Less House, More Cash
Anxious to lock in profits before real estate prices fall, some homeowners are trading their super-size homes for something more modest. Should you?
(MONEY Magazine) – For the past decade, real estate has been a virtually foolproof moneymaker. The mantra: Buy the biggest house you can afford. Then, as prices soar, trade up. Repeat the process until rich. And that wave has yet to break. In July, for example, existing-home sales jumped 8.6% over the previous year, according to the National Association of Realtors. But after so many years of loading up on real estate, a lot of people now find that most of their net worth is in their homes. That, naturally, has made them wonder what would happen if real estate prices should plateau or start to fall. In other words, is now the time to sell the McMansion and downsize?
Cynthia McKay, 49, and Paul Gomez, 48, have decided it is. Three years ago the couple bought a 5,000-square-foot, $600,000 home in Parker, Colo., near Denver. Initially happy with the move, they invested an additional $150,000 in lavish home improvements, which included adding a wine cellar, a movie theater and a deck.
But they now realize that the six-bedroom home is just too big for a childless couple—"I haven't set foot in four of the bedrooms in months," Cynthia says—and that their money could be put to better use, like paying down debt. So the couple have decided to sell and move to a smaller place.
"We're seriously concerned that the real estate market may be reaching a peak," says Cynthia, who runs her own gift-basket company. (Paul is an assistant Colorado attorney general.) "We can use some of that equity money to pay down our loans and credit-card debt and build up our retirement accounts."
The couple figure they could get about $800,000 if they sold the house today. Cynthia estimates that would net them $500,000 to put toward their debts, investments and a new house.
Should you cash out too? If you are a long-term homeowner and are building a diversified investment portfolio, you can probably ignore the bumps and dips in the real estate market.
There are three types of owners, however, who should be thinking seriously about downsizing: those who are planning to retire in three to five years, those who need the cash from a sale soon and those who have bought more house than they can comfortably afford. If you fit into one or more of these categories, financial advisers say, it's important to evaluate your overall financial situation and the role of real estate in your portfolio. (You also need to weigh the tax consequences of selling. Capital gains on primary residences are tax-free up to $500,000, or $250,000 for single filers, as long as you have lived in your house for two of the past five years.) And you'll also want to consider what's happening in your local market as well as your own lifestyle preferences.
Your first step should be to calculate the percentage of your net worth that is tied up in your home equity. (For a net worth calculator, go to money.com/tools.) Divide the value of your home by your total net worth and multiply by 100. You may be surprised by the large number—the average middle-class American has 60% of his net worth invested in his home. That's not necessarily too much for younger homeowners, who can build additional assets as their income grows. People closer to retirement, however, may want less exposure to changes in the real estate market.
David Diesslin, a financial adviser in Fort Worth, uses this benchmark: "If you have more than 20% of your assets in home equity, and you plan to stop working in five years, that's a warning sign." It's essential to determine whether your other assets will generate enough income to support you throughout your retirement. You can find online retirement income calculators at fidelity.com and troweprice.com or you may wish to consult a financial adviser.
Another thing to think about is whether the real estate market in your area is getting too hot. Yale economics professor, real estate consultant and author of Irrational Exuberance Robert Shiller thinks that prices in many parts of the country may be due for a fall. He says, "This could be a good time to sell—the market may continue to boom for a while, but it will cool off down the road."
Even if real estate stays strong, it's risky to bet too much of your financial future on an illiquid asset such as your home. Says Sheryl Garrett, a financial adviser in Shawnee Mission, Kans.: "You can't be sure of tapping your home equity until you actually sell and net a gain."
There's no sure gauge of when prices have gotten too high, and it's not wise to try to time the market. Still, you should look at recent sales of comparable homes. Get estimates of what your house might bring by talking to real estate brokers and comparing the prices of your neighbors' homes. Have prices been climbing by double-digit rates over the past couple of years? If so, you may be in a superheated market, which raises your level of risk.
Downsizing is not always a simple proposition. In many parts of the country, a comfortable condo can be just as costly as a house. That is especially true in popular retirement areas. Diahann Lassus, a financial adviser based in New Providence, N.J. and Naples, Fla., says, "I'm seeing people buying retirement homes that cost just as much as their original homes." Of course, you might decide to take on a bargain-priced fixer-upper or move to a less costly area (Costa Rica, anyone?), but that may require a much bigger change in lifestyle than you are prepared to take on.
Downsizing, finally, may simply mean moving to another area, a choice not everyone is willing to make. But that's what Dick and Lorrie Rennick did last year, when they sold their 3,800-square-foot home in Palm Springs, Calif. for $625,000 and downsized to a $220,000, 1,725-square-foot home in nearby Yucca Valley.
"We wanted to be in the country," says Dick, 61, who enjoys Yucca Valley's cooler climate and access to the nearby Joshua Tree National Monument. And the $250,000 that the couple cleared on the sale of their old home doesn't exactly hurt either.