chapter nine

REAL ESTATE

Live in Your Home; Make Your Money at Work

Can We Continue to Make Lots of Money on Our Homes?

In the late 1980s my friends Peter and Julie paid more than $1 million for an apartment on Manhattans Central Park West. Their beautiful 4,000+ square foot residence is in a prestigious building and has a view of Central Park.

Peter bought the property even though he held negative views on the economy. Accordingly, I asked, If you think the economy is in trouble, doesnt that mean that housing prices will fall? Doesnt your doom and gloom view mean that you will lose money on your home?

Make your money at work and live in your home. That was Peters response to my query. He explained that he expected to continue to make good money at work, and that he didnt really care what happened to real estate prices. He intended to live in his apartment indefinitely, thus the ups and downs in valuation were irrelevant.

Peters dont expect to make money on real estate philosophy seemed reasonable for three reasons.

First, housing appreciation will have its ups and downs. For every buyer of a house, there must be a seller. Unless sellers are idiots, they should sell only if the price is fair. Since housing prices sometimes go up a lot, fair requires that housing prices should sometimes go down. Houses are risky investments and should not be expected to increase continuously. There should be bear markets in houses. This is predicted by both the rational (efficient markets hypothesis) and irrational views of markets.

Second, throughout most of history land and home prices have, in fact, gone up and down. The most obvious U.S. example of a real estate bust is the dustbowl of the 1930s. But it does not take a depression to hurt land prices. From 1992 through 2004, for example, Japanese land prices fell every year and lost almost half their value.1 This severe decline took place even though Japan remains one of the richest countries in the world and did not suffer an economic depression.

Third, the theory of comparative advantage-one of the most important theories in economics-suggests that most people should make their money at work and not in real estate. According to an oft-told story, Professor Paul Samuelson, winner of the 1970 Nobel Prize in Economics, was once asked by a physicist to name one idea in economics that is true and nontrivial. Without hesitation, Professor Samuelson answered comparative advantage. What is this theory, and why does it validate Peters cautious view of real estate prices?

Comparative advantage, first articulated by David Ricardo in the nineteenth century, suggests that we (both as a country and as individuals) can make the most money by focusing on what we do best.2 In his famous economics textbook, Professor Greg Mankiw (whom we have met before and will again in a minute) asks whether Tiger Woods should mow his own lawn.3 The theory of comparative advantage says that even if Tiger Woods has an absolute advantage-meaning that he is better than all others-in lawn cutting, he should spend his time with a golf club in his hands and not grass clippers.

My favorite example of a failure to understand comparative advantage comes from a 1979 article written by James Fallows about President Jimmy Carter. Mr. Fallows worked at the White House and would ask for time on the private tennis courts through President Carters secretary. Mr. Fallows claims that President Carter himself would schedule the White House tennis courts. On his request for court time Fallows writes, I always provided spaces where he [President Carter] could check Yes or No; Carter would make his decision and send the note back, initialed J. 4 (President Carter has denied this.)

Comparative advantage and common sense suggest that even though President Carter was in a unique position to schedule the courts, his time would have been better spent elsewhere.

What does comparative advantage have to do with real estate prices? Most people are not experts in real estate, but are experts at something else-often the work they do for a living. Is it more likely that you will make money by doing what you have trained for all your life, or in something you spend a few hours on a year?

The answer seems as clear as the fact that Tiger Woods should not mow his own lawn and Jimmy Carter should not schedule tennis courts. Those of us who are not real estate specialists should expect to make our money in the area where we are experts-at work. This provides the connection between Peters enigmatic comment and economic theory. We should expect to make our money where we have a comparative advantage (in our jobs) and not where we are comparative neophytes (in our home purchases).

So how did Peter do in his work and with his real estate investment? His outcome was exactly the opposite of that predicted by the theory of comparative advantage. Peter has done fine at work, but even better in his home. Peters real estate investment has soared in value and has increased his net worth by millions of dollars. So Peter actually lived in his home and made his money in his home!

Both economic theory and historical experience suggest that Peter was right to seek shelter in his home and profits in his paycheck. His actual