I think Felix and I are coming to agreement about housing as an investment, thanks to Ryan Avent at The Economist, who attempts to provide a grand unifying theory of housing investment. Let me give a few final thoughts on this issue, and hopefully make this my last on this topic.

Felix suggests, for the most part correctly, that I would agree with this statement by Ryan:

“Sure, it’s fine to think of homes as investments, so long as the kind of investment you have in mind is the highly risky sort you wouldn’t recommend to anyone who didn’t have the ample knowledge and financial cushion you’d expect to see in a successful entrepreneur. And that does not describe most potential homeowners.”

I certainly agree with the general sentiment that homeowners should know the risks, understand fully what they’re getting into, and have some financial safety nets in the event of an income shock. However, I can’t agree that only people aware of the risks and with ample financial cushions should think of homes as investments. In fact,  quite the opposite, I think the people who most need to think of a home as an investment are those who are unaware of the risks, don’t have a financial cushion, but are going to do it anyway.

Felix and Ryan may think we should tell people like this not to buy homes at all, but we don’t know their preferences. Remember, buying a house is an investment and consumption, and whether or not someone should buy a house depends on how much they value owning versus renting. (I don’t think we need to get into the non-financial reasons people value homeowning, but one important reason is that the stock of homes to buy is systematically different than the stock of homes to rent, and people may be unable to rent a home they like in a neighborhood a want.)

Felix gets at the core problem with home buying, and I think the thing that is both his and my biggest concern, when he argues that buyers aren’t thinking about the decision like they should be. He says that

“…no one ever buys a house with their eyes that wide open, fully cognizant that they are taking a calculated risk in which they know full well that there’s a non-trivial probability that the consequences of their “investment” will be foreclosure, bankruptcy, and homelessness. Investments don’t work like that: if you’ve laboriously saved up enough money to scrape together a downpayment on a home, that’s money you’re not going to gamble. The number of people genuinely comfortable with taking that kind of downside risk is basically zero, as it should be.”

And he may be right, most homebuyers may be completely underestimating the probability of a worst-case scenario, or may not be considering that at all. I would be very interested in seeing a study that looks at that, and I think Felix is probably correct. Either way, even if the majority of homebuyers are fully aware of their risks, surely many many homebuyers aren’t.

But what’s the solution to that problem? As I’ve said, you can’t a priori argue that people shouldn’t buy homes, since we don’t know their preferences, but what you can do is argue that people should make the decision, as Felix puts it, with their eyes wide open.

This means that potential home buyers should consider, to name just  a few things, their income and job stability, the covariance -if any- between the home price and their income, the covariance between their house value and their existing investments, whether or not the home could be rented in the event of an income shock, the expected path of future prices based on their private knowledge and/or knowledge of their realtor, the expected future rental opportunity costs, and more. In short, they should be thinking of a home like an investment as well as consumption. If more people thought like this we would almost certainly have many fewer homebuyers, more renters, and fewer foreclosures.

I think Felix will agree with most of that. So let me discuss one last area where we may still have disagreement.

Since most buyers will choose to sell at some point, and even those who don’t plan on it should consider the scenario in the case of a severe income shock, the difference between what they pay for their house and what it will or could sell for is an important consideration.  I think, probably, that Felix would agree that housing markets are not perfect, and that unlike commodities there isn’t just an obvious observable market price for a home that represents the best possible information about it. If this were so, then people would not need to hire realtors to negotiate for them and tell them whether a seller’s offer is a good one. This lack of an observable market price means that the buyers private expectations of the homes future price, and/or their realtor or other expert’s expectation, is often important information, and may actually be a better estimate than the seller’s offer price. This means buyers can reasonably believe that homes will have negative or positive appreciation, or at least a probability distribution with a positive or negative expected value. These valuations are definitely uncertain, and buyers should recognize that, but that does not mean buyers should, or can, be agnostic about them; especially since it may be the best information available.

I think Felix would well agree that if someone believes that the value of a home is going to go down by 25% in the next 10 years, then even if that fact is not implicit in the buyers selling price they probably shouldn’t buy it. Thus they should have preferences over the future returns of the asset if those returns are negative. Where I think Felix and I disagree is that buyers should have preferences over future returns if they are expected to be positive as well. For instance, a home with 10% expected appreciation should, ceterus paribus, be valued more highly by a buyer than an identical home with 0% expected appreciation. Thus on the margin, homebuyers should take expected financial returns into consideration, which is very specifically thinking of it as an investment. In the same way, someone who -with their eyes wide open to the risks- is otherwise indifferent between buying and renting may decide to buy based on their beliefs about the expected appreciation of the home. Even if the individual is, somehow, indifferent to the monetary value of those returns, they should still have preferences over them because an appreciating home makes it less likely that the buyer will have to foreclose in the case of some unforseen events, because they will be more likely to be able to sell it and not ruin their credit.