Can a house be a retirement plan?
An article by Peter Drake of Fidelity Investments
The love of houses, whether they be single family dwellings, townhouses, condominium apartments or anything in between, has been pretty strong in recent months. Interest rates are low, house prices have been rising and some people, still turned off by the market volatility of the past couple of years, are viewing a home purchase as an alternative to investing in financial assets such as stocks or bonds.
I am often asked the same question advisors are: Should I invest in my home, pay off my mortgage or should I save and invest for retirement? Let me say right up front that comparing the investment value of a home with the investment value of financial investments is a complicated, tedious and often inconclusive process and I have deliberately left the tax considerations to the tax experts. Regardless, I think it is useful to review some of the key issues.
A house as an investment
Comparing the return on investment from owning a house to various financial investments isn't easy. At first glance, one could simply compare the return over a period of a set amount of money invested in a house compared with various types of financial investments such as equities, bonds, cash and a combination of the three. The problem with doing that is there is so much more to consider.
Most home purchasers must borrow - usually a substantial amount - to buy their house. Even in a low-interest-rate environment, there is a cost to do so, which varies both with the interest rate and the amortization period of the mortgage. It is true some investors also borrow in order to invest, but it isn't a requirement and many investors invest from their employment-related cash flow. So, the cost of borrowing effectively reduces the rate of return on the housing investment.
Similarly, people who don't own houses still need a place to live. Rental payments should be factored into the equation comparing the return on a housing investment versus financial investments.
Housing markets, like financial markets, fluctuate. The rate of return on the purchaser's investment will vary depending on the buy and sell dates. The volatility of house prices nationally was less than that of the S&P/TSX Composite Index over the past decade, though home owners in some parts of Western Canada might dispute that assertion. The point is unlike financial markets, where the extent of volatility is often related to specific financial asset classes, volatility in real estate markets is partly a function of geographic location. Another point here is it is possible to structure a financial investment to adjust its potential volatility. It is much less easy to do with an investment in a house.
On this point, diversification is either difficult or impossible for a real estate investment. Impossible if your one real estate investment is your home, merely difficult if you are fortunate to own more than one property in another district, town, province or country.
Most people who make financial investments give some thought to the liquidity of the investment (or at least their advisors do). Simply put, how easy is it to sell an investment and how quickly can you sell it? It is true not all financial investments are perfectly liquid (think about the past couple of years), but most are. A discussion of liquidity around residential real estate investments involves a number of factors. One is that unlike a stock or a bond, most houses have some unique characteristics, and that can affect both their sale price and how quickly they sell. Another is that real estate markets (which are largely regional or urban markets) are smaller than financial markets. A third is while a buyer or seller in a financial market has the option of stating the price at which they are prepared to do the transaction, a seller of residential real estate is required to do so. We have all heard stories of houses that were, in retrospect, priced either too low or too high.
Maintenance fees are also an issue. Nearly every financial investment has some maintenance costs. So do houses. There isn't an easy way to separate house maintenance costs relating to the value of the investment versus those that make a house more inhabitable. As well, home owners pay property taxes.
We can't forget transaction costs. For many, transaction costs around buying or selling a home are infrequent. But, they are often significantly larger (relative to the value of the investment) than the transaction costs associated with financial investments. And there are many of them, such as real estate commissions, lawyers' fees, title insurance, land transfer taxes, and, for the prudent buyer, home inspection costs.
The house as a place to live
This comparison is easy. You can't live in a mutual fund, a stock or a bond. A house keeps the rain off your head and the cold outside. More significantly, a house provides more than simple shelter. Economists refer to it as "psychic income": a house becomes a home. Relationships develop and evolve, children are raised, and the local community becomes part of your social fabric and your life. It is true that you don't need to own a home to obtain these benefits. However, the likelihood of obtaining these benefits as a renter may be somewhat less than as an owner. Factual evidence is hard to pin down on this point, but it may be that renters tend to stay in their rental accommodation for shorter periods of time than owners and it may be that owning simply engenders a different attitude than renting.
That is the good news. But, as the next section discusses, the 'psychic income' that we can receive from owning a home also puts some severe limitations on a house as a generator of retirement income, mainly because the attachment that many home owners feel toward their homes and neighbourhoods makes them reluctant to sell.
The house as a generator of retirement income
Houses don't do terribly well as generators of retirement income. You can sell part of your investment portfolio, but not part of your home. It is true you can rent out some of your house, but that will depend on the type of dwelling and how you feel about being a landlord. You can also borrow against the value of your house, either through a reverse mortgage or a bank line of credit. Doing that does solve the potential problem of a reluctance to leave the family homestead, but it does so at the cost of running up a bill for interest on the loan. It can hardly be otherwise, since the lenders involved in these programs must get paid.
That leaves the choice of selling the house and purchasing a less-expensive residence or investing the proceeds and renting accommodation. Notice that I used the term "less-expensive". The traditional term was "down-sizing". The problem is down-sizing the physical size of where you live doesn't necessarily mean down-sizing the price, although it certainly is possible to do so. And, it may mean moving out of a neighbourhood to which you have become strongly attached.
We have already discussed home maintenance costs. If you have purchased - and paid for - a house and have made the decision to remain there in your retirement, you will most certainly have maintenance costs. In fact these could be larger than when you were working since the house will be that much older by the time you retire.
Finally, an interesting side note to this discussion comes from the people concerned with defining adequate income coverage in retirement. On more than one occasion, I have heard the opinion expressed that if someone is a homeowner, her need to accumulate financial assets can be adjusted down accordingly. In other words, once an individual's savings are exhausted, she can simply sell her house and fund her retirement with the proceeds. Those who hold this opinion clearly do not give any credence what so ever to the 'psychic income' component of home ownership.
The verdict: by all means own a home, but also save for retirement. This is just about as middle of the road a conclusion as there is. But, often, middle of the road approaches are the ones that prove most effective. Saving for retirement and paying for a home should be viewed as complementary activities - each serving to support the other (Home Buyers' Plans and a home equity loan for emergencies come to mind). Developing a tailored plan for optimizing both choices should help your clients wind up with the best possible solution.
Peter Drake is vice-president, retirement & economic research, for Fidelity Investments Canada. With over 35 years of experience as an economist, he leads Fidelity's research efforts in examining retirement in Canada today. |
