Is buying a house a better investment than buying stock?

Americans are optimistic about housing as an investment again according to Gallup, with a plurality saying real estate is a better long-term investment than stocks, bonds, gold, or savings accounts:

Catherine Rampell, channelling Yale economist Robert Shiller, says they’re wrong. She cites Shiller’s data, which shows that “over the past century, housing prices have grown at a compound annual rate of just 0.3 percent once one adjusts for inflation.” Bill McBride disagrees, saying that Shiller is using the wrong price series and if he had used the CoreLogic series instead the “real return over the period Rampell analyzed would have been closer to 1.5 percent.”

But this dispute about the performance of real estate relative to other asset classes is what you need to know if you have millions of dollars to invest in this or that. The practical choice facing a normal middle class person is shaped by factors beyond these numbers.

A big problem with homeownership as an investment strategy is a lack of diversification. If you want to put $300,000 into the stock market, you can own a very small slice of hundreds or even thousands of publicly traded companies. You don’t need any special skill in picking stocks to benefit financially from the long-term growth of the economy.

Put into housing, by contrast, your $300,000 is going to get you one house. If something bad happens to your neighborhood, or the entire regional economy of the metro area you live in heads downhill, you’re in big trouble. And the real problem here is that you live in the city where your house is located. That means a downturn is going to be bad for your earnings potential and bad for the value of your investment.

Most homeowners buy their house with the assistance of a mortgage. Investing in part with borrowed money is known as leverage, and it amps up the risk factor. Using leverage means that if the value of your investment rises, profits go up faster than they would with a non-leveraged investment. The flipside is that using leverage means that if the value of your investment falls, losses mount faster than they would with a non-leveraged investment.

Since, on average, house prices do go up (even the skeptical Shiller data says this) that means that, on average, the availability of leverage is a good thing. But contrary to the perception of real estate as an unusually safe investment, the pervasive presence of leverage actually makes it an unusually risky investment.

If you itemize your tax deductions, any interest you pay on your mortgage is tax deductible. If you’re in the 10 percent tax bracket, that’s a small financial bonus. If you’re rich and paying a 39.6 percent marginal rate, it’s a really big deal. It’s an even bigger deal if you live in a state with an income tax that also lets you deduct mortgage interest.

Another issue is capital gains taxes. Profits made from buying and selling shares of stock are subject to capital gains tax, while profits from selling an owner-occupied house are normally exempt.

In some jurisdictions, the property tax code also hits homeowners at a lower rate than renters. This has become an important controversy in New York City where a lawsuit is alleging that the bias is racially discriminatory. In political terms, homeowners pay property taxes directly to the government while renters pay them only indirectly, via higher rents to cover landlords’ tax bills. That makes property taxes more salient to homeowners and in many places encourages the construction of a biased tax system.

Last but by no means least, the income you derive from “renting your house to yourself” accrues tax free. People sometimes express this by saying that you can’t live in your stock portfolio. That’s true, but you certainly can use the dividends that your stock portfolio pays to cover the rent. The problem is that the IRS is going to make you pay taxes on that dividend income first. If you spend the money on a house and then live rent-free, you don’t need to pay any taxes on the benefit you derive. In principle, the government could tax imputed rents (Switzerland does) and the failure to do so is a large but obscure subsidy to homeownership.

It makes relatively little sense to try to pronounce generally on the wisdom of buying a house, since price is key variable. At times in a given place the ratio of house prices to annual rents will be high. At other times it will be low.

But in general, owner-occupied real estate is an attractive investment for many families. Not because housing is so great as an asset class, but because its purchase is subsidized. Government guarantees mean that relatively low interest loans are available. And both the federal income tax and many state and local property tax codes provide additional subsidies for homeownership. Ironically, the very fact that homeownership is financially attractive for many families is often invoked as a rationale for the subsidies. In reality, the logic runs in the opposite direction. Borrowing money to buy a home is attractive largely in virtue of the subsidies.