Understanding the Risk and Return of Individual Assets

There is a difference between the return of individual assets and that of a group of those assets.  There is also additional risks involved.  Having a clear understanding of the difference  in the behavior and return of individual assets and the whole market is critical when making financial decisions.  Unfortunately, many people make decisions with individual assets based on the behavior of a group of assets or an entire market.

One prime example is the reverse mortgage.  In a reverse mortgage, one borrows against the equity in their home.  One popular way of doing this is to take payments from the mortgage company for a period of time, the time period of which is based on the age of the homeowners, the size of the payments, and the value of the home.  During the period during which you are receiving payments, this is like a traditional mortgage, but in reverse.  At first the loan value will grow almost entirely due to the equity you are removing.  As you get closer to the end of the payment cycle, however, the amount of interest added to the loan value increases drastically, making most of the increase in loan value due to interest.  This is similar to the start of a traditional mortgage where the first payment of $1000 may be $50 in principle and $950 in interest, while the last payment may be $950 in principle and $50 in interest.  The bigger the balance of the loan, the more interest is paid each month.

There is a big difference between the average rate of appreciation for the entire housing market and the rate of appreciation for an individual home, or even an entire community.  It is true that the average home will appreciate at a rate somewhere near the rate of inflation, plus a little bit more because the number of people in the world is growing and the number of people buying homes is increasing.  If you factor some average rate of appreciation into the calculations when projecting the amount of equity that will remain after a certain period with a reverse mortgage, this can lead to misleading results.  It can make it lo0k like taking out a reverse mortgage isn’t much worse than selling the home and buying a smaller home, but there is a huge amount of uncertainty in the assumptions made, which in turn greatly increases the risk of the transaction.

As an example of this mistake, see the comment stream in Reverse Mortgages — Run Away, Don’t Walk.  Newechm, who claims she sells reverse mortgages, states:

“So if the [$450,000] home sells and you buy a $250,000 condo, you can offer the seniors $8000/year given $200K invested. If there is no market correction or LTC need you will have a total of $200K plus $80,000 plus new home value $370K = 650,000

With the reverse you will have the same annual draw $8000 and the home value will be $666,100 after ten years. There will also be a line of credit available of $208,000 to handle any LTC needs if they arise and the funds are protected and guaranteed, no matter what the market does they are there. The total remaining equity available will be $535,680. So the total is $615,680 it is only $35,000 difference in ten years, not $203,000. ”

The home that was worth $450,000 at the start of the reverse mortgage is assumed to be worth $666,100 now after ten years.  How did that happen?  She is assuming that the value of the home increases by something like 5% each year as if it were money deposited in a bank account in the 1970s where you could be sure of earning 5% every month like clockwork.  The housing market in general doesn’t work like that, however.  If you look at the price of homes over a long period of time, like 50 years, you may find that you’ve made the equivalent of earning 5% per year (a 5% annualized rate, as the accountants would say).  In actuality, however, you had some years where home prices increased 20%, and others where they lost 15%.   You could have a period during those 10 years where you have the reverse mortgage where home prices only rise by 1-2% total, or even have a year like 2009 where prices drop significantly.

Individual cities and neighborhoods are even worse.  As any realtor will tell you, all real estate is local.  There are areas where the value doesn’t increase at all for ten or twenty years and then there are areas that prices double in a few years.  There are areas where home prices get really expensive and then fall back down to reasonable levels (see Phoenix or Las Vegas).  There are even places where home prices implode and may not recover for twenty to fifty years (see Detroit).

Within a neighborhood, not all homes increase the same way.  You may have a pool when no one wants to own a pool, so no one wants to buy your house even though others without pools are selling.  Your home may be too small or two big, or your appliances may be too dated.  You might need to put $100,000 into your home to sell it, and where are you going to get the money to do that when you’ve tapped out a reverse mortgage because you didn’t have any other money to use for food and medicine?

What happens in the example above if the home stays at $450,000 during the life of the reverse mortgage, which is entirely possible for a single home over 10 years?  Well, you owe $130,000 to the mortgage lender (home value, $666,000, minus equity, $536,000 ) and you have gotten only $80,000 from the lender ($8000 per year times 10 years), so you therefore have paid $50,000 and change to the mortgage lender.  Note that number is certain.  You’ll owe it no matter what that home price did.  After the ten years, you’ll continue to see equity sucked out of your home and you’ll be paying the interest rate on the entire loan balance, which will only compound since you are not making payments.

If you had sold the home and bought a smaller one, you would have that money minus realtor and moving expenses, or maybe $50,000 – $30,000 = $20,000 more.  You would also have invested the proceeds in a diversified group of assets, many of which are fixed income, and you therefore would have gained additional income there instead of paying out interest.  Because you are diversified and because many of the assets are fixed income your chances of making a good positive return there is much higher.

If your goal is to stay in you existing home because it has high sentimental value but you have no other money to live on, a reverse mortgage is a way to do that.  But you pay a high price and would be much better off moving down in home.  One option I’ve seen is to sell the home to your children and then subdivide the land and build a smaller home next door.  If you have enough land, this might be an option to explore.

In any case, don’t make the mistake of assuming an individual asset will provide the return of the whole market, and don’t let anyone convince you to make a purchase or sign a contract with calculations that do so.  This goes for individual homes, individual stocks, or individual businesses.  Unless it is a bank account or a CD, expect returns to be unpredictable without a lot of time and a lot of diversification.

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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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