Real Estate

You may know people who gained nicely from homeownership. This article analyzes a critical element for sustaining the high growth: leverage using mortgage loans.

Is This Article for You?

This article assumes that you desire to maximize the growth rate of your investment in your home, at the price of higher short-term risk in the early years. The risk is very real: many people lost their home or went bankrupt by incorrectly analyzing their risks or simply panicking during a downturn in real estate or stocks. To add to the difficulty, real estate cycles are typically longer than stock market cycles, testing the patience of the most disciplined investors.

Note: To make the article tangible, specific cases are provided. Actual numbers can vary wildly depending on the specific home and timing, but the principles should apply to many cases.

No Leverage: Let’s start with non-leveraged returns. Real estate returns with no mortgage loans are typically moderate. For example, you may obtain combined returns + savings of 6.2% on owning your own home instead of renting it, assuming:

• 4% appreciation (U.S. real estate growth in the long run)
• 4% saved rental payments (a common ratio)
• -0.8% property tax of ~1.1% after tax-deduction
• -1% repairs

Such returns are nice relative to bond investments, but are below stock returns. 

With Leverage: With a mortgage, the results improve. With the addition of an 80% loan with a 5% interest rate (below the average of the past 20 years), you get an additional gain of (6.2% – 5%) x 4 ¹ = 1.2% x 4 = 4.8%, for a total of 11%. This is more in line with some stock investments.

Notice that the returns change dramatically depending on the mortgage interest. If you can get today a loan with a 3.5% interest rate, the increased returns thanks to the mortgage, jump to (6.2% – 3.5%) x 4 = 2.7% x 4 = 10.8%, providing a total of 17%, competing with most stock portfolios.

Key point: The returns above are returns on the amount invested. If you bought a $1M home, and put down 20% ($200k), your 17% return is $34k. While this is a great return on the amount invested, taking the loan makes financial sense only if you can invest the rest of your money and expect higher returns than the interest paid when averaged over the life of the loan. This applies to any money you have, whether it is the full remaining home value ($800k), or any smaller amount. If you spent the rest of the money, or invested in bonds with low returns, your financial position will be worse than not taking the loan and keeping the money invested in the house. Here are a few examples for returns depending on the return on the rest of your money:

Year-1 Returns on $1M house with $200k down payment and the remaining $800k invested elsewhere, and 6.2% return on money investment in home
$800k investment	Return calculation	Total return	Loan Benefit
You spent the remaining $800k	(34k – 800k) / 1M	-76.6%	-82.8%
You kept the money in cash	(34k + 0) / 1M	3.4%	-2.8%
You earned 3.5% in bonds (same as loan interest)	(34k + 3.5% x 800k) / 1M	6.2%	0%
You earned 10% in stocks	(34k + 10% x 800k) / 1M	11.4%	5.2%
Your earned 17% in stocks	(34k + 17% x 800k) / 1M	17%	10.8%

While such gains are appealing, they cannot be sustained by taking a 30-year mortgage, and keeping it until it is fully paid off. They assume that the loan as a percentage of the home value (called loan-to-value, loan/value or LTV) stays at a fixed 80%, when in fact the returns drop quickly, as the mortgage is paid off. There are two things working to reduce the loan-to-value:

1. Principal paid: A 30-year fixed mortgage is paid off over 30 years, meaning that every year some of the principal is paid off, reducing the loan balance. This decreases the nominator of loan/value.
2. Home appreciation: Increases the denominator of loan/value.

The following table shows the decline in returns over the years:

Returns on investment in home with 30-year fixed mortgage, 3.5% interest Assumptions: 4% appreciation, 4% saved rent, 0.8% after-tax property tax, 1% repairs
Year	Principal Paid 2	Home appreciated 3	Loan-to-value 4	Returns 5
0	0%	0%	80%	17%
1	1.9%	4%	75%	14.3%
2	3.9%	8%	71%	12.8%
3	6%	12%	67%	11.6%
4	8.1%	17%	63%	10.8%
5	10.3%	22%	59%	10%
10	22.6%	48%	42%	8.1%
30	100%	224%	0%	6.2%

Problem: Within a few years, most of the leverage benefit is erased

For example, the return after as little as 5 years is much closer to the non-leveraged return than the 80%-loan return (10% vs. 6.2% non-leveraged and 17% leveraged).

Solution 1: Add a second loan: either a mortgage or a HELOC (home equity line of credit)

This is a good solution for a few years, since it increases the leverage (loan/value) without losing the benefit of the low rate on the remaining loan balance. There is a negative to this approach: the rate on a second loan tends to be higher than a primary loan, and the rate on a HELOC is variable, adding to the risk and cost of the HELOC as rates go up. While this negative is moderate in the first few years, when the balances are low, it becomes much more meaningful as the years go by, and the second loan or HELOC become large. At that point, you are typically better off refinancing (Solution 2 below).

Solution 2: Refinance to increase the mortgage

This solves the shortfalls of adding a loan (Solution 1 above), but requires accepting a new interest rate, even if it is much higher.

Key Point: If you are eager to lock a 30-year mortgage at today’s low rates, the benefit is likely to be outweighed by the declining leverage. Solving this problem requires accepting future, potentially higher, rates.

Optimization 1: adjustable-rate mortgage (ARM)

Since you are not likely to benefit from holding the same mortgage for many years, you can consider an adjustable-rate mortgage (ARM). Such a mortgage guarantees a certain rate for a limited period – typically 3, 5, 7 or 10 years, and later adjusts annually. By retaining the risk of rising rates, you are compensated through a lower initial fixed rate.

Choosing the optimal ARM term:

1. When rates are high, you can choose a shorter lock, to get the lowest rate, since rates are likely to decline at some point, anyway making a refinance beneficial.
2. When rates are low, it can be beneficial to lock the mortgage for longer at the price of a higher fixed rate.
3. An important subcase: When rates are low because real estate declined substantially, and in an attempt to help real estate recover, you may choose a shorter fixed period, since (1) rates may keep being reduced while real estate keeps declining, allowing you to refinance with better terms, and (2) once real estate declines stop, the reversal may introduce unusually large gains early on, reducing your leverage quickly, and leading to a quicker refinance.

Optimization 2: interest-only adjustable-rate mortgage (IO ARM)

A variation of the ARM loan is interest-only ARM. With such a loan you pay only interest for the first few years, keeping the loan balance fixed. This has the benefit of slowing down the decline in leverage. The leverage declines only through the appreciation in the home value. An IO ARM typically carries a slightly higher interest rate, and, depending on how you invest the loan proceeds, can make sense.

More potential issues: While keeping a high mortgage balance can help maximize your wealth, it is not advisable or possible for most people, even if they desire to do so:

1. Cannot Qualify for Loan: As you seek increasing loan amounts, you may not qualify for the loans based on your income.
2. Excessive Risk: Any additional borrowing to invest increases your short-term risk. This is pronounced with rates that may adjust higher. A careful risk analysis is necessary to determine the short-term risk, before focusing on the potential long-term benefit. The risk analysis should address factors such as loss of job, a stock market crash, a deep and long real estate decline, and a spike in interest rates, to name a few.
3. Refinance Labor Too Great: The work for a refinance every 1-3 years, to keep the leverage high, may not be appealing to many homeowners.

Once you reach your capacity to borrow, buying additional real estate as an investment would often be inferior to simple investing in a globally diversified stock portfolio, in terms of returns (with no leverage) and in terms of complexity.

Owning a more expensive home will typically cost you money

Once you realize the benefits of leveraged homeownership, you may ask if you can make more money by owning a more expensive home. The answer is “no”. Let’s review the scenario from the top, modified to exclude the saved rent, to calculate the growth in the amount spent on the extra home value. We get: 4% appreciation – 0.8% property tax after tax-deduction – 1% repairs = 2.2%, as the return without leverage. While this is a positive return, it is far worse than other investments, losing you money compared to the alternatives (and even compared to the typical inflation).

As long as mortgage rates are higher than 2.2% over time, leverage would only hurt the returns (for example with an interest rate of 5%, any leveraged returns would be negative, based on: 2.2% growth – 5% cost of borrowing = -2.8%.

From a financial standpoint, you would be best to own the cheapest home that fits your needs.

Summary

Homeownership (vs. renting) can turn from a moderate investment to an appealing one with the help of leverage, but the leverage has to be high (80%) to get the benefit. Even a mild reduction in leverage erases most of the appeal. For the few who (1) can qualify for loans to keep the leverage so high, (2) can afford the short-term risks, and (3) have the desire for such a plan, the potential gains can be substantial.

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¹­­ 6.2% – 5% is the gain in the home value (6.2%) beyond the cost of the loan (5%). 4 is the multiple of the down payment that is borrowed. With an 80% loan, the down payment is 20%, and the multiple is 80%/20% = 4.

² The principal paid is calculated using a loan amortization formula by a financial calculator.

³ Home appreciation at 4% per year, for example, in year 5, the appreciated home value is: 1.04 raised to the power of 5 = 1.22, and the appreciation is 22%.

⁴ The initial 80% loan-to-value is adjusted by: (1) multiplying by the reduced loan balance, and (2) dividing by the increased home value. For example, in year 1, the loan-to-value is: 80% * (1 – 1.9%) / 1 + 4%) = 80% * 0.981 / 1.04 = 75%.

⁵ The returns are calculated similarly to the base case described in the “With Leverage” section above. For example, in year 1, the leverage multiplier is: 75% loan / 25% down payment = 3, and the returns are: 6.2% + (6.2% – 3.5%) * 3 = 6.2% + 2.7% * 3 = 14.3%

Disclosures Including Backtested Performance Data

[Updated February, 2011]

Conventional wisdom says that owning a home is a smart financial move. It is smart because you can borrow most of its value, leaving most of your money to grow in faster growing investments like stocks, while eliminating rent payments and enjoying the growth of your home value. You get the maximal benefit if you can borrow most of the home value or even all of it.

The catch is that buying a home with a large mortgage introduces substantial financial risks, if not done right. The article “When should you own your Home?” (Hanoch, December 2007) presents a long list of these risks, and a list of rules to help you determine whether you can afford buying a home without taking excessive risk.

This article goes one step further and presents a calculation for the amount of money you should have in disciplined stock investments, so when combined with your income, you can buy your home with limited financial risk.

Assumptions:

1. You borrow as much as the bank will lend you up to 100% of the home value.
2. You fulfilled the full list of requirements for holding a mortgage together with stock investments, presented in the article ” Should you Pay Off your Mortgage or Hold Stocks?” (Hanoch, February 2008). Please read carefully the full article, including the strict investment requirements. If you do not follow these principles, you might end up losing your home in the next severe recession.
3. You invest in Long-Term Component by QAM, or any other portfolio that can sustain 4% annual withdrawals, growing with inflation, without any harm to the long-term growth of the portfolio during periods worse than all recessions in recent decades (including 1973-1974, 2000-2002 & 2008).
4. The annual homeownership cost is approximately 10% = mortgage interest (8% fixed) + property tax (1%) + repairs (1%). You can adjust this based on your specific case.
5. You have income to cover expenses other than homeownership costs.

Rules of thumb: Based on these assumptions, we provide rules of thumb for the size of stock investments needed for buying a home. Let’s start by demonstrating the rule for different homes:

Rule of Thumb: Minimum Recommended Stock Investments for Buying a Home With Maximal Borrowing (100% of the home value)
Home Value	Needed Investments	Calculation	Based on Rule
$200,000	$40,000	0.2 x $0.2M = $0.04M	X times Home Value costing $X million
$500,000	$250,000	0.5 x $0.5M = $0.25M
$1,000,000	$1,000,000	1 x $1M = $1M
$2,000,000	$4,000,000	2 x $2M = $4M
$4,000,000	$16,000,000	4 x $4M = $16M
$5,000,000	$20,000,000	4 x $5M = $20M	4 times Home Value

Expensive homes ($4M+) : Before buying a very expensive home, it would be wise to save enough money to cover all homeownership costs + reasonable living expenses, regardless of income from work. Since such an expensive home is typically a luxury rather than a necessity, you wouldn’t want a loss of job or business to put you in serious financial trouble.

To summarize: a rule of thumb for the total assets you should have for expensive homes:

Homes above $4M: Minimum stock investments recommended = 4 times home value

Cheaper homes : The cheaper the home, the more it is reasonable to count on your income from work. Lower home values have lower maintenance costs, and require a lower paying job which is typically easier to find even if your job is lost during a recession.

A rule of thumb for depending on more income (and less stock investments) for lower home values is:

Homes below $4M costing X million: Minimum stock investments recommended = X times home value

Examples : The following table summarizes the maintenance financing of different homes. Given a Home Price, its Maintenance is estimated at 10% of the home price. The Recommended Investment is taken from the formulas above. The investment is assumed to provide 4% in annual income. The last two columns show the maintenance cost that is left to be covered through other sources of income.

Home Price	Maintenance (10%)	Recommended Investment	Investment Income (4%)	Other Income (Maintenance – Investment Income)
				Amount	Pct. of Maintenance
$200,000	$20,000	$40,000	$1,600	$18,400	92%
$500,000	$50,000	$250,000	$10,000	$40,000	80%
$1,000,000	$100,000	$1,000,000	$40,000	$60,000	60%
$2,000,000	$200,000	$4,000,000	$160,000	$40,000	20%
$4,000,000	$400,000	$16,000,000	$640,000	-$240,000	< 0%

1. As you can see, with relatively cheap houses costing $200,000, we can mostly depend on income from work, since many jobs can provide $18,400 to cover homeownership costs.
2. As we go into more expensive homes of $500,000, $1,000,000 & $2,000,000, we want to be less dependent on income from work (80%, 60% and 20%, respectively).
3. Once we reach the luxury home of $4,000,000, we would like to have investments that can cover the full maintenance of the home and leave us with $240,000 for other living expenses.

Summary

The article presented quick rules-of-thumb for calculating the price of home you can afford while maintaining high short-term and long-term financial security. This may be a good starting point for a detailed analysis.

Disclosures Including Backtested Performance Data

The previous article, “When should you own your Home?” (Hanoch, December 2007) provides guidelines for determining if you can afford owning a home. The next step is to determine the size of mortgage you should take.

After putting a down payment that the lender required, you may be left with extra money. You have to decide whether to use it to pay off some of the mortgage or put it in an alternative investment. This article discusses the option of investing the excess in the stock market.

You may view this option as: (1) paying off the mortgage no faster than the required pace or (2) borrowing to invest – both statements are correct. Whatever your perspective, having a large loan combined with stock investments has led many to lose their homes and declare bankruptcies. This is the result of counting on the stock investment to grow enough to help pay the interest on the loan, while in reality the investment can decline in value for many years. When combined with a loss of job for an extended period, the results can be devastating.

You should be very careful, and review important requirements for considering this idea:

1. Conservative stock investing: Diversification, No stock picking, No market timing. Most investors (including professional money managers) underperform the S&P 500 (10.5% in the long run), due to concentration in certain stocks or asset classes, stock picking and/or trying to avoid decline periods. In many cases, they underperform their mortgage rates, resulting in high risk combined with negative returns.

   In order to limit the decline periods of your portfolio, you have to diversify it globally, and include large and small stocks. You should avoid trying to predict which stocks will go up or when the portfolio will go up. Stay diversified using passive investments like index funds and hold onto them for the long run. This is true for any stock investor, but an absolute must when you have a mortgage to pay – you should not gamble with borrowed money.

   Note that stock diversification reduces risks without reducing returns. You cannot use bonds or any other low return investment for risk reduction, because it will reduce your overall returns, significantly increasing the risk of underperforming your mortgage rate in the long run.

   To be clear, you should have some money in bonds or money market, to carry you through recessions, but not as part of a long-term investment.

2. Be prepared for a very bad combination of events: Make sure that you can handle many things going wrong at once, including no less than the following:
   1. Extended loss of your ongoing sources of income: Losing your job or clients from your business for a long period, during a severe recession.
   2. Extended decline of your stock portfolio: A decline of your stock portfolio, longer than all declines in recent decades (for Long-Term Component: nearly 3-years; for the S&P 500: 6 years; with stock picking or market timing: 10 or more years).
   3. Rising interest rates: A significant increase in the interest on your variable-rate mortgage. As mentioned in the previous article, you should be prepared for a prime rate of no less than 8%-9%. Alternatively, stick with fixed rate mortgages.
   4. Real estate recession: A very long real estate recession. Property values have declined for a full 10 years before recovering their peak value, as recently as the 90’s in many places. Be prepared for even longer declines. This means that you will not be able to refinance your loan to get a higher mortgage, lower interest rate, or fix the rate on the loan.
   5. Unexpected costs: A large combination of the following occurring at once: All home expenses not covered by your insurance, like home damage from earthquakes, floods or ongoing repairs like a roof replacement. All deductibles for insurance, including homeowner’s, health, car, etc. Car repairs and replacements. Uncovered medical expenses, including long-term care (or consider long-term care insurance).

   Make sure you can handle the above events occurring at once, as unlikely as it may seem to you. You should be able to handle the events in two ways:

   1. Financially : Make sure you can handle your ongoing living expenses when a combination of the events above occurs.
   2. Emotionally : Make sure you are unshakably confident about your stock investments, so you will never even consider selling your investments at a decline unless you have no other financial choice. If you stick to the conservative investment approach presented above, you have a good reason for being confident.

If the requirements above seem too harsh, you might be getting yourself into trouble. When borrowing to invest you choose to take certain risks in hopes for increased long-term returns. If you are not prepared for everything that can go wrong on the way, you might end up with much lower returns and even face bankruptcy. This would be very unfortunate since you chose to take the risks – you were not forced into the situation.

A Tradeoff . Note that there is a clear tradeoff between paying off a mortgage and continuing to carry it while investing the excess in a stock portfolio. The following table summarizes it:

Option	Short-Term Security	Long-Term Security
Pay off mortgage	Higher Short-Term Security: lower mortgage payments	Lower Long-Term Security: forgone growth of stocks beyond interest on mortgage
Invest in stock market	Lower Short-Term Security: higher mortgage payments	Higher Long-Term Security: extra stock growth minus mortgage interest

Example 1a. John has $4,000,000 in savings and qualifies to purchase a $1,000,000 home with 100% mortgage based on his assets. He is retired, and has only social security income.

He requested that his broker balance his current financial security with future growth, since he is 65 and wants to prepare for the possibility of a long life. His money is invested as follows: 60% in selected high quality Large US stocks and 40% in Bonds.

Low Potential Returns : Since his stock investments are concentrated in Large US stocks, his risk level is very high. This is exaggerated by the stocks being actively selected. The bonds reduce the volatility of his portfolio, but also reduce the long-term returns. He pays high fees for an actively managed portfolio (could be 2%-4% or more). Based on this information, we can expect his long-term returns to be 5%-8% at best. Since this is just about what he would pay on mortgage interest, there is no potential long-term gain on holding a mortgage.

Conclusion : Given the low potential returns, despite his high financial means, he should buy the house with cash (no mortgage).

Example 1b. See example 1a + John realizes that his actively managed, concentrated investments, are too risky for him. He decides to diversify them globally, and eliminate the risks and costs of active stock selection by focusing on index funds. Whenever a severe decline is expected, he can shift some of his investments to more conservative places like the virtually risk-free government bonds.

His long-term portfolio returns are 12%, while he qualifies for a 30 year fixed mortgage at 7%. He also learns that he can conservatively withdraw 4% annually without a real risk to the long-term viability of his investments.

High Potential Returns : Since this long-term return is significantly higher than the interest rate he might pay on a mortgage, he has the potential for significant gains by not paying off his mortgage. Specifically, on a $1,000,000 mortgage, he can make (12% – 7%) x $1,000,000 = $50,000 per year to supplement his social security income.

Low Financial Risk : His $4,000,000 savings can supply him with $160,000 income per year (at a conservative 4% withdrawal rate), enough to cover his full mortgage payments, property taxes, repairs and other living expenses.

High Investment Risk : When stating that he is open to shifting some of his investments to bonds when a decline is expected, he intends to engage in market timing. He would change his investment strategy based on predictions of future returns. When wrong, he would miss out on growth periods, and reach lower lows during declines with higher overall risk.

Conclusion : Despite his excellent financial situation and globally diversified indexed investment, he chose to incur the risk of timing the market. In this case, he should still buy the house with cash.

Example 1c . See example 1b + John understand the risks of any type of market timing. He decides to have a written investment plan and to stick to it at all times. Knowing that he might not be strong enough at times of financial turmoil and severe recessions, he uses the services of an investment advisor that specializes in disciplined investing.

High Potential Returns : See example 1b.

Low Financial Risk : See example 1b.

Low Investment Risk : By holding globally diversified investments during all recessions, and sticking to the plan with a low withdrawal rate, he is likely to recover future severe recessions.

Conclusion : With the combination of high potential returns, low risks and discipline, John should maximize his mortgage loan and enjoy extra potential income of $100,000 per year.

Example 2 . Mary is 45 years old and works as the CEO of a public company. She has a private jet, 3 houses, a large yacht and clothes designed by top designers that are updated regularly to meet with recent trends. She tends to spend her $2,000,000 income (including salary and bonuses).

She is about to buy a $2,000,000 house and is committed to disciplined investing in a globally diversified portfolio, avoiding stock selection or market timing.

High Potential Returns : See example 1b, resulting in $200,000 extra potential growth.

High Financial Risk : Mary has very high fixed costs for maintaining her private jet, 3 homes, yacht and designer clothes. Being a CEO, she can lose her job for many reasons well beyond her control, leaving her with very large fixed expenses and no income or liquid assets to cover them. After liquidating some of her assets, she might be miserable getting used to a much lower standard of living.

Low Investment Risk : See example 1c.

Conclusion : Despite the high potential returns and high income, Mary is already under great financial risk. She should avoid new mortgages, and consider significantly scaling back her spending until she has substantial savings to carry her through severe recessions without being so dependent on her job.

Example 3 . Lisa is a 70 year old retired high school teacher, with pension payments to cover her expenses. She is currently renting, and would like to buy a $200,000 house. She has savings of $400,000 and can qualify for a 100% mortgage at 7% fixed interest. She is a disciplined investor, working with a written plan and committed to a globally diversified portfolio of index funds, held through all market cycles. Given her limited assets, she carries long-term care insurance, and other insurances to protect her from all common risks.

High Potential Returns : See example 1b, resulting in $20,000 extra growth.

Low Financial Risk : Lisa has guaranteed pension payments to cover her expenses. Her $400,000 savings can supply her with $16,000 income per year (at a conservative 4% withdrawal rate), enough to cover her full mortgage payments, property taxes and repairs.

Low Investment Risk : See example 1c.

Conclusion : Lisa has low income and low assets for a retiree. But her expenses and house cost are also low. In fact low enough to allow her to take a 100% mortgage, enjoying an extra long-term growth of $20,000, to increase her financial security over the years and leave a larger inheritance to her children.

Disclaimer about the examples : Note that the examples demonstrate the ideas of this article, and do not represent a full analysis of each of the cases. A full analysis with a clear written plan should precede any of these investments.

Summary

Most people would do best if they paid off their mortgage as quickly as possible, other than maintaining reserves for recessions. This is true for many reasons, including: concentrated investments, risks of active stock selection or market timing, panic during recessions, and most importantly not having enough assets to carry them through severe recessions without a job.

If you are one of the rare people with iron discipline, investing responsibly and with enough assets to carry you through recessions, you can grow your financial security substantially by carrying a large mortgage and investing the proceeds, regardless of your age. When done right, your risk level should be lower than an investor with 60% Large US Stocks, 40% Bonds and no mortgage.

Due to the complexity of this activity, it is recommended to hire an investment advisor that has experience with the task and is very comfortable with it.

Disclosures Including Backtested Performance Data

The previous article “Why should you own your Home?” (Hanoch, Oct. 2007), described many benefits of homeownership. Despite the long list of benefits, not everyone should own their own home as soon as they can afford the down payment.

Let’s say you found a property that you like and it passed a thorough inspection with no major findings. Here are some financial risks and potential problems to look for:

1. A need to move again. A need to move has several risks:
1. Selling and buying a house involves very high expenses, and you might not be able to afford them right as you need to move.
2. Even if you can afford the costs, a move after a few years makes the homeownership much less appealing financially.
3. If the home value declined, or you paid less than the interest on the loan while you owned the home, you might end up owing more than you own. You will have to come up with money out of pocket to sell your home!
2. Being unable to make the mortgage payments, resulting in a default on your loan and losing your home and/or declaring bankruptcy. This can happen for many reasons. Here are some of the main ones:
1. You lost your job and cannot find another one quickly enough.
2. Your mortgage has a variable interest rate (ARM) and interest rates have gone up.
3. The ‘teaser rate’ period on your mortgage ended, and now the payments are much higher.
4. You took a mortgage that allows you to pay only part of the interest on the loan (e.g., Option ARM) for some time. The period ended and your payment jumped significantly.
3. Major repairs come up. Over the years, every home needs to be repaired and kept up. Some repairs can be very expensive and put you at financial risk if you don’t have large reserves prepared for them.

When should you own your home? Considering all the risks mentioned above, there are certain conditions to reduce the financial risks of owning a home:

1. Long Stay. You are likely to stay in the house for a good number of years.
1. Any stay under 3-5 years will make the transaction costs very significant. A 6% transaction cost (just realtor fee, not counting other costs) spread over 3 years comes out to 2% per year!
2. Since real estate recessions tend to be very long, any stay shorter than 10 years can result in a selling price lower than the purchase price (just looking at the recent 1990’s recession). In that case, you might have to add money to sell your home.

Alternatively, if you need to move after a few years, you are willing to do one of the following:

1. Rent out the house and rent a house in a new location for several years. I would not recommend taking this approach unless you are ready for extra work and risks related to renting out a house.
2. Rent out the house and buy a house in a new location. In addition to the extra work related to renting out a house, this option requires significantly higher financial means to own both properties. A future article will discuss this option in more detail.

If you are not sure you are going to stay in one place for long, consider renting. You can always buy a house a year later, after you ‘tested’ the area for a while. You can even look for a place for rent with an option to buy (sometimes called: lease-option or rent-to-own).

2. Money to cover move-in expenses. You have money to cover the down payment, closing costs and moving expenses. You also have money for repairs, furniture and anything else you might need as you move in.
3. Ongoing cash reserves. After paying for the costs mentioned above, you still have cash reserves to cover the mortgage payments. Make sure to consider the payment:
1. After the expiration of any ‘teaser rate’ period.
2. Based on the full interest amount, in case you initially pay partial interest for an Option ARM. To be conservative, you may want to consider the full amortization (principal + interest).
3. For variable interest rate, based on an index rate higher than the long-term average. For example, for loans based on the prime rate, I would consider a prime rate of about 8%, maybe even 9% to be conservative. This is based on the following historic averages of the prime rate:
   

   Period	Average Rate
   1929-2006	5.83%
   1970-2006	8.73%
   1990-2006	7.25%

In addition, remember that there could be spikes in this rate (18.9% average in 1981).

4. Money for property taxes. The property tax bill is typically about 1.25%, but can be much higher in certain cases. Make sure to check!
5. Money for repairs. Plan on 1% or more of the house value per year. If that sounds high, think about the following relatively infrequent but expensive items: new roof, repairs related to flooding, repainting (interior and exterior), kitchen and bathroom remodel, and many more.

It is much safer to buy a cheap home. Note that the financial risks of homeownership are much smaller for cheaper homes. With a cheap home, more job options can provide income that is adequate to afford the home. If you want to live in an expensive home, you might do best by waiting until you have substantial savings, and in the meantime choosing between buying a cheaper home or renting the more expensive home. A future article will discuss the price of a home you may consider depending on your savings.

Disclosures Including Backtested Performance Data

There are many benefits to owning the home you live in, when compared to renting. Let’s review them:

Psychological pleasure of home ownership . Owning a home has a psychological benefit beyond the financial considerations listed below. You own a substantial physical asset, and this asset is also a place for you to stay.

Freedom to remodel . You have the freedom to modify your home to your liking without a landlord to report to. Money you spend on remodeling may partly increase your home value. This may have some financial value if you borrow the increased value and put it in other profitable investments, or if you ever downsize to a cheaper home.

An automatic savings plan . When buying your home, you commit to save systematically for many years. You commit in advance, and have a huge incentive to keep your commitment – you do not want to lose your home! This is a very important benefit, especially if you have trouble with disciplined saving. The savings include your principal payments, if you pay off the principal over time. Note that this is not a benefit until and unless you make principal payments.

It may turn into an investment . Your home can turn into an investment if you borrow part of its increased value to invest in a place that grows faster than the interest on the loan. A simpler, less common option is that you sell it to buy a cheaper home and enjoy the growth of the home value.

Forced discipline in investing . Typically, you should not sell long-term investments whenever they decline in value – if anything, you should invest more. Unfortunately, most people have the opposite instinct when investing in the stock market. This risk is reduced when you use your home as an investment, for several reasons:

1. You cannot easily find your home value frequently. By not seeing the decline as it happens, you are less susceptible to an irrational panic.
2. You also use your home for living, not just as an investment. If you sell it, you will have to start renting another place, something not desirable after you became accustomed to homeownership.
3. Selling and buying real estate is a fairly long, expensive and time consuming process. You are not likely to choose to do it frequently.

A source of funds in tough times . If you haven’t borrowed the full value of your home, you can establish a home equity line of credit on the unborrowed portion of your home, to provide you with money for use in tough times.

Tax benefits . Interest on your mortgage is tax deductible up to a limit. Since the IRS sees your home as an investment, you get a tax deduction.

Own a potentially appreciating asset with limited cash outlay . Since real estate is considered a relatively stable investment, banks are eager to lend most people large amounts of money to own their home. This lets you own an asset that typically appreciates in the long run without having most of its value in cash.

High leverage possible . Large loans let you own an investment with very high leverage. Under the following conditions, you can make significantly higher gains than the actual growth of the home value:

1. You are ready to live in it for a long time.
2. You are very confident you can make the payments, even if many things go wrong.
3. The home value appreciation plus the saved rent is higher than the expenses, including: interest on your mortgage and property tax minus the tax savings on the two, plus repairs.

In certain cases, when structuring your finances right, you can even outperform diversified stock investments.

Summary

As you can see, there are many benefits to owning a home. Despite this list of benefits, you should not rush to buy your first home as soon as the bank will lend you the money you need. There are many conditions for making it a smart financial move. The next article will present the main ones. Future articles will elaborate on some of the benefits of homeownership.

Disclosures Including Backtested Performance Data

Real estate markets throughout the U.S. are growing more slowly and in some cases are declining. This article provides some guidelines for dealing with this environment.

Statistics

First, let’s put the recent growth of real estate in long-term perspective. The following graph shows the inflation-adjusted annual growth of two high growth areas from 1977 to 2005: California as a whole and a high growth area within California :

Source: Office of Federal Housing Enterprise Oversight (OFHEO)

The following table compares recent performance with the two recent cycles:

Annual Growth of Real Estate (adjusted for Inflation: CPI – Shelter)
Period	California	Riverside-San Bernardino- Ontario
Last 5 years	14.2%	16.4%
Recent cycle (1990-2005)	3.8%	3.4%
Previous cycle (1980-1989)	3.9%	2.0%

Based on this data:

1. Growth since the beginning of the recent cycle was similar to the previous cycle. Therefore, there is no statistical reason to believe that long-term real estate values should adjust significantly downwards to make up for the recent excessive growth.
2. Recent growth of real estate was approximately quadruple the cycle average. Statistically, you can expect the next 5 years to have lower and possibly negative inflation-adjusted growth.

Please note that there is no guarantee that the future will behave similar to the past. These are just statistics that give you an idea of where we stand historically.

What should you do next?

This section provides ideas for dealing with the slow down in real estate, depending on your goals.

Speculator . If your goal is to make fast money on real estate, with the intention of buying and selling quickly, you are dealing with risky business, no mater when you do that. The risk increases as you borrow more of the cost. Statistically, you may lose money in the next few years, especially when considering inflation and the large transaction costs. This makes speculation at this point even riskier than at other times. Therefore, you should be inclined to avoid buying for short-term speculation and consider selling short-term speculative investments, or be prepared to hold on to them for many years.

Long-Term Investor . If your goal is to buy a property as a long-term investment, you may see a decline in your investment in the next few years. If history is any indication for the future, it may even take 10 or more years to see any profit. But in the long run (20+ years), you are likely to make money, regardless of the upcoming years. Given the recent history, you should be especially careful not to buy overvalued properties, but you do not have to avoid purchases altogether, and you do not need to rush to sell your long-term investments.

Buyer of personal residence . If you are buying a place to live, there are many benefits, both financial and non-financial. As long as you expect to keep owning a home for many years, you should outlive any potential decline period and enjoy the long-term growth of real estate. Even if you expect to move within 5-10 years to a place with similar growth patterns and of similar or greater value, you should be immune to short-term declines, or even benefit from them. The one caveat is that the high transaction costs may be prohibitive, if you expect to move in very few years.

On the move . If you are thinking of moving you should not necessarily hold off. Since you are selling one property in exchange for another one, you are staying in the real estate market. You should be careful not to upgrade to a much more expensive place that requires stretching your means or that is located in a market that recently increased significantly more than the market you currently live in.

Disclaimers

The guidelines above are general. Every transaction should be evaluated individually. There are many factors affecting each transaction. These include the value of the local real estate market in question and the specific property. At all times there are both overvalued properties and bargains.

In all cases you should consider transaction and maintenance costs and the risk of declines, repairs, extended periods of a vacant rental property and increasing interest rates on variable loans.

Sounds familiar?

This advice above is similar to the advice I would have given to stock investors in 2000. Since you don’t know when the slowdown will end and how deep it will go, your best bet is to invest for the long run, or avoid the risk altogether.

One difference between real estate and diversified investments in the stock market is that real estate recessions tend to be significantly longer, transactions are much more expensive and the investment is less liquid (takes longer to sell). Globally diversified stock portfolios usually recover from recessions within less than 5 years, but real estate recessions may last 10 years or more. Therefore, think very carefully before speculating in real estate for short and even medium periods.

Disclosures Including Backtested Performance Data

We have all heard about people that purchased properties 5 years ago and doubled the value of their homes. Some of you are in this group of lucky people. If you have any money to invest today, you might be asking yourself: should I jump on the bandwagon and double my own money in the next five years? Is this the new face of real estate or is the bubble going to burst?

After getting many requests to write about real estate as an investment (not as your primary place of residence), this article will look at residential real estate, with specific attention to desirable locations. It will start with a historic perspective, and then offer my personal observations.

Data

Growth. Below is the growth of real estate from 1975 to 2004. The first graph presents the US as a whole, California and New York. The second presents 3 locations in California.

Source: Office of Federal Housing Enterprise Oversight (OFHEO)

The average long-term growth and growth in the last year are presented below.

Location	USA	California	New York	Riverside-San Bernardino-Ontario, CA	San Francisco-San Mateo-Redwood City, CA	San Diego-Carlsbad-San Marcos, CA
Annual Growth 1975-2004	5.9%	8.2%	7.5%	7.37%	8.77%	8.42%
2004 Growth	11.2%	23.44%	12.6%	29.58%	13.77%	24.41%

Historically, real estate grew at an annual rate of about 6%-9%, depending on the location measured. In 2004, the growth rate reached 11%-30%.

Cycles. In the limited history available we can see 2 real estate cycles, averaging 15 years.

The recent recession in the 1990’s lasted up to 10 years from decline to recovery.

Mortgages. As home prices go up, more people are using adjustable rate mortgages, in order to afford buying a home. Some mortgages allow for payments that are much lower than the accruing interest rate for the first few years. After the fixed period, the loan amount is bigger and the payments increase rapidly.

With mortgage rates near long-term lows, and the federal rate increasing, mortgage rates should go up and increase the cost of borrowing. This, in effect, raises the price of the houses and makes them less affordable.

Investor activity. Investor activity had grown in the residential housing market, as noted in the December 14, 2004 meeting minutes of the Federal Open Market Committee: “speculative demands were becoming apparent in the markets for single-family homes and condominiums”. In March 1, 2005, The National Association of Realtors reported that investment home sales increased by 14.4 percent in 2004 compared to 2003.

Affordability. In recent years home prices grew much faster than income, making homes less affordable.

Supply vs. demand. According to data released on February 28^th by the U.S. Department of Commerce, the supply of homes increased by 20.5% from January 2004 to January 2005. Sales in the US as a whole and in the North East declined, while they kept increasing in the West.

Change from January 2004 to January 2005
Region	USA	West	North East
Sales	-4.2%	16.6%	-33.7%
Supply1	20.5%	Data Not Available

¹ Ratio of houses for sale to houses sold.

Observations

The US as a whole. In the past year, US home prices appreciated by 11.2%, nearly double the historic pace of 5.9%. There are several possible explanations for the accelerated growth in recent years. In 2000 to 2002 the stock market crashed, positioning real estate as a stable and secure alternative investment. In the meantime, interest rates reached 40 year lows, significantly reducing the cost of houses. As demand increased, house prices went up. This gave lenders the opportunity to come up with more sophisticated loans, letting people pay very little today and more in the future. These loans let people keep buying homes despite the high prices.

As the stock market is recovering, interest rates are going up, and the affordability is going down, real estate is becoming less attainable to many people. More of the buyers are investors and speculators who are hoping for continuing rapid growth, based on projections from recent history.

Based on 2004 supply vs. demand data and the other factors mentioned above, it shouldn’t be surprising to see the US real estate market resume its long-term pace, or even a slower pace for a few years.

High growth areas. In high growth areas, the recent trend is much more emphasized. The 2004 growth was up to nearly 30%, quadruple historic averages of about 7.5%. Many claim that it is due to physical boundaries that limit supply in some of these areas. They say that the US market as a whole may go back to historic averages, but not places with limited supply. Good examples are the San Francisco Bay Area and the coasts.

At first, this sounds convincing, but it implies a very unique future. The price difference between the coasts and the rest of the US will keep growing. Assume half of last year’s growth moving forward, or 15% compared to 6% throughout the US. With this difference in growth, the price difference will grow 3,500 times bigger in 100 years. If today a $100,000 house in Nebraska can cost $500,000 near the coast of California, the same house would have to cost $1,750,000,000 in 100 years compared to $100,000 (all in today’s terms). That would give the coastal homes the same value as 17,500 homes in Nebraska, and California would be full of billionaires.

My conclusion is that locations with limited supply that become popular can appreciate faster than other places, but this faster appreciation cannot be sustained forever.

Historically, US real estate as a whole did not decline for any calendar year since 1970. The high growth areas did decline during recessions. This goes along with the behavior of investments in general: in order to achieve high returns, you have to accept high risks. Unless history is changing, a slow down in the US as a whole, could bring a bigger slow down (or even a decline) in locations that appreciated more recently.

I am not predicting anything specific, but I do claim that sustaining the recent growth has to be based on fundamental increases in home values. Below are a few recommendations that are true for real estate as well as other types of investments:

1. Invest in undervalued properties – not overvalued ones. As an investor, your goal is to make money. Don’t buy a property for more than you believe it’s worth. Make sure you have good reasons to expect future appreciation.
2. Do not project the future based on the past few years, especially if they are out of line with long-term historic behavior. If you think recent history is expected to continue, make sure you have a clear idea why.
3. Make sure you can afford to hold the property for a period longer than past declines. In high growth areas, the recent decline to recovery period was 10 years. In addition, there are very large transactions costs for buying and selling properties. If you can’t hold the property for 15 years or more, you could end up loosing purchasing power if you buy at a peak.

Note that this article refers to residential real estate investments. Specifically, buying a home as a primary residence has many additional economic and non-economic benefits, entailing different considerations.

Resources

1. Office of Federal Housing Enterprise Oversight (OFHEO)

2. New Residential Sales in January 2005, US Department of Commerce, February 28, 2005

3. Second-Home Market Surges, Bigger Than Shown in Earlier Studies, NAR (National Association of Realtors), March 1, 2005

4. Are Home Prices the Next “Bubble”?, Jonathan McCarthy and Richard W. Peach, Federal Reserve Bank

Disclosures Including Backtested Performance Data