Meditations on Money Management

Andrew Silton: Your home should be part of the retirement plan, not the whole plan

CorrespondentMay 31, 2014 

In the past few months I’ve probably made more than a few active money managers and financial advisers a bit agitated as I’ve critiqued the investment practices and fees of the money management industry. This weekend I’m going to make real estate agents and developers a bit uncomfortable.

Many investors struggle to put away enough money in their retirement accounts, so they are hoping that their homes will serve as both shelter and a retirement nest egg. There is little doubt that the equity in your home is probably one of the largest assets on your balance sheet, unless you are one of the unfortunate people who live in an area that is still suffering from the credit crisis.

For those of you with equity in your residence, a portion of that equity will be available to support your retirement when you downsize or move into a retirement community. Thus your residence can play a role in your retirement plan. It can’t be the plan.

If you’ve owned your house for 20 or 30 years, it appears that you’ve enjoyed spectacular appreciation because your $80,000 purchase in 1984 is now worth over $275,000 (these figures are based on national averages).

However, that is a compound return of only about 4.2 percent. Your gross return might actually be a bit higher, because you probably only put 20 percent down. As a result, the gross return might be about 5.5 percent. Yet by the time you’ve paid real estate commissions and associated legal and closing expenses, your annualized profit will be down to something like 4.5 percent.

In reality, a significant portion of these returns are being driven by tax benefits. Your mortgage interest, some points and real estate taxes are deductible.

For many of us, the interest rate itself is subsidized by the implicit government guarantee provided by Fannie Mae and Freddie Mac. These government subsidies are worth hundreds of billions of dollars. While many of us benefit, we’re also the ones paying in the form of higher tax rates and long-term government borrowing. In the end, the biggest beneficiaries are the investment banking and real estate industries.

Subsidies for all

Imagine what would happen to the profit in your home if the sale of your home were subject to tax when you decide to downsize. Fortunately, individuals and joint filers enjoy a $250,000 and $500,000 exclusion on gains on the sale of the homes. Unlike stocks, bonds, and mutual funds, residential real estate doesn’t incur capital gains taxes below those thresholds.

Although your 401(k) or IRA has tax advantages, they represent a deferral, rather than an outright exemption from taxation. Thus your house has a privileged position in the tax code.

You probably think that only poor folks receive housing subsidies. Actually, we’re all in subsidized housing. According to a report of the Congressional Budget Office in 2013, the lion’s share of those housing subsidies benefit the wealthiest Americans.

The average taxpayer would probably be better off if we eliminated all the housing-related tax subsidies and let the markets determine the price and allocation of housing. My guess is that many professionals involved in real estate believe in free markets, except when it comes to real estate.

If your home is going to form a portion of your retirement plan, you are going to have to keep in mind several considerations. First, you can’t afford to move too often. Every time you move, you pay something like 8 percent to 10 percent of the sales price in the form of commissions and other expenses. Imagine what would happen to your mutual fund returns if there were huge back-end brokerage and transactions costs each time you sold. That’s what happens when you sell your home.

There’s nothing wrong with buying another home if you want more space or a better view. However, those moves come at a steep price if you’re trying to build long-term equity. When you buy and sell every couple of years, the real estate brokers are the ones enjoying a big chunk of your profits. Even in my example of the average home purchased 30 years ago, about 15 percent of the gain would be eaten up by transactions costs.

Second, resist the temptation to extract cash from your residence in the form of a home equity loan or line of credit, especially if the money isn’t being invested back into the house. Millions of Americans are still suffering because they treated their homes like piggybanks and siphoned out the equity. Since lending standards have become stricter, some people have turned to their 401(k) to borrow funds. Either way, the short-term solution of borrowing against your house or retirement account is going to create a long-term problem.

Third, don’t expect to earn outsized returns on most home improvements, particularly if you are planning to move within a few years. There’s nothing wrong with renovating a kitchen, but the primary return should be your enjoyment, not a big profit. Unfortunately, there’s almost always some anecdotal evidence from somebody who put in granite countertops and a Sub-Zero refrigerator and then sold their home for top dollar. Usually, these are the same folks who claim that they made a killing in some small biotech stock or brag that they employ the smartest hedge fund manager on the planet.

Prices fluctuate

Fourth, be honest with yourself when it comes to your home. We tend to remember what we paid for it, but we’re apt to forget all the money we put into the property. Houses don’t take care of themselves, so the original purchase price winds up being a relatively small component of the overall cost.

Moreover, real estate prices appear to be much more stable than they really are. While real estate investing (absent excessive leverage) is less risky than stocks, much of the price volatility in your home is masked because houses don’t trade on a public exchange. Nonetheless, prices don’t move steadily upward. On occasions when speculators start to flip houses in your neighborhood, you can expect the value of homes in your area to start bouncing around like stock.

Finally, expect the two-tier market to continue. Wealthy folks with plenty of cash will drive selected housing markets higher. This is not the norm for most people, who need a mortgage in order to buy a house. Because bank credit remains tighter than it was before the credit crisis, both buyers and sellers are likely to be frustrated at times. This is not a bad thing. The housing markets will likely be healthier in the long run if banks maintain tighter underwriting standards.

While long-term homeowners can expect to generate a portion of their retirement savings from investing in a home, many folks in their 20s and 30s may find that their lifestyle, career path or location are better suited to renting. Home ownership has been central to the American dream and government policy for several generations. The dream is built upon the idea that a home can be both a residence and wealth builder. Many younger Americans may be better off building their wealth through savings and meeting their housing needs as renters.

The home can be part of your retirement plan. However, the best strategy remains saving money, and the sooner you start the better.

Andrew Silton’s Meditations on Money columns can be found twice a month in The N&O’s Work&Money section. He is a retired money manager living in Chapel Hill. He was CIO for the North Carolina Retirement System from 2002 to 2005. He writes the blog http://meditationonmoneymanagement.blogspot.com/

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