In a previous post, I wrote that I like investing in REITs because it gives me more exposure to real estate (i.e., more diversification) than I’d get from buying index funds alone. (Recall that the typical market-capitalization-weighted S&P 500 index fund is going to be about 3% REITs.)* I think that real estate is a decent investment, but I’m too lazy to handle 2 a.m. calls from tenants about clogged toilets. So, for me, REITs are perfect. I want more than 3% of my portfolio in real estate, I don’t want to deal with taking tenants to court or fixing their plumbing, so I buy REIT shares.
But, you might be asking, what about your personal residence? If someone is a homeowner with a bit of equity in their property, aren’t they already “overweight” real estate? Is it really smart to be adding REITs to the portfolio on top of that personal residence? Consider the example of Hypothetical Harold (“HH”). HH, despite his old-mannish-sounding first name, is a 30-year-old white collar worker in a moderate cost of living city. A couple years ago he purchased his first home for $350,000, putting 20% ($75,000) down because he is a prudent dude who makes good financial decisions. As he continues to pay off his mortgage and his house continues to appreciate, he now has $100,000 in equity. HH also contributes regularly to his 401(k), which is invested 90% in a low-cost S&P 500 index fund and 10% in bonds. Right now, the balance of his 401(k) is $100,000. He holds no other investments.
So what is HH’s asset allocation? Of that $90,000 in S&P 500 index fund shares, about 3% ($2,700, more or less) would be REITs. Do we add that to his $100,000 in home equity and conclude that he has roughly $102,700, or about 51% of his invested capital, devoted to real estate? In my view, the answer here is no. His REIT allocation is ~3%, not ~51%. Here’s why: The ugly truth is that for most people, your personal residence is not an investment and shouldn’t be considered in your asset allocation. You can read the linked article if you wish (and you should, because it makes the argument more eloquently and succinctly than I could), but the bottom line is that your personal residence is not (unless you are renting out a spare bedroom on Airbnb or something unusual) an income-producing asset.
That’s not to say that you shouldn’t buy a house if you are financially able to do so. By all means, be my guest. (Or, more accurately, don’t be my guest, because you just bought your own house and don’t need a place to stay.) It’s not like home-ownership can’t be financially beneficial for many people, especially with interest rates remaining in the 3% range. There are plenty of benefits to owning a home:
- Your monthly living costs stabilize (assuming you get a fixed-rate mortgage), which means that (assuming your income continues to increase and inflation continues to exist) the effect of that payment on your budget gets less and less severe each month. This contrasts favorably with rent, which is likely to increase every year at lease renewal time. Consider an example: Suppose that before HH bought his house, he paid $1,300/mo to rent an apartment, and now his mortgage payment is $1,600. That’s a step up, sure, but if that apartment rental increases by 5% per year his rent would be $1,659 (i.e., more than his mortgage payment) after only 5 years. After 10 years, his old apartment would cost about $2,093/mo, and that $1,600 mortgage payment starts to look like a bargain. One of the biggest benefits of a mortgage is that it fixes living costs for decades at a time.
- The equity belongs to you, it builds every month when you make payments, and you can access it in an emergency by taking out a HELOC or selling the house. Nobody wants to sell their house to pay some emergency bill, but it beats going bankrupt. If you pay extra on your mortgage, you get a guaranteed rate of return equal to the rate of interest on the loan.
- Depending on where the property is and a whole host of other factors, it’s likely to appreciate, although the amount is going to vary widely from place to place and year to year.
- If you move out of the house and keep it, it can eventually become an income-producing investment.
But if you’re like HH, just a regular person living in his or her house and not using it to produce income, then despite the fact that there are very real financial benefits incident to home-ownership, your house is not an investment and should not be included in your asset allocation.
- You should probably buy a house if you can afford it, but understand that your primary residence is not a great investment and should not count when you evaluate your asset allocation. (Keep this in mind when some realtor tells you that your personal residence is going to be the best investment you ever make, recall that they are paid on commission, and maybe consider buying less house than you can afford instead of leveraging yourself to the gills and straining your budget.)
- If you devote 20-30% of your portfolio to REITs and own a home, you do not need to worry (in my humble opinion) that you are “too much” in real estate.
- If you rent out some portion of your home (or, to use a profoundly annoying term that has gained credence in recent years, “house hack”), the above may not apply to you. In that case, your personal residence is an income-producing asset and may need to be included in your asset allocation.
*Note: The 3% figure is a little bit out of date as it comes from a January, 2019 article. If I had to guess, though, I would say that the current number is smaller because the trend in the past year has been for a small number of gigantic companies at the top to comprise a larger and larger share of the S&P 500’s total market capitalization. I also don’t know what percentage of the total stock market (as opposed to the S&P 500) is comprised of REITs, so if you buy shares of a low-cost total market index fund like VTI (which you should), the REIT composition is probably somewhat close to 3% but may be a bit off in one direction or another. The broader point, though, is that if you want 20%, 30%, or even more of your portfolio to be devoted to income-producing real estate, you’ll want to add some REITs to those broad-market index funds.