Tuesday, May 1, 2012

When Leverage Attacks

The real estate market is certainly heating up in the San Francisco, my new city, despite the broader Case Shiller Home Index still hovering near cyclical lows.

How soon we forget.

I will admit, real estate does sound like close to a sure thing with mortgage rates at record lows, potential inflation on the horizon, negative real rates in savings accounts (i.e. zero opportunity cost), and prices as much as 50% or more off. And it may be, but not necessarily when leverage is introduced.

But, first, let's take a look at housing without leverage.

Case Shiller Index (without Leverage)

As last week's post The Power of Momentum outlined, the broad Case Shiller Composite-10 index was stagnant from 1987 to 1997, rocketed between 1997 and 2006, and has tumbled since. However, over this entire period we have seen a healthy increase in the price (a bit more than the rate of inflation... assuming growth using the composite-10 index, a house worth $100,000 in 1987 is now worth a bit less than $250,000)

Case Shiller Index w/ Introduction of Leverage

As James Montier of GMO has pointed out:
Real risk is the risk of permanent loss of capital.
Investments made with borrowed money reduces the range that the investment can move without causing a permanent impairment of capital.
Using the same Case Shiller Composite-10 index data as in the above chart, we introduce leverage using the following rules:
  • 5x leverage (i.e. a 20% down payment... pretty standard, though not so much during the bubble)
  • If prices rise, sell your investment property each year and with the equity gains, buy a more expensive property at 5x leverage
Simplifying Assumptions:
  • Mortgage payments = rental receipts
  • No taxes / transaction fees
Using the same $100,000 house as an example (this time with 20% down), we get the following:

Returns were actually okay from 1987 to 1997, but were dwarfed by the boom seen from 1997 to 2006 as property values, debt to go along with it, and equity SOARED, taking the original $20,000 investment to $3.7 million.

BUT, it all came crashing down. As property values declined, the new outsized level of debt remained, which resulted in all that hard earned equity flipping negative (in the above example) by early 2008. 5x leverage means that when the value of the property turned down just 20%, the entire equity stake was gone.

  • Real estate investment is not riskless, especially when leverage is introduced
  • Down payments of 20% do not prevent bubbles (as the chart above shows, asset appreciation allows an investor to put gains back in the market)
A case can be made (specifically within real estate) that negative equity does not equal permanent impairment. As long as payments continue to be made, an investor is still alive. While this is true, it does completely reduce liquidity (i.e. you can't sell without making the loss permanent) and it require an investor to make mortgage payments that are higher than the current market clearing price for similar properties.

Source: S&P


  1. Good post. One question, along with this disclosure: I know nothing about real estate investing.

    "If prices rise, sell your investment property each year and with the equity gains, buy a more expensive property at 5x leverage"

    It's this assumption/strategy that gets you more than just simply leverage, isn't it?

    Because under that strategy, when a bubble comes, you'll almost by definition use all your money and buy at the top....and then blow up when the bubble pops.

    It's like some sort of bizarro, much worse version of a Martingale where you double up your bets when you win...

    I wonder what would happen using Case Shiller stats if instead of rolling into pricier property when your equity rose, you followed this strategy:

    --Assume X years to save enough for 20% down payment (granted the value of X increases as home prices do, but it's possibly mitigated by having your salary or however you earn other income increasing, too) and buy a house every time you hit it

    --Never sell the houses you buy

    --Rinse. Repeat

    In the 20 years before the bubble burst, you'd have a portfolio of homes bought at different times (with varying degrees of leverage left).

    Assuming some sort of reasonable, annual increase in rents, you'd be cash flowing very positive on your early buys (and even maybe have paid them off?).

    And that cash flow might help offset the losses from a later purchase(s) in the bubble. Or it might at least let you ride out the time you describe in your italicized final paragraph.

  2. You are way too conservative my friend!

    Kidding... what you outline is a legitate means of investing. The example presented was meant to show the dangers of constant leverage in any investment that may have a great long term track record, but one tail event and you're screwed.

    It would be great if all investments, financial institutions, etc... allowed their investments to delever during the good times, but the reverse generally happens. When an firm has a "proven" track record (perhaps in mutual fund space) they are pushed in hedge fund space where leverage reigns supreme. When a bank squeezes out a 18% ROE, they are granted flexibility to leverage even more to get to 20%.

    Look at the banks last cycle and their 30x (or in some cases 60x with off-balance sheet) leverage as examples.

  3. Boy oh boy. I can just see the look on the faces of all the real estate hacks in the great states of california and florida during the long long painful decline in the price of real estate in the golden state.. Contrary to popular belief that a large decline in the price of real estate is a bad thing. Those who profited most from the meteoric rise in the price of real estate in california over the last twenty years are now the ones suffering the most. First time buyers with good credit can now qualify for a thirty year mortgage at a interest rate of just four percent. Or think about this the young couple with fairly good credit but not quite perfect credit making a reasonable down payment of ten percent' they have been waiting for the so called chance of a lifetime to appear and wanting to seize the opportunity to buy that dream house at a rock bottom price. Having picked out their dream house made the deposit. Than nervously waiting for two whole weeks to see if they qualify for their thirty year fixed rate mortgage at 3.99 percent. Than only to hear back from their banker. Im sorry but you just don't qualify for the thirty year fixed rate mortgage.