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Real Estate and Asset Allocation

A question that recently came up in a comment here was whether investors should include their home value when calculating their current asset allocation. Or to phrase the question differently, does owning a home provide all the benefits of diversification that come from investing in an additional asset class?

The major benefits of diversifying your portfolio among multiple asset classes are that:

So does owning your home help you to achieve those two benefits? Or would it be wise to include additional real estate holdings (probably REITs) in your portfolio as well?

Reducing Portfolio Volatility

I doubt that owning a home provides much in terms of the psychological benefits that are usually associated with decreased portfolio volatility. Why? Because (I think) most of us see home value and 401(k)/IRA value as totally separate things rather than as pieces of one larger portfolio.

That is, when an investor gets his 401(k) statement in the mail, he’s probably not thinking “Oh, my portfolio is down, but that’s no problem, because according to Zillow my home value has appreciated by roughly 7% this year.”

That said, owning a home does provide psychological benefits/peace of mind. When you own your home, that’s one big piece of your financial picture that you don’t need to worry about. Even if your home never appreciates in value, there will still be a point in your life at which your living expenses drop dramatically due to having paid off your mortgage.

Now, does that peace of mind allow an investor to comfortably and safely take on more volatility in his portfolio? I don’t really have an answer here, and I imagine it depends upon the individual. But if I had to guess, I’d lean toward “no” being the answer for most of  us.

Real Estate and the Rebalancing Bonus

Obviously, when you own your home you can’t exactly use it to rebalance in the same way that you can use stocks, bonds, or cash. So while owning REITs in your portfolio would likely contribute to a rebalancing bonus, regular home ownership probably will not.

On the other hand, there certainly are ways that you can take advantage of increases in real estate prices (a reverse mortgage during retirement, for instance). So owning a home certainly does give you a degree of exposure to real estate markets.

What do you think?

Overall, I tend to think that investors should consider their home value to be a part of their asset allocation–and that, therefore, many investors (whose home values are already a huge portion of their net worth) are over-allocating toward real estate when they invest a significant portion of their brokerage accounts in REITs.

I am, however, very interested in hearing your thoughts: Do you think that owning your home provides sufficient exposure to real estate markets (provided that the home value is a large enough portion of your overall net worth), or do you think it’s wise to further invest in real estate in your brokerage accounts?

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  1. I had to laugh; I just got my property tax assessment in the mail. Apparently my home appreciated 7% in value this year. I suspect, though, that it has more to do with the county’s need to raise revenue than any actual increase in the market value of my home…

    But I agree that home ownership is definitely just about all the real estate exposure you need.

  2. Well, you can convert the value of your home into consumption, but it isn’t as easy as doing so with other assets. You have to repay a HELOC. Reverse mortgages are a field of land mines. You can downgrade to a simpler home. Will you? Maybe, maybe not. You don’t know now do you?

    All that means to me that the home is generally not the same as other assets dedicated to long-term savings. If you could easily sell off a fraction of your home then, yes. But you can’t, so I say no: keep (primary) home separate.

  3. Rick Francis says

    The other problem is that a single home is not at all diversified- an index REIT fund is not only much more liquid but is also a much better representation of the housing market.

    Did you pick the location of your home based on it’s investment potential or where you wanted to live?

    -Rick Francis

  4. Along this lines, I’ve occasionally wondered why the target retirement funds of funds which Vanguard and others offer don’t include REIT index funds as part of their holdings, to increase those assets among the fund’s holdings. Anyone know?

  5. I think it is important to include your home value in determining your investment position and to understand your asset allocations and risk exposure.

    While it is an illiquid asset, this can be considered when evaluating your portfolio position (liquidation discount, refi costs, etc). For example, you may have a signficant asset that is a) Dollar denominated and b) exposed to the US economy – this needs to be considered when you evaluate your allocation to emerging markets.

    Theoretically, you should take this further to other “intangible” asset classes: your salary represents a cash flow stream that is exposed to the industry of your employer – work at a bank? Then stay away from financial services when purchasing stocks! Otherwise, just as the industry is tanking and you have investment losses, you could also be exposed to the risk of job loss. By investing in financial services you have not diversified your risk.

    I would also consider a fixed rate mortgage balance as a type of “negative” bond fund. As interest rates rise, you will have losses in your bond investments, but gains in your “negative” bond fund. If you have a fixed rate of 5% and the market rates rise to 7%, you have an embedded value in your fixed rate mortgage.

    What about your compulsory “investment” in the social security annuity you will receive upon retirement – this is a future cash flow stream that has value today; albeit with a healthy discount for default!

    Just some random thoughts.

  6. I count the value of my home (which is fully paid-off) when making financial decisions. To not count it would create a bias against paying off a mortgage. If Person A directs $200,000 to paying off a mortgage and Person B directs $200,000 to buying stocks, is it right to say that Person B has $200,000 in his retirement account and Person A has zero?


  7. While many good points have been made, I’m against it.

    Most people put it in their balance sheet so they can feel better about themselves.

    My home is also paid off but I see it more as a contributor to my income statement than a balance sheet item. I know that sounds crazy but since I have to live somewhere, the home is almost an income generator because it reduces my need to create income.

    I don’t consider it a financial asset because it’s hard to monetize quickly, I won’t refinance and invest the money & I have to live somewhere.

    The value of having a balance sheet in my mind is for one reason – to calculate how much income I can generate. I don’t need to count the asset in my balance sheet because it already contributes to my income statement.

    This may sound nuts but it works for me….

  8. I think your home should be considered your net worth (especially if you include your mortgage). But I’m not sure it has a place in asset allocation. You can’t trim back or buy up your house to maintain an investment policy.

    Home equity might be a financial resource if you plan to downsize to a lower value home at some point, but most people don’t plan to “spend” their home in retirement like they do other investment assets. If you don’t want to be forced to do that, you need to plan for other resources anyway.

    As far as REITs, they’re companies, not real estate (just like mining companies are not gold). If you invest in a broad market index, you will be invested in REITs. If you have a separate REIT allocation, all you are doing is overweighting a sub-sector of the overall market.

    Owning income producing real estate is an investment, but in the same way owing a small business is. You can’t simply provide the capital and then go about your other business; you have to invest time and effort as well. It’s not a bad thing if your willing and able to step up, but I don’t think there it qualifies for “oblivious” real estate investing.

    One last thing about REITs, they really seemed to gain in popularity as their own asset class about 10 years ago. I suspect it is due to the REIT companies’ unique structure and great past-performance. Before that there was another quasi-asset-class that had a ” unique structure and great past-performance.” Remember when people had a separate Internet stock allocation? This trend didn’t seem to die out until almost a year after the tech bubble burst.

  9. Great comments here. On balance, I think you have to include your home in your portfolio.

    I frequently have an argument with my girlfriend who says that I am wrong to say that her parents have made money on their home they bought in the early 1980s for, say, 5-10% of the value it is today.

    Her argument is that they need to live somewhere, so they can’t sell it. We can say that’s overly simplistic, but I think that’s how a lot of people think.

    Another way to think is “what would it cost them to replace this asset?” i.e. Not just the utility cost, where you might use monthly rental as an approximation, but the cost of having a stake in the UK property market in a leafy village with a great little coffee shop and farmer’s market.

    The answer is about £500,000. An identical couple who rented all their lives would not have this £500,000 (all things being equal – I think it’s safe to say rental increases over the years will have outpaced any periods where it cost more to rent then buy, or even the cost of maintaining the home).

    You can’t leave £500,000 (or $750,000) off the average middle class balance sheet. Imagining you didn’t have it shows why.

  10. I agree with Wealth Pilgrim. First, I do include my home equity in my net worth calculation mostly just because it makes me happy.

    Really, it belongs more in the same category as three years of canned goods. It’s a way to stock up on housing at today’s prices and it’s a way to reduce future housing costs once your mortgage is paid off.

    I think it greatly improves diversification. If my taxes get too high for me to afford, that probably means my house is worth a lot and I can sell it and move someplace cheaper. Even if I don’t like the new area as much, at least I have the consolation of profiting from the sale of my house.

    That said, one house isn’t diverse. Neither is one job. Oh, well, that’s the way things work. Like JL implied, you can make sure your REITs are in some area other than your house the way you make sure your stocks are outside your employer’s sector. You could have it be business properties or be in some other part of the world.

    One thing about including home equity is it usually makes it look like your net worth is heavily weighted toward real estate and thus you shouldn’t buy REITs. But in many ways, it’s not comparable to REITs, just like stocking up on canned goods isn’t really comparable to buying stocks related to groceries. On the other hand, if this overweighting inspires you to get a less expensive house than you otherwise might, that’s probably a good thing.

    I’ve heard of people saving for their housing down payment in REITs–this way if real estate goes up, you have more money, but if it plummets, then although you have less money, you don’t need as much money.

    As far as your original questions, I think it does reduce overall portfolio volatility because if your other investments are plummeting then you can sell your house and move somewhere cheaper, get a HELOC, or get a reverse mortgage. And because paying off a mortgage means all you have to pay are taxes, insurance and repairs, which surely are less volatile–or at least costs less–than rent. However, I don’t think it allows for a rebalancing bonus. You can’t rebalance without paying horrible fees. No, actually I guess you could “invest” more of your money in prepaying your mortgage when stock prices are high and pay only the minimum when stock prices are low so you can invest more of your money in stocks.

    So I’d say owning a home provides some, but not all of the benefits of diversification that come from investing in additional asset classes.

  11. If you don’t include home value, then doesn’t that ignore the
    inflation hedge (& of course the downside risk that we’ve seen
    recently) that you get with owning a home? Is a renter in the same
    financial boat as the home owner? If you choose to ignore home value,
    then it seems that the renter and owner should have vastly different
    asset allocations in order to put themselves in a similar risk/reward

    I think the mortage debt is even more important to include. Mortgage
    debt is the inverse of buying bonds and to ignore the debt doesn’t
    seem to make sense. Here’s a good article on debt & real estate:

    I haven’t been including my home value or my
    mortgage debt, but if you don’t include the debt then paying off the
    debt doesn’t show up in your asset allocations & creates a bias
    against paying off the mortgage as RobB put it above. Of course if we
    include the debt w/o the equity then it would look like many of us
    have a (false) negative net worth so that leads me to believe that
    including the home value & the debt is the way to go.

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