Is a home a nest egg or an investment risk?

For many couples, their home is their largest asset. What they may not realize is that asset could represent a significant investment risk as they approach retirement.

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When couples buy their first homes, they usually don’t think of themselves as real estate investors, notes Robert Stammers, director of Investor Education at CFA Institute in New York. “They see it as a place to live and raise a family, so the investment risk isn’t a high priority.”

But as retirement nears, the risk becomes similar to being heavily over-allocated to a single asset class.

“As you get closer to retirement the utility you’re getting from your home goes down because the kids leave, the house is harder to maintain, etc. As that utility goes down, the […] investment risk goes up,” says Stammers.

“If the equity in their home is their single largest financial asset, they’re taking considerable investment risk [because] they’re not diversified.”

The risk can be mitigated by getting clients to start thinking about downsizing 10 years prior to retirement. The excess cash generated from the eventual move should then be funneled into clients’ stock and bond portfolios.

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Planning that far in advance is critical, says Stammers, because there’s no way of knowing if real estate prices will be up or down at the point clients transition into retirement.

“Residential real estate is highly correlated to the economy, the job market and the local real estate market,” he notes. “Variations in value aren’t such a big deal when you’re living there and getting a lot of utility from the home.” But as retirement approaches, those variations could be the difference between meeting and falling short of drawdown cash flow targets.

By raising awareness a decade before clients retire, they’ll have more flexibility to wait through a down market, or seize the opportunity a strong market presents. “Real estate doesn’t go up a certain percentage every year. What usually happens is the value is pretty flat, and then it pops,” explains Stammers.

This flexibility, he adds, will also allow them to follow the 25% Rule advised by Denver-based National Endowment for Financial Education. It says clients should only downsize if they can expect a minimum 25% savings on the carrying cost of the new home (including mortgage, utilities, taxes, etc.).

“A lot of people overestimate the value of their homes, and underestimate what a smaller home may cost,” says Stammers. “Where they really miss the boat is in transaction costs, which are significant. You’ve got sales costs, commissions, and transfer taxes.” Those costs need to be factored into the 25% Rule calculation.

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