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Using REITs to Save for a Down Payment

A reader writes in, asking:

“What do you think about using Vanguard’s REIT ETF rather than CDs or a savings account as a way to save up money for a down payment on my first home? My line of thinking is that a REIT fund would likely outperform such low-risk investments, and if the fund has a loss, it might not even be a problem because it’s likely that real estate prices will be falling as well.”

There’s certainly a degree of common sense appeal to such a strategy.

  • Like any stock fund, it’s true that a REIT fund will earn higher returns than CDs or savings accounts over most periods.
  • And it’s true that a REIT index fund or ETF would usually be more closely correlated to home prices than other stock investments would.

But it’s still a risky way to save because you can’t count on a high correlation between the price of the home you want to purchase and the performance of a REIT index fund or ETF.

Commercial Real Estate vs. Residential Real Estate

Most REIT index funds have the majority of their assets invested in commercial REITs rather than residential REITs. (See, for example, the holdings of Vanguard’s REIT index fund.) As a result, there’s a real possibility that home prices could be rising (making your desired home purchase more expensive) at the same time that the price of your REIT fund is falling due to a poorly-performing commercial real estate market.

Real Estate is Local

It’s also important to remember that home prices don’t move in lock-step across the country. Home prices could be falling overall, while home prices in your area are holding steady or even climbing. If your REIT fund’s price falls along with most home prices, saving for a home in your area will be a challenge in such a scenario.

To pick two examples off the top of my head: Asheville, North Carolina and Hot Springs, Arkansas — two places we had considered moving to last year — both saw home prices increase through 2007 and 2008. Trying to save for a down payment in one of those cities would have been rather difficult if you were using an investment that, like Vangaurd’s REIT index fund, lost almost half of its value (47%) over those two years.

It’s Not Crazy. But It’s Not Safe Either.

Using a REIT fund to save for a home down payment probably would make more sense than using something like a total stock market index fund, because the REIT fund probably would have higher correlation to home prices in your area. But again, that correlation isn’t going to be very reliable.

And a REIT fund will likely earn you greater returns than a savings account would. But when I say “likely” here, all I mean is “greater than 50% probability.” It’s not at all something you can count on. And it makes the worst-case scenario significantly worse (home prices increasing while the value of your savings is decreasing — something that can’t happen with a savings account).

In short, unless you’re very flexible with regard to when you purchase the home (such that you wouldn’t mind waiting several years for your REIT fund to bounce back after a decline), I’d suggest sticking with the normal advice: Use something safe for short-term savings.

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Comments

  1. Mike

    This question is a good example of an investment idea with a good sounding story which turns out to be unsound upon investigation. As with any money needed for near term [less than five years?] goals, whether college, retirement, a wedding, or buying a house, the “normal” [safe] advice is absolutely correct.

    Investing in risky assets for short term goals, often done in desperation, can destroy your dreams.

    Many folks in 2005-2007 watched as the increase in home prices outstripped their ability to save for a down payment and thought, “I am missing my only opportunity to ever be a home-owner, I better leap at the offers on TV from realtors and sub-prime lenders!”. Thus did their [mistaken] desperation [and asymetric information] make them vulnerable to being exploited. Their real goal was to OWN a home, not just to BUy a home – and lose it afer a short time!

    As someone who has lived through several market cycles in both real estate and investing, I assure all eager buyers, Mike is right.

    Whatever you do in desperation or panic you will likely later regret at your leisure when prices have returned to normal [reversion to mean].

    Best wishes for a happy, healthy, and prosperous 2012 to all!

    Jim

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