Can Your House Be Considered "Investment Real Estate"?

Many homeowners have often considered their home the best investment they ever made. This perception is fostered more by the long-term holding period of most homes than the increasing value of older homes. Unlike most securities, homes are not priced regularly. There is no boy pacing on the front walk wearing a sandwich board saying the value of your home just went up or down since yesterday creating a possible emotional reaction and subsequent decision to act on that information. The illiquidity and relative lack of marketability of homes compared to other investments, lends to better investor understanding the long-term nature of real estate investments in general.

Should a home be considered part of an investment portfolio? Home equity grows as principal is paid down and increasing home values also contributes to equity. As home ownership becomes a greater part of a household's net worth, it is reasonable to think of it as an investment. Most Certified Financial Planner™ professionals feel the home is a use asset, like jewelry, and not an investment. I agree. A home usually does not lend itself to creating income to pay for utilities in retirement, for example. Yes, a home can be liquidated in a downsizing and the cash proceeds invested to produce income, but this scenario is not part of everyone's retirement planning. In a low interest rate environment, reverse mortgages have been attractive only as a last resort after other assets are depleted.

WHAT ABOUT DIRECT REAL ESTATE?

Financial and Retirement Planning is sometimes accomplished with direct real estate ownership. Most think of duplexes, office condos and the like as great for investment because of the regular cash flow. Many also enjoy the hands on nature of direct real estate investment. Some also justify the purchase of investment real estate because of the potential for mixed use, personal and investment. Hey, tax deductions and a vacation property in one! Investment assumptions of investment/vacation property need to be very conservative and the merits of the investment aspects need to justify the purchase. It is not necessarily a financial planner's role to dictate lifestyle, but to indicate when lifestyle goals are in conflict with other goals such as retirement and financial independence.

The ongoing management needs of direct real estate should also be a consideration. Is direct real estate an investment or an occupation? Direct real estate ownership becomes a vocation to the extend it consumes an investor's time. The cost limitations of most directly owned real estate creates the need for more management. For example, because of limited resources, investors buy smaller properties leased by smaller tenants who may have credit issues and whose time horizon is short. The leases may also be structured to satisfy the needs and limitations of the smaller tenant rather than be "net" leases where the tenant agrees to pay for the property taxes, insurance, and maintenance. Large tenants will usually take on the risk of these variable costs as part of a lease.

Smaller owners of direct real estate usually must expose their other assets to the risk of loan default as required by lenders. Larger corporate real estate owners can be more successful in obtaining "non-recourse" financing where the lender's only recourse is to take back the property and where the lender is unable to seize other assets or income of the corporation.

All the above issues increase the time and costs involved in the investment of direct real estate. Lack of economies of scale and hiring property managers also increases the expenses and reduces the returns of small owners can expect out of direct real estate. In addition, small landlords have a more difficult time increasing rents with market rates for fear of losing a tenant they perceive will provide steady cash flow.

VARIOUS WAYS TO INVEST IN REAL ESTATE

Often when investors consider real estate they think only of direct ownership or Real Estate Investment Trusts (REITs). REITS are only one type of legal structure, there are others. Real estate companies, such as REITs offer several types of securities depending on your objectives of fixed income, variable income, or participation in the earnings growth of the company. Some of the major types of securities are: common shares, preferred shares, corporate bonds and secured mortgage real estate securities. Each type has its own risk characteristics and benefits.

DECLINING INTEREST RATES

Not all interest rates move in lock-step. There are short-term rates, controlled by the Federal Reserve. Long-term interest rates are controlled by bond investors' inflation expectations. There are also interest rates changes reflecting the outlook about general business credit quality. Since real estate is considered a long-term investment, it is usually financed with long-term debt. It has been observed occasionally that after the Federal Reserve raises short-term interest rates, long-term rates and mortgage rates have declined. When talking about interest rates with respect to real estate, therefore, we are discussing long-term rates and mortgage rates. It has been widely noted that we are currently in an environment of mildly increasing rates coming up from a 45 year low on interest rates and reversing a 25 year period of decreasing rates. It is also the general consensus that rates will continue to increase, with a contrarian position being that rates will go up faster than most are expecting. Only a very tiny group believes interest rates will decline.

Declining rates and the greater ease in obtaining credit have made more money available for the purchase of homes and the cashing out of equity. In February, 2004, Allan Greenspan indicated it would be good "if lenders provided greater product alternatives to the traditional fixed-rate mortgage"1. He went on to suggest that for those households willing to manage their own interest rate risks, "the traditional fixed rate mortgage may be an expensive method of financing a home."

In August, 2005 Mr. Greenspan remarked that lenders routinely convert the gains in homes to facilitate "purchase transactions". He credited a financial innovation that greatly reduced the cost of such transactions. He seemed to be referencing interest only and adjustable rate mortgages. He concluded by saying: "history has not dealt kindly with the aftermath of protracted periods of low risk premiums" or high home values. He didn't mention that he previously advocated alternative and innovative financing options that now appear to have created higher asset values for homes.2

Most types of real estate have benefited by low rates and easy credit. To protect themselves lenders have pushed for more variable rate financing. I recently toured a $4,000,000 parade home in Raleigh. Lenders were outside near the pool illustrating how the home could be financed with nothing down, and monthly payments starting at only $19,000 per month. This was accomplished with three mortgages. What was not disclosed is how the financing options pushed almost $1,500,000 in principal payments to the middle and remaining years of the payment schedule. With a variable rate, the borrower is assuming a tremendous amount of interest rate risk. Perhaps this home is a monument of our country's prosperity. The grand home may be monument to the ignorance of risk. Only time will tell.

RISING INTEREST RATES

Declining rates have caused the increase in most types of real estate. It could be said that increasing rates will dry up some of the demand to finance all types of real estate. Some argue that interest rates are increasing because of general inflationary concerns sparked by a business recovery and that this will increase the financial health of corporate tenants and their ability to pay rent. It is important to note that not all types of real estate and all type of real estate securities have the same correlation to interest rates. For example, REITs and stocks have historically low correlations to interest rates. Preferred stocks also have had almost half the correlation to interest rates of government and corporate bonds.

Rising rates could affect the housing market by depressing home prices generally. In the late 1970s and 1980s, a loan feature helped with the purchase of homes to buyers that would otherwise be more limited in their selection, the assumable mortgage. The assumable mortgage helped to sustain home prices by maintaining affordability. Normally, rising rates translates into increased mortgage payments. With the assumable mortgage, the payment would remain the same and the down payment and/or second mortgage would increase. The lender would allow a new buyer of similar credit quality to continue the mortgage under the same terms as the original borrower. The assumable mortgage, once used in the marketing of homes, has long faded from the scene during the 25 year interest rate decline we have experienced. Who wants to assume an old mortgage when rates are constantly declining?

Apartment operators could benefit from rising rates. As more potential home buyers get priced out of the home market, they end up in apartments. Wise apartment operators who have locked in low fixed rate financing can turn every rent increase into wider profit margins. Apartment owners also have pricing power as demand for apartments increase and competition for homes decreases. In an increasing interest rate environment, operators building new apartments compete less favorably with those operators that have existing space financed at low rates. The rents in new apartments must be higher to support the higher interest rates costs and this also drives rents on existing apartments.

DIVERSIFICATION WITH REAL ESTATE

Because of the low correlation of real estate to stocks and bonds, investment real estate should be considered an excellent portfolio diversifier. Real Estate securities have also had lower volatility than stocks.3Investors and their advisers need to be skilled in identifying those investment types offering the best risk adjusted returns during the current and anticipated business cycle and interest rate environment. While past returns are not a guarantee of the future, history does suggest that real estate securities warrant a position in investor portfolios.

Troy Smith, Certified Financial Planner™ offers fee-based or fee only Financial Planning advice to clients in Raleigh, Durham, Chapel Hill, Cary and other locations. His home page is www.asktroy.com.

1 Understanding household debt obligations 
At the Credit Union National Association 2004 Governmental Affairs Conference, Washington, D.C., February 23, 2004 
http://www.federalreserve.gov/boarddocs/speeches/2004/20040223/default.htm

2 Alan Greenspan, Closing Remarks 
At a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, August 26, 2005 
http://www.federalreserve.gov/boarddocs/speeches/2005/200508272/default.htm

3 Preferred stocks as measured by the Merrill Lynch Preferred Index, corporate bonds by the Salomon Brothers Broad Corporate Bond Index, and government bonds by the Bloomberg/EFFAS 7-10 Yr. Bond Index, for the period January 1992 to March 31, 2005.