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Creating Wealth Through Homeownership – The Proof

Today, we are honored to have Ken H. Johnson, Ph.D. — Florida International University (FIU) and Editor of the Journal of Housing Research as our guest blogger. To view other research from FIU, visit http://realestate.fiu.edu/. – The KCM Crew

Several real estate economists have shown that the average homeowner accumulates more overall wealth than the average renter.[i]  However, it is not clear how this is done.  Is it that owned property usually appreciates at such a rate that, after considering leverage, returns to ownership are extraordinarily high?  Said another way, might homeowners accumulate more overall wealth because ownership is a great levered equity creator through property appreciation?  Or, is it that owners acquire greater wealth, on average, because they are systematically paying down a mortgage thereby creating equity thanks to loan amortization?  In other words, paying off property creates wealth.

In ongoing research being conducted by Beracha and Johnson,[ii] these and other questions concerning homeownership and the accumulation of wealth are being investigated.  In earlier research, Beracha and Johnson show that renting is the superior investment strategy; however, in this earlier strict horserace between buying and renting, a very bold assumption is made.  Specifically, it is assumed that any rent savings (from lower rent versus mortgage payments) are reinvested without fail. Thereby, after balancing all of the costs and benefits from ownership and comparing them to renters’ portfolios from reinvesting rent savings, renting wins.

The question, however, very quickly becomes that, in a setting where Americans generally save less than 5% of their disposable income, is this assumption realistic and how might the removal of this reinvestment decision alter the outcome of the horserace between buying and renting?  As part of their current research, this question is directly addressed.  In particular, Beracha and Johnson find that after allowing renters to spend any rent savings on consumption (beer, cookies, healthcare, education, etc.), ownership leads to greater wealth accumulation, on average.  The graph below highlights this finding.

The graph looks at the ratio of renters’ portfolio values to owners’ proceeds from sale for the entire U.S. between 1978 and 2010 both with strict reinvestment of rent savings and without reinvestment of rent savings.[iii]  Clearly, numbers greater than 1 indicate that renting leads to greater wealth accumulations, while numbers less than 1 indicate that homeownership creates greater wealth, on average.

When renters are forced to reinvest (top line in the graph), the results confirm the earlier findings of Beracha and Johnson (2012).  That is, in a strict horserace between buying and renting, renting wins in the vast majority of cases.  However, when renters are allowed to spend rent savings on consumption (i.e. economically act like the typical American consumer), homeownership wins in virtually all instances.  Notice that in the bottom line of the graph (no reinvestment), the renters’ portfolio values divided by owners’ sale proceeds is great than 1 for only four of the 32 years of the study.  Thus, when renters are allowed to spend rent savings, homeownership is the clear winner in the wealth accumulation horserace.

Finally, in the same current research, Beracha and Johnson find that allowing for property appreciation rates to increase as much as 20% over their actual historic values results in virtually no change in the outcomes concerning wealth accumulation.  That is, property appreciation contributes only marginally to wealth accumulation.

Implications

Without proof many have speculated about this outcome for years.  However, there is now actual quantifiable evidence that homeownership is not the great levered equity creator that it has so often been touted to be.  Instead, it appears that homeownership creates extra wealth mainly through its ability to force owners to save rather than through property appreciation.  Thus, homeownership appears to be a self-imposed savings plan, which through time leads to greater wealth accumulation as compared to comparable renters.  In short, buying a home makes Americans save.

Who says that Americans are horrible savers?  Apparently, we are not.  We have simply been saving through our homes rather than putting our savings in the bank.


Endnotes


[i] Homeownership is the most viable path to wealth creation for the majority of Americans.  See Engelhardt (1994), Haurin, Hendershott and Wachter (1996), and Rohe, Van Zandt and McCarhty (2002), among others.

[ii] Eli Beracha and Ken H. Johnson, 2012, Beer and Cookies Impact on Homeowners’ Wealth Accumulation, ongoing research.

[iii] The research assumes 8-year holding periods.  When the holding period is allowed to vary between four and twelve years, the results change only marginally.  Thus, holding period has very little to do with the results.


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48 replies
  1. Bill Baxter, CFP
    Bill Baxter, CFP says:

    Thanks for the research, and I have a few questions: It appears from the data presented that the forced savings are in the form of increasing equity via the amortization of debt (since appreciation in value seems to have been ruled out in the model, if I understand the last paragraph).  The thought occurs to me that more than a few homeowners have been quick to extract this equity to fund spending in the form of home equity debt.  When this occurs, the “saving” amounts are converted into spending, and the spending is increased by the tax-adjusted interest costs.  I would be interested in research showing how much equity is pulled out of home for reasons other than home improvement the amount that stays in the home.  Also, renters do not typically pay maintenance costs and property taxes as an additional amount – although presumably these costs are built into the rent they pay.  I wonder if these costs are factored into the research Dr. Johnson cites?

    Thanks

    Reply
    • Anonymous
      Anonymous says:

      Hey Bill, we let Dr. Ken Johnson know about your questions and here is his reply:

      (1) Appreciation is in the model. It simply does
      not have that much of an impact as often believed.

      (2) The thought for additional research is worthy.  However, all should
      recognize that removing equity by way of a line of credit is akin to removing
      savings from the bank.  One is simply a little more costly and difficult
      than the other, which adds further support to the idea that ownership is a
      self-imposed savings plan.

      (3) Maintenance and taxes are accounted for in the model along with other costs
      and benefits of ownership.  For complete details on the model, see Beracha
      and Johnson (2012), Lessons from Over 30 Years of Buy versus Rent
      Decisions: Is the American Dream Always Wise?

      Reply

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