Risks associated with owning a home as an investment

Is owning a home a risky investment? originally appeared quora: A place to gain and share knowledge, helping people learn from others and better understand the world.

answer Written by Marco Giacoletti, Assistant Professor, School of Finance, University of Southern California, quora:

Homeownership is often considered the American dream, but it is also an important financial decision and perhaps one of the biggest decisions an individual or family makes. A home is not only a place that provides shelter for the owner and his family, a place where daily life unfolds, but also an investment asset.

A home passes through multiple owners over its lifespan. A study conducted from 2019 to 2021 calculated that the median length of time homeowners stay in the same home is 13 years. Considering that the median price of homes for sale in the United States as of 2019 was built in 1978, you can see that homes have changed hands many times over their lifetimes. Upon resale, the homeowner realizes a price gain (capital gain) or loss. These price increases have been positive and large on average across the United States over the past 20 years. The S&P Case-Shiller Index, which tracks the rate of price appreciation of resold homes, had an average annual growth rate of 4.8% from 2000 to 2022, an impressive 280% increase over that period.

However, this growth is accompanied by significant fluctuations. The timing and location of purchases and sales can significantly impact the return on this investment. For example, between 2006 and 2012, the annual price increase for the US index was -3.2%. The differences in growth rates become even more pronounced when comparing different metropolitan areas and neighborhoods. As an example, in the Los Angeles metropolitan area, from 2000 to 2022, home prices rose more than 7% annually in Culver City, but only 5.6% in Montebello. Overall Los Angeles home prices rose 6% annually, compared to Detroit home prices that rose 2.3% annually between 2000 and 2022.

Beyond these elements of time and place, there is an important element of “.Unique housing risksThis is not due to market-wide fluctuations (even when considering very narrow local markets such as zip codes), but rather differences in price increases specific to individual home sales.

Research in this area shows that idiosyncratic risk may be the most important factor in housing risk.In my own research, when I decompose total housing risk into regional market risk (postcode level variation) and idiosyncratic risk, idiosyncratic risk Outweigh local market risks, especially if the holding period is short. I provide evidence that idiosyncratic risk is tied to the uniqueness of each home and transaction and is influenced by factors such as buyer interest and market liquidity at the time of sale. Due to diverse buyer appraisals and a limited number of potential buyers at any given time, sales prices for the same property can vary widely. For example, John, who likes to spend time outdoors with his dog, may value the on-site pool and garden, but may not care about a small living room, kitchen, and dining area. Another potential buyer may have opposite preferences. Whether or not John visits your residential property with a swimming pool can make a big difference in the selling price. This buyer “risk matching” factor is the main source of idiosyncratic risk.

I also discovered that Idiosyncratic risks become less important as a home’s tenure increases. This is because idiosyncratic risk is caused by the matching risk effect, which occurs especially during sales. Therefore, the longer the period between resales, the lower the average impact of this risk per year of the holding period. The diagram below illustrates this point in more detail.

The left panel of the figure plots the median, top quartile, and bottom quartile of idiosyncratic risk rates across California ZIP codes for home tenures of 2 to 15 years. First, idiosyncratic risk determines a large proportion of the risk for most holding periods. Second, across all postcodes, the share decreases with increasing tenure. For the median ZIP code, the idiosyncratic rate is close to 70% if the home has been held for 2 years, but less than 50% if the home has been held for more than 15 years.

As mentioned above, this is due to some special characteristics of idiosyncratic risks as opposed to local market risks. Over the holding period of a home (time to resale), the annual amount of risk (or variation) in local market factors is approximately the same, regardless of the length of the holding period. However, the amount of idiosyncratic risk per year is decreasing.

The right panel of the figure shows the median annual total risk of a home over its tenure. Solid lines indicate estimates from the data. Because idiosyncratic risk accounts for a large portion of total risk, total annual risk also decreases with increasing holding period. For a two-year holding period, it will be 15%, and for a 15-year holding period, it will be approximately 11.5%. The dotted line in the same panel shows the value of total housing risk if the idiosyncratic factors were “forced” to be the same over the holding period. This shows that short holding periods underestimate the total risk, while long holding periods overestimate it.

The numerical estimates in the figure can be interpreted by making some simplifying statistical assumptions. Suppose that for the median zip code, the average annual price increase over a given holding period was 5%. With a two-year holding period, 7 out of 10 homes in the zip code will have a capital gain of -10% to 20%. With a 15-year holding period, 7 out of 10 homes will have a capital gain of -6.5% to 16.5%. Therefore, taking into account idiosyncratic factors, the risk of price increases is very high. However, homeowners can reduce their annual investment risk by holding on to their home for longer.

References:

1. Data on housing characteristics in the United States are available from the American Housing Survey.
2. Data on homeowner tenure (tenure period).
3. Federal Reserve Bank of St. Louis S&P Case Shiller Index.
4. Zillow zip code level index.
5. Giacoletti, Marco, 2021, “Idiosyncratic Risks in the Housing Market”, Financial Research Review, 2021, Volume 34(8), Pages 3695-3741.
6. Landvoigt, Tim, Monika Piazzesi, and Martin Schneider 2015. “San Diego Housing Market.” American Economic Review 105(4), 1371-1407.
7. Piazzesi, Monica, Martin Schneider, and Serare Tuzel, 2007. “Housing, Consumption, and Asset Pricing.” Journal of Financial Economics 83, 531-569.
8. Sagi, Jacob, 2021, “Asset-level risk and return in real estate investing”, Financial Research Review, Vol. 34(8), pp. 3647-3694.

this question originally appeared quora – A place to gain and share knowledge, enabling people to learn from others and better understand the world.

follow me twitter. check out my website.