Originally posted at Liberta blog [6],
Many people have a weird obsession with homeownership.
When it comes to buying a house, they are willing to overlook, or even completely throw out, a bunch of financial values and principles they claim to hold dear.
The unfortunate truth is, for many middle-class folks, buying a house is often a very silly financial decision, especially if they are young (in their 20s or early 30s), or have a low net worth.
A well diversified portfolio
The most mind-boggling thing I’ve come across is that most people who punt the importance and wisdom of home ownership, will also tell you they believe you should have a well diversified investment portfolio.
You know…
“Spread your investments over many asset classes.”
“Don’t put all your eggs in one basket.”
And so on.
Well, for the average middle-class-30-year-old Joe, buying a house is akin to gathering up all his eggs, borrowing another 9 times as many, and putting them all together into one basket.
Not only is the the average middle-class-30-year-old-home-owner Joe way over-invested in exactly one asset class (residential property), he is also completely undiversified within that asset class, since he owns exactly one property, in exactly one area, based in exactly one town, located in exactly one country.
In short, it’s just about the most undiversified investment portfolio a person could dream up and manage to get himself into.
Leverage
Leverage basically comes down to borrowing money to invest in something.
If you invest R1,000,000 in something, but you borrow R900,000 and only use R100,000 of your own money, then you have an investment in which you are leveraged 10:1.
That 10:1 is called the leverage ratio of your investment. And it is 10:1, since the thing you’re investing in is worth 10 times as much as the cash you put in.
Leverage is great if the thing you invested in grows a lot in value over a short period of time, because it allows you to make a lot of money by investing only a small portion of your own cash!
Unfortunately, the reverse is also true.
If the thing you invested in loses value, then it is very easy for you to lose a lot of money – even more than the initial amount you put in!
While Warren Buffet’s ethics may be a stinker [7], I do agree with his views on employing leverage:
If you’re smart, you don’t need leverage. If you’re dumb, you have no business using it.
Warren Buffet
Even though, over the long-term, returns made on equities outperformed returns made on property, by far [8], almost no sane person will leverage themselves 10:1 to invest in equities (i.e. shares).
For most people, this is way too nerve wrecking to even consider. If you suggest such a thing, you might be labelled a gambler, or worse, a madman.
And yet, everyday, average middle-class-30-year-old Joes [9] all around me are buying properties in which they are leveraged 10:1 (and even more), without a second thought.
After spending many months thinking about this phenomenon I can only put it down to the fact that the truth doesn’t matter [10].
It’s just another asset class
In case you think I have a deluded and deep seated mistrust of property that most likely stems from a childhood nightmare of being swallowed by a house, let me just make my position official:
I have zero issues with investing in residential property.
Residential property is just another asset class.
I don’t currently, but I have in the past allocated a portion of my investment portfolio to residential property (both locally and abroad), by buying shares in publicly listed companies whose business it is to buy and rent out houses and flats.
I just don’t view residential property as a magic-unicorn-galloping-over-a-rainbow-of-profits type of investment with which “you can never go wrong”.
I’ve spent a significant portion of my adult life looking for investments like those, but unfortunately I haven’t found one yet.
Liability and Liquidity
If you are still adamant that you want to invest in residential property, then I have a great suggestion for you:
Why don’t you just buy some shares in publicly listed companies whose business it is to buy and rent out residential properties?
If you do some research and choose a good one, chances are that they are better than you at spotting and buying well-priced properties and collecting rent, because that is what the people who work for those companies do for a living.
There are also some other advantages about investing in residential property by buying shares in publicly listed companies.
You can have a more diversified investment portfolio: By only buying a few shares you are able to limit your exposure to residential property to a reasonable percentage of your net worth [11].
You have limited liability: If the company goes bust, you will not be liable for any losses. Comparatively, if you buy a property using debt and, for whatever reason, become bankrupt and can’t afford to make the bond payments, then you most likely have quite a few years of hell to look forward to.
Shares in publicly listed companies are liquid: If you ever need to do so in a hurry, it will only take you about 5 minutes and a few key-strokes to sell all the shares you hold in almost any publicly listed company. Selling a house, on the other hand, is a ludicrously expensive multi-month administrative nightmare.
Interest rates and timing your property purchase
Residential property is an asset class that is very directly influenced by the cost of borrowing money.
In our society, it is considered a perfectly normal and responsible thing for a person to finance the purchase of a house by getting a 20-year loan from a bank.
In fact, it is considered such a normal thing for the average middle-class-30-year-old Joe to be a debt slave for most of his life [9], that if you had to suggest to him that he should save up for a house and only purchase it once he had saved up enough money to buy it outright, using cash, he will probably think that you are crazy to even suggest such a thing.
But, I digress.
My point is, the vast majority of residential properties are paid for using borrowed money.
Because of this, when interest rates go up, so do monthly bond payments. When bond payments go up, some people can’t afford to make their bond payments and they are forced to sell their homes, or default on their bond. A few actually do default, resulting in a seizure and forced sale of their properties by the bank.
To summarize: When interest rates go up, property prices fall (or increase very slowly, usually at a rate lower than inflation), because the available supply of residential properties increases, while at the same time the demand for residential properties decreases. Conversely, when interest rates go down, residential property prices usually go up quickly, because more people can afford to take out bigger loans!
The first rule of business is: buy low, sell high.
This is such an obvious concept and yet, in practice, it is very difficult to do, because it usually means doing the exact opposite to what everyone around you is doing.
If you are going to buy a property, for whatever reason, then at least buy it at the best possible time.
And when would that be?
Well, of course, a few months after interest rates hit their peak after having risen quickly for two or three years in a row.
Take a look at the graph below, which shows the [10Y Treasury rate in the US] over the last few decades.
[12]
...with interest rates near record lows and just entering an upward cycle.
In my opinion, the present is just about the worst possible time for anyone to be invested in residential property.
You will know it is the right time to buy your dream home by looking for a few of these signs:
- Interest rates are starting to stabilize at a high rate, after rising steadily for two or three years in a row.
- Many people are trying to sell their properties, some in a real panic, because they are struggling to make their monthly bond payments.
- You hear many tales of properties being foreclosed on, also in neighbourhoods where people are considered to be wealthy.
- People around you are generally feeling quite negative about owning property.
When the blood is in the streets, [13] my friends, that is the ideal time to buy your dream home.
Paying rent is simply throwing away money every month
I often hear people making this argument. I’m sorry, but that is just a silly thing to say.
Upon purchasing the average middle-class-suburbia home, you’re not only paying a massive amount of TAX to the government, [14] you’re also forking over a significant amount in fees for bond registration, deeds and a bunch of other stupid banalities. Never mind the commission that goes to the estate agent.
Property tax, commission and other fees can easily add up to over 15% of the purchase price of a house. This makes residential property one of the most expensive asset classes to invest in, at least as far as up-front costs are concerned.
Then, once your bond is registered and you are the proud owner of your new home, you’ll be paying interest to a bank, every month, until your bond is paid off.
And don’t forget about maintenance! You know… paint starts peeling, roof start leaking, toilet stops flushing, that type of thing.
Lastly, you’ll also be forking out on a monthly basis for rates & taxes. Which, as property owners in Greece found out just recently, [15] can easily go up by sevenfold in two years, if your government is anything like most governments are.
Safe-haven investment my ass.
Except for squatting on someone else’s land, there’s no such thing as living for free.
So are you saying no one should ever own a house?
No, of course not.
I’m saying people should save up for their family homes and buy them cash.
The saving part should be done by building a well diversified investment porfolio and the home buying part should be treated as an expense, rather than the purchase of an asset.
I know… in the world we live in [9] I’m very much on my own in suggesting such a boring and outdated thing.
But I’ve looked at the facts, and even though I’m well aware that the truth doesn’t matter, I also know that nothing matters to anybody until it matters to everybody – and by then it’s too late.