Thursday, May 19, 2011

On Investing: Part 14

Real estate, starting with home sweet home.

All the other postings on investing included a musical reference. With a home, a musical reference would be too easy and a cheap shot. The same would be true of any reference to “Our House.” (Oops). But, it is a very, very fine house, even if it isn’t on the range.

Seriously, real estate should be a part of any portfolio. Problem is that it is hard to separate real estate investments from leverage issues. Nevertheless, there are a number of misconceptions about real estate that commentators repeat. They are now mouthed more frequently than the wisdom repeated back in 2006 that a general home price decline couldn’t occur. They should be noted by anyone serious about the issue. The nonsense said about housing and the potential financial mistakes it causes will be the subject of the next few postings.

One that’s particularly interesting is statements like “for most consumers a house is their biggest investment” or “a home is most people’s biggest asset.” First note that these are two very different statements. The value of an asset is quite different from the amount invested in the asset. People who take a 100% mortgage have nothing invested; it’s just a big asset with an offsetting liability. However, the interesting thing is neither statement (i.e., biggest investment nor biggest asset) is accurate.

First, at any given point in time “most” people don’t have a lot invested in a home. For starters, 35% to 40% of households rent. In addition, a lot of “owners” haven’t built up much equity by paying principal. They may be consuming a lot of housing by living in a big house, but they aren’t investing in it unless they’re paying down principal. If they made a down payment, that constitutes an investment, but the days of 20% down as the norm went away over a decade ago.

So, in fact, it is probably more accurate to say a large MINORITY of people have a large investment in their house. For each one, over time it will become a larger investment and MAY become their largest investment, but there is a good chance it will be less than what they spend to borrow money for cars, their house, education (theirs and/or their kids’), and other consumption. Over their lifetime, most Americans spend more to consume tomorrow’s income than they invest in housing.

How about the largest asset claim? That claim is on less shaky ground, but still questionable. The validity of the claim depends on one’s definition of asset, and in particular, asset liquidity. An asset doesn’t have to be liquid. In fact, one definition of an asset is anything that produces a steam of benefits.

Real estate is not a particularly liquid asset. One definition of liquidity focuses on the cost of converting to money. Real estate is very illiquid by that definition. If you doubt it, compare the transaction cost on a stock verses real estate. The commission on a stock trade isn’t even in the same ballpark as real estate closing costs. Another dimension of liquidity is the time it takes to convert to money. Buying or selling real estate takes time. The most sophisticated (i.e., broadest) definitions take into account cost, time, volume, price stability, uniformity or interchangeability of offerings, and even information flows. Real estate is illiquid by each measure. Finally, even more serious is the fact that real estate markets aren’t guaranteed to clear. Governments may intervene to stop foreclosures from clearing, as is currently happening, or buyers and sellers may refuse to trade at current prices, also currently happening.

With real estate we’re dealing with an illiquid asset. In a previous posting, “Data is no substitute for thinking,” The Hedged Economist made the passing comment “…Shiller hasn’t gotten over the housing bubble; he still talks about housing prices as if one’s home where an asset rather than a place to live.” Technically it should have said “liquid asset.” Once one focuses on a home as a place to live it become analogous to any other stream of benefits (i.e., real income). A house is far from the largest stream of benefits. One’s income is the largest stream of benefits for “most people.” Thus, for MOST people the discounted present value of the income stream is their largest asset.

Nothing can ruin an investor’s day, or for that matter an economic and financial system, quicker than mistaken assumptions about the liquidity of assets. However, a close second is not knowing what has been invested and what has been consumed. Anyone who lets these misconceptions about housing influence their thinking is risking both mistakes. That’s true of investors and equally true of policy makers.

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