By Robert Klemkosky
The above title is probably a sexist remark in today’s society, given that most residential property is also held in the wife’s name. Whether married or single, residential real estate is the largest investment most individuals will ever make. As a result, residential real estate is the largest asset class in the world, much larger than stocks, bonds and commodities, including gold and silver.
Before housing prices started to decline in 2007, it was estimated that residential real estate worldwide was worth about $60 trillion versus commercial real estate of about half that, $30 trillion. At the end of 2010, residential real estate was estimated to be worth $50 trillion worldwide and commercial real estate about $28 trillion. But worldwide estimates, while down $10 trillion, mask or hide the devastation in some countries. In the U.S. home values have fallen more than 30 percent, from $23 billion in 2007 to $16 trillion today. Similar wealth destruction or worse occurred in Spain, Ireland, Iceland and numerous other European countries.
Why are people so enthused about owning real estate? For one thing, most individuals have an innate or intuitive feeling that home ownership is a good, safe investment that offers attractive financial returns. Many just want more control over their living space and perhaps a better environment for children, including schools. As pointed out in an article in the Economist, people don’t fall in love with a stock or bond certificate, but it is easy to fall in love with a home. So emotional and psychological factors play a role in homeownership.
How good of an investment is a man’s castle? Most homeowners don’t have the slightest idea what the annual return is or even how to calculate it. Most look at it this way: Buy a home for $150,000, borrow 80 percent or $120,000 to finance it. Fifteen years later the home is worth $250,000 and the 30-year mortgage is down to $80,000. Investors think: Wow! I have invested $30,000 and now have home equity of $170,000, an increase of more than five times the original investment, a return of 12 percent per annum. In reality, the home price increased 3.46 percent annually, but leverage (borrowing) magnified the owner’s return to 8.35 percent per annum. But reducing the mortgage principal, while giving you more equity, would not affect the return on ownership.
It would be extremely difficult to calculate the real return from home ownership if one factor’s in the costs of such things as real estate taxes, maintenance costs, depreciation and opportunity costs. Opportunity costs would include the return on investing the $30,000 in alternative investments such as stocks and the implied rent that is derived from ownership. Opportunity costs may be negative, which would be a positive thing for home owners. But opportunity costs do complicate the comparison of home ownership with renting.
While the above example is hypothetical, it is realistic. It is hard to generalize about returns on housing because the housing markets are inefficient; prices are localized, homes are illiquid assets, and lack of mobility doesn’t allow one to take advantage of cheaper prices elsewhere. But recent California data as reported in The Wall Street Journal sheds some light on a home as an investment. The median price of a single-family home in California rose from $99,550 in 1980 to $296,820 in 2010, an annual increase of just 3.6 percent. Even if sold at a peak price in 2007, the return would have been 6.6 percent annually. If the $20,000 down payment had been invested in 1980 in a diversified portfolio of stocks returning 10 percent annually, the stock portfolio would be worth $349,000 in 2010 – $52,000 more than the house.
At the macro level, real estate can create havoc for an economy as experienced by Spain in the 1970s; Norway in the 1980s; Sweden, Finland and Japan in the 1990s; and Ireland, the U.S. and a multitude of other countries in the 2000s. This is because real estate is subject to speculative bubbles whereby people buy homes not based upon fundamentals such as population growth, rents, interest rates and economic conditions, but simply because prices have gone up and are expected to continue going up. Valuation factors sometimes don’t count as much as collective investor euphoria. It’s as if the laws of supply and demand are reversed. As prices go up, demand should go down. In a housing bubble, as prices go up, so does demand.
So investors become overconfident and buy and banks overlend because they feel they have a tangible asset as collateral. However, banks in the U.S. and Europe haven’t held mortgages on their balance sheet since the 1980s. They securitize them whereby individual mortgages are pooled as collateral for mortgage-backed securities where the cash flows from the mortgages pay the principal and interest on the securities. Securitization worked well and still does as long as investors and lenders monitor quality. It was another financial innovation called a collateralized debt obligation (CDO) that created huge problems for the financial systems of the U.S. and Europe. In CDOs, mortgage-backed securities were pooled together as collateral for the CDOs. The CDO security would be divided into tranches whereby the equity tranche would absorb the first 5 percent of default losses, a second tranche might absorb the next 10 percent of losses, a third tranche the next 10 percent of losses, and the fourth tranche the remaining losses. The fourth tranche was AAA rated. And this is where low-quality subprime mortgages came into the picture. Bankers and investors thought it was possible to create AAA-rated debt out of low-quality mortgages.
This may have worked if default rates had stayed at historical levels and if housing prices hadn’t declined starting in 2007, big assumptions that didn’t hold in the housing bubble. In the U.S. today, 25 percent of the homes have less value than owed on the mortgages. As in Japan, where housing prices fell by 75 percent in the 1990s, housing will be a drag on the U.S. economy for at least another five years, and that is probably being optimistic.
Who is to blame for the housing bubble and subsequent mess in the U.S? Almost everyone – the U.S. government, mortgage lenders, investors, home speculators, ratings agencies, the Federal Reserve, regulators, financial innovation and a host of others. There is enough blame for everyone involved. It has created a mess for the U.S. economy with no easy solution. It also has made renting a more viable alternative to ownership for many. This is already happening in Korea, as jeonse has increased, especially for more expensive homes.