On Investing: Part 14 (contd.)

Some old fashion beliefs had a sophisticated basis.

This is the third posting on real estate. You might legitimately ask, “When will real estate as a capital allocation issue be addressed?” That’s understandable; the previous posting addressed myths and mistakes associated with the ownership of a house. Remember, however, the oft quoted axiom of investing: “Rule one: don’t lose the capital. Rule two: don’t forget rule one. Rule three: there are only two rules.” So, it seemed appropriate to start with the nonsense and bad advice. It’s now time to allocate capital.

When one addresses home ownership as a capital allocation issue, some interesting questions immediately surface and the answers point to some old fashion beliefs about home ownership. Things like 20% minimum down payment, amortizing mortgages, payments that represent 20-25% on income, total ownership costs under 30-35% of income, little or no other debts that must be services at the time the mortgage is initially taken out, savings (i.e., investments) other than the home, all have often unspoken balance sheet management justifications. Old fashion, but hardly unsophisticated. Similarly, much of the trendy, supposedly sophisticated advice is naïve occasionally bordering on financially suicidal.

A home purchase can be a very low risk-real estate investment. Remember, the primary return, a place to live, doesn’t change. We, inventive creatures that we are, have figured out how to make it risky; just leverage the heck out of it. Nevertheless, it is still a potentially productive way to use capital. First, however, there has to be some capital involved. So, nothing that follows is at all relevant to zero-down-interest-only housing purchases. That’s really a totally different issue; it might be better treated as whether to rent housing or rent money.

Mortgages where there is an interest only option can raise similar issues at times since whether any capital is allocated to real estate is an open issue. In fact, if housing prices are falling, the interest only payment actually involves a reduction in capital when marked to market. Granted, the primary return hasn’t changed (i.e., a place to live), but leverage has increased as discussed previously.

The return isn’t without risk, but it would be naïve to assume that leverage and price are the only risks. The amount of the benefit from having a place to live that is attributable to the capital does vary. Maintenance and real estate taxes vary, so not all of the benefit from a place to live is return on capital.

Since this posting is approaching home ownership as a capital allocation decision, it takes a balance sheet management approach. That’s consistent with a focus on net equity rather than asset value. However, as mentioned in all the previous discussions, leverage often confuses the issue. Further, leverage is an important aspect of balance sheet management.

Therefore, without trying to discuss personal (or household) leverage as a general issue, some comments are essential. Most real estate purchases involve a mortgage. That makes infinite sense. Remember most peoples’ largest asset is their future income stream. Initially it is usually their only asset. Under those conditions, it makes sense to diversify by selling part of the future income stream to purchase a different asset.

Leveraging future income makes sense since selling it outright (i.e., explicitly indenturing oneself) isn’t legal: borrowing is about as close as you’ll be able to come. An amortizing loan such as a mortgage is particularly convenient from a personal perspective. An amortizing mortgage automatically builds equity in real estate as the value of the future income stream decreases with age; thus, it rebalances for you and replaces one asset that is decreasing with another.

Granted, most people do not consciously approach the issue as a balance sheet management issue. Cash flow is often the major consideration. Viewed from the balance sheet management perspective, one can see that just focusing on cash flow can lead to balance sheet management mistakes.

To illustrate, when one is young, wage and salary income tend to go up over time. That has been true over most historical periods and has been especially true during inflation. If that income stream goes up with the passage of time, the value of the discounted future wages and salary income does not keep pace. The length of time decreases since some of the income stream is in the past; retirement’s getting closer. Similarly, the value of the benefit from the home decreases since that benefit is also effected by the short timespan over which the home can be owned; one can’t live forever.

For many people, the values of these two major assets are falling with the passage of time quite independently of price fluctuations. Under those circumstances, amortizing loans make sense. Debt is automatically decreasing with the value of these two assets. From a purely cash flow perspective, this, is occurring at a time when more debt seems to make sense, or at least not be harmful; after all, the income is there.

While a home isn’t most people’s biggest asset, it’s usually the core of the real estate investment of those who choose to accumulate assets. That makes sense from an investment perspective. It’s an investment where the primary return is very predictable: a place to live. Since the leverage issue was addressed above (to the extent this posting is going to address it), now things get quite simple since the focus is equity. With equity in focus, the important questions are: How much real estate should one own, and how should it be accumulated over time?

There is some old fashion wisdom here as well. Buying one’s place to live and retiring the leverage over time are widely recognized as “old fashion,” and they are often honored in the breach. As damaging as that breach has been for many people lately, there is more. The concept of 20% down clearly has balance sheet implications. The implications for leverage are obvious. However, that’s quite minor. It is more important to recognize that it mandates net equity, the down payment, as a starting point.

With 20% down and amortizing loan, there is an implied shifting of portfolio weights. One is increasing home equity. However, if one hasn’t fallen into the cash flow trap discussed above, those assets are replacing the decline in the value of the discounted value of future wage or salary income. Further, a subtle symmetry is automatically built in. As payments accumulate on the mortgage more of each payment applies to principle and less is interest. Thus, the rate at which equity is being accumulated is accelerating. That offsets the fact that the rate of decline in future income accelerates as more of one’s raises, promotions and increases in wage and salary are in the past.

The symmetry doesn’t end there. The initial 20-25% of income falls as a portion of income as wages and salary rise with time in the labor force. However, while the symmetry discussed above is automatic, the benefit of this might require action. As the increases in wages and salary slow down and eventually reverse, a smaller portion of wages and salary is needed to build real estate equity. That drop facilitates allocating more of the employment income to other income-producing assets. Thus, income-producing assets can replace the slowdown in raises common in older workers. Eventually much of the income from employment has to be replaced by income from capital and the drawdown of the capital eventually replacing it entirely in retirement.


Since 20% down payment was viewed as a minimum down payment, it limited the purchase price. The guidance of no more than 20% to 25% of income for mortgage payment also tended to limit the price. However, one could buy a bigger house by increasing the size of down payment. Another popular way to purchase more home is to extend the length of the mortgage. So, the 20-25% of income didn’t put a fixed limit on real estate exposure. It put a limit on the leverage resulting from the home purchase since just borrowing more was not an option. Something else was needed.

“How,” you say, “does that relate to how much real estate one should own?” Well, first, it dictates that one actually own some real estate in the net equity sense. Second, when combined with reasonable guidance regarding the portion of one’s income to obligate to a mortgage, it sets a ball park on how much real estate to own. Interestingly, the concept of “over-housed” (i.e., having too much capital tied up in home ownership) arose almost simultaneously with the rise in the portion of income that it was thought to be OK to obligate to a mortgage. In the 1950s most long-term home loans lasted just 20 or 25 years with 25 year mortgages viewed as boarding on imprudent. Now, 30 year mortgages are common. So, lengthening the term also was at play.

The balance sheet approach provides additional guidance. There the guidance is completely at odds with “Hedging Your Home Value: The Greatest Idea Never Sold,” WALL STREET JOURNAL, May 14, 2011.

The article promotes hedging an overexposure to real estate. The balance sheet approach would dictate diversifying beyond real estate as soon as feasible. In practical terms, don’t go for a larger house; start an IRA or 401(k) well before further increasing one’s exposure to real estate. The balance sheet approach would also suggest investing in income-producing uses of capital so that the discounted future income component of your balance sheet can be rebuilt after using (selling) it to get real estate.

The balance sheet focus would suggest not prepaying your mortgage until some other assets have been added to the balance sheet. Remember the focus is net equity. Prepayment increases the net worth of the asset, but prepayment does it by concentrating the capital in one asset, residential real estate. Prepayment isn’t bad. It is an effective low-risk investment when done within the context of a broad asset base. As always, there is also the leverage issue. If over leverage is introducing too much risk, then by all means debt repayment is the solution.

There is still the issue of how much of a portfolio should be in real estate. Here the owner- occupied house presents an almost unique asset class. It is residential real estate, but it has far less risk than most real estate. Remember, the primary return, the benefit of having a place to live, is pretty predictable. While there is some research, it is putting it mildly to say the resulting “recommendations” are all over the board. That is perhaps why the mortgage-payment-to-income guidance hung around so long.

Some of the research, or at least the advice that comes from it, is ridiculous. Take, for example, the advice that 5% of a portfolio should be in real estate. Clearly, 5% is only reasonable if your home is excluded. So, the issue of how much to invest in real estate has really been ignored. If you’re “over housed,” putting 5% of your other assets in real estate is silly. By contrast, the opposite may be true, in which case 5% is too little.

On the other hand, nonsense about selling your house to finance retirement is dangerous. It encourages portfolio concentration in real estate. Further, it depends upon selling an asset with a very stable return (in the form of a place to live) at exactly the time when assets with fixed predictable benefit are usually needed. The only possible justification would be that it could move assets from a highly illiquid asset (real estate) to some other form. That, however, involves paying a significant transaction cost to secure the liquidity. Selling a house should be a lifestyle choice, not a response to economic necessity.

Thus, in would appear that despite its limitations, the “old fashion” guidance looks pretty reasonable when compared to the nonsense inventive minds can come up with when it is ignored. Yet, refining this limited guidance is possible. There are various studies of how wealth is preserved and grown. Those that The Hedged Economist has read put the portion of the portfolio in real estate at 30% to 60%. Those figures include residences and income-producing properties. Much of the explanation for the range has to do with how other non-liquid assets are treated (private businesses mainly). My own view is that the guidance provided by the “old fashion” approach to home ownership is adequate until the mortgage has been paid off. Then the 30% to 60% guidance should be a target -- always including home sweet home as well as “investment” property in the calculation.