Thursday, June 2, 2011

On Investing: Part 14 (contd.)

Superficially simple until reality impinges…or it’s the leverage that matters.

Picking up on “On Investing Part 14,” let’s look at the types of mistakes that misconceptions about housing cause. The easiest to dispense with is the “housing is most people’s largest investment” nonsense. Aside from not being true for most Americans, it is irrelevant. It shouldn’t have any impact on an investor or a policymaker. What has been spent is a historical artifact; it is a sunk cost as economists like to say. What matters to an investor is future return. That really should be all that needs to be said, but alas it’s not.

Isn’t whether the investment is worth more than one paid for it the criteria one should apply to an investment? No, the relevant measure is total return. With housing, that distinction is particularly important. Much of the return on a home comes in the form of having a place to live. Over a lifetime the “place to live” swamps the capital gain. That return starts with the first home and continues until one doesn’t need a home. Throughout that period, whether real estate ownership represents a good use of capital depends on the alternatives available going forward, not looking back. It has nothing to do with sunk costs. If your house is the best place for you to live, it’s the best place for you to live regardless of whether the price went up or down.

“But,” you say, “if house prices go up, one can sell it and move to a nicer house.” Not based on the price move. If the price of housing goes up, the price of the nicer house will go up too. One might benefit from relative price movements if your home’s price went up faster than housing prices in general. That, however, is a totally different issue.

Here is where leverage can cloud the issue. People see the greater equity that house price appreciation creates as a vehicle for the bigger down payment. Bigger down payments are prudent with a bigger house. But, the issue is totally a leverage issue and has nothing to do with house prices.

This is easy to understand, but harder for people to internalize. At the risk of some overkill, here are some illustrations. Let’s use 20% down payments in order stay with reasonable consumer behavior. Let’s start with 20% down on a $200k house which equals $40k initial equity. Now imagine moving in and having housing running up 25% before any of the monthly payments appliy to principal. The person now has $90k in equity.

With $90k equity and 20% down, a $450k home is feasible assuming an adequate income. Leverage ratio when applied to equity on the new home is the same as when the first house was bought (original position: $40k = 20% of $200k. new position: $90k = 20% of $450k). However, when applied to income the leverage ratio changes (unless the persons income when up by 25% also). Similarly and importantly from an investor’s perspective, the leverage ratio relative to total assets, and especially relative to non-real estate assets, changed (unless all the persons assets also went up 25%). The person’s portfolio has the same $90k in real estate equity regardless of which house the person lives in.

More than likely, other assets and income didn’t increase at exactly the same rate as housing. If that more likely scenario occurred, the asset on which the leverage has concentrated is also an asset on which the majority of return is NOT going to increase; the person may have a nicer place to live, but that’s the trade. It is totally due to increasing the dollar value of the leverage. Essentially, the person has increased their aggregate leverage by concentrating it in an asset with a largely fixed return. The house isn’t going to increase in niceness. They have a nice asset, but all assets tend to be nice. It has a fairly secure return in the form of a place to live.

If instead of increasing 25%, the home price went down 25%, eating up the equity and then some, has the person been wiped out? Not at all. The person has no equity, but the return of having a place to live hasn’t changed much. The leverage relative to the home equity has grown phenomenally. The person is leveraged in excess of 100% on the real estate investment. The real estate equity portion of the portfolio has been wiped out. The leverage (debt) relative to income hasn’t changed, nor has the leverage relative to other assets. The aggregate leverage ratio has gone up.

What are logical responses to these two scenarios? If housing prices run-up faster than other assets or income, modern portfolio theory (MPT) would advise reducing real estate exposure and rebalancing into other income producing assets. In the inverse situation, rebalancing into real estate from other assets would be the MPT response. That would rebuild the real estate equity. Simple isn’t it? Not really because it’s the leverage that matters.

In scenario one, the run-up in housing has created a greater equity in an asset with a largely fixed return in the form of a place to live. It has also reduced the leverage relative to what is for most people their most leveraged asset. Neither is bad; in fact both are highly effective risk reduction strategies. Here’s the rub. Overall leverage is also reduced. Some people believe they should spend every cent they can beg, borrow or…. Thus, the reduced leverage isn’t appealing to many people.

While the point of departure for this discussion was the mistaken conventional wisdom about “most people,” what is true for most people is that leverage is more readily available on their home than any other asset. There are powerful incentives encouraging people to concentrate the focus of their leverage on real estate. But, that has a lot to do with government policy, not investment returns.

The more relevant scenario currently is the price decline scenario. Unfortunately the “largest investment” nonsense is used to encourage behavior that only makes sense in very narrow circumstances. Specifically, much of what is said about mortgage default is both false and terrible financial advice.

Defaulting on a mortgage is seldom a good idea and certainly not one that should be based on the profit or loss on the real estate when subjected to mark to market accounting. Remember, the key issue is the return on future cash outlays, not past outlays. Most of the return comes in the form of “place to live.” Cases where defaulting will put one in a better place to live are rare. The usual outcome is relegation to rentals for some amount of time. Further, although less an issue for some people, there is also the psychological cost of living with the failure to live up to one’s promise.

From a purely financial perspective, the return on investment (i.e., a place to live) hasn’t changed. The price relative to other assets has. If income hasn’t changed, the logical response is to allocate more investment capital to real estate. Again, leverage is the rub. Overall leverage has increased. If the leverage has gotten too great, then a default may be the outcome, but overall leverage, not real estate investment, is the issue. In fact, it would be quite legitimate to argue that an underweight in real estate in the form of equity was the source of the overleverage.

One would think a price increase scenario and a price decline scenario would cover mistakes encouraged by “biggest investment” nonsense. Alas, this is a brave new world where once a myth has been established it will be played for all the mileage possible. Witness “Hedging Your Home Value: The Greatest Idea Never Sold,” WALL STREET JOURNAL, May 14, 2011. Here’s advice on how to waste money regardless of whether housing prices change or not. All that’s required is ignoring the fact that living in a house is a form of consumption. Just start thinking of it as investing.

The confusion extends to what to hedge, what hedge is being discussed, and why to bother hedging at all. Whenever discussing any hedge it is important to understand what risk is being hedged. Otherwise one can end up getting an ugly surprise. The WALL STREET JOURNAL article discusses hedging housing prices without addressing whether it is recommending hedging the risk associated with the amount invested, the equity, the asset’s value, or the leverage. It totally ignores the fact that the primary return to a house is having a place to live.

It is easy to illustrate the confusion this creates. Consider this quote, the first line of the article: “…. why is it so fiendishly difficult to protect yourself against the risk of a further drop?” Now if the risk is leverage, it not hard to “protect yourself against the risk.” Since the article goes on to fret about “roughly one in four homes ‘underwater,’ or worth less than the outstanding mortgage,” there is at least passing concern about leverage risk.

That same quote about underwater would lead one to think that how much has been invested isn’t a major concern since getting to negative equity is usually associated with not having invested much in building equity in the first place. However, that seems to be contradicted by another quote: “People can always rent, of course. But once you own a home free and clear, you have the option of selling it and using the proceeds to fund your retirement. That makes a fall in home prices worth protecting against.” Aside from avoiding the real issue, whether renting makes sense (i.e., is the best way to secure retirement housing), the quote implies it is equity that needs to be hedged.

There is always a plausible argument for hedging the price of an asset if the hedge doesn’t decrease the total return to the asset. However, the article never addresses total return nor does the hedge being touted. That leaves open the question the article seeks to address (i.e., whether hedging home prices makes sense).

If “largest investment” can lead to mistakes, the mistaken notion of largest asset is even more dangerous. That’s a topic for another day.

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