectly coincidental:

Vanguard: Hello, this is Mike at Vanguard World Headquarters, how may I direct your call?

Caller: Hi, this is Karen    … and this is Brian! (in the background)

Vanguard: Hi Karen and Brian, how may I direct your call?

Caller: We are Vanguard customers! We are huge fans! We even know a guy who once talked to Jack Bogle!

Vanguard: Oh, that’s marvelous! How may I direct your call?

Caller: Actually, we’re downstairs!

Vanguard: Oh, I see, do you need a visitor pass? Who will you be meeting here?

Caller: Oh, no, we were thinking about moving in here.

Vanguard: (shocked) What???

Caller: Yes, we brought our moving van. We are downstairs. Do you have a loading dock?  …   Brian in the background: Yeah, we’re double-parked with our U-Haul! Where’s the loading dock?

Vanguard: Why do you think you can move in here?

Caller: Oh, we are personal finance bloggers and we proved that investing in Vanguard index funds is so far superior to owning your home. You know, homeowners hardly make any return but we make 12% a year with our Vanguard funds! Unfortunately, those “home boners” have one crucial advantage, haters that they are: they get to live in their house, while we have to pay rent. So, we thought that we only need a free place to live now. Or a really cheap one, maybe up to $800 a month?! …     800 Canadian! (Brian in the background)  …      Then we can make the math work again.

Vanguard: Oooohhhh-Kayyyy???

Caller: You know, we like to “math shit up,” it’s our motto on the blog!

Vanguard: Mess Shit Up?

Caller: No, no: Math shit up!

Vanguard: There is a fine line between “math shit up” and “shit math out,” I guess   [ERN: please excuse the foul language, but this is just how some people talk!]

Caller: What did you just say?

Vanguard: Uhhm, nothing. Bless your heart, Karen and Brian!

Caller: Don’t try to sweet-talk me! We do have a sizable portfolio, you know? We are Saskatchewan’s youngest retirees! So can we move in now?

Vanguard: Uhhm, you know, I don’t know how to tell you this, but…

Caller: What?

Vanguard: Actually, we are fully booked right now!

Caller: What?

Vanguard: Yup, fully booked!

Caller: Oh, bummer! Maybe we can crash in one of your conference rooms? They should have a TV, right? At our old place in Toronto, we got free cable TV from our landlord!

Vanguard: Uhm, unfortunately, we just gave away the last conference room. Broom closets are booked as well. Sorry!

Caller: What?

Vanguard: Yes, sorry, but I heard that two blocks down the road, TD Ameritrade has some openings and they … uhhmm … (suppressing laughter) … they even have units with a city view and free cable TV!

Caller: Oh, wow!

Vanguard: Yeah, and tell them that Mike from Vanguard sent you! Good luck!

Caller: OK, we are so moving back to TD. Thanks for nothing, Vanguard. …   Brian in the background: Yeah, thanks for nothing! If Jack Bogle was still alive… !

Vanguard: Thanks for calling, Karen and Brian! 

Well, rumor has it that the folks at TD Ameritrade had much less of a sense of humor than Mike at Vanguard and they called the police. But that’s not the point. The point here is that your Vanguard (or TD, or Fidelity, or Schwab, or whatever) account is just that. It doesn’t entitle you to anything more than the interest, dividends and capital gains paid for your paper assets. In other words, …

… you cannot move into your Vanguard account, you dummies!!! 

My home, on the other hand, gives me a roof over my head. I save the rent I’d have spent otherwise. Ignoring that in my cost/benefit analysis will give me nonsensical answers, just like in the Altucher blog post and countless other posts in the blogosphere out there. For the finance/economics/accounting buffs it just boils down to this:

It’s impossible to compare the housing price return with the equity total return!

A landlord gets the rental income as an additional “dividend” (after subtracting costs, such as property taxes, etc.) but even I, the homeowner, get that same implicit return because it saves me the money I’d have to spend on rent (again, net of the costs of homeownership, more on that later). In fact, that implicit return is even counted in the GDP calculations to the tune of almost $1.7 trillion per year. Trillion with a “t”!!!

LieWithPF_Part2 Table01
The implicit “rental income” homeowners receive is counted in GDP! Source: Bureau of Economic Analysis.

Once we factor in this additional trillion-dollar income into the real estate returns we get much more attractive returns for real estate. And that will make a very sizable difference, more on that below!

How to spot this “lie” in the field: 

Everyone who says “real estate is a great investment when you’re landlord, but a horrible investment as a homeowner!” Notice the contradiction in this phrase?

Any reference to the “Case-Shiller Home Price Index” to gauge the housing investment return is suspect. That index, by construction, is a pure price index that ignores the benefits of homeownership (and just to be sure, it also ignores the cost of homeownership, more on that later, see item 3 below). So, comparing the S&P 500 Total Return index (dividends included) with the Case-Shiller Index (no rental income included) is useless.

Also, I’m in no way saying that the Case-Shiller index is bad. It has its role when a price index rather than a total return index is called for, say when you’re constructing price-to-rent ratios, or a homeowner affordability index, etc. Just like the Shiller CAPE Ratio (yup, that same Robert Shiller; the guy is pretty amazing, isn’t he?!) has to be based on the S&P 500 Price Index rather than the Total Return Index. But you still have to use the S&P 500 Total Return Index when tracking your investments in the stock market!

How to do this right:

I found a great San Francisco Federal Reserve Bank working paper, aptly titled “The Rate of Return on Everything, 1870–2015” where the authors calculate returns of different assets: Stocks, Bonds (government intermediate bonds), Bills/Cash (short-term instruments, money market) and real estate for 16 economies (!!!) and over the 1870-2015 time span (145 years!!!). And again, this study, written by very well-known researchers, tries to make the numbers comparable, so that we can look at the investment returns side by side, without hiding costs and benefits of the different asset classes. An apples-to-apples comparison! There is a whole section on how they construct the returns on the housing asset, taking into account both the rental yield and the maintenance cost, depreciation, etc.!

Side note: The proper citation for the academics among us: Jorda, Oscar, Katharina Knoll, Dmitry Kuvshinov, Moritz Schularick, and Alan M. Taylor. 2017. “The Rate of Return on Everything, 1870–2015,” Federal Reserve Bank of San Francisco Working Paper 2017-25. Available at https://doi.org/10.24148/wp2017-25

The results are quite intriguing. Over the entire universe of 16 countries, it turns out that housing had higher returns (measured as the geometric, compounded mean) than equities. And lower annualized risk as well!

LieWithPF_Part2 Table02
Over the entire 16-country sample, housing had higher returns than equities! Source: Federal Reserve Bank of San Francisco Working Paper 2017-25.

Unfortunately, though, the results look a little bit less attractive for U.S. housing vs. U.S. equities. This table below shows that the equity vs. housing outperformance at 2.36% over the entire sample and as large as 3.43% Post-1980.

LieWithPF_Part2 Table03
Equity vs. Housing returns by country. Now we see a 2.36% to 3.43% p.a. return advantage for equities in the U.S., but there’s a caveat!!! Source: Federal Reserve Bank of San Francisco Working Paper 2017-25.

That said, there’s one part of the study I don’t really quite agree with. In the table above are only the arithmetic mean returns and not the true geometric (compounded) mean returns that should be used in the context of personal investment returns. So I went to the site of one of the coauthors and downloaded the return source data to redo some of the return calculations. I replicate the arithmetic returns in the SF Fed study down to a few basis points. Why there is a small discrepancy, I can’t tell. But it’s close enough. But also notice that the differences in the geometric return is a lot smaller than in the arithmetic returns. For the stats geeks, it’s due to the significantly higher variance in stock returns!

LieWithPF_Part2 Table04
Equity vs. Housing returns: arithmetic vs. geometric real (CPI-adjusted) means for different time intervals. Source: MacroHistory.net

So, we’re now down to somewhere between 0.9% and 2.2% measuring the return advantage of equities over housing. A far cry to the 9.5%-3.7%=5.8% that Altucher uses. But notice that in every single country, housing had better risk-adjusted returns than equities, measured as the Sharpe-Ratio, see below:

LieWithPF_Part2 Chart03
Sharpe Ratios of Equities vs. Housing. Housing beats equity in every country! Source: Federal Reserve Bank of San Francisco Working Paper 2017-25.

Update 10/17/2019: As some people pointed out, the risk measure for the national housing market will clearly understate the risk of one specific house. Your primary residence is just that one single home, not the nationwide average. So, if we account for that idiosyncratic risk in your one single home you’d have a higher expected risk and thus a lower Sharpe Ratio. But even then the Sharpe Ratios for housing are still really attractive in most countries.

So, is housing still a bad investment since in the U.S., housing slightly underperformed stocks? Was James Altucher merely wrong quantitatively but still correct qualitatively? Probably not, because homeownership will still beat stocks if we account for the leverage normally used in housing investments. Which is a great segway to the next Housing Lie…

2: Messing up the leverage and “Return on Equity” calculation

For the next “lie” look no further than the next paragraph in that Altucher post.

“Let’s pick another time period: 1975-2013. A $100 investment in a home would have returned $100. A $100 in the stock market would have returned $1,600. This does not include the interest rates you pay. 30 year rates right now are 4%. If you borrow $100,000 to buy a house, you aren’t paying $100,000. Over 30 years, you’re paying an additional $234,000 in interest payments. So your net return is probably close to zero or negative.” Source: James Altucher

And I’ve seen this piece of misinformation on quite a few personal finance blogs and podcasts as well. Notice what James does here? He subtracts the cost of a mortgage but the return series he quoted is for an unleveraged housing asset (and the return series was missing the implicit rental yield, too, see lie #1 above). Why would I subtract a mortgage payment from a house that I own free and clear? How sneaky! This is again a way to fudge the numbers and make housing look less attractive. In fact, as we will see below, a house with a mortgage is almost certainly going to raise the return on your capital, not lower it.

How to do this right:

When I calculate a return on an asset, whether it’s a rental or an owner-occupied property or any other non-housing asset, I have to make up my mind what I like to calculate:

  1. The ROA. The return on the asset. The unleveraged return. In the real estate world, it’s sometimes called the “Capitalization Rate” or “Cap Rate” in short. It takes the Net Operating Income (NOI) = gross rental income minus all the costs (maintenance/upkeep, taxes, vacancies, etc) and divides by the current market value. Also, very importantly, these costs don’t include any financing costs. The idea here is that before we ever calculate a return of a leveraged asset we’d like to know how well the asset would perform unleveraged. This unleveraged return is also roughly what the researchers in the Fed Study were after, see Lie #1 above.
  2. The return on equity (ROE), does take into account leverage and borrowing costs. This is the measure I compare to my stock investment. (Side note for all the real estate geeks out there: I understand that there are slight differences between ROE, ROI and Cash-on-cash return. I’m using the ROE here, but qualitatively I could make a similar point with the other concepts as well…)

If I have no mortgage I’d certainly calculate version 1 because without leverage and any borrowing costs the two are the same anyway. If I do consider getting a mortgage I’d certainly want to compute both as well. First, the Cap Rate will inform me whether it’s even desirable to use any leverage. If the Cap Rate is not much higher than the mortgage rate I will not even want to borrow anyway – and maybe not even buy at all! But when calculating the ROE from the Cap Rate, I can’t just subtract the borrowing cost.  To do the return on equity calculation right is no trivial task. I always use this formula, see below. It links the three return variables: 1) the unleveraged return (=Cap rate+capital gains), 2) the borrowing rate and 3) the ROE:

ROE formula01
Return on equity is not just “r-i” as Altucher seems to insinuate.

If you’re not into formulas, here’s a diagram of how this leverage equation works in the real world. If your return is less than the financing cost, the profit from the leverage, Debt times (r-i), is spread into the equity portion to give you the ROE. If r>i then ROE>ROA!

LieWithPF_Part2 Chart05
How leverage works in the real world!

Notice the difference here? I still receive a return of r on my capital. But I add(!) to that the net return (r-i) on the part that’s financed. Let’s look at a real example. Imagine you have a property that returns 6%, the interest rate is 4% and the debt-to-equity ratio is 4 (e.g., 20% equity + 80% mortgage). Altucher’s la-la-land fake return is 6%-4%=2% and that’s completely wrong, of course. Your actual ROE would have been 14%, constructed as the unleveraged return on my equity, 6%, plus 4 times the net return on the debt-financed portion: 4 times 2%=8%! 14% is seven times bigger than Altucher’s number!

ROE formula02
Numerical example to showcase the huge difference between the true ROE and Altucher’s fake ROE.

So, there you have the power of leverage (provided the cap rate is higher than the borrowing rate!) and this is also the reason why, for example, my own internal rate of return on my previous homeownership “investment” was 15.85%, even though the unleveraged return was a paltry single-digit percent figure!

Further reading: Paula Pant/Afford Anything has a great post that goes through a very detailed Cap Rate calculation scenario. And an example of how you can create crazy-high ROEs with leverage!

Side note – a variation of this lie: Imagine the housing return on equity is 10%. I’ve seen people subtract the opportunity cost from that, i.e., the foregone return on an equity investment, let’s make that 8%. So, you’re only left with 2%. If you leave it at that, you obviously and correctly conclude that the housing investment is better than equities. But some very sneaky (or very, very incompetent) folks out there now compare the 2% to the equity return again. Because 2% – 8% = -6% <0 they conclude that equities are a better investment. Notice the flaw in that calculation? You’ve now subtracted the equity return twice! Your asset would need to have double the equity return to be considered better!

3: Ignoring pass-through costs

And another gem from the Altucher post is – you guessed it – in the next paragraph. Jimmy Altucher wants to go three for three:

And, of course, this does not count maintenance, or property taxes, which could be up to another 4% per year.

Wow! I didn’t know that if you’re renting you avoid all the hassles of homeownership: you don’t pay property taxes, you don’t pay for repairs and all the other hassles of homeownership! Of course, this all requires renting from a landlord with a charitable mood who is nice enough not to pass all those costs onto you, the renter. I tried to reach out to James Altucher and ask for suggestions about where to find such landlords but I haven’t heard back yet!

But seriously, for most renters, probably 99.9% of you, of course, the costs of homeownership, ALL OF THEM(!!!), are indeed passed through to your rent. Your landlord may not tell you that out of your, say, $1,500 monthly rent payment …

  • $123.45 will go to pay property taxes (all just sample numbers)
  • $234.45 is set aside for repairs
  • $1.23 is used to amortize the cost of setting up the LLC that owns the property
  • $5.43 is set aside for the local and/or state business license
  • $45.67 is used to pay an accountant to do the landlord’s business taxes
  • … and many more costs!

Too bad this is never itemized like that but that doesn’t change the fact that the renter will pay a ton of money to the landlord to reimburse him/her for the long laundry list of costs.

How to do this right:

Again, I’m not saying that we should ignore the various costs of homeownership. They are factored into the housing return, see the SF Fed study above. But when you take into account the cost of homeownership, do it consistently; the cost will impact both homeowners and renters. One could even argue that renting involves more costs because of the higher costs the landlord faces, e.g., setting up an LLC, hiring a CPA, vacancies, delinquencies, tenants trashing the place, the cost for acquiring new tenants, credit checks, etc.

4: Overconsumption is not a good investment

After beating up the radical renters let’s also make sure we point out the #1 lie of the “real estate mafia” comprised of developers, brokers, bankers, probably even politicians who try to convince you that buying the biggest house you can afford is a great idea. Makes sense, right? If a home is a good investment, then a bigger home is an even better investment! Just like $2,000,000 in VTSAX is better than $1,000,000 in VTSAX, right? Sorry, but the “too much of a good thing” caveat applies here. One beer may taste great, but ten beers may be a health hazard, and in the same way, too much house will most definitely wreck your finances.

How do I reconcile this with my writings above? Very simple, let’s look at the diagram below. On the x-axis, I plot the cost of housing, per unit. So, if home-ownership beats renting, then renting would show up as a wider rectangle than owning (larger cost). The size of the home is a completely different dimension. Literally, because the size of the property is on the y-axis, i.e., the height of the rectangle. Costs of renting/owning would then be the area: width times height. If I own a house that’s too big (cost=A+B) it may still be inferior to renting an appropriately-sized house (cost=A+C). Of course, ideally, I would simply want to own a house that’s exactly the right size and spend only as much as area A, instead of A+C. But that’s not always in the cards.

LieWithPF_Part2 Chart01
Own vs. Rent calculations are about the cost of owning vs. renting per unit. Owning too large a primary residence can still be a bad financial decision!

Of course, there is one way to turn a house that’s too big into a money-maker, after all. It’s called House-Hacking. Rent out the extra space and one could potentially live for free. In the example below, your housing cost is areas A+B and your gross rental income is B+C. Your net cost of living in your own small space is A-C (i.e., area B drops out of the calculation completely, SMART!!!) and this might be really small or even negative.

LieWithPF_Part2 Chart02
Turn a money pit into a money-maker. The benefits of “house-hacking” explained in one simple chart.

How to spot this “lie” in the field: 

This lie is pervasive! Banks have calculators to determine how much house you qualify for; based on your income, not on your actual needs! Realtors often size you up and try to put you into the biggest house possible to maximize their commission. Don’t fall for this lie! Too big a house is overconsumption. Whether it’s rented or owned!

How to do this right:

Read any FI/FIRE blog and educate yourself on how to be happy with less. Check out Coach Carson’s post on house hacking.

Conclusion

Whacky math is everywhere around us and some of the whackiest I’ve seen surfaces in the rent vs. own discussion. It sometimes takes almost a forensic accountant to determine where people fudge the numbers. James Altucher certainly fudged his numbers very artfully! That makes you wonder: what’s the motive of Altucher the other radical renters? Are they secretly investing in private equity multi-family housing deals and trying to talk potential tenants out of buying their own home! Nah, that’s preposterous! I have a different theory, though. I found a link to a cool survey of what homeowners and renters regret. 8% of homeowners would rather be renters but 45% of renters would rather be homeowners. Maybe a lot of renters just realize that they missed out on homeownership and try to ex-post-rationalize their bad decision. By hook or by crook. Don’t listen to the crooks!

Hope you enjoyed today’s post! Please share your own favorite personal finance lies!

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