Your house is not an asset. It is a hedge.
You are born with a natural short housing position. For the rest of your life, you will need somewhere to live. Ideally, somewhere with a roof. To use a (slightly tortured) trading analogy, you are born with a short housing position.
There are several ways to cover this short. In the beginning, your parents usually pay it for you. Once you are on your own, you have various options that can generally be divided up into two categories:
- A floating rate (e.g. a short-term lease)
- A fixed rate (e.g. a long-term lease or a house purchase)
The best option for you will depend on many things e.g. the relative cost of renting v. owning, your need to be geographically flexible (i.e. your liquidity requirement), your ability to obtain credit etc. There is not necessarily a “correct” answer. I have done both at various times of my life.
Whatever option you choose, however, you need to understand that you are only covering a short position. If you choose to buy a house, you are not going long the housing market. You are going flat the housing market using a fixed rate product to lock in your exposure.
If house prices rise, the value of your house (the hedge) increases but so does the cost of shelter, which you are always going to need. If house prices fall, your home loses value, but the cost of shelter falls.
Why does this distinction matter? Because if you purchase a house, you should not fall into the trap of getting excited when house prices rise. You should especially not fall into the trap of borrowing against the rising value of your house (your hedge) to fund increased consumption.
Think about it this way. Imagine if a gold producer used the futures market to hedge future production and lock in a sales price. If the gold price fell (not that it ever will, of course. Fiat money and all that), then the producer would have a gain on its hedge.
However, that gain would be offset by the fact that they can only sell their production at a lower price. If the producer borrowed against that gain in the hedge to buy jet-skis and a winter chalet in Vermont, it would be clear that they were taking a massive gamble.
The same thing applies to your house. If you buy a house, you have covered a short rather than gone long. This means that you need to be very careful about borrowing against that hedge, and even about counting your house value as part of your total assets.
This is hard to do, since a house is usually a large part of someone’s assets, and it is tempting to include it when counting up retirement assets. Except that you still have a natural housing short when you are 66. Sure, you can downsize your house, but then you are playing more of a big house/small house spread game.
You are born naturally short shelter. Your house is not an asset. It is a hedge.
thezikomoletter 
nobody
/ December 11, 2012That covers the first house. What about my second house in the Hamptons? Or the lake house? Or my private Swiss chalet? Clearly at some point I really would be long on the housing market.
thezikomoletter
/ December 11, 2012Your second house makes you long housing. Your lake house makes you short weather volatility. Your Swiss chalet gives you a CHF exposure. Your Hamptons mansion legs your into a first spouse/second spouse spread…. 😉
Ozzie goldschmied
/ December 11, 2012Very interesting way to consider housing.
Koko Ro
/ December 11, 2012Sorry, the last two paragraphs contain too much financial jargon to be understandable to normal people. Try simpler analogies.
thezikomoletter
/ December 11, 2012From Wikipedia: A hedge is an investment position intended to offset potential losses/gains that may be incurred by a companion investment. In simple language, a hedge is used to reduce any substantial losses/gains suffered by an individual or an organization.
A hedge is also a line of closely planted trees and shrubs, so I imagine there is a punny joke to be made about your back yard incorporating a “hedge”…
econmajor
/ December 18, 2012Please don’t try to be understandable to normal people! Some of us love thinking about the world in terms of hedging, long and short.
Pete
/ December 11, 2012Of course, the matter changes entirely if you have two or three houses – then you are long on house, and appreciation would matter.
thezikomoletter
/ December 11, 2012Totally agree.
SP
/ December 11, 2012Your assessment is entirely fallacious. Housing is a binary decision and rent is a sunk cost. Mortgage payments, by contrast, are investments that offer you partial ownership of an asset in the same way that purchasing equities offers partial ownership of a company. Your argument ignores these fundamental facts.
thezikomoletter
/ December 11, 2012SP, I agree that mortgage payments leave you with partial ownership of an asset. The point is what that asset purchase is for. I am arguing that buying a house (whether using a mortgage, cash or self-build) can be viewed as paying a fixed price to cover a long-term position. Once you have done that, you are largely unexposed to changes in the cost of shelter. Using a short-term lease leaves you open to pain if the cost of shelter goes up, or benefit if the cost of shelter goes down.
Purchasing a partial equity stake is generally an outright long position: you benefit if the equity value rises, and suffer if the equity value falls. There is no offsetting “short” position. Unless, perhaps, you consume an extraordinary amount of bananas each day and buy shares in a banana company.
hansvandeun (@hansvandeun)
/ December 11, 2012Rent is a sunk cost. So are mortgage interests, property taxes, maintenance costs, and all other costs you never have to worry about as a renter. Not to mention the opportunity cost of being to able to pack up and leave on short notice.
Elle
/ January 7, 2013@SP: If I rent for $3k, and mortgage+tax for equivalent house if $5k (out of which $1K goes towards principal), how is my rent “a sunk cost” and mortgage is not?
vinocat
/ January 7, 2013Well, two things about rent vs. mortgage… #1: in your example, your $3k rent has no residual value, i.e., when you move, all that rent money is gone. #2: with the $5k mortgage example, it’s a bit more complicated. Initially, it’s true that most of the payment is interest, but over the life of a 30-year note, only about half to 2/3 of the payments go toward interest, so it depends on where you are in the life of the loan. Either way, with the mortgage, when you sell the house and move, you get the proceeds, less any remaining mortgage balance, but you also get any appreciation that has occurred. True, in the 2008 meltdown, housing values declined sharply, but this is not the long-term norm — it was really a return to scale after several years of over-appreciation. The “normal” housing market appreciates at roughly 3-4%/year over the long run — pretty much in line with inflation.
Steve Knight
/ December 11, 2012Absolutely agree with the sentiment, debt is a liability, plain and simple. But I like the way you’ve illustrated the ‘need’ for housing as a future liability. Which it clearly is also.
By extension then we are ‘naturally short’ other things like food, access to clean water and sleep. The difference is that those items are hard-to store, relatively easy to obtain (for westerners) or intangible and so not prone to the same sort of effects as houses are.
In Europe, for a long time, it was more common for average people to rent their homes than own them. Home ownership is a relatively new phenomenon, it’s quite simple but it keeps surprising us!
thezikomoletter
/ December 11, 2012Glad you enjoyed the post.
We have a “short” position in all sorts of things, and most of us simply cover them in the “cash” or “spot” market by buying them when we need them.
Wade Venden
/ December 11, 2012I’ve been “short” on housing a few times in my life, no doubt about it. And I agree that housing is definitely a hedge – a hedge against dying from exposure! In all seriousness, I love the analogy here – your title immediately caught my attention – well done.
thezikomoletter
/ December 11, 2012Glad to hear it, thanks for reading.
askcuecfrei
/ December 11, 2012I like your analogy – however it’s difficult to assess the value of this short position. you might add that being short in housing varies over time, since you acquire more stuff in your life and need the additional storage space or even a home for your family. so you might say it makes sense to not just cover your housing exposure as needed, but it might actually make sense to go long (renting out apartments which you don’t need and profit from the convenience yield), because the price to cover the underlying asset (ie. buying a house) will probably increase in the future.
pauljoslin
/ December 11, 2012The only problem with your theory, is that it assumes that house prices on a whole will move up and down across the board. This is rarely the case, with only local house prices moving in line with the property you own. Even within the same country, one area of house pricing can be rising, while another is falling. Therefore the position would only be flat, if you plan to move to a house in the same location as your existing house.
If however, you choose to relocate to another location, or perhaps even another country (with a completely different economy) then you may have gone long on your house in an area where house prices are rising and then you move somewhere later where the house prices were falling or flat, and make a profit.
For example. In the south of England (London) house prices have still been rising over the last few years, where as the north of England house prices have been falling.
If you factor in moving to a completely different country as an option, then it makes your house a bet not on house prices rising or falling, but rather your countries economy rising versus others. Ensuring that you can sell your property and move to an equal house in another cheaper country and make a long term profit.
I do see your point though, that ultimately the rise in house prices assuming you will always stay in a similar location and expect a similar house is not a gain.
thezikomoletter
/ December 11, 2012Thanks for commenting. Several people have commented that I have assumed that the housing market is homogenous and that there are no regional variations etc. I don’t think I have, but I obviously need to clarify that somehow.
Part of the answer is that you still have the risk of the difference in prices between where you live and where you might end up living.
David
/ December 11, 2012See also Nick Rowe on this topic.
http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/07/we-are-born-with-a-short-position-in-housing.html
thezikomoletter
/ December 11, 2012Great link, thanks.
jsonmez
/ December 11, 2012Excellent post! This is a great way to look at housing. I employ this thinking myself.
One point to add to the equation though, typically we buy a house with leverage.
In that respect buying a house if very much like futures trading or options trading. The leverage is very high.
So if you own a house and the house price goes up, your investment increases at a scale much larger than the cost to rent.
Quick example with fictitious numbers:
I buy a house for 100k, I put 10k down payment, rent would cost me 1k per month.
House goes up to 150k value in 5 years.
I sell the house and get 40k return on my investment.
Rent goes up to 1.5k per month.
My net gain is 40k which is 40k / 1.5k = 26 months of rent.
Contrast that to renting during the same time period.
Great article none-the-less, this is how we should think about housing.
thezikomoletter
/ December 11, 2012Thank you. And don’t forget that leverage runs both ways: do your math if the house value falls to 50k…
jsonmez
/ December 11, 2012True, you do get to choose then to sell though. So in that case if the value drops to 50k, the rent should be .5k and so you lose an opportunity cost of .5k per month of extra rent you are paying.
Edward Price
/ December 11, 2012“If house prices rise, the value of your house (the hedge) increases but so does the cost of shelter, which you are always going to need. If house prices fall, your home loses value, but the cost of shelter falls.”
What exactly does this mean? What cost of shelter, the general cost of shelter? I live in Chicago where purchase prices are dirt cheap, and rent prices are sky high. The United States, as a whole, came out of period were rent was cheap and purchase price was through the roof.
The market isn’t working as efficiently as it should because of the meddling by our fearless & too helpful overlords in Washington, among other issues.
I feel that in your post there are sweeping generalizations — including the one about the gold hedge — that do not take into account transaction costs or leveraging for that matter.
Maybe you were just looking to get stir up a little controversy. If so, I say: well done!
thezikomoletter
/ December 11, 2012I was trying, rather inelegantly, to describe how a hedge works. If you hedge something, the value of your hedge generally moves in the opposite direction to your underlying exposure, creating a net zero effect on your balance sheet.
My arguement is a simplification, but I believe that it is a useful one. Notice that I never said that owning was better than renting, or vice versa. Whether one makes more sense than the other will vary with e.g. prices, time, geography (as you correctly observed) and your stage of life.
My point was that if you do buy a house, then you should not be super-excited if house prices rise, because even if you sell your house at a higher price you will still need somewhere else to live.
Jayson Elliot (@JaysonElliot)
/ December 11, 2012Can anyone explain this article to someone who is not an investor? Every single piece of jargon, including “born with a short position” is inscrutable to me, the layman, and I have the feeling there’s valuable information trapped in those words.
thezikomoletter
/ December 11, 2012Try this:
– You are always going to need somewhere to live.
– Your basic choices are between renting and buying.
– If you choose to buy a home, you can think of it as paying a lifetimes’ worth of rent in advance.
– That may or may not be a good idea: it will depend on how house prices change, how rents change, transactions costs, if you want to move, etc. It might work out, it might not.
– If you do buy a house, then you should not be super-excited if house prices rise.
– That is because even if you sell your house at a higher price, you still have to find somewhere to live.
– You will either need to buy another house or go back to renting, and the costs of those two are likely to have gone up as well, leaving you no better off.
Does that help? My arguement is obviously a simplification, but I believe it is a helpful one.
devondjonesD
/ December 11, 2012“If the gold price fell (not that it ever will, of course. Fiat money and all that)” Smells like bubble thinking.
thezikomoletter
/ December 11, 2012Lol, totally. I was being sarcastic and flippant, which doesn’t always come across on a blog. 🙂
John Galt
/ December 11, 2012This is true. The same is true of energy and food. If you go buy a couple CL contracts you’re just making yourself neutral.
cbrewbs (@cbrewbs)
/ December 11, 2012Inflation tax. You buy a house for $100,000. The dollar inflates by 10%. You sell for $110,000. You now have $10,000 that is taxed as capitol gains. Inflation tax, it’s not just for those with cash assets.
Gerry Bamberger
/ December 11, 2012Owning a house only hedges you insofar as it neutralizes the costs of housing yourself. In fact, in the real world, homeowners are taxed by government entities as well as monopolistic utilities, and therefore the hedge is a poor one. And it promises to get worse and worse, for all the following reasons:
1. Past incentives for individual home ownership (interest deductibility, CA Prop 13) are proving too expensive for ever-thirstier governmental entities;
2. Homeowners are viewed (correctly or otherwise) as wealthier than renters (many of whom are former homeowners) and populist sentiments will favor punishing homeowners to achieve some form of equalization;
3. Apartment complexes are better risk-spreaders and are better equipped than individual, unassociated homeowners to obtain favorable terms from taxing entities and utilities.
Jason
/ December 11, 2012The size of your natural short position does change over time though. My natural short position was small as a bachelor, larger now that I have a family, and will be smaller when the kids are finally gone.
thezikomoletter
/ December 11, 2012Yes, agreed.
John DeHope
/ December 11, 2012Another hacker news visitor, just saying Hi. This is a great blog; it’s like Zero Hedge, David Ramsey, and the Dalai Lama had a baby!
thezikomoletter
/ December 11, 2012Appreciate the feedback, thank you.
Rich Gautier
/ December 11, 2012However, when you die – you are no longer in need of housing – so your house becomes an asset at that point. If you can generate income on the house as well as extract value from the home to trade for other needs, such that when you die, the value of the house is now 0 (e.g. you’ve borrowed your equity and spent it), then it has performed just like an asset. I can imagine this is where the idea of reverse mortgages might come in.
matthjw
/ December 11, 2012Is there any way I can buy into some kind of diversified residential housing fund to hedge this short position, rather than have to buy, like, a real house? Ideally it would still correlate well with local housing costs.
Terry Omond
/ December 11, 2012The short analogy explains why a mortgage on a house you are living in is a poor strategy for wealth creation – a leveraged covered short. However, borrowing against the house you live in to purchase real estate is a leveraged long position, a much better exposure to a rising market. This is cold comfort to those that couldn’t make payments & lost their house early in the downturn. It’s hard to cash in the short unless you exit the market. The death dividend? These market analogies are getting strained.
Menachem Began
/ December 12, 2012I’m moving somewhere A LOT cheaper, and warmer, when I retire. My ~$1M property (by then, probably) will be leveraged; either leased or sold. It’s free money, and a nice place to live in the meantime.
Keith Alexander Ashe
/ December 12, 2012This is an excellent analogy for home ownership. Khan Academy has a couple videos running the numbers on renting vs. owning. A lot of people look at home ownership as an investment; yet, as you mentioned, the actual benefits are garnered from tax deductions and home equity loans rather than checks in the mail (rent).
thezikomoletter
/ December 12, 2012Thank you. Haven’t seen the Khan videos yet – will check them out. Home ownership certainly makes sense for some (including me, right now), while renting makes sense for others.
ameriplexnetwoks
/ December 12, 2012Great post! the house is an asset if it will give you cashflow and it is not an asset or a liability if it will cost you.
thezikomoletter
/ December 12, 2012Glad you enjoyed it, thank you for reading.
A mea culpa: I should not have said that your house is not an asset. Your house is an asset. My point is that the value of that asset is offset by a corresponding liability (your lifelong requirement for housing) that is not often acknowledged.
ameriplexnetwoks
/ December 23, 2012Thank you
Ira
/ December 13, 2012I remember when someone first explained a hedge to me as investing in futures. If I run a bakery and want to be sure that I can buy flour at a price that I need to make a profit, then I buy futures in flour at the price I need. If I buy a house and know what my annual housing costs are fixed except for re taxes, then I’ve bought futures in housing. A future is a hedge, hence “hedging your bets/”
thezikomoletter
/ December 13, 2012Agreed: a hedge using futures tends to be risk-reducing, and often has the effect of “locking in” a purchase or sales price. Risk-reducing is not risk-eliminating, of course.
It has some similarities to insurance.
vinocat
/ December 13, 2012It’s an interesting way of looking at what housing means, but it’s also a fundamentally wrong analogy, and over-generalizing on a couple of other points. Any time you deploy capital in a way that you can recover some, all, or more than what you put in, that is an investment. Most beginner investors (and non-investors) fail to understand that investments can have a negative ROI, in capital terms; in terms of shelter, however, that is a necessary expense, so you don’t necessarily factor it into the notion of the capital investment’s ROI, but it is a benefit. To illustrate: owning may or may not turn out to have a positive capital ROI, and renting by definition has a negative ROI (-100%); but both have the same nominal shelter benefit.
Your most valid point is that one shouldn’t carelessly borrow against one’s home value, lest the value go down, and you wind up underwater (and in a leveraged way). Doing so is the investing equivalent of counting your chickens before they are hatched.
But frankly, calling it a short position is pretty misleading, and deeply inaccurate as an investment analogy. A short position in investing is where you sell an asset you don’t own (by borrowing it from somewhere else). For this sale, you *receive* money, which is where the analogy totally fails. Buying a house is buying a house (call it an asset, which is increasing or decreasing in value). If you don’t have the money to buy the house outright, you borrow the *money* (not the house) in the form of a collateralized loan called a mortgage. It’s your name on the deed, and the mortgage lenders claim a lien (but not ownership) on the property in the event you default on the loan. If the house loses value, you still own it, but you also owe the lender the amount you have borrowed. This is the exact opposite of short investing, in which you *want* the value of the asset you shorted to decline, so you can buy it back for less than you short-sold it, and close out your position with a profit.
thezikomoletter
/ December 13, 2012vinocat, thank you for taking the time to comment.
I was taught that you are “short” a market when you will make money/ be better off if the price falls. It is a wider concept than simply selling something you do not own.
You do not necessarily have to borrow something you do not own in order to be short: in the futures and fx markets you can instigate a short position without borrowing. In equities, you can purchase a put option to get short. In cash equities you have to borrow stock you don’t own to sell and get short, but that is confusing how you get a short position with what it means to be short.
In your final paragraph, you have misunderstood what I said. I did not say that buying a house was equivalent to shorting housing. Buying a house is a way of covering your pre-existing short, not the short itself.
vinocat
/ December 13, 2012Well, fair enough to define being “short a market” in that way, but by that definition, you are only short in the housing market if you are homeless. And yes, I understand the intricacies of the different ways one can be “short” on an investment or market — I’ve been in and around the financial services world (including investment houses) for many years, and am an active portfolio manager of my own family’s accounts, trading equities, options, commodities and more…
If you pay to live somewhere, you are by definition long in that market, not covering a short (in other words, you wouldn’t say you’re short the horse market simply because you don’t own or rent any horses). As a renter, your long (monthly) investment has -100% capital ROI, but you get the benefit of shelter. As a home owner, you have taken a long position as a result of your purchase (regardless of how you got the money to buy the house), and may wind up with a positive, negative or zero capital ROI, and you also get the shelter benefit. If the value of housing goes up, your investment as an owner goes up, not down as with a short position; if home prices go down, your investment declines, plain and simple.
I’ll grant that you are inherently short the *benefit* of housing until you cover that benfit shortage by buying or renting someplace. But that is quite different from looking at it as a matter of capital investment.
Lastly, one investment industry tenet you didn’t mention is the one that says that nothing matters until a transaction is executed. Until then, all those gains and losses, long and short positions, are just paper (or in one’s mind). This is where people who use(d) their home as an ATM went wrong, thinking that the notional value of their home was as good as gold, when in fact the true value turns out to be the value you receive from a real transaction at a specific time and place.
thezikomoletter
/ December 13, 2012Thanks for the reply. Imagine that you are 18 years old and about to head out in the world on your own. Would you prefer it if house prices and rents were high or low? Generally, such a person would want houses to be cheap and rents to be low. i.e. they would be better off if house prices and rents fall…. which is the definition of being short.
It is only once people buy a home that they start thinking they are better off if prices rise. If you buy a house, then you are going long that market, but you cannot forget about your pre-existing short position. Long + short = net flat (in a simplifed model, where you don’t buy a bigger house than you need).
Another way to think about it is that your house is an asset, but you have a corresponding liability that offsets it.
The difference with the horse market is that I have no long-term need to buy horses, whereas I have a lifelong requirement for shelter.
vinocat
/ December 13, 2012I suppose you can make the claim that you are short on anything that you *need* but don’t have (as opposed to electively want, like a horse). But I personally see that as a situational observation, not an investment analogy. You have many good and useful points in your original post that could benefit your readers, especially the less savvy ones. Ultimately, I think the analogy you chose undermines the strength of those good points, by being confusing at best (as witnessed by many of the other comments), or indefensible at worst. If you wanted a money analogy/metaphor in there for spice, perhaps you could have titled your post “shelter is a hedge against the elements, and your home is not an ATM”…!
thezikomoletter
/ December 13, 2012Thank you for the feedback, and for engaging.
Alex
/ December 13, 2012“Imagine if a gold producer used the futures market to hedge future production and lock in a sales price. If the gold price fell (not that it ever will, of course. Fiat money and all that), then the producer would have a gain on its hedge.
However, that gain would be offset by the fact that they can only sell their production at a lower price.”
what do you mean they can only sell their production at a lower price? they hedged their price (i.e. locked in the higher pricer). that’s the whole point of hedging. have i missed smth here?
thezikomoletter
/ December 18, 2012You are correct, perhaps I worded it clumsily.
If the gold price falls after they hedge, they will get less for their product in the physical market, but they will make a profit on their short futures position. Net, they will effectively have sold at the higher price.
The “Fiat money and all that” was a flippant and sarcastic dig at the “end of the world” crowd.