How Valuable is Your Home?

Introduction

We often hear that one’s home is one’s castle, but how true is that? It’s always been part of the American dream to own real estate, whether a single-family residence (SF), townhouse, or condo. Traditionally, we get the impression that investing in and holding property will make us wealthier. Indeed, stories go around telling us that most billionaires built their wealth from owning properties on a large scale. So, as a homeowner, it may be worthwhile knowing the ins and outs of property ownership and its chances of making a nice nest egg for you down the line. Read on.

The statistics tell a tale.

Zillow shows that the average residence in the US appreciated from $163K to $312K over something like ten years. The SF category over the same period went from $186K to $362K – around 5.4% compound growth. SFs in Birmingham, Alabama, beat the national average trend, rising by slightly more than double from an average of $58K to $118K (i.e., 7.4% compound growth, and 37% above the rest of the country). So, bottom line, real estate is a great asset to own. The question is, then, what derailed homeowners’ dreams despite this when we see so many foreclosures over the years?

It’s not real estate but leveraging that’s at fault.

What do I mean by “leveraging?”

It refers to how a homeowner relies on mortgage funding to acquire the asset. Few of us can think of buying a house without financial assistance, generally around 70% of the real estate’s appraised value. Over the last few years, the interest rates have thankfully been low, hovering between three and four percent. So, for example, if a Birmingham married couple bought a home for $100,000 back in 2011 with a 70% mortgage, they only had to invest $30,000. The bank funded the rest with the property secured as its fallback in case the borrower defaults.

Now watch this:

• Let’s suppose the couple paid 4% fixed interest annually (interest only) or $2800 x 10 years = $28,000.
• Supposing they sold the house ten years later after it appreciated at the average (i.e., 7.4% pa) for a fair value of $202,000.
• How did they fare on the deal?
  • Well, as a start, they pay back the bank’s loan – $70K.
  • Additional closing costs (paying realtors, lawyers, the title company, etc.) of $20K leave them with $110K net value for their original investment of $30K.
  • Indeed, the leveraging arrangement magnified their wealth by more than tripling the investment (i.e., around a 13.3% compound return – nearly twice the asset appreciation rate).

From the above, you may conclude that the leveraging effect is fantastic, and borrowing bank money is the optimal route to becoming wealthy. But is this too good to be true?

There’s a downside to leveraging.

1. An assumption that interest rates stay low is a lethal tripwire. During the Carter presidency, inflation went crazy, and double-digit interest rates ruled the day. That’s why savvy borrowers lock in a low rate when they can secure it. Those that don’t may pay a heavy price down the line.
2. Property appreciation doesn’t always travel in a steadily upward direction. The financial crisis of 2008 taught us that a recession can slaughter capital gains in the blink of an eye while simultaneously erasing jobs left, right, and center.
   1. When homeowners get caught in a financial crunch, the home’s value could drop below the loan commitment. It’s called “being underwater.”
   2. Also, with insufficient income to pay interest, the bank will zone in and foreclose on the home. In that event, the total principal (in our example, $30,000) dissolves to nothing. The couple would have to leave their home and lose their original input to boot.
3. In the recent COVID-19 crisis, many people lost their jobs and began slipping behind their mortgage obligations.
   1. Those who invested in residences relied on their tenants’ rent to pay the mortgage costs. However, landlords couldn’t eject defaulters (and there were many), barred by the CARES Act provisions. The latter forbade it for over a year to ease people’s pain.
   2. The bottom line was this: No rent + Continuing interest payments = A likely track to real estate bankruptcy.
4. These disruptions can occur even in a vibrant property market, spelling disaster. To be clear, it’s not failing asset appreciation that’s necessarily the culprit, but more frequently leveraging pressures overwhelming the homeowner.

Indeed, leverage is a double-edged sword that can cut both ways, and the wrong side of it can get pretty hairy if it takes one by surprise.