Real estate index funds as down payment savings

Question

My wife and I are saving towards a first house down payment (already have $50k expecting to save another $30k with about 2 year target).

Rather than leaving them in CD, I was thinking of investing the savings in a real estate index fund (like this one for example FIDELITY MSCI REAL ESTATE INDEX ETF).

The idea is:

• expected on average better yield and more liquidity than a CD (we are not sure on the exact purchase time frame)
• by investing in real estate we can offset the risk of real estate going up in the next couple years: if real estate goes up we will still be able to use our down payment for a comparable house as of now. Inversely, if real estate goes down we will lose on the down payment but be able to get a house cheaper.

Does this reasoning make sense? Is this a common practice, or would you have other recommendations in saving for down payment?

Answer 1

Frequently people saving money for a down payment, or for their emergency fund, feel that they need to find a way to speedup the process via methods that will generate more interest than a bank account or a CD. Once they have reached their goal they also feel that having the money sitting around not generating income is a missed opportunity.

All investments that aren't 100% safe introduce risk. To entice you to invest they offer the opportunity make more money than a bank account or CD. But the downside is that the extra money isn't guaranteed. In fact the introduced risk also opens up the investment to the possibility of losses, including a total loss.

You have identified risks with bank accounts and CDs. With the bank account you will generally lose money vs. inflation. With a CD the investment is less liquid if you sell early, or you want/need to sell 1/2 a CD, you will give up some of that extra income. Also if rates on a CD rise next month you are stilled locked into your current rate til the CD ends.

Putting some or all of the money you are saving for the house into a risky investment means that you may shorten or extend the time period. Nobody knows.

by investing in real estate we can offset the risk of real estate going up in the next couple years: if real estate goes up we will still be able to use our down payment for a comparable house as of now. Inversely, if real estate goes down we will lose on the down payment but be able to get a house cheaper.

Unless the REIT matches the market of residential real estate in your city/metropolitan region there is no guarantee that home prices in your city will move the same way the REIT does.

A recent listing of the 10 largest holdings of the index is:

• AMERICAN TOWER CORP
• SIMON PROPERTY GROUP
• CROWN CASTLE INTL CORP
• EQUINIX
• PROLOGIS
• PUBLIC STORAGE
• WELLTOWER INC
• AVALONBAY COMMUNITIES
• EQUITY RESIDENTIAL
• WEYERHAEUSER CO

none of these tell me what home prices in my neighborhood will do next year.

Answer 2

If you're trying to hedge the ups and downs of your local residential real estate market, a REIT fund holding commercial properties across the country is not the ideal match. Here's a comparison of an index tracking single-family home prices in one region (Los Angeles) and VNQ (another popular REIT fund).

There's some correlation but there's clearly different magnitudes and sometimes different directions. With a national home price index, the correlation is only 68%, and it would be lower for individual cities. You could still use it for hedging, but there's significant "tracker error" risk to be considered.

Unfortunately, I'm not familiar with any investment that would be a better match for individual residential markets. So, if you decide to use this, I'd also adjust the level of exposure to get a closer result. E.g. using approx. 50% VNQ and 50% cash results in a closer result after 2 years (compared to national single-family home price changes) than either 0% VNQ and 100% cash, or 100% VNQ and 0% cash.