Beware of the housing wealth effect!
Given the recent insane property price growth in Australia I thought it would be time to re-iterate something that been saying for years. Your home is not an asset.
What?
How can this be? My house appreciates in value like companies, or gold or any other asset, it must be an investment.
While it is true that your principal residence changes in value with time, the reason why I say it’s not an asset is because most people do not extract the equity from their property to create an income stream. Let’s take a fairly common scenario where someone buys their first home; lives in it for 5 or 10 years; then upgrades to ‘better’ house. Unless the first home they bought increased at a faster rate than the house that they are moving to, property price movements are roughly a zero-sum game.
What about downsizing then? Yes, this is one way to extract the equity growth in your property, however you must be willing to accept lower living standards in the form of a smaller property; or moving to a lower value suburb. I don’t think this is not something most Australian households are planning to do.
What is the housing wealth effect?
Now, because price changes in our principal residence don’t provide the FFE house with a source of income, I don’t count it as part of our financial modelling or net worth. However, this is not true for the majority of Australians, which do, instinctively, count their principal residence as part of their overall wealth. While this in itself is not counterproductive behavior, the tendency to alter spending habits as a result of price growth, in absence of income growth, is. This is known as the housing wealth effect and slows the journey towards financial independence because increasing cost of living disproportionately to total income results in a decreased savings rate. We already know how important your savings rate is to achieving financial freedom.
How you should actually think about price growth
As a homeowner you need to be aware that seeing the value of your property increase may cause a tendency to increase discretionary spending on motor vehicles and other durable goods (May, Nodari and Rees 2019). However, it’s important to understand that because the equity can’t be realized easily price growth in your principal residence does not increase your material spending power in the same way that investment portfolio growth does.
In actual fact, property price growth actually decreases your spending power since your council rates will increase. This is because council rates are calculated based on the annual rental potential of each residence which, in turn, is based on your property value. Funny that, because I’m pretty sure that even when our property value has fallen, I’ve never seen our council rates drop – I guess the Valuer Generals Office must be very bullish on property price growth!
In conclusion, if you are not planning on extracting the equity from your principal residence by leveraging against it; renting rooms out; downsizing; or becoming a renter then you should ignore property price growth. As a reminder, your spending patterns need suit your target savings rate, not the value of your principal residence.
Engineer your freedom
References
May, D., Nodari, G., Rees, D., 2019, Wealth and Consumption, Reserve Bank of Australia, available from: <https://www.rba.gov.au/publications/bulletin/2019/mar/wealth-and-consumption.html>