During recessions and market downturns, homeowners often take comfort in their biggest investment asset: their home. But should they? With spending and investing on many people’s minds these days, home prices, and the widespread conviction that investors never lose money on a house purchase, are being tested.
As with much in life, the value of a client’s home depends on what was paid and how much is still on the balance sheet. During the last boom and bust cycle, it took many householders a full decade to recover the price they paid in 1989. All along, they were devoting 32% of gross income to mortgage costs. These days, depending on the amortization period, the ultimate cost of a house could be a third more than its purchase price.
It’s useful to remember that houses, historically, appreciate over the long term at pretty much the rate of inflation. In other words, they are closer to a real-return bond than they are to an equity investment. Indeed, a rental investment can have a bond-like payout, assuming, say, it takes 10 years to amortize the purchase price. As a result, if one wants a rental property to cover the purchase price over 10 years, why would one buy a stock trading at 20 times earnings? A similar analysis can be applied to a house purchase, too: what is the imputed rent and how long does it take for the rent (mortgage, plus taxes plus maintenance) to cover the purchase price?
Still, house-buying also resembles some of the more aggressive aspects of stock investing. For one thing, it involves leverage. For another, the investor is seeking a capital gain rather than income, often inside a very short horizon. Finally, house prices can get out of whack with historical metrics, such as the price-to-income or price-to-rent ratio.
It’s clear enough that a house can be considered an investment, but that leads to a more pressing question: what is an investment?
We need to go back to Ben Graham’s distinction between a speculator and an investor. A speculator chases returns, darting out of that stock and into this one, hoping to find momentum. An investor buys a business, generally at a discount. In fact, an investor is buying a stream of income, dividends, at a discount to intrinsic value. (If there were no discount, then one would be buying a bond, assuming, of course, that the income stream is safe).
If a house and a business can both be considered investments, then they must share some characteristics. And if they are to be fruitful investments, then there must be some source of capital growth.
For a business, growth comes from setting aside something from earnings to reinvest in the business, thereby magnifying future earnings. We say the same about the average household. There is, for example, the prospect of building a rental apartment.
For a business, acquisitions should be accretive: mergers should add to a company’s capacity to magnify future earnings. Do household acquisitions add to future earning capacity? Again, there is the prospect of laying out a vegetable garden, for example, or adding green energy sources to defray heating costs.
This deserves a little more discussion. A business makes acquisitions by issuing shares or paying cash or some combination of the two. If share issues are not to dilute current shareholders, then there must be some tangible value being purchased (which is tougher than one might think, looking at the sorry tale of Northern Telecom; many tech companies were acquired by the former Canadian tech giant in the late 1990s, but their purchase price, carried as goodwill, essentially, had to be written off).
When people sell a house, it is often said that the quickest way to add value is to renovate the kitchen. But kitchen renovations do not come cheap, often costing in the neighbourhood of $30,000.
How do we characterize such a renovation? Is this borrowing to fund dividends, or is it a genuine application of retained earnings? If the latter is the goal, then why not raise the earnings capacity of the household by, for example, adding a rental apartment?
How about an accretive purchase? Will it add to earnings, or cut expenses? There’s the prospect of a vegetable garden, or green retrofitting to cut operating costs. Indeed, these are much more in tune with the zeitgeist than kitchen renovations.
In fact, there are many ways to treat a house like a growing business. But, most homeowners are not used to analyzing the business reasons for investing in the stock market. Probably most would be happy with high-paying but safe bonds.
Still, there are parallels between house-investing and stock-investing, providing one understands that the underlying logic is to purchase a business at a discount and help it grow. And this is clear to see in a recession, where only the highest-quality assets appreciate.
Business versus household: The parallels
A good quality company has free cash flow; an investor’s household has savings.
A good quality company has a solid franchise; an investor’s household has a secure source of income, e.g., a job.
A good quality company has a low debt-to-asset ratio; an investor’s household pays off all but mortgage debt every month.
A good quality company makes accretive acquisitions; an investor’s household buys an affordable place to live, one whose cost of carry is less than rent would have been for comparable space.
A good quality company keeps cash reserves against delinquent accounts receivable; an investor’s household saves for a rainy day.
A good quality company lays off risk or delays taking on new risks (e.g., expansion); an investor’s household is prepared to cut fixed costs.
Advisors often comment that the need for financial planning is greater than the demand. One might add that the scope for financial planning — for thinking like a business — is greater than its current application.
A recession is as good a time as any to get clients to put the precepts of financial planning into practice.
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(02/10/09)