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Volume 45, No. 1
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Boom or bust, owning a home is still the key to wealth for most people, says Professor Gary Smith, who has charted a contrarian, common-sense approach to the housing market.

By Karen E. Klein

All over the country, homeowners and would-be home buyers are hanging back, nervously testing the waters of the housing market: Has the bubble truly burst? Have home prices hit bottom? When will prices start to appreciate—and by how much?

They and their real estate agents are busy poring over sheets of “comps”— recent sales prices for local homes that are comparable in location and square footage to the homes they are interested in buying. They follow the fluctuations of interest rates and home prices constantly, hoping to “time the market” for just the right moment to make a purchase.

But they’re doing it all wrong, says Gary Smith, Pomona’s Fletcher Jones Professor of Economics. Instead of focusing on how much their home’s value might go up on the local market within a few months or years, homeowners should focus on their “home dividend.”

In a nutshell, the annual home dividend is the owners’ rent savings for a comparable house in the same neighborhood plus their mortgage interest and property tax deductions, minus their mortgage payment, property tax and other homeownership costs, such as insurance and maintenance. Rents are often higher than mortgage payments, particularly as rents increase over time and mortgage payments stay flat (if they have fixed interest rates). The amount saved by owning a home can be viewed as an annual dividend. And if that dividend is invested at a reasonable rate of return, it can generate considerable wealth for the homeowner—even if the home’s market value increases by only a small percentage each year, or not at all.

This home dividend—rather than any clever timing of the market or short-term “house flipping”—explains why the average homeowner has a net worth of $200,000, while the average renter’s net worth is closer to $5,000, Smith says.

The home dividend concept is at the heart of a book Smith and his wife, certified financial planner and registered investment advisor Margaret Hwang Smith, have recently co-written. Houseonomics: Why Owning a Home Is Still a Great Investment (2008, FT Press) is Smith’s first book for a popular audience, though he has written several textbooks and numerous scholarly articles detailing his economic research in various journals.

The book relies on research the Smiths did in 10 cities, looking at hundreds of homes for sale and rental rates for comparable homes in the same neighborhoods. Despite the much vaunted “housing bubble,” they conclude that home prices in cities like Dallas and Atlanta were actually too low. And while the prices in the Bay Area city of San Mateo were clearly too high, the research showed that average homes in Los Angeles last year were selling at reasonable rates. “All real estate is local. There’s no U.S.-wide housing bubble and there never was,” Smith says.

But with the book’s publication coming in the midst of the housing downturn and the foreclosure crisis, the couples’ central premise—that owning a home is nearly always a good decision—has come under some scrutiny. “Do you still stand by that idea?” asked a radio commentator skeptically, in an interview shortly after the book came out. Smith replied emphatically that he does, and went on to explain why in a convincing fashion.

Smith is no stranger to proposing ideas that run against the grain of popular wisdom or entrenched theories (see "The Contrarian" below). In Houseonomics, he and Margaret explore the economics of homeownership from a common-sense angle that nevertheless defies the way real estate has been discussed for several decades.

Smith recognizes the disconnect, describing a presentation he gave at a recent conference where he laid out the economic theories behind Houseonomics and argued that the home dividend made Indianapolis a great place to be a homeowner. But shortly after he sat down, a prominent professor of real estate got up and said that Indianapolis is a terrible place to buy a home because prices only go up 2 to 4 percent a year. “Even esteemed academics don’t seem to get it,” he says, shaking his head. Houseonomics quotes a 2007 New York Times story stating that homes have “no underlying revenue stream” upon which to base an assumption of their true value. That’s just not true, Smith says.

The book presents a case study on a home purchase in Fishers, Ind., an attractive suburb of Indianapolis with average income of $80,000. Although house prices have not historically risen meteorically in the Midwest, particularly compared to prices in desirable locations on the coasts, even a modest appreciation of 2 percent to 4 percent can be a terrific investment if the home dividend is calculated.

The couple in the book buy their home in Fishers for $135,000, with $27,000 down. Even if the home appreciation in the area is a low 2 percent annually, Smith points out, the house is a financial boon for the couple due to the home dividend, which he calculates at $5,622 annually. The dividend works out to a 21 percent after-tax return on their investment (the down payment of $27,000), which could be favorably compared to a boom year in the stock market.

And as rents go up, and the equity in the house increases over years of paying off the mortgage, the home dividend continuously gets larger. So even in an area where a home purchase does not seem to be a good investment due to slow property appreciation, Smith contends, it surely is.

Timing the market—whether you are waiting to buy or holding off selling—is a risky proposition, the book contends. Wait too long to make the plunge and it’s possible that you will be priced out of owning a home in your preferred area—not to mention that you’ll be throwing money away on monthly rent that much longer. He advises that individuals who plan to be in an area for at least five to seven years should buy a home as soon as they can. Although sales closing costs may affect your home dividend in the first year or two of homeownership, particularly if your mortgage payments and homeownership expenses are initially more costly than local rents, over time the purchase will pay off handsomely.

Just as with stocks, “it’s the cash flow that’s important [in homeownership], not the selling price. I want a place to live in for five to 20 years. I don’t want to be thinking about whether the home will do well financially in a year or two,” Smith says, adding that he has no sympathy for house flippers who’ve lost bucket loads of money in the current price downturn.

Money aside, even an economist can recognize the intangible, emotional payoff of homeownership. Having a piece of property to call your own, a place that you can remodel and decorate and count on for shelter after you retire, is an invaluable asset. “My parents never thought of their home as an investment. But, like millions of others in their generation, purchasing a home was easily the best financial decision of their lives,” Smith says.

The Contrarian
Whether it's theories about the harvest moon, common knowledge on investing or the idea of an athlete with "hot hands," Professor Gary Smith has a bent for contrarian research.

Economics Professor Gary Smith seems to have a bent for contrarian research. It’s not that he goes looking for conventional wisdom to debunk, it’s just that his life’s work is driven by his inner-economist.

“We look at the numbers and follow them wherever they lead,” he says—even when the conclusions are contrary to established ideas and accepted theories.

In one paper, Smith tested the “efficient market hypothesis,” the widely accepted notion that great companies don’t necessarily make great investments because their well-known virtues already have been factored into their stock prices. Using Fortune magazine’s annual list of mostadmired companies, Smith and co-researcher Jeff Anderson ’05 found these companies’ stocks did indeed outperform the wider market, calling the theory into question.

In a similar research project, Smith determined that a portfolio of companies with clever, eye-catching ticker symbols (LUV for Southwest Airlines, MOO for United Stockyards) also beat the market.

Why does stock picking so often flummox even the professionals? “There are anomalies where peculiar things go on with emotions,” Smith says. “We [human beings] are all about processing information— looking at the data and thinking about it. But there’s no pure processing because emotions and psychological factors come into play, and emotions influence how people process.”

Smith’s research has often taken him far beyond the financial markets. For instance, he has written several articles disproving common ideas about life and death.

One examined the hypothesis that elderly Chinese-, Korean-, or Vietnamese-American women can prolong their lives until after the celebration of the Harvest Moon festival.

Another article, co-written with Heather Royer, looked at the idea that famous people postpone their deaths until after their birthdays.

In both cases, Smith concluded, the hypotheses were incorrect. In fact, his birthday research showed a relatively large number of deaths surrounding birthdays.

While sometimes-sentimental beliefs about death don’t pan out, according to Smith’s research, some long-held hunches do seem to have more going for them than superstition.

In another whimsical bit of research, with Reid Dorsey-Palmateer, Smith discovered there may just be something to the idea that athletes can have “hot hands.” Their analysis of professional bowling indicated that the probability of rolling a strike is not independent of previous outcomes, and that the number of strikes rolled varies more between games than can be explained by chance alone.

Does that mean that athletes really do get “hot hands”? Well, maybe, Smith says: “It turns out that the idea of getting on a hot streak really does work, at least a little bit. As humans, we’re pre-disposed to looking for patterns [where they might not exist] but we’re also likely to undervalue the influence of luck.”

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