Did that get some attention? I hope so. The conclusion that realtors should rent comes directly out of urban economics, an understudied and ignored branch of modern economics. But while it is a cute fact you’d expect to see in Freakonomics– it wasn’t there. I wanted to take some time to explain this counterintuitive fact, and then use this to maybe reshape the question of renting or buying.
One of the reasons why we hear that we should hold a balanced portfolio is that, for whatever reason, it reduces our exposure to risk. If our eggs are in one basket and that basket drops, we have a mess. So by diversification, we’re not so S.O.L. if one of the baskets drops. But that isn’t necessarily true. If, for instance, basket 1 and basket 2 tend to drop together, then we haven’t really diversified as much as we might suspect. Consider an asset portfolio of a typical family(Cash-Like, Stocks, Bonds, Income, House). In the classic portfolio of stocks and bonds, those two tend to trend in opposite directions, so that’s one way of diversifying away risk.
If we consider the house to be a part of our asset portfolio, then we have to consider how it co-varies with our other assets. So if our income moves together with house prices, buying a really big house doesn’t mitigate any risk on our portfolio…it makes it riskier. It would behoove such a person to either rent, or own smaller and put the difference in an asset that doesn’t vary much with income.
The underlying non-economic logic is the same reason why you wouldn’t just buy stock in the company you work for. Your income is very much related to the value of the company. If the company goes belly up, your stock is worthless and so is your job. Change company to house and the situation is the same.
Real Estate is a part of our overall investment portfolio. In fact, it is typically the biggest chunk for most households. If I look at my Net Worth estimate, about 40% is our estimated house equity. So we should consider our house part of our investment portfolio.
Now, let’s go back to our realtor. When house values rise, realtors tend to make a lot of sales and thus money (this is a fairly well established relationship in urban economics). When house values decline, realtors tend to make few sales. There’s a lot of economics behind these simple statements but I’m going gloss over them.
Since portfolio theory tells us to diversify, and since a realtor’s income and home values are very much related, diversification indicates that the realtor should RENT (or own smaller) to mitigate risk. Now how about that for some counterintuitive fun! The person selling your house should be renting theirs, if they’re properly diversifying. HA!
How does this tie in to DiNK readers? For one, the buying vs. renting decision is often thought about in terms of interest rates, time frames, and available down payment. But in addition, whether or not your income is related to house prices should ALSO be a consideration, and this is NEVER mentioned in buy vs. rent guides. Of course, this would imply that a foreclosure specialist should own their home, since their business goes up when house values go down.
Anyways, I hope that adds a wrinkle to the buy vs. rent debate. Can you determine whether your income varies alongside house prices? Sort of. Government employees tend to have income that is little related to house prices. Some banking, investment, and local business owners income may be quite related to house prices. It is worth considering.
And if you do buy, ask for a realtor who rents. They get it.