Thursday, January 22, 2009

Houses Are Not Investments

As Dr. Reisman has pointed out in Capitalism and in his recent post, houses should not be regarded as investments. Houses are depreciating consumer goods although the rate of depreciation is slower than many consumer goods. So why do people regard houses as investments and often see equity in their home as a primary savings vehicle? Quoting Dr. Reisman:

Only decades of inflation and credit expansion could make it possible for people to think of the houses they occupy as an investment. In reality, a house is a consumers’ good, just like an automobile or a refrigerator. The only difference is that it depreciates more slowly than they do. Only a long string of years in which inflation took place more rapidly than houses depreciated enabled their prices to rise every year and people to come to regard them as a source of financial gain. If not for inflation and the rise in prices that it produces, it would be very clear that housing is a wasting asset, a slowly wasting asset to be sure, but a wasting asset nonetheless.

As this chart shows, when you express the price of a house in terms of another real asset like gold (as opposed to government dollars), you can see that the price of houses is currently the same price as it was in 1900. The house itself depreciates and the land should stay about even with gold so this chart is about what you would expect.

Another way in which the government fuels the illusion that housing is an investment is by effectively subsidizing the real estate market. It does this in two primary ways.

One way it does this is through FNMA, FHLMA, and GNMA (Fannie Mae, Freddie Mac and Ginnie Mae as they are popularly called) which underwrite pools of mortgage loans. In other words, mortgage banks can sell pools of mortgages to these companies who are tacitly supported by the federal government. This means that mortgage banks are more likely to lend than they otherwise would be if they were on the hook.

The second way is through the mortgage tax deduction. This deduction allows one to deduct mortgage interest against their taxable income. This creates the illusion that the home owner is getting a discount on their mortgage. However, I would argue that all it does is raise home prices so that you are no better off. For example, imagine that the government gave everyone a pizza subsidy. At first, you might pay $2 for pizza that originally cost $3. However, this subsidy would increase aggregate demand for pizza and ultimately the cost of pizza would rise to say $4. Then with your $1 subsidy, pizza would again cost $3 so that you are no better off. In housing, this tax deduction enables people to buy more house than otherwise so it increases aggregate demand for housing. I believe this generally has increased the price level of houses more than otherwise so that the mortgage deduction is actually a facade in terms of real savings.

In all, the government policy of inflation and housing subsidies has created a situation in which a large portion of our nations' savings has been poured into the equivalent of refrigerators. The world is now beginning to realize the consequences of this mistake.

5 comments:

seine said...

There is an overlooked aspect of investment in housing. Using money otherwise spent on rent in order to acquire equity in a house is probably the easiest means for the average person to improve their net worth.
As a person living in Canada, the home interest deduction scheme is not applicable to me and I agree, the home values in the US reflect that perk.
By wisely spending on maintenance, the value of an older dwelling can remain on par with new houses for many years and judicious renovations can further extend the value of a house.
That too many people were mislead into thinking themselves wise speculators in the recent housing fiasco seem largely due to the artificially low interest rate on borrowing and poor returns on traditionally stable investments such as bonds.

Brad Williams said...

One's *own* house is not an investment. A house as a rental property is an investment.

Doug Reich said...

Thanks for comments.

Brad, I 100% agree that those who buy rental properties are making a true investment. This should be distinguished from one who buys a home to live in with the idea that it is an "investment" in and of itself either over a long or short period of time. The latter was the subject of my post.

I am going to do a follow up post on buy-rent analysis to show how people are further misled into thinking that buying is always better than renting which to some degree represents a general lack of knowledge of finance rather than anything political. That will address Seine's comment about acquiring equity with which I do not necessarily agree.

Amit Ghate said...

Not sure how this fits in with Reisman's and your thinking, but to me a house is a consumption item not because it's slowly wasting away, but because it stands at the end of a line of production. The goal of having a house is to live in it, it's not an investment aimed at making some other consumption good possible. On the other hand a machine in a factory, while also slowly wasting away, is an investment good because it represents resources that weren't consumed but were put towards producing other goods (which ultimately are to be consumed). Hope that makes sense...

Per-Olof Samuelsson said...

Amit: "...to me a house is a consumption item not because it's slowly wasting away, but because it stands at the end of a line of production."

Both those points are true.

"On the other hand a machine in a factory, while also slowly wasting away, is an investment good because it represents resources that weren't consumed but were put towards producing other goods (which ultimately are to be consumed)."

Perfectly true - and also perfectly compatible with sound "reismanite" economics!