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Note: I accidentally published this post early, then deleted it, then remade it. This is the correct post, but most RSS readers will also show the original, incomplete post just before this. Ignore it. Sorry!
Yesterday Catherine Rampell wrote about the strong preference Americans have for home ownership. Robert Shiller speaks of the "homeownership delusion." The more I think about housing, the stranger I think it is.
Owned housing provides a stream of housing services (which everyone needs), the nature of which can be exactly customized to the owner's preferences. A house is a large fixed asset with a low depreciation rate that is easily collateralized, allowing owners with equity to better smooth consumption or finance entrepreneurship. It sits on land, an asset with somewhat inelastic supply. Robust insurance markets exist for countering unexpected depreciation of the physical asset. Owning a house is like being able to pay rent with untaxed income. An owned house is a lifetime inventory of housing services; once paid for, this inventory allows owners to avoid large monthly living costs that can make retirement or job loss difficult and risky.
On the other hand, as a capital gains investment housing typically performs poorly compared to alternatives like stocks. Ownership imposes large adjustment costs on housing consumption. As a result, home owners are likely to often hold (and pay for) larger housing inventory than they need (e.g., owning a large home in anticipation of having a large family before said family arrives or after children leave the nest); in these situations, many people may be better off renting for extended periods. For most people, an owned house is a massively concentrated, highly leveraged, totally undiversified bet on one asset class (real estate) in one geographical region. It's a long-term bet on the local labor market and natural environment. It may be a long-term bet on the owner's job match or occupation. The home purchase includes a bundle of local amenities--school district, voting district, neighbors, public administration, commute, etc.--and the new owner is making a bet about the outlook for that bundle as well. In the past, owner-occupied housing may have been the only way for average people to gain exposure to the real estate asset class, but diversified real estate investment is now available to anyone with a Vanguard account.
In many personal finance books home ownership receives no attention in the context of optimal portfolio allocation, which I find very odd.
One pro-ownership argument I've seen made is that owned housing allows households to "lever up," which is true but a bit misleading. The housing investment is typically leveraged, and the collateral value is nontrivial (and much better than stocks), but a new home owner doesn't get leverage benefits compared to the renting alternative.* A mortgage allows one to buy a large inventory of housing services now but pay for it over time (albeit a time shorter than the duration of the service stream), while renting is just paying for those services at the time they are consumed. In some cases, the opportunity cost of owning is high as some of the money that would have gone toward mortgage payments could be invested elsewhere instead. Once the house is paid for, of course, the owner holds a lifetime inventory of housing services that can be consumed at (almost) no recurring cost; then the owner can devote a huge share of income to other investments. But observe that this strategy turns the Ayres and Nalebuff approach on its head, concentrating portfolio risk in the short time period between house payoff and retirement.
All of these risks are diversifiable, but only for people with enough extra wealth to make hedging investments.
None of this is to say that buying a home is a bad decision. Occasionally I see people suggesting such. I'm simply arguing that the housing tenure decision is nontrivial. The standard norm that adults should buy a house as soon as they can save the down payment is probably inappropriate. Many people are probably financially better off renting. The right decision depends heavily on relative magnitudes of mortgage interest rates, ownership costs (e.g., property taxes and maintenance), rent, adjustment costs, returns to alternative assets, and time preferences. Spend some time with this excellent tool at NYT (be sure to fix some of the advanced settings, like investment returns). It doesn't take much experimentation to see the sensitivity of the tenure decision to parameterization. Of course, there are non-pecuniary benefits of owning, but in many cases these come at a significant financial cost.
Whether a person should rent or own depends on their circumstances, preferences, and assumptions about the future. I suspect that housing policy is made without accounting for the complex nature of the optimal decision. Maybe a lot of personal tenure decisions are as well.
UPDATE 30 April 2014: Josh Barro has a very nice video with MSNBC, here, in which he makes the argument for renting as the American dream. "Buy a home if you want to own a home, can afford a big down payment, and can afford to absorb the hit if house prices fall."
*I received a lot of push-back on this point in the comments. This is because I'm pushing the word "leverage" a bit too hard. Obviously I realize that a home allows people to use leverage; I mention its collateral value in several places in the post. When I say owning does not provide leverage benefits compared with renting, I am thinking in terms of the Ayres and Nalebuff lifecycle investing concept. This is the idea that leverage should be used to consume and invest now but pay for it later. Owning a home is basically the opposite of this, since it means you're prepaying your rent. You're paying now to consume and invest later. This reduces your ability to lengthen the time exposure of your investment portfolio, unless you think of the house itself as a capital gains investment portfolio (and history suggests that you shouldn't).