Real estate decisions can be a polarizing topic for many families, not just because it is often the largest financial asset they own, but also due to differing opinions on whether it should be considered an investment or a living expense. Recently, I shared my insights with Nathan Place from Financial Planning magazine, and in this article I’ve included my complete thoughts.
So, should real estate be treated an investment? The short answer is “it depends”, but it really comes down to the purpose for which the property was purchased.
Primary residences are a living expense
Primary residences should be treated as a living expense, rather than an investment, for several reasons. First, keep in mind that the best time to buy or sell a home is when life conditions are such that you need one, as opposed to uprooting your family every time market conditions might make it beneficial to transact.
When market conditions are advantageous, you can sell any amount of a portfolio of stocks and bonds to take profits. However, you can’t sell half a house, and you wouldn’t sell your primary residence unless you had another suitable place to live. Just imagine what would happen if someone came home to find out one day that on a whim their partner had unexpectedly sold their home for a profit. That wouldn’t go over too well.
In fact, scarcity of housing supply on the market is the primary reason that prices for single family homes have remained as elevated as they have despite towering increases in mortgage rates. For locations where many people want to live but there is little buildable land (i.e., cities, and popular suburbs) prices have declined only marginally, so affordability has been badly hit from higher mortgage rates.
People that recently conducted a search may have also noticed that nearly all newly constructed homes are quite large or are crammed together on small lots. Much like cars, new homes sell at a premium to similarly equipped existing homes, as their physical condition ages over time and they require more maintenance. Essentially, land in a desirable location appreciates over time but structures built upon them depreciate as they age.
When it comes to home improvement and renovations, it’s best to put your own needs ahead of a potential future buyer, to a point. It’s true that certain improvements can increase the value of a home, but changing real estate market conditions are a far greater factor that will overwhelm the value of most changes you might make.
So, if you’re planning to sell your home, cosmetic upgrades such as replacing ancient appliances with new ones or repainting old cabinets might make sense, but anything involving a contractor probably doesn’t make sense for the purposes of future resale. In many cases, people stay in homes longer than they anticipate, and in the long run styles and buyer interests do change.
In rare cases, people make design choices which are so idiosyncratic that they detract from the interest level of buyers. During my own search, I came across a handful of homes where there seemed to be a lot of “personality” left behind even where it was already vacant due to unusual design choices. If you’re considering any changes that really speak to you (and few others), make it something you can take with you if you move, which you’d probably want to do anyways.
Rental and resale properties should be treated as investments
Real estate is clearly an investment when the exclusive purpose of buying a property is to produce either rental income, or to produce a gain on selling the property (often after making improvements). So in cases where you rent out a property to a full-time tenant for income (most often an apartment), or renovate a property to sell it at a gain, these are each investments.
Why?
Simply put, you aren’t mixing business and pleasure (i.e. second home), and if you don’t live there it can’t be considered a living expense.
At the same time, real estate does have very different attributes from other investments such as stocks and bonds. Someone once asked me if a specific investment would be capable of producing a loss greater than their initial investment, which was very astute. In cases where you are employing some form of leverage (i.e. controlling more assets that you have paid for), the answer is yes. That is the exact purpose of a mortgage, so it’s important to keep that in mind.
Second homes and Airbnb rentals straddle a blurred line
The least clear cut situation is for second homes which are partly rented as vacation properties. Often, people want to have it both ways by owning a vacation property without (fully) paying for one. In fact, this is a much riskier proposition than a property that is rented to a full-time tenant given that rental income is not largely guaranteed for the typical 12-month length of a lease.
Additionally, vacation properties aren’t always in places where people would want to live, or be able to work, on a permanent basis. In most cases, this involves renting out the property during the most advantageous times of the year (i.e., summer, or winter, depending on its location), and enjoying the property mostly in the off-season when you might not otherwise choose to be there.
That’s why for a part-time rental or vacation property, there are two important questions to ask yourself.
“Will I enjoy spending time at the property due off-peak times of the year?”, and…
“Can I afford this property if I earn little to no rental income?”
If the answer to either of these questions is no, it’s probably best to go on vacation than to purchase another property. Vacationing also bears the benefit of a variety of destinations, limited cash outlay, and an expense profile that can be easily increased or decreased any time you like.
And if the answer to both is yes, just think of it as a way to defray some of the expenses of a second home from time to time.
Putting it all together
If you’re considering a real estate transaction, or renovations to your home, it almost always involves debt so it’s important to update your financial plan before making any decisions.
How come?
Spouses can only rely on one another to save for their retirement, and most parents want to provide some amount of assistance in covering their children’s education, which is also often funded by large amounts of debt.
Pick a time to discuss updating your financial plan, or give us a call at your convenience.
This blog was written by Jeremy Bohne, Principal & Founder of Paceline Wealth Management. Paceline is a fee-only investment advisor serving clients in the Boston area, and on a remote basis throughout the country. Paceline specializes in helping tech and biotech executives, physicians, and those seeking financial planning services.