Buying a house in a housing boom seems like a dangerous economic move. On the other hand, your personal residence isn't simply an investment; there are many reasons for buying a house that have little to do with making money. Here are some thoughts on both sides of this interesting question, beginning with the characteristics of a housing boom and the housing bust that follows.
Economists have long known that financial markets are essentially cyclical. The housing market, among other things, is a financial market subject to the same cyclical forces. The cycle can fairly be described as having four quadrants.
The first quadrant is the recovery phase that follows the previous decline. During the recovery period, new construction is limited as market participants recover from their losses and struggle to regain confidence. However, populations continue to increase. Eventually the disparity between this relatively static housing supply and a growing population causes market tightening. Nevertheless, early in the the recovery phase rental properties are still widely available and there's plenty of houses waiting to be sold. Generally, the first indication that the housing market is tightening is that there's an observable decrease in the time houses and rental properties remain on the market.
The second quadrant is the expansionist phase, which is favorable to new enterprise. In response to increasing demand for a limited housing supply, housing prices begin to rise and builders resume building. Owners of rental properties begin raising rental rates. This puts more pressure on the housing market as renters faced with rising rents begin to buy houses instead. A side effect of the expansionist phase is that occupants of residential housing stay in their houses longer, further reducing the available supply.
The third quadrant, also an expansionist phase, may seem to be a continuation of the second. Prices still rise and new construction, if anything, accelerates as builders take advantage of generous capital markets to finance new, often ambitious building projects. Confidence and optimism are in the air. Few market participants seem to be aware that some of this confidence and optimism is excessive – that, to use former fed chief Allen Greenspan's memorable phrase, the housing market is in a state of "irrational exuberance." Rental housing vacancies are increasing, as does the average length of time a house remains unsold.
In the fourth quadrant, optimistic builders have not only replenished the supply of available housing and rental units; they've overbuilt. Occupancy falls, first slowly, then with gathering speed. Houses now remain unsold on the market for increasing lengths of time and are often eventually sold at sharply reduced prices. Building projects go unfinished as financing tightens. Eventually, the financial pressures on builders and developers lead to many bank repos, which then go on the market for less than the cost of construction. The fall in housing prices accelerates. Confidence finally collapses as the market capitulates to the crash.
This fourth recessionary quadrant in the housing market cycle can be especially brutal, for several reasons. Often, unhelpful fed policies are contributory. For instance, in response to an overheated boom economy, the fed may decide to raise interest rates late in the third phase. Mortgage rates increase in tandem, which increases the inability of buyers to qualify for available housing – already offered at premium prices in response to the housing market boom. This accelerates the growing discrepancy between an overbuilt housing supply and a population with decreasing financial ability to buy housing.
Another contributor to a housing market crash in the U.S. is the nature of residential financing, where buyers rarely put down more than 20 percent of the cost of a house and often put down five percent or less. Buyers, and certainly real estate agents, rarely consider the reality of such purchases, which is that they are buying with an extreme amount of leveraging, the acquisition of an asset with borrowed money.
In the stock market, the maximum amount of leveraging available for many years has substantially less. You buy $1,000 worth of stock with $500.00. This means that until the market value of your purchases declines by 50 percent, you still have an asset. Its value may have gone down substantially, but you still have an asset you can sell.
In the housing market, where 5:1 leveraging is the general rule, a 20 percent drop in the value of housing puts recent owners "under water," a phrase expressing the idea that the debt exceeds the total value of the purchase. They have nothing to sell and can only partially escape the consequences of the debt by declaring bankruptcy – or, like what happened in the housing crash of late 2007, where housing prices dropped by about a third from their peaks – simply by giving up and walking away from house with nothing.
It seems pretty clear that buying a house at the peak of a housing boom isn't a great idea. If you'd bought a house in 2007 with a 20 percent down payment, the crash would soon have left you with a house saddled with debt that exceeded its value.
So goes the conventional wisdom on the subject of when to buy a house. But there're are several flaws in this reasoning. The first among them is that no one can tell what the peak of the housing market may be until the peak has passed. In late 2017, more than half of the U.S. population believe a housing crash is either "likely" or "very likely." But that doesn't mean that the market will crash in 2018. It may or it may not. Often the conventional wisdom is wrong. The average cycle time from boom to bust is 18 years. This market has been booming for 6 years.
Another point is that if the 2017 housing boom continues long enough, even when the market crashes your house will still be worth more than you paid for it, possibly a lot more. The long-term average market gain in U.S. residential housing is about six percent each year. Like many long-term averages, this is a compounded return, meaning, that in the first year after you bought a house for $300,000, you'd gain six percent, or $18,000. But in the second year, you'd gain six percent of $318,000 and so on. Sometime during the 12th year, the house you paid $300,000 on would have doubled in value. If the market crashed at that point and you lost 30 percent of its value, your house would still be worth $120,000 more than you paid for it.
Another point still is that just as the housing market cycle includes the crash, so does it include the following recovery. Even in the 2007 crash, the second worst in U.S. history, if you'd stayed in that house you bought at the very peak of the market at the beginning of 2006 – and that had dropped in value by about a third in 2012 – by 2016, you'd have recovered everything you'd lost. And remember, so long as you're not selling the asset, it's only a paper loss to begin with. You bought the house for a certain price, hopefully with a fixed mortgage. Those mortgage payments continue without any increase and with nothing more out of your pocket meanwhile until you are fully recovered 10 years later.
According to Robert Schiller, who won a Nobel Prize in 2013 for his research and analysis primarily of the U.S. housing market, residential housing is not a particularly good investment. The stock market's average gain of more than nine percent is considerably better than the housing market's six percent gain, even before you take various expenses into account. On a house you pay annual taxes; while these vary from state to state, they're generally at least one percent of the house's value – sometimes much more. House owners frequently underestimate upkeep costs; the reality is they average from one to three percent of the purchase price every year. Also, there's insurance. When you put all these costs together, the probable annual net gain in a house from an investment perspective is probably no more than three percent, and more often less.
Another reality, however, is that most financial analysts don't think you should look at a house as an investment to begin with. In addition to being a residential property, it's your home. Most of the benefits of owning a home are very real, but not literally tangible: pride in ownership, feelings of security and well-being, and ability to control your housing costs without regard to booms and busts.
So, yes, if you're thinking about buying a house as an investment, and particularly if you're planning to cash out anytime soon, it's at best a mediocre idea. Late in a prolonged boom phase in a cyclical market, which is where we seem to be as 2018 rolls around, it might be a very bad idea. But if that house is your home and you plan to live in it for several years, buying it is a very good idea.