How much of your net worth should be tied up in your home? Experts recommend a surprisingly cautious approach.
Safe as houses. That's what the British call a sure thing. And that's how many Americans have felt about real estate.
Then they watched the value of those houses melt away, along with their own net worth. Las Vegas, at one point, saw home values fall 63%.
But housing isn't a gamble only in the nation's boom-and-bust centers. If you've got a mortgage, even a small price decline can wipe out your equity. The bank still expects the same check every month.
In the wake of the housing crisis, a number of academics and investing experts are urging homeowners to take a more sophisticated approach to the risks of real estate. A home can be as risky as a stock, and it needs to be treated that way. That means considering how much risk you're taking before you buy. And, after you buy, it means seeing your home equity in the context of all the other risks you're taking with your money.
While no place is immune to housing risks, certain markets have been especially wild. Las Vegas, Phoenix and Riverside, Calif., are the most volatile, according to a Zillow.com analysis of quarterly home value fluctuations from 1985 to 2012. The stablest markets include Pittsburgh, Cincinnati and Detroit. (Zillow's calculations include the entire metropolitan areas, not just the central cities.)
People who buy only for investment reasons can cause big spikes in home values — take Miami. Local economic conditions can also add real estate risk. In Riverside, a housing bust in the 1990s coincided with cutbacks at defense contractors.
Yet even if your region has a quiet real estate market, your neighborhood may not. Low-income areas and high-income areas have twice the home price volatility as middle-income neighborhoods, the University of Colorado's Liang Peng and Thomas Thibodeau report in a forthcoming study. Home prices more or less track incomes, which for the rich and poor can vary a lot from year to year.
If your local market is prone to big, temporary spikes, consider being more conservative with your stocks and bonds, says David Blanchett, head of retirement research at Morningstar Investment Management. If you live in Phoenix or Miami, for example, you might shift a bit more money into bonds. If your local market is relatively tranquil, you might put a little extra in an emerging-market stock fund.
A SURPRISINGLY CAUTIOUS APPROACH
A more cautious approach to real estate contradicts much of the advice homebuyers get, especially from family. “We take young buyers and say, 'Take every bit of your savings and put it in real estate,' ” says Florida International University real estate professor Ken H. Johnson. Especially if you're using a mortgage to pay for 90 or 95 percent of the cost, “you've exposed yourself to tremendous risk.”
That said, some real estate can provide stability in a portfolio. In an upcoming paper written with the University of Wyoming's Eli Beracha and Alexandre Skiba, Johnson analyzed the risk and return performance for portfolios that mixed real estate and traditional investments in various ways.
The best mix of risk and return: Combine about a dollar in home equity for every dollar in more traditional investments. A pure stock-and-bond portfolio usually performs better, but the authors found that real estate provides diversification that makes the whole package less volatile. What you give up in returns you may gain in peace of mind.
