Why the housing is still the best investment for middle class Americans--A Bond Trader's View of Housing

To make sure that I am not wrong in my math, I have constructed a spreadsheet for the following example. We have Al and Bob, who are making the same amount of money, $100k per year, and spend the same amount of money in housing: Al pays $2500 per month for his mortgage, maintenance, tax and insurance; while Bob pays his rent. They also have $90k in their respective bank account. The question is, how they would fair in the coming 30 years.

We need to make a little more assumptions to further simplify the situation. Assuming both Al and Bob has investment accounts, and once they have some free money, they put it in the account; if they need some money, they draw it out from the account. Also the mortgage Al was able to get was 20% down, 4.5% 30-year fixed mortgage.

Assuming that the economy is growing slowly, the inflation is low, say 2%. It is reasonable to assume that the rent and the house value would also follow the 2% appreciation. If the investment account is returning 5% annually, Al, after 30 years, would have built $723k equity, while Bob, unfortunately, would have to come up with $164k somewhere to keep up with the higher rent.

Someone could argue that we have a Japanese type of recession. 0% inflation, rent increase or house appreciation for 30 years. The investment account return, in this case, we can still assume returning 5%. They probably are loyal investors of Bondsquawk and make good investment decisions in bonds. In this case, Al and Bob roughly breaks even, ended up with $400k. Oh By the way, the 5% is after tax return. The caution is that, it is possible to earn that kind of return, but it takes skills, training, and hard work to achieve that kind of return. Put simply, it is hard. Assuming the return in the investment account is only 3%, then Al ended up still with roughly $400k, but Bob would only have $225k.

Now let's go to the real depressing scenario: 0% inflation, 0% rent increase and 0% expected return in the investment account. Quite counter intuitively, the house has to depress 4.8% every year to make Al as poor as Bob after 30 years.

How is this possible?

First, we have to closely examine the tax benefit of owning a house and paying a mortgage. Assuming the down payment is 80k and the house is worse 400k, the mortgage interest is about $14k and thus assuming a 25% marginal tax rate, the home owner gets $3500 every year from Uncle Sam. It is a $3500/$80k = 4.4% risk free return! and tax free. As a bond trader, I can never find a deal as sweet as this.

The second benefit is still tax. The capital appreciation in the house is tax free too up to $500k for primary residence. If people are willing to invest in $401k, this is a better deal. You get a tax free (not deferred!) account with up to $500k appreciation.

The third one is a little bit embarrassing. I have to admit that I cheated a little bit. In the $2500 dollars Al and Bob spent, A portion of Al's payment is paying down the mortgage and thus counted as a saving; Bob, unfortunately, is paying the rent. Depends on the regional rental yield; or in plain English, the housing market prices, Al and Bob might not ended up getting the same housing. Some places in the country, Al can live like a king and Bob lives in a slam; in places like New York City, probably the opposite is true. That is my caveat.

Now given the benefit of all the above, how come the housing market still crashed? The crisis, was and has been a subprime crisis, a credit crisis, not a housing crisis. The housing market should follow the inflation, mostly to keep a reasonable relationship with rental yield and available mortgage rate; even adjusting for inflation and mortgage rates going lower, the housing market run up in the 2003-2007 is still unsustainable. Mostly because people that should have not invested in housing did it.

Still using the $401k account analogy. We all use it; and it turns out reasonably beneficial for our dream of retiring securely. Let's assume suddenly we allow kids to invest in $401k too, and also let them over leverage using their lunch money, then what happens? We would see a stock market run up. Very significantly. Kids are putting money to work and buying stocks. Then we say, oops, kids should not playing with stock market using their lunch money, and we stop lending them money, raise interest rates, and force them to liquidate. The first kid is fine, he probably still makes some money, but the later kids would end up getting wiped out, because they are on shoelaces and the stocks are going down. More kids start to sell, and less banks willing to lend, and the stocks keep going down to force more kids to sell. A vicious cycle in full force. Despite all the tax benefit.

Housing is not a right, it is a privilege for American middle class to build wealth with significant tax benefit. As long as the tax benefit is there, the tool is bullet proof in the long run. Keep in mind, even if the housing market stays flat, you get 4.8% return from the money you put down from Uncle Sam.

Now how do we get out of this housing market slumber? Yes, a lot of people lost money in housing market, but a better understanding of the tax incentive would stop the panic sale. Also, people need to realize that the privilege of housing comes with the responsibility of maintaining a good credit score. If you strategically default once, you are out of this tax benefit account for 7 years. Do your math right.

The talk of revising the housing tax benefit is not helping at all. If this country believes the long term benefit of housing ownership, it needs to maintain its tax benefit, if not increase it. Here is one proposal for the DC people: if you really want to help the middle class people; you should make sure the mortgage interest could reduce the alternative minimum tax. Otherwise, all the middle class people who got caught by the AMT would not be able to benefit from the tax benefit of housing. Do not say you believe in housing market and middle class and then screw them using the AMT.

I attach the spreadsheet I created here: CPI Inflation.xls