Re: leverage only as a hegding position, what's wrong with the following use of leverage? Notice the risk to cash flow vs. the risk to lost equity. The dicussions seems to have focused mostly on risk to equity which matters when you sell and less so when you hold.
Say you have an investment that returns a rate of 10% . Let's even say the standard deviation on the return is 2% - so very stable. Let's also say that your cost of money is 6% - so you've got a spread of 4%. If you leverage with a 50% loan, your spread has been leveraged so that your cash-on-cash return requires half the investment at twice the return resulting in a cash-on-cash return of 14%. Of course, what's been talked about is the additional risk. The risk in cash flow comes from the distance between your income (the 10%) and your requirement to service your debt (at 6%). In the case where you have no debt, it's the risk that your cash flow becomes negative. Completely unleveraged, this distance between your 10% return and negative cash flow is 5 standard deviations - essentially risk free. If you leverage (50%) with debt payments at 6%, your debt service is now 3% (6% on half the purchase price) or 3.5 standard deviations from your income. That's a 0.02% chance of your income falling below your debt service requirement - higher than zero leverage, but still safer than many other investments. Now if you leveraged at 100% (say buying a house), while you have zero room for any downward movement in value (and therefore equity), your debt service is right at 6% so your spread has been reduced to the 4% (the investment return rate minus the cost of money). This is still 2 standard deviations before you have cash flow problems. That's less than a 2.3% risk.I'm not recommendting this 100% financing scenario, but even that is less risky to cash flow than many other choices.
So given that I can invest the proverbial no-money-down, get cash flow that represent the 4% spread, and have 2.3% risk to ever having a cash flow problem, tell me again why leverage should be used only for hedging rather than magnifying. Remember, I'm talking about an individual investor - not a govt or large fund.
Re: Great article
yalanand
6/5/2011 3:58:46 AM
@Value Hiker,
I totally agree with you that "Real estate is not risky, Leverage is". Leveraging is more appropriate for hedging your existing position rather than using it as an investment tool itself.
Why we can't afford houses
Tenacious
6/3/2011 12:53:59 PM
I agree with your comment that most of the risk comes from leverage. When I buy apartment buildings, there's a balancing act between the amount leveraged and the risk reduction strategies. When you buy stable and performing apartment buildings, banks look at the historical numbers to make sure you have a significant buffer between your NOI (net operrating income) and your monthy debt service. A typical ratio today would be 1.25 (i.e. you have a 25% buffer). If you plotted your NOI line on a chart, you'd see ups and downs resulting from fluctuating income (e.g. rent), and expenses (e.g. utilities, repairs, etc.). The trick is to look at the volatility of that line and make sure it doesn't get too close to the debt service line that's below it on the chart. You can even use Six Sigma principals to make sure that the NOI is a sufficient number of standard deviations away from the debt service line. Using strategies to reduce the volatility is often overlooked at a great way to further reduce risk. Having said all this, the NOI line for a single-family home is way too volatile for me. You're either 100% occupied or 100% vacanct! It's way to easy to be under water in any particular month.
Real estate is not risky, Leverage is. No matter what kind of investment you make, bond, equity, real estate, commodity, once you leverage yourself too much, there is a chance you end up like these investing bankers in 2008.
If I understand correctly, the scheme is your partner put down 20%, the original owner loaned you 20%, and then the banker loaned the rest 60%, I guess you must be reponsible for the interest & principle payment of the 80% house value loan. (If not, tell me your partner's name, I want to do business with him :-))
Leverage is magnifier, if you bet right, your return is magnified. if you bet wrong, your loss is also magnified. Practically, your leverage dwarfs these Wall Street Firms.
With this high leverage, it is possible that your return is infinite, only if you bet right, (i.e. you paid the bargain price, had a consistent, positive cash flow), you will win big time.
However, if you paid a price higher than the house's real value, or for some reason, the cash flow is disrupted. what can you do? Either you sell the house below the price you paid, or you hangs on with a negative cash flow. Either case, your return from the positive cash flow so far can be wiped out easily, and you may also need to cough up some money to cover the loss. (If your partner's 20% down is the first line of defense, congratulation! You found a generous partner, but I doubt he will cover more than 20% loss, or share the negative cash flow with you)
That is the risk of high leverage, I don't think you minimize this risk, it just does not show up during good time.
People at AIG FD collected CDO premium for quite long time, made easy money hand over fist, and assumed they took no risk at all. Then in 2008, they lost every penny they made before, plus dragging down the whole AIG with them.
I know you're talking about the macro issue of whether a single-family-home is an investment or not, but at the micro level it all depends on who holds the risk and who hold how much return. Let's say I buy a cash-flowing income property with a 60% LTV bank loan, and 20% owner-carry loan, and for the last 20% (the piece that's the most at risk), I find an equity partner who puts up the 20% cash down and we share the cash flow and equity above my partner's 20% 50/50. I've done several deals like this. Minimizes risk for me and my returns are infinite since the rest is someone else's money. I'm not saying this scales to a macro level, but don't presume that staments like "real estate is risky" are a blanket truth.
Re: Great article
Tenacious
6/1/2011 2:30:42 PM
Do you think all those real estate agents who never stop yapping about what a great investment a home is will ever get the message? I mean, owning a house offers great benefits, and you might make money on it in the end. But it shouldn't be viewed as a retirement fund. For that,. you buy investment properties.
One thing we need to keep in mind is the leverage that is allowed on Real Estate. When you buy a house, mortgage company allows you to down 20%, a leverage of 5 times. During the boom time, they let you down 5%, or even less. If you bet right, you make tons of money in a short time. Of course, there is the risk of leverage, you can be easily wiped out if you bet wrong.
Before the Great Depression, Brokage firms allowed investors to bet on stock (margin trading) with 10% down. You put down $1 dollar, and bet $10, we all knew what happened after that -- As the dark joke goes, when people required a windowed room at any hotel near Wall Street in 1930s, hotel stuff usually asked "You need the room to sleep or the window to jump?". After the Great Depression, we have the SEC rule, 50% minumum on any margin trading.
If the government setup the new law that all real estate transactions required at least 50% down payment, will there be any subprime crisis in the future, I bet not, at least not as serious as the one happened in 2008
Most people blamed the greedy Wall Street firms for the sub prime mortgage meltdown, actually the government is the primary guilty party in this case. The removal of Glass-Steagull Act, the lax tax loophole on real estate, all have a share to the crisis.
Falling Home Prices
impactnow
5/31/2011 11:05:59 PM
So many people got used to being real estate wealthy that they thought it would never end and used their homes like an ATM only to be faced with the cruel realty that they spent phantom money and now have debt they can’t afford. Understanding that real estate wealth is not realized until someone actually sells a property is a good realty for owners to keep close to their heart. If you stay for the long term you should be okay but speculation and phantom money are a deadly financial combo.
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