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Think your home is a safe investment? Think again
Think your home is a safe investment? Think again
By Roger Martin and John Kelleher | Thu Apr 07 2011
http://www.moneyville.ca/article/970767--think-your-home-is-a-safe-investment-think-again
Think housing investments are safe? Check your assumptions. It's difficult to read a magazine or go to a cocktail party without hearing that housing investments are safe choices, certainly much safer than investing in the stock market. This belief is so prevalent that the average Canadian family maintains the majority, if not all, of its net worth in housing.
Unbeknownst to most of these families, their theory of home ownership as a safe, low volatility investment is based on the often-mistaken premise of no or little debt. This is a crucial blind spot because the moment that a large amount of debt is used to buy a home, that safe investment theory goes completely out the window.
Put simply, housing is only a safe asset under conditions of no or very low financial leverage or debt. A lack of appreciation for this critical assumption led to major tracts of the U.S. housing sector being wiped out and with it, the net worth of millions of U.S. families.
But Canadian homeowners have no reason to be smug — while our housing sector hasn't been wiped out like the U.S., the assumption of low debt is also false in Canada. This means Canadian homeowners' equity is much more risky today than is recognized.
Since most Canadian families buy a home with the aid of a large mortgage, it is critical to understand the risk/return dynamics of a family's home equity under conditions of high financial leverage.
When a family buys a home with, say, a mortgage of 90 per cent of the purchase price and equity of 10 per cent, the first income the family earns needs to pay the mortgage holder. The mortgage holder gets the safest cash flows from the family. In essence, the equity value of the house only maintains its value or increases if the mortgage holder is paid. That means that the equity holder, i.e. the family, is holding a much riskier financial asset than the mortgage holder. This is one of the most important principles in finance, yet this is not broadly well understood.
How risky does the family's home equity investment become? Financiers measure equity risk in relation to the stock as a whole. Studies show that home equity investments have a strikingly low risk relative to the market, 30 per cent of the risk, in fact, lower than investments in things such as regulated utilities. This is the source of the confidence in the safe investment thesis.
But that is the risk level for a debt-free home investment. What happens when that family buys that house with just 10 per cent cash down and a 90 per cent mortgage that promises an interest rate of 3 per cent to the bank over the long term?
Amazingly, the equity in the house has now become dramatically more risky than before. The equity is now three times as risky as the overall market rather than 30 per cent as risky. This is more risky than an investment in nickel mining stocks or Internet start-ups. Does this family understand that its net worth has been “banked†on something this risky? Does its financial adviser understand this? While it is true that the family will pay off the mortgage over 25 or 30 years, for very long periods of time debt levels are high and therefore the effective riskiness of the equity is very high, as millions of families across Florida, California and Arizona found out, sadly.
Part of what makes this difficult to see is the fact a house isn't a traded asset. You can't log on to Google Finance and see the value of your home's equity going up and down when the market moves. But that doesn't mean it isn't volatile.
A rule of thumb is that risk rises exponentially as debt levels approach 100 per cent. To make this clear, imagine a simple case. If one purchases a home with just $1,000 of cash and all of the rest in debt, even a minuscule percentage drop in the home's price would destroy one's entire equity.
Interestingly, the effect we are describing is exacerbated during times when the cost of debt (interest rates) is high. Given that we are likely in a period of rising interest rates, Canadians would be well advised to consider this effect and either avoid large amount of leverage when they purchase a home or pay down debt as quickly as possible if they already have a large mortgage.
Home ownership as a safe investment is a theory that holds under conditions of low leverage only. At the root of the U.S. financial crisis is the failure to appreciate that the large amounts of debt used to finance home ownership wrecks the “safe-as-houses†theory.
With all the safe cash flows promised to debt holders, housing equity was jammed chockablock with risk in a way that is difficult to see until equity values are massively impaired or wiped out altogether.
Canadians should check their own assumptions behind their belief in the safety of housing investments to avoid a similar fate as to what happened in the U.S.
Roger Martin is dean of the Rotman School of Management at the University of Toronto as well as chairman of the Institute for Competitiveness & Prosperity. John Kelleher is president & CEO of RHB Group LP, a former consultant at McKinsey & Co., and an expert in corporate finance.
Think your home is a safe investment? Think again
By Roger Martin and John Kelleher | Thu Apr 07 2011
http://www.moneyville.ca/article/970767--think-your-home-is-a-safe-investment-think-again
Think housing investments are safe? Check your assumptions. It's difficult to read a magazine or go to a cocktail party without hearing that housing investments are safe choices, certainly much safer than investing in the stock market. This belief is so prevalent that the average Canadian family maintains the majority, if not all, of its net worth in housing.
Unbeknownst to most of these families, their theory of home ownership as a safe, low volatility investment is based on the often-mistaken premise of no or little debt. This is a crucial blind spot because the moment that a large amount of debt is used to buy a home, that safe investment theory goes completely out the window.
Put simply, housing is only a safe asset under conditions of no or very low financial leverage or debt. A lack of appreciation for this critical assumption led to major tracts of the U.S. housing sector being wiped out and with it, the net worth of millions of U.S. families.
But Canadian homeowners have no reason to be smug — while our housing sector hasn't been wiped out like the U.S., the assumption of low debt is also false in Canada. This means Canadian homeowners' equity is much more risky today than is recognized.
Since most Canadian families buy a home with the aid of a large mortgage, it is critical to understand the risk/return dynamics of a family's home equity under conditions of high financial leverage.
When a family buys a home with, say, a mortgage of 90 per cent of the purchase price and equity of 10 per cent, the first income the family earns needs to pay the mortgage holder. The mortgage holder gets the safest cash flows from the family. In essence, the equity value of the house only maintains its value or increases if the mortgage holder is paid. That means that the equity holder, i.e. the family, is holding a much riskier financial asset than the mortgage holder. This is one of the most important principles in finance, yet this is not broadly well understood.
How risky does the family's home equity investment become? Financiers measure equity risk in relation to the stock as a whole. Studies show that home equity investments have a strikingly low risk relative to the market, 30 per cent of the risk, in fact, lower than investments in things such as regulated utilities. This is the source of the confidence in the safe investment thesis.
But that is the risk level for a debt-free home investment. What happens when that family buys that house with just 10 per cent cash down and a 90 per cent mortgage that promises an interest rate of 3 per cent to the bank over the long term?
Amazingly, the equity in the house has now become dramatically more risky than before. The equity is now three times as risky as the overall market rather than 30 per cent as risky. This is more risky than an investment in nickel mining stocks or Internet start-ups. Does this family understand that its net worth has been “banked†on something this risky? Does its financial adviser understand this? While it is true that the family will pay off the mortgage over 25 or 30 years, for very long periods of time debt levels are high and therefore the effective riskiness of the equity is very high, as millions of families across Florida, California and Arizona found out, sadly.
Part of what makes this difficult to see is the fact a house isn't a traded asset. You can't log on to Google Finance and see the value of your home's equity going up and down when the market moves. But that doesn't mean it isn't volatile.
A rule of thumb is that risk rises exponentially as debt levels approach 100 per cent. To make this clear, imagine a simple case. If one purchases a home with just $1,000 of cash and all of the rest in debt, even a minuscule percentage drop in the home's price would destroy one's entire equity.
Interestingly, the effect we are describing is exacerbated during times when the cost of debt (interest rates) is high. Given that we are likely in a period of rising interest rates, Canadians would be well advised to consider this effect and either avoid large amount of leverage when they purchase a home or pay down debt as quickly as possible if they already have a large mortgage.
Home ownership as a safe investment is a theory that holds under conditions of low leverage only. At the root of the U.S. financial crisis is the failure to appreciate that the large amounts of debt used to finance home ownership wrecks the “safe-as-houses†theory.
With all the safe cash flows promised to debt holders, housing equity was jammed chockablock with risk in a way that is difficult to see until equity values are massively impaired or wiped out altogether.
Canadians should check their own assumptions behind their belief in the safety of housing investments to avoid a similar fate as to what happened in the U.S.
Roger Martin is dean of the Rotman School of Management at the University of Toronto as well as chairman of the Institute for Competitiveness & Prosperity. John Kelleher is president & CEO of RHB Group LP, a former consultant at McKinsey & Co., and an expert in corporate finance.
