Mortgage - fixed versus interest only

"David Moore" wrote

The one statement of Shiller's in this article which I find dubious is: "In fact, I'm inclined to think there's a good chance that the return on real estate will be negative, substantially negative, over the next 10 years because all booms reverse in the end."

One particular housing report that I thought good pointed out that many or even most booms do not reverse. Rather, they just slow and flatten, such that home values do not decline but instead slow in their increase.

Actually, there is plenty of empirical evidence that housing booms may actually reverse. Japan saw house prices decline by one-third in the

1990s after the 1980s boom. Spain -for instance- also saw a 20 percent decline in average house prices between 1992 and 1997 (just a 5-yr period). In the US, as Shiller points out in his papers, there are many examples of local markets with steep house price declines. Nothing prevents average house prices to decline, especially after a big boom like the recent one in the U.S. (biggest boom in history).

The real problem regarding these booms and busts is not whether they can happen but how often they happen and where they happen. I think everybody would agree that house prices CAN decline. But that is a far cry from saying that they always decline after a "boom" or a sudden rise. Of course it is equally foolish to say something like "real estate is always a winner," or "housing prices never go down." That belongs in the same category of foolishness as "Always invest in stocks, never real estate."

I know exactly the phenomenon of which you speak (I live in a house over 100 years old). It's very difficult to measure that though in terms of housing prices.

I have heard people say of current houses, "They don't build them

Essentially this means the houses will have higher depreciation rates. It's like when the builders cut corners on insulation-- for the rest of the life of the house, someone will be paying that extra heating/cooling cost.

mcMansions as they call them. Plasterboard and cheaply fitted. The whole process of building a house has been deskilled, using more preassembly etc. The result is there isn't the craftsmanship, things don't fit together etc.

Vancouver is the classic case. It rains a lot in Vancouver, and there is a problem with many or most of the condos built in the 70s (I can't remember, can you?, it's either that they used steel joists and water leaked through the concrete and corroded them, or the same problem but with wood). This has necessitated heavy structural repairs to many condos of that era.

It's a valid and well used investment strategy. Never pay off debt, use the cash flow to buy more assets. Like all leveraged strategies, it works well in a rising market (it's what hedge funds do, professionally).

All real estate fortunes are built on 'other people's money'.

My own gut is that real estate runs on about a 14 year cycle. Sometimes it's only 10 years. Because it is a 'sticky' asset, with high transactions costs, it takes a long time for overbuilding to cause the next slump. This is thinking more commercial RE than residential, but there is some overlap (when residential RE is in a slump, residential apartment rents come under pressure, etc.).

But that is a far cry from saying

The centre of the 'housing bubble' argument in the US. The only thing worth noting is that this time, the housing 'boom' was pretty general, across most of the country. So far, the subprime lending debacle, etc. seem to be concentrated in a relatively small number of areas. If it spreads, it will put downward pressure on housing prices more generally.

Of course it is

the implication is that you ought only to invest in either asset when it is 'cheap' relative to the other asset. If you can figure out when that is.

It is certainly true to say, that relative to their historic ratios, stocks are not expensive on a PE basis (although profits ie the E are arguably at a cyclical peak-- companies haven't made this much profit relative to sales since the 1960s), in fact they are somewhere around their 20 year average I think, but houses, relative to historic ratios, are still at all time highs relative to incomes. That unfortunately doesn't mean that you can predict that a strategy of shorting houses, and going long stocks, is going to make money.

Stocks return more than real estate but 1). it's easier to use leverage to invest in real estate (you can't really do that in stocks)

2). it's easier to ride out a downturn in real estate (providing your rental income covers your cost of debt) 3). it's only in the very long run that you can bet on stocks. The higher returns from stocks are bought at the cost of higher volatility.

It all depends on your time horizon. If you look at stock market data for 1871-2005 (Shiller's website), for periods 18 years or longer, stocks always had positive average real returns (the last 18-yr period with negative returns was 1902-1920). For periods or 25-30 years, the lowest rate of return of stock market investments (2.52%-3.07% respectively) beats the average real return of housing market investments (around 1 percent in real terms). And this is if you invest in the representative stock market portfolio. If you choose small cap value stocks, the lowest 30-yr average real return has been

10.4 percent between 1927 and 2006 (the lowest return of 10.4% corresponds to the 1951- 1980 period). All these data are posted in the small micro caps group, and the sources are Shiller and the Center for Research in Security Prices/Ken French website.

So, given empirical evidence, for a long time horizon (if you, for instance, invest when you are 35 and don't plan to cash your investments till you are 65 or older), it makes perfect sense NOT to diversify and invest only in stocks (except for an emergency fund - cash- whith a size wich depends on how the volatility of your non- investment income).

I know exactly what you mean since I live there. Four of five years back I could drive around and see many, many condos (not two or three, but hundreds) covered with big canvases while the walls were being ripped out the rotten interior wood replaced. The owners of these condos were typically hit with a special assessment of $50,000 or more needed to fix the building. When the problem was discovered, the builders of these places were long gone. It was found that the original building materials, especially the exterior walls, were suitable for Southern California, but not for the rains and the moisture of the Northwest. The government was roundly criticized for allowing it to happen--not adequately inspecting the buildings and not paying enough attention to the credentials of fly by night builders. I believe the problem was with wood, not concrete. Since this "leaky condo" fiasco, buyers in this area have been looking for concrete construction, and they shy away from wood.

Figures like that look convincing at first glance, but a few things that are important in are left out. You can buy a house at age 35 with a 10% down payment and have control of an asset worth 10 times what you paid for it. If it increases in value by only 10% over the next five years, you have doubled your money and paid no rent in the meantime. In theory, it could decrease in value, but If you keep the house until age 65 that is not very likely to happen. And all the while you are living in it and paying no rent. If you buy a vacation property in addition, the same leverage works and you get good vacations and maybe some rental income. I am not suggesting that stocks are no good, just that both stocks and real estate can be good long term investments

historical comparisons of returns in stocks vs real estate, you do not see leverage mentioned very often, but it is seems to me this is a huge advantage of real estate investment. The typical comparisons show that returns are x percent for one and y percent for the other over various spans of years, but not much attention is paid to where the money comes from in the first place, i.e. how difficult it may be to raise the cash to begin either type of investment plan. If you simply say, "a house worth 100K will on the average appreciate x percent in 20 years" and "stocks worth 100K will on the average appreciate y percent in 20 years," that may be true, but for most young investors it is far easier to save 10K to buy a house with 10% down than it is to save 100K to buy stocks.

Suppose investor A invests 2K in mutual funds every year for five years and then stops. Investor B puts 2K in a savings accounts for five years and then buys a house. The question should be: Who will have the most equity after another 30 years? Of course, the mutual fund investor might typically go on putting money into stocks for a long time instead of stopping but will also have to pay rent all those years. By the same token, the homeowner will have to pay the mortgage instead of rent, but might also invest in mutual funds along the way.

You can do the same thing with stocks. Have you heard about margin lending?

I agree, in a 30-yr period it is highly unlikely that a house will lose value. But in the same 30-yr period, the average stock market portfolio would have returned nearly 800 percent in real terms.

The bottom line is that, when we look at 135 year data -Shiller's data goes back to 1871- stocks have a much higher rate of return than houses. Houses are good investments if you buy them at the right time and the right place, and sell them at the right time. But, on average, stocks are much better long-term investments. Houses are more like consumption goods -you buy a nice house because you like the comfort it provides, just the same way you buy a good car because you like a smooth drive and safety-, not the right asset to rely on during your old age if you want to maintain your living standards.

But you've left out important items, too. Namely: mortgage interest, property tax, insurance, maintenance, and transaction costs. You may not be paying rent, but you will be paying for these.

-Will

Probably investor A.

-Will

Apropos of this discussion, recently I was looking for some insight on how home equity should be factored into asset allocation planning. Here are some articles I found:

(PDF)

-Sandra the cynic

No. You are 'marked to market' in margin lending.

So you can't ride the volatility of stock markets, but you can in housing. A downturn will lead to a margin call, forcing you to liquidate at the bottom.

The only way the individual investor can really gear a stock position is to invest in leveraged vehicles, eg closed end funds with borrowings.

(you might be able to do something in option markets *but* you are again marked to market, and you can only do this on large, liquid indices like the SP500).

He is talking about the case in which prices go up. In that case, you are not forced to sell to repay the loan because the collateral - equity- is always higher than the loan. In that case, you can have a nice return for your initial investment (similar to the down payment of a house, when the house value goes up).

You've heard about margin requirements and margin calls?

You can't use such a high leverage ratio when buying stocks on margin. You are also subject to margin calls in a volatile market while a real estate owner can "ride out" in bad times.

Quite so, and you would have to add up everything to find the truth. I have heard many apparently informed and intelligent people claim that in the long run investment in mutual funds is wiser than investment in real estate. I would like to know how many of the people so advising own their own homes. That would be an interesting statistic. My guess is that most of them do.

In the *long run*. Not on a daily basis

In that case, you

But if the value of a house goes down, and you are renting it out, you are not forced to repay. Whereas in stocks, you are forced to sell on the day-- liquidation into a falling market.

This is a crucial difference between investing in rental real estate and investing in stocks.

As I suggested elsewhere, owning your own home, even in Canada, is something of a no brainer, assuming you are in a major city with a long term record of price appreciation:

- it's capital gains tax free (in the US, the interest deduction makes it even more of a no brainer)

- housing prices have tended to rise faster than inflation

- 'other people's money' - if you rent, you pay your money to live in a place. If you own, you still pay your money, but at the end of the day you have an asset

However:

- owning residential property as an investment is a more complex calculation-- I think you can make money, but you have to treat it as a 'small business' to which you devote considerable personal time and effort

- owning 'too much' of a personal home (ie too big a mortgage) is increasing your investment in an asset class that doesn't do as well, long run, as stocks

- housing prices don't always go up: Toronto 1989-1995 fell 40%, Calgary in the early 80s fell at least as much, Vancouver has had its ups and downs. This situation may be pervading the US now.

- most non-homeowners underestimate the repairs, maintenance and future property taxes of owning your own home (new condos in particular tend to have lots of amenities, and unrealistically low condo fees which go shooting up. Those amenities *cost*)