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