Realtors Should Rent

by Team Dinks on April 19, 2010 · 3 comments

Stephen PopickDid 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.



{ 3 comments… read them below or add one }

1 Derek Sisterhen | Past Due Radio April 19, 2010 at 10:56 am

Hey Stephen, awesome post!

I think most folks recognize that their homes are a part of their overall investment portfolio, but they don't typically go that extra step to assess the risk factor. Likewise, when most of us talk about risk in our investments, we think we mean the risk of losing everything. When portfolio managers talk about risk, they mean price volatility.

On the personal side of personal finance, it's interesting how we're predisposed to "buy up" in house if we're making more money, simply by the virtue that we have more money to spend. We tend not to think about what happens to that investment if the income goes away.

2 Anonymous April 19, 2010 at 9:23 pm

There's an argument to be made that the American economy would be better off if MOST people rented, because owning can often anchor people too much to a particular city so that when that city tanks, it's hard to move in search of better opportunities.

There is also an argument for separating one's liquid from one's illiquid investment portfolio. You write about residential real estate as part of one's "portfolio", but I'd prefer to bracket off that "investment" and consider it as nothing more than a place to live. Paying off the mortgage is nothing more nor less than a way to free myself from future rent payments. My mortgage doesn't go up or down depending on how "The Market" is doing (rent, of course, CAN go up or down), and I have no idea whatsoever how much the rent I'm not paying 20 years from now will be "worth". All I do know is that I will probably need a place to live, and from that perspective it doesn't make even the slightest difference whether the market is in a bubble, or I'm underwater, or anything like that.

And of course realtors, too, need a place to live. I'd suggest, then, that the decision by a realtor as to whether or not to buy residential property should be subject to the same criteria that the rest of us (ought to) use: 1. Can I afford it– including not only the mortgage but a conservative estimate of the associated maintenance and other expenses?; 2. Is it at a good price– e.g., what is the multiple between a year's worth of rent and the total selling price of the property?; 3. Can I commit several years to living in this residence, i.e., to make it worth the price of the closing costs, to be not dependent on the price rising (even to be not dependent on the price not falling!)?

If a realtor can say "yes" to all these questions, I think he/ she can safely afford to disregard the idea that his/ her house is part of the "portfolio"– again, on the theory that a realtor, like the rest of us is going to have to live somewhere, no matter what the state of The Market is. However, there is certainly a case to be made that realtors shouldn't buy investment property, REITs, etc., for the reasons you say.

3 Coffeecents April 20, 2010 at 8:09 am

@Derek,

Thanks for the feedback. My article was an attempt to get people to look at the risk factor of home ownership differently. It may be true that "risk" does mean "losing everything" but that's an incorrect definition of risk. I would think by improving our definition, we can improve our returns.

On the "buy up" thing, what we learn from Urban is that an increase in income can do one of two things : Move one further out and into a bigger home, a bigger home where one is currently at, or a smaller home closer in to the job-site but more leisure time. Thus the buying up idea must be a real estate industry convention, and not true to reality, since more money should allow us a choice dependent on our own personal peccadilloes.

@Anon

It is very difficult to separate out a home into just an investment, since we also consume a house (we do have to live somewhere). It is both a consumption AND an investment good (this creates a tendency to over-purchase).

Due to tax treatments of home-ownership, owning may be a dominate strategy, or renting might be. I do think that not recognizing that a home has an investment component would lead to a non-optimal purchase / rent decision. The cost of renting is lower rent trades price risk for rent risk.

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