Updated: May 4
1. Introduction and background
As an American tradition, our culture teaches us that homeownership is a path to wealth. Certainly, our tax code encourages it. Our mortgage finance system, broadly the system including Fannie Mae and Freddie Mac, provides lower-cost mortgage finance options. Included in this system is a government mortgage insurance program, collectively managed by the FHA, VA, USDA, and GNMA. This federally-backed program enables low-to-moderate income individuals to achieve homeownership. [i]
All is not well, though. As a result of the 2008-09 financial crisis, tens of millions of Americans either lost their homes or suffered significant delinquency. This was the result of a major economic recession and a collapse in home prices. This perfect storm caused many to rethink their relationship with housing. And perhaps, to rethink their trust in the American housing system. This episode taught many that America's housing system is not as safe as previously believed. While there were many institutional failures leading to the financial crisis [ii], this episode left entire generations of people with the mindset:
Fool me once, shame on you, fool me twice, shame on me!
....and people generally do not suffer being fooled again.
This attitude is both understandable and unfortunate. The U.S. housing system, despite its past failures, is still one of the best mass wealth-producing systems on the planet.
This article is presented in the following sections:
Introduction and background
What makes homeownership a better option?
The renting challenge
The adaptability mindset - home buying in action!
Conclusion and notes
A significant outcome of the financial crisis was a new set of real estate rental-based institutions. These companies were originally created to help America's financial institutions resolve the tremendous influx of distressed housing inventory. Just prior to the financial crisis, the U.S. was at an all-time low in distressed single-family inventory. It switched almost overnight. It was like a dam breaking and flooding a formerly dry valley.
Distressed properties flooded a marketplace completely unprepared to handle the historic volume. Companies quickly evolved to manage the "darker side" of the financial crisis. These were the companies that handled separating loan collateral from distressed borrowers and then remarketing (including renting) the properties. While some of the distress was related to foreclosure, many were handled outside of foreclosure, but still resulted in the same loss-of-home outcome. These rental and real estate management firms started as smaller company operations. Over time, a subset of these firms grew to become a professionalized industry and well funded by investment banks. This system was originally catalyzed by Federal government programs to support banks and homeowners through the financial crisis. [iii]
Fast forward to today, this financial crisis-rooted industry is focused on providing Single-Family Rental (SFR) housing. These are companies that buy single-family homes with the intent of renting them. Their funding generally comes from large investment banks like Blackstone or BlackRock. These investment firms are making markets for bonds and funds holding SFR-based investments.
“The median price of an American house has increased by 28 percent over the last two years, as pandemic-driven demand and long-term demographic changes send buyers into crazed bidding wars. Might the fact that corporate investors snapped up 15 percent of U.S. homes for sale in the first quarter of this year have something to do with it?”
The industry’s growth depends on people’s willingness to substitute rental housing for homeownership. Depending on the market dynamics, the SFR industry can be either helpful or a significant challenge to homeownership. This challenge may deepen wealth-based social divisions.
We appreciated the SFR industry when we are in a buyer's market - that is a market where there is more housing supply than buyers. This was certainly the case during the financial crisis. In the buyer’s market case, the SFR industry is an important source of capital and liquidity.
However, in a seller's market like today - where there is more demand than homes available - the SFR industry can become a barrier to homeownership. It is difficult for an individual first-time homebuyer to compete with an all-cash offer from an investment bank! In the seller’s market case, the SFR industry is more likely to crowd out private home buying capital.
As a final background point, systemic bias impacting mortgage credit is a valid concern. Systemic bias may be found in the data used to train mortgage loan assessment algorithms. The presence of systemic bias may make it unfairly more challenging for some people to obtain housing credit. This risk is particularly concerning for those that traditionally do NOT participate in the U.S. banking system. (I.e., The "unbanked.") This is a challenge that U.S. regulators, CRAs (the credit data repositories) and credit modeling companies are attempting to correct. The simple systemic bias reasoning is that:
Since racism and other forms of discrimination are found in our recent past, and
Our credit data is a representation of our recent past reality, then
It is reasonable to expect systemic bias may be found in our credit algorithms today.
Fixing our credit data is the critical step to correcting bias in our credit algorithms. That means including payment data from non-traditional data sources to train credit algorithms. This will enable credit algorithms to properly assess the traditionally unbanked population. Credit assessment bias is a big topic and beyond the scope of this article. For a deeper dive, please see our related article Resolving Lending Bias - a proposal to improve credit decisions with more accurate credit data.
This article is intended to be helpful, regardless of your social class or banking related background. Ultimately, knowledge of the broader housing system, an adaptable mindset, decision assistance apps, and some no nonsense risk management thinking are great tools to overcoming potential bias and making the best decision for you!
Next, we explore why homeownership is a superior alternative to renting.
2. What makes homeownership a better option?
It is natural for people to think in terms of current cash flow. The most salient question is:
"Do I earn enough money today to pay my bills and hopefully have a little left over to save?"
If the answer is "yes" then all is good! Right? …. Not so fast! The answer is more nuanced: “It depends.”
Housing, whether rented or owned, is usually the single largest household payment. In this section, we show that where we make those housing payments is critical. We model the time-value impact of paying a rental payment and compare that to a similarly modeled mortgage payment. In our models, the starting rental payment is lower than the mortgage payment. We show how rental firms drive up the cost of housing, whereas a mortgage effectively fixes a homeowner’s housing payments over the long-term. We show how about half a homeowner’s mortgage payment is a tax-benefited investment. We show how our own psychology, known as "salience bias," is working against us.
Next, we start at the base. We answer the question “What is in a mortgage payment?”
This chart is provided by economist Bill Knudson. [iv] It shows the breakdown of the typical amortizing mortgage payment based on mortgage rates in February 2022. This is based on a $100,000 loan. You may apply a multiplier to make this graph relevant to your situation. Please notice the yellow and pink boxes. They show that only about half a mortgage payment, the interest, is the portion of the payment going to others. The rest, the principal and tax benefit, is for the homeowner! This means that only about half the mortgage payment is comparable to rent, the other half is a scheduled benefit for the homeowner.
Fun Fact: The word "amortization" is from the Latin stem "-mort." "-Mort" means "to kill" in Latin. As such, an amortizing loan payment literally means "killing the loan."
The rule of thumb is:
"About half a mortgage payment is an investment in yourself."
Good to keep this in mind when comparing renting to owning a home.
The next step in our reasoning process is to show the true long-term financial impact in a more meaningful (salient) way. Salience bias is a holdover from our own evolutionary biology. Thousands of years ago, it was important to our ancestors' survival to be hyper-focused on the present. If you were eaten by a wild animal today, it hardly mattered how well you saved for the future! This legacy genetic coding made sense millennia ago. However, today it is both a) largely unnecessary and b) contrary to building wealth.
Today’s evolutionary challenge is that paying a little less today for rent than a mortgage "feels" like the right thing to do. To help us overcome our natural brain wiring, it is important to educate ourselves on how our rent vs. own decisions has a BIG impact on long-term wealth. Because it is in our nature to rent, homeownership must be intentional. The following is a graph showing the outcome of our homeowner’s stoic’s arbitrage model. This shows the long-term impact of homeownership vs. renting.
The headline is: A renter’s long-term opportunity cost is approximately $9 million! Another way to look at it is - You have 9 million good reasons to take a chance on homeownership! As such, even if the model is not exactly your expectation, it still pays to own.
Side note about the stoic’s arbitrage: We all have high-value choices to make. The rent v. own decision is one of those choices. The stoic’s arbitrage is the long-term value trade associated with a particular choice outcome. The following graph shows the expected outcome of just such a trade. In this case, the trade is selling yourself out of a rental property and buying yourself into homeownership. Both of which provide a similar “roof over your head” utility. Please see our article series The Stoic’s Arbitrage - A Personal Finance Journey for more context and additional examples.
There are a few assumptions and observations worth mentioning:
The model is based on a $400,000, 30-year amortizing loan with a tax-adjusted rate of 3.5%. There are certainly lower price, more affordable home buying options. Below, we suggest some savvy adaptability options to help find the home that meets your financial needs. Also, do not worry if your mortgage rate is higher, the mortgage rate has a smaller outcome impact in the blue part of the graph.
The growth in the blue (homeowner) part of the graph is from the “invest in yourself” part of the loan payment shown earlier. It is also the result of home appreciation.
The person starts work at 22 and retires 40 years later at 62.
We assume the starting rent payment is only 80% of the mortgage payment. The model demonstrates the power of fixing a long-term housing payment v. the rent increasing over time. [v]
We assume rent payments increase generally at a 5-year average, based on actual past annual rental payment change experience. This is a significant driver and is represented in the orange part of the graph. If rental rates change faster, the future value opportunity cost of renting increases significantly.
Next, we discuss the challenge of renting. Particularly given the incentives of the large investment banks that fund much of the SFR housing.
3. The renting challenge
Investors generally seek yield. This should not be surprising. For most of us, making more money on a stock or bond portfolio is better than making less. If you were given the choice of making more or less money on similar investments, you would likely choose to make more. In the last decade, interest rates have been low. This generally means investment returns, on average, are lower. SFR bond yields are now higher and are generally increasing. This means an investor may get a higher return on a rent-based bond than on a similar mortgage-backed bond. (Technical note: risks of different bonds may be evaluated by comparing bond convexity-based characteristics [vi])
Notice the most recent bond volume is increasing significantly. This is because, according to Realtor.com and Rent.com, and others, U.S. rental payment rates have increased annually by over 7% since 2020.
For those living in particularly hot markets like Los Angeles, these rents have increased by double, triple, or even more than the national average. This relates to an individual’s long-term wealth risk management. As observed in the earlier graph, this is why we see such a big wealth separation between the homeownership and rental value creation potential. When you originate a mortgage, it is based on your ability to pay TODAY. For many, including professional and non-professional employees in their 20s, salary increases over time. The growing difference between future salary increases and your fixed mortgage payment is your PRIMARY source of wealth-building capacity. This is an important point. Homeownership not only provides a roof over your head, but it also provides the foundation for wealth accumulation. However, it is likely a landlord, often backed by investment banks, will regularly increase your rent. As such, over time, the rental is sucking away your wealth capacity.
By the way, do not blame the landlord or the investment banks, they are simply doing what they do: optimizing return under a market and legal-based rule set. However, individuals should use this stoic informed knowledge to evaluate "doing what you do." That is, if you are renting, consider buying a home. Admittedly, in a seller's market and competing against investment banks, it is more difficult to find the best home buying alternative. Homeownership success is directly related to your willingness to be adaptable.
4. The adaptable mindset - home buying in action!
Humans are amazingly adaptable. It is in our nature. However, sometimes it is hard to be adaptable when we lack knowledge or experience with something that seems scary or difficult. Your adaptability is a key enabler to homeownership success. The good news is, once you start, you will find buying a home is neither difficult nor scary. The following are a few adaptations to consider:
1. For some, the pandemic has provided more work location flexibility. If you are presently living in a hot/high-cost market, it may be time to relocate to a lower-cost but rising housing market. A new norm called the "donut effect" enables people to live outside a headquarters city, but close enough for periodic onsite meetings. A hundred years ago, the U.S. saw a rural to urban migration as people flocked to big cities for work. Today, there is a new “urban to less urban” migration owing to pandemic concerns and new work-from-anywhere company employee location policies.
2. Some have taken the new pandemic work-from-anywhere norms to explore many areas. Some are moving with the seasons to areas that interest them. WiFi and mobile technology enable them to work hard. Interesting areas (ski, beach, hiking, etc) allow them to play hard. If you are currently living in multiple locations, it may be time to buy an investment property. [vii] Buy it in an area you may want to eventually live. You may need a property manager to handle the rental since you are not always in town. While this will reduce the blue or homeownership value, it will still enable you to eliminate the larger orange or renting opportunity cost. Eventually, you may wish to live in this home. Once you do, this will help you realize the homeownership value.
3. If you are just entering the workforce, consider a lower-cost city and buying a home with the intent to rent rooms to others. Mortgage companies do have programs to include rental income from others for mortgage loan income qualification. Most mortgage companies have low down payment mortgages (e.g., FHA-insured loans) for those with income but not as much in savings. There are many resources for finding more affordable U.S. housing markets. Here is one example from the google search “most affordable us housing markets:” Forbes Article.
To achieve homeownership, it will help to engage professional advisors. Your home buying team may include both:
A realtor: someone to help you find a home, and
A mortgage loan officer: someone to help you get a mortgage.
The best part about the advisors is your success is aligned with their success. That is, their job performance evaluation is enhanced when you close on your new home. There is some nuance to the realtor’s incentives. They are incented to make sure the house transaction closes, but not necessarily at the best price for you. You may consider the realtor as part of a 3-way negotiation:
seller - wants to sell at the highest price
buyer - wants to buy at the lowest price
realtor - wants the transaction to close with as little work (cost) to them as possible.
This is not such a bad thing, since getting on the housing ladder is most important. As we show in the next section, your final price is not so important when you view it as part of a long-term series of housing transactions. Finally, with today’s information and decision tools, it may be possible to buy a house without a realtor. [viii] The pro is - you should save money on the commission. The con is - you will be trading your time value for the expertise a good realtor provides.
For first-time homebuyers, I recommend using a realtor.
At the beginning of the house-hunting process, be sure to get pre-qualified for a mortgage loan. Particularly for first-time homebuyers, an experienced mortgage lender will help you learn the important aspects of mortgage lending. This is critical for managing your long-term stoic’s arbitrage-based wealth. Most important, you will learn what you need to do to be successful both now and in the future. You will be amazed at the number of mortgage options available. If for some reason you do not qualify for the house you had in mind, remember this is not a “Yes or No” result. It is a “Now or Not yet” intermediate step toward homeownership success.
There is certainly more to home buying than cost. You will also need to weigh your many preference factors. Such as size, location, schools, rental readiness, neighborhood type, and many more. Our brains have some amazing strengths, the preference weighting process is NOT one of them. Multiple criteria, costs, and multiple home alternatives create a burden for our brain to process. This is especially true since home buying is infrequent. For those in the real estate business, they train their brains to handle these decisions. For the rest of us, the volume of information and lack of process transparency may create confusion and a lack of confidence.
The good news is that there are affordable decision science-enabled apps available to help! I suggest using simple and effective decision apps to help you weigh and order your preferences, costs, and home alternatives. I‘ve used Definitive Choice in the past.
Decision apps are like “pocket confidence!” It is reassuring to know where you stand and when to walk away from a home sales negotiation.
Earlier, we discussed the potential bias found in loan assessment algorithms. Keep in mind that bias, more broadly defined, simply describes part of a process leading to a less than accurate outcome. This can happen to anyone. Decisions apps and housing education are your greatest countermeasure. By actively owning the homeownership decision process, you are increasing the likelihood of the best result.
5. Risk management
People worry that they may be buying in a bubble or at the top of a housing market. This may or may not be true. Regarding real estate market forecasting, the three things I have learned are:
Markets are cyclical,
The current market cycle always lasts longer than I thought, and
The current market cycle always changes faster than I thought.
This means - the season will eventually change, I’m just not sure when. Be that as it may, we all must live somewhere. This leads us to an important point - do not just focus on the gain or loss of a house as a single buy and sell transaction. Think of your housing decisions as a series of transactions over decades. This series of transactions approach provides a hedge that means it doesn’t matter whether a single transaction is a gain or loss. In the context of housing as a series of transactions, your long-term housing value is hedged with a serial collar. This fancy-sounding finance word means:
A gain on a single transaction means you are likely to buy your next house for more. If you buy a house, sell it, and it goes up in value - that is good news just for that transaction. In the graph, this is 1. The home was bought “B” at the beginning of the yellow period and sold “S” at the end. Notice the house transaction was bought below the dotted line and sold above the dotted line. However, you still need to buy your next house. Very likely the next house you buy will share the same higher market value dynamics. All you have done is moved your gain into the higher price you had to pay for your next house. The gain is a wash.
A loss on a single transaction means you are likely to buy your next house for less. The same concept works on the downside. If you buy a house, sell it, and it goes down in value - that is bad news just for that transaction. In the graph, this is 2. The home was bought “B” at the beginning of the blueish period and sold “S” at the end. Notice the house transaction was bought above the dotted line and sold below the dotted line. However, you still need to buy your next house. Very likely the next house you buy will share the same lower market value dynamics. All you have done is moved your loss into the lower price you had to pay for your next house. The loss is a wash.
Nobel laureate Daniel Kahneman [ix] teaches us that people are weirdly more sensitive to losses as compared to gains. As such, buyers tend to "lock-up" when it is perceived a housing market is peaking. The serial collar provides confidence it is ok to buy or sell, even when you think the market is at the top.
To be clear, this is not to suggest doing your homework and negotiating the best price is not important. It is. Allow your decision-making to benefit from a long-term risk management perspective. In the end, do not use “the market is too high to buy” mindset as an excuse not to participate in the housing market. Especially for first-time homebuyers, you have the advantage of time and the likelihood that you will be “trading-up” via multiple transactions through your life. As we explored in section 2, the opportunity cost of renting is generally much higher!
Home size and unwinding your series of housing transactions. Let's say you have been using this serial collar strategy throughout your life. You have been "trading-up" through a series of housing transactions. At some point, it may be time to downsize or move to a retirement community. The following are economic observations related to home size:
Less expensive homes generally have more people eligible to buy them. A higher stock of demand generally provides more price competition and home value stability.
More expensive homes, conversely, generally have fewer people eligible to buy them. A lower stock of demand generally provides less price competition and home value volatility.
Thus, when it comes time to "trade-out" of homeownership, look for a way to sell into a market increasing for more expensive homes. The 2021 pandemic time period provided such an opportunity for those ready to trade out.
Risk management summary: Whether a single housing transaction results in a gain or a loss, you have a serial collar hedge because the next housing transaction should share similar market dynamics. Also, given you will likely buy and sell multiple houses over many decades, do not get too hung up on the current sales price. In the big picture, this is akin to jumping over dollars to get to pennies. The most important assumptions when executing this serial collar strategy are:
The housing markets you are selling and buying are relatively homogeneous. Meaning, that the selling and buying housing market value changes should be correlated. The good news is that housing markets are often correlated. Rarely do housing markets move in opposite directions.
The transactions of a) selling your current house and b) buying your next house - occur relatively close in time.
In the long run - i.e.: across multiple business cycles - the housing market is increasing above the rate of inflation. With very few exceptions, this has been occurring in the U.S. for centuries.
Clearly, the homeownership effort is its own reward.... with the reward estimated at $9 million for retirement! Finally, do not forget Voltaire's very relevant admonition:
"Perfect is the enemy of the good."
That is, don't let "FOMO," fear, and our natural, but not helpful loss aversion biases [ix] get in the way. It is your curiosity and desire to learn, long-term value focus, adaptability, and risk management understanding that power a great home buying decision.
[i] Office of the Comptroller of the Currency (OCC), Mortgage Banking, Comptroller's Handbook, 2014
See the background section for a nice mortgage market summary.
[ii] Financial Crisis Inquiry Commission, The Financial Crisis Inquiry Report, 2016
[iii] Financial crisis programs such as:
The OCC $25 Billion Mortgage Consent Order and related mortgage settlements
[iv] Knudson, Mortgage Rates: February 3, 2022, The Curiosity Vine, 2022
[v] A natural reaction is, then "Why doesn’t the government just fix rental prices?" This is known as "rent control." Rent control has been used in the past and still exists in some large cities like New York City and San Francisco. As we discuss in our article, demand-side policies like rent control have been shown to be contrary to affordable housing goals. This means, when the government “squeezes the balloon,” what pops out has a higher cost than the squeeze benefit.
Hulett, The affordable housing paradox and complex credit policy decisions, The Curiosity Vine, 2022
[vi] Bond convexity is a way to compare bond risk. Comparing only expected yield could be deceiving. Convexity is generally derived by a mathematical calculation. What follows is my intuitive definition of bond convexity related to RMBS and SFR bonds.
A bond may be described as the functional relationship between the market interest rate and the bond price. Convexity involves the first and second derivative of this functional relationship. Bond prices and interest rates typically move in opposite directions. All bonds have pricing and yield volatility. Basically, "good" convexity is when there is upward interest rate volatility, the bond yield improves more than the yield declines when there is downward volatility. Just the opposite, "bad" convexity (or concavity in the extreme) is when there is upward interest rate volatility, the bond yield improves less than the yield declines when there is downward volatility.
It is important to compare convexity characteristics of rent-backed (SFR bonds) v. mortgage-backed (RMBS bonds) securities. Since the collateral of both SFR and RMBS bonds are a) based on single-family homes and b) generally similar (a basket of single-family homes) there is reason to believe these two bond types share similar convexity characteristics. But as some wise person said, "Hope is not a strategy." As such, it is always good to confirm bond risks.
[vii] Hulett, The Stoic’s Arbitrage: A survival guide for modern consumer financial services products, The Curiosity Vine, 2020
See the mortgage and adaptability sections for more information and examples.
[viii] Steve Levitt in his book Freakonomics does a nice job describing the nuanced realtors’ incentives and the potential impact to the buyers. Levitt, Dubner, Freakonomics - A Rogue Economist Explains The Hidden Side Of Everything, 2006
[ix] Loss aversion is a potentially destructive cognitive bias. It is covered by many behavioral economists. Below is a sample:
Thaler, Sunstein, Nudge, The Final Edition, 2021
List, The Voltage Effect, 2022
Kahneman, Tversky, Prospect Theory: An analysis of decision under risk, Econometrica, 1979
The Stoic's Arbitrage: Your Personal Finance Tour Guide
Making the money!
7. Career success - Success Pillars - A Life Journey Foundation
8. Career choices - Do I need to be a Data Scientist in an AI-enabled world?
9. Career choices - Diamonds In The Rough - A perspective on making high impact college hires
Spending the money!
10. Budgeting - Budgeting like a stoic
11. Home Buying - Homeownership is an important wealth-building platform
12. Car Buying - Cutting through complexity: A car buying approach
13. College choice - The College Decision - Framework and tools for investing in your future
14. College choice - College Success!
15. College choice - How to make money in Student Lending
16. Event spending - Wedding and event planning guiding principle
Investing the money!
Pulling it together!