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Nest or Nest Egg?Nest or Nest Egg?Hatching Best Investment PlanHarold D. Hunt and Clare Losey2018-09-06T05:00:00Ztierra-grande
Investment
The Takeaway

Between 2000 and 2017, renting and investing in the stock market generally yielded a higher rate of return than investing in a home. However, households faced with both options are likely to consider other factors such as current stock market conditions, their ability to qualify for a mortgage, housing stock, the obligations of homeownership, and the social and community aspects of owning versus renting.​

​Buying a home is typically the largest investment a household makes. One alternative is to rent a home and invest the down payment in something else. From purely an investment perspective, the anticipated rate of return plays a crucial role in the homebuying decision. This article compares the financial gains from investing in the stock market with the gains from purchasing a home. Households faced with either renting and investing in the stock market or purchasing a home should consider the historic performance of both before making their choice.

The point of initial investment ranges from the beginning of 2000 to the beginning of 2016, a period with significant disruptions in both the stock and housing markets.

Multiple investment opportunities are available to households. However, stocks and real estate have shown to be two of the more popular. According to the Survey of Consumer Finances (conducted by the Federal Reserve Bank), 63.7 percent of all families in the United States held a primary residence in 2016, while 51.9 percent of all families had direct or indirect stock holdings.

Although the proportion of families who held a primary residence was somewhat similar to the proportion of families with direct or indirect stock holdings, the values of the assets differed significantly. In 2016, the median value of stocks for families with direct or indirect stock holdings was $40,000, whereas the median home value was almost five times that at $185,000. Home equity depends on whether the homeowner holds a mortgage and the remaining mortgage balance.

By renting and investing in a stock portfolio, the household forgoes the potential to earn appreciation from homeownership but may benefit from selling the stock at a profit. Conversely, by purchasing a home, the household forgoes the future earnings from a stock portfolio as well as the potential to earn dividends. However, renting can cost more than homeownership, in which case a renter household might not have the funds to invest in a stock portfolio.

The question is, if between 2000 and 2016 a household had the option of either renting (and consequently investing in the stock market) or purchasing a home, which provided the greater financial gain? The answer isn't simple.

Stocks versus Homes

Numerous differences complicate a comparison between renting and investing in the stock market and purchasing a home. The Real Estate Center's analysis attempted to control for the differences through a number of assumptions.

  • The household either purchases a home or rents and invests the entire down payment in a stock portfolio at the beginning of the year.
  • In the case of a home purchase, the household meets the qualifying requirements for purchasing a home. 
  • In the case of an investment in stocks, the household does not trade any stocks during the holding period and reinvests all dividends (a buy-and-hold investment strategy).
  • The household does not face any constraints in the sale of either the stock portfolio or the home.
  • The internal rate of return (IRR) results, based on stock portfolio and home price appreciation or depreciation, are the sole criteria for buying versus renting. The analysis does not account for qualitative differences between owning and renting, any advantage from leverage in homeownership, or any equity increase from mortgage balance reduction. 
  • Households seek a longer-term investment in a primary residence. Second-home or investment property purchases are not considered.

Assume a household with $10,000 has two options: rent and open an investment portfolio or spend the money on a down payment on a home. For this analysis, the home price is $100,000.

Investment Por​tfolio

The value of the investment portfolio at the end of each year after a minimum two-year hold depends on the year the $10,000 was invested (Table 1). Table 2 depicts the IRR on the initial investment based on the year in which the portfolio is liquidated.


The timing of the initial investment, the duration of the holding period, and the volatility in the stock market during the holding period produce dramatically different returns. In general, opening a portfolio in a year with strong stock market returns produces a higher initial IRR due to the positive impact of compounding in the early years.

For example, a portfolio opened in the beginning of 2003 earned an IRR of +12.7 percent after five years (at the end of 2007). The high return stems from the large upswing in the market in the initial year (+19.2 percent) as well as fairly strong growth in the following years, ranging from +12.7 to +14.6 percent (Table 2). Higher growth in the initial years of a holding period effectively acts as a hedge against future market downturns.

Conversely, a portfolio opened in a year characterized by a stock market decline needs much higher growth in subsequent years to recoup the early losses during the initial years of the holding period. A stock portfolio opened in the beginning of 2002 earned a return of just +6.1 percent after five years (at the end of 2006). Return is significantly lower, as the +0.1 percent increase in the initial year significantly lessened the impact of subsequent stock market growth on the portfolio's value (Table 2).

How do the IRRs compare if both portfolios were sold at the end of 2008 during the early stages of the Great Recession (GR)? At +2.4 percent, the return for a portfolio opened in 2003 remains slightly higher than the –1.5 percent return for a portfolio opened in 2002. The poor +0.1 percent annual return in 2002 diminished the ability of the portfolio opened that year to offset the downturn in 2008. By comparison, the initial strong growth in 2003 allowed the portfolio opened that year to better offset the decline in 2008 (Table 2).


Home Pur​​​chase

Home values at the end of each year the home could have been sold, based on the year of purchase and FHFA home price appreciation data for Texas, is shown in Table 3. Table 4 shows the IRR based on those values.


Similar to renting and investing in the stock market, the return for a home purchase is affected by the timing of the initial investment and the duration of the holding period. While high market volatility significantly impacted the range of stock market investment returns, the low volatility in Texas' housing market tempered homeowners' returns.

Overall, lower volatility translated into much less IRR variation from homeownership than from the S&P 500 portfolio. Annual IRR ranged from –1.3 to +7.9 percent for a home purchase (Table 4) versus –18.2 to +23.8 percent for the stock market portfolio (Table 2). Thus, households had the potential to earn a significantly higher rate of return from the stock market than from owning a home. However, they also risked losing substantially more money. Both results rely heavily on the timing of the initial investment.

In the years immediately preceding the GR's housing downturn, the return on homeownership remained relatively unchanged. Unlike states such as California and Florida, Texas experienced neither excessively high home price appreciation during the national housing boom of the mid-2000s nor the exceptional price decline immediately after the GR.

Since the GR, Texas home prices have increased more rapidly. For homes purchased from 2013 to 2016, the IRR from homeownership ranged from +5.9 to +7.9 percent (Table 4).


More Rew​arding Investment?

Based on the IRR, renting and investing in the stock market was generally the more financially rewarding option for a household between 2000 and 2016 (Table 5).


If the initial investment was made in 2000 or 2001, homeownership was, on average, the option that yielded a higher return through 2012. However, for all other years, on average, investing in the stock market proved the more financially beneficial option.

Alternatively, the higher incidence of negative returns and greater return volatility experienced in the stock market indicates renters assumed much greater risk compared with buying a home. The IRR from a stock portfolio produced negative returns 23 times (Table 2). Meanwhile, IRR from homeownership produced negative returns in only six instances (Table 4).

Furthermore, the severity of the negative returns was much greater for an investment portfolio than for homeownership (–18.2 percent versus –1.3 percent). On average, the potential loss in initial investment proved higher for renters than for homeowners. The IRR from the stock portfolio varied significantly across holding periods, whereas the IRR from homeownership remained in the low single digits.

Note that the analysis for the stock market portfolio reflects before-tax returns. Capital gains tax is not factored into the returns for the stock market or homeownership.

According to the Tax Policy Center, the average effective tax rate for capital gains ranged from a low of 12.5 percent in 2009 to a high of 19 percent in 2000. This represents a significant portion of the overall value of the stock portfolio and would have a large impact on its after-tax return.

If the analysis for the stock market portfolio had accounted for transaction costs and capital gains taxes, the IRR would have decreased. Depending on the severity of the decline in the IRR, this could have reversed the investment decision (i.e., purchase a home rather than rent and invest in a stock portfolio).

Weighing the Options

On average, investing in the stock market offered a greater IRR than purchasing a home for Texas households from 2000 to 2017. However, the introduction of capital gains tax can dramatically affect the investment decision. In most cases under current tax law, avoiding capital gains tax on sale of a home gives homeownership a tremendous edge. The impact of capital gains tax and transaction costs, along with other factors such as the impact of leverage from homeownership and equity increases due to mortgage loan reductions, will be discussed in a future article. 

Additionally, high rent growth over the past several years has diminished the financial gain from investing in the stock market. Another important factor is the substantial up-front cost of purchasing a home versus investing in the stock market. Potential homeowners should typically expect to remain in a home at least two years before the front-end costs are recouped.

Finally, investing in the stock market at the bottom of a recession and selling within a few years is almost always the superior financial investment. The stock market tends to grow at a much faster rate than home prices coming out of a recession. However, when investing for a longer duration, purchasing a home often proves the winning option.

Ultimately, a household's decision to rent and invest in the stock market or purchase a home will be determined by a combination of personal and investment preferences, not just the IRR the household would have received from either option. Households are likely to consider factors such as each market's historic performance and its current conditions, and the ease and ability of qualifying for homeownership. Other factors include the need for flexibility in living arrangements, the obligations of homeownership, available housing stock, nearby amenities, and the social and community aspects of owning versus renting. 


____________________

Dr. Hunt (hhunt@tamu.edu) is a research economist and Losey a research intern with the Real Estate Center at Texas A&M University. 

Digital and Print2210https://www.recenter.tamu.edu/articles/tierra-grande/Nest-or-Nest-Egg https://assets.recenter.tamu.edu/Documents/Articles/2210.pdf

 

 

Nest or Nest Egg?Nest or Nest Egg?Investment
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