Felix Salmon has a lovely metaphor that helps me articulate something I've been wanting to say about the risk of buying a house:
"In that sense buying a house isn’t an investment, so much as it’s a way of permanently covering your built-in short position when it comes to the shelter market."
If you have a long position in TD stock, you receive annual dividends. If you have a short position in TD stock, you have to pay annual dividends (to the person from whom you borrowed the stock to sell it short). If you are neither long nor short TD stock, you neither receive nor pay annual dividends.
The rent on a house is like the dividend on a stock. If I do not own a house, and rent one to live in, I pay rent, which is like having a short position. If I own a house and live in it, I neither pay rent nor receive rent, which is like being neither long nor short. If I own two houses, live in one and rent out the other, I receive rent, which is like having a long position.
So we are born with a short position in housing. We need shelter, and must pay rent to live somewhere. When we buy a house to live in, we are covering that short position.
That metaphor drastically changes the way we think about the risks of investing in housing. Having a long position is risky. Having a short position is risky too. Covering a short position eliminates that risk.
Therefore, not owning a house, and having to rent one, is risky. Buying one house eliminates that risk. Buying a second house to rent out creates risk again.
Like all good metaphors it contains a kernel of truth; but like all imperfect metaphors it is not the whole truth.
The kernel of truth is that future rents are uncertain, and when we switch from renting to owning we eliminate that risk; but when we buy a second house and rent it out, we again face that same risk. Though now we fear falling rather than rising rents. The owner-occupier doesn't care about how much rent his right hand pays his left hand.
Why is that metaphor not the whole truth? There are many reasons.
1. My house may burn down, fall down, or in some other way stop providing me with the shelter I need. Some of those risks I can insure against; others I cannot.
2. The house may stay the same, but the type of shelter I need may change. I may need a bigger house, a smaller house, or one in a different place. I face the risk that my old house may fall in price when I sell it, relative to the price of the new house I buy. True, but if my old and new house prices are positively correlated, I have at least partly hedged my risks, which is better than renting.
3. If I need to borrow money to buy the house, the future interest rate may be uncertain, and the risk that my mortgage payments will rise needs to be compared to the risk that my rents would rise.
4. If my house will last another 100 years, but I will only live another 40 years, I will have covered 60 years more than my short position. The future reverse-mortgage value of my house is uncertain. But if I make a bequest to my children this is not a problem. My children will have a short position in housing too. They will need somewhere to live.
5. Other reasons I can't think of right now.
Of course, none of this means it is always prudent to buy a house that is more expensive than the one you would otherwise rent. But there is a risk/return trade-off, so it could be prudent to pay a little over the odds (an insurance premium) to eliminate the risks of renting. (Not forgetting of course the risks cited above, plus the extra transactions costs of selling and buying a house compared to switching rental accommodation).
And we are also born with a short position in food, clothing, cars, etc. as well. So you reduce risk by covering those short positions by buying shares in companies that produce food, clothing, cars, etc. as well. Especially the sort of food, clothes, and cars you like.
And since we are born with a long position in labour, we would want to sell labour short, if we could, to reduce risk. And use the funds to cover our short positions in houses, food, clothes, and cars. But we can't sell labour short. So instead we would need to use leverage: using mortgages to buy a house and buying shares on margin, thus facing the risks above.