Thursday, July 09, 2009

Your Home and Other People's Money

One of the many arguments surrounding real estate investment, whether as a true financial investment, or as a lifestyle investment for personal residence, involves using "other people's money" to finance the purchase. That is, use leverage through mortgages and secured lines of credit to provide the necessary financing. This is often touted as a benefit of real estate investing -- lever up and a small investment of $20,000 turns into $200,000. Fancy terms are thrown around by financiers showing double-digit returns on initial capital invested. Wow. But don't sign me up just yet.

Let's look at a simple case of me with a business idea. I want to open a store selling popcorn. I think have a decent business case but, unfortunately, no money with which to carry out my fancy plans. I need to find some capital through investors. One place I can go is the bank which has boatloads of money. I can also see if some of my business contacts are willing to pony up the dough for my venture.

The thing is, when I use "other people's money" they have a funny way of wanting a cut of the returns for use of their money. The bank manager sees me and looks at my business case, offering me a loan at 10% annual interest. My business partners are willing to invest but want an equity share of the business. Some even offered to fund it and have me work as an employee. No matter how I slice it, I have to give up some of my potential returns in exchange for the use of capital.

Now we can turn to real estate and housing. When my family walks into a bank interested in applying for a mortgage, there is little difference between this and my popcorn investment. Sure popcorn is a bit more risky than housing, but for the bank, which has access to a fixed amount of capital, both are considered pretty much equally, adjusted for risk. The bank needs to maximise its returns and manage risk.

It may not seem like it, but when the mortgage specialist fills out the online form including your income, assets, liabilities, credit history, et cetera, she/he is but filling out a streamlined business plan on our behalf. We can sometimes lose sight of this with the big rosy smile on the broker's face and McMenus of financing options.

Mortgages are, in their essence, nothing more than business ventures. The most important thing to realise is that, like most business ventures, you are passing on some of the profits to the initial holders of the capital. Unless you are speculating and benefit from unsustainable capital appreciation, your returns will, on average, be less with borrowed money than they would should you have your own money to invest instead. There is nothing absolutely wrong with this -- one may forgo future savings for present day benefit and borrowing capital is often necessary for a venture to happen at all; both are usually the case with owner-occupied real estate purchases.

Using "other people's money" is not free, especially if other potential non-real estate investments are producing decent returns, such as in the late '90s. I asked a few people why they didn't invest in properties ten years ago that were netting 7-8%. The answer: there were lots of other investments doing better with a lot less overhead. In fact, mortgage rates of the day were over 7%, reflecting how competitive other businesses were for available capital. It seems the trough of money is not bottomless after all, especially when business is booming.

Disagree? Do you think you can always do better with borrowed money? Let's hear it.

19 comments:

david said...

I have to agree with this. Everyone always says that they can borrow money, invest it, and make more money than the interest they pay, with very little risk.

I have trouble buying this because if that was true, why wouldnt the bank just invest straight into that, and earn the higher rate there?

The bottom line is it is all about risk. The safest investments generally pay the lowest interest.

It is very intersting that mortgages are so cheap right now, yet I would consider buying a house right now very risky from an investment standpoint. Of course, when this happened in the States, all hell broke loose when house values started to fall. You would think we would have learnt from that, but apparently not.

Patrick said...

I agree with the point that people are unaware the amount of risk and leverage they're taking on when making a real estate "investment".

However, the problem in the bank's perspective is that the mortgage is secured by the real estate property in question. If the borrower is deliquent, the bank can just sell the home and recover its monies. It is less easy with a popcorn business. This explains the significant difference in the rate charged for a mortgage and a business loan.

jesse said...

"mortgages are so cheap right now, yet I would consider buying a house right now very risky from an investment standpoint."

It should be quite obvious that banks are pretty much isolated from falling property prices, either through high downpayments or borrower funded insurance schemes. Their business case's biggest risks are default, fraud, and late payments.

david said...

"It should be quite obvious that banks are pretty much isolated from falling property prices"

What?!?! I sure hope that was sarcasm (it doesn't always come across on the internet).

I thought the crisis in the states made it painfully obvious that the bank can be stuck with a house worth far less than the amount of money the people borrowed to pay for it. I am pretty sure 1/4 of las vegas is now owned by the banks. I checked vegas craigslist and pretty much every place listed on there was bank owned.

I know they had the 0 down mortgages and all, but 5% down payments are still very common, and the value of a house can easily take a 10% hit in the span of just a few months (as we have seen). Not to mention some disgruntled foreclosees (is that a word?) will trash a place before leaving as a way of getting back at the bank. It makes no sense to me but it still leaves the bank with a hefty cleanup bill.

If the banks think they are safe with real estate, there are about 500 failed lending institutions down south that would disagree.

Declan said...

"It should be quite obvious that banks are pretty much isolated from falling property prices"

Anything with less than a 20% down payment is insured under Canadian law so this provides a buffer for the bank.

Nevertheless, the bank will face significant costs in foreclosing and selling a property so the true margin of safety is a fair bit less than the 20%.

Even if the loss on a loan is fully recovered the bank still takes a hit from having its money tied up in the property earning no return on capital while the property is dealt with.

Longer amortizations also mean less equity over the life of the loan and less cushion for the bank.

You'll find that if there is something unusual about the property such that the bank might be worried about the ease of reselling (e.g. out of the way places, very large properties), the demanded down payment may be higher.

This is similar to auto loans, where the bank will demand tougher terms for something hard to sell quickly (like an R.V.)

jesse said...

"I know they had the 0 down mortgages and all, but 5% down payments are still very common, and the value of a house can easily take a 10% hit in the span of just a few months (as we have seen)."

Perhaps someone directly involved in the industry can clarify, but AFAIK in Canada any mortgage with LTV > 80% is required to be insured. This means, whether the lender likes it or not, they are isolated from price drops to the tune of around at least 20% assuming they don't have insurance.

Now if an insurer finds a way to weasel out of the agreement or the insurer defaults a la AIG then yes the bank is on the hook.

I think that in certain situations banks will be underwater on some uninsured mortgages. It is a fair comment that foreclosure proceedings can be expensive and often properties trade at a discount in this situation.

I don't foresee massive price erosion risk for banks but I do foresee increased delinquencies and, when the economy picks up, mortgagees will find competing for the bank's money at current interest rates a tad more difficult.

mohican said...

jesse - you have it right

Banks underwrite and service the mortgage but the risk falls on CMHC if the value of the property does not cover the outstanding loan. Even mortgages that are less than 80% LTV are often packaged off and put under the NHA mortgage program.

Banks still face quite a bit of risk associated with these property values, especially on second position debt like HELOCs or second mortgages. There are also many instances where the CMHC/NHA may take issue with the underwriting standards of various mortgage brokers. This hasn't happened yet but it will be interesting to see how fierce the CMHC gets on enforcing the underwriting standards on defaulted loans if and when it does.

david said...

Good point.

I forgot about the CMHC insurance.

jesse said...

The other thing to remember, as pointed out by other astute local bloggers, is that commercial RE loans are not subject to mandatory insurance. mohican, I don't know if secondary mortgages and HELOCs have similar restrictions (I assume they do).

Patrick said...

The most troubling aspect in my view this:

The CMHC is government owned corporation that is essentially encouraging these less than prudent people in purchasing homes with 5% down etc. This is very troubling because I would venture to guess the insurance CMHC charge isn't likely to adequately account for the risk of these "less than prudent" homebuyers w/ 5% down 35 year amortizations, especially when rates begin going up or become unemployed.

Therefore, it is likely significant government funds will be dedicated to make good on these insurance policies (i.e. bailouts) which ultimately comes from our tax dollars. I would be extremely upset to see my tax monies used to bail these people out indirectly through CMHC.

mohican said...

Commercial loans, HELOCs, and second mortgages are not covered by NHA/CMHC. This is the biggest risk for Canadian financial institutions. Fortunately for the major banks, the risks are spread across the country.

Local credit unions have a lot of exposure to our market specifically and it would be troubling to me if I were in senior management at one of these institutions.

jesse said...

"Therefore, it is likely significant government funds will be dedicated to make good on these insurance policies"

I think we should look at CMHC's balance sheet to see what level of defaults they can handle. They have been collecting insurance in a secular bull market lasting decades so, IIRC, they should have decent capital to handle a substantial increase in defaults. As mohican mentioned, the "bubble" is not nation-wide to the extent seen in many western cities.

The irony of CMHC is that they allow people to hoist themselves with their own petards. The insurance is borrower-funded and when they default it will in effect be CMHC who will be showing up to repo the property. How's that for improving home ownership?

Michael said...

Patrick says:

"I would be extremely upset to see my tax monies used to bail these people out indirectly through CMHC."

Just to be clear: the CMHC would in fact be bailing out the banks who made the bad loans. The folks who can't pay their mortgage will still be foreclosed and out on the street.

The buyers pay the premiums, but the banks are the ones protected.

Patrick said...

True that CMHC would be essentially bailing out the banks and the not-so-prudent homeowner will be SOL. However, it is still an addition drain on our tax dollars that is ultimately tied to these 5% down 35 yr amortization home "buyers'" actions...

Fix the system said...

The bank's are protected from a 20% decline by downpayments or insurace out of hand.

It get better thought because unlike the US, here in Canada the bank can come after your personal assets.

You cannot just walk away from a home unless you declare bankruptcy too. I don't think hundreds of thousands of Canadians are going to declare bankruptcy.

Ice said...

Feds should be clamping down on CMHC and shifting more risks over to the banks.

It's a big gov't shell game which tax payers are on the hook.

CMHC original purpose has gone to the wayside and is becoming a pseudo public/private entity which has NO risks and accountability because tax payers are on the hook. Execs are getting their plum bonuses.

Should we experience a housing bust like in USA do you really think CMHC can payout on all the losses? It's you and I on the hook.

jesse said...

Before railing on CMHC and its close ties to taxpayer pockets, it would be useful to review its balance sheet. Remember CMHC has been collecting insurance fees -- coupled with relatively benign default rates -- for a very long time.

What is egregious is CMHC purporting to have Canadians' best interests at heart by expounding the virtues of home ownership. Their mandate while potentially well-intentioned throws fiscal responsibility to the wind. Its savage means speak to how it really operates and survives: collecting front end loaded fees and wielding the foreclosure scythe behind its back.

milo said...

“Should we experience a housing bust like in USA do you really think CMHC can payout on all the losses? It's you and I on the hook.”

We are not much different from the US. Nortel’s directors after paying themselves hefty bonuses to the tune of $30 million, is begging Ottawa for taxpayers’ money. Some crown corporations are there for purposes best not to know.

Joan said...

this is not always true because ongoing companies create business plans, project plans, new product plans, and plans for acquiring and integrating other ventures. General Dwight D. Eisenhower once said, “Plans are nothing. Planning is everything.”
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