Residential: not as safe as bricks and mortar

Since 2003 I've argued that many academics, economists, commentators and consumers confuse two fundamentally different concepts: the risk observable in a broad-based house price “index” and the probability of loss (or risk) faced by individual homeowners. This is a profoundly relevant issue for us all. 

The popular notion of bricks and mortar being a safe investment for owner-occupiers is at least partly based on the observed volatility, or risk, associated with regional house price indices.

The problem here is that a house price index proxies for literally millions of homes worth billions or trillions of dollars. An index is, therefore, an incredibly well-diversified portfolio.

In contrast, an individual homeowner is making an economic commitment to one highly idiosyncratic asset. 

You are buying one home, on one street, facing one direction, with all of its manifest peculiarities. This is, by definition, a poorly diversified investment with a much larger prospect of loss. 

A similar analogy can be found when comparing the risk of a micro-cap listed on the ASX with the fluctuations observed in the ASX All Ordinaries index, which captures every company listed on the exchange.

The micro-cap’s volatility will be much greater than the variations observed in the index. This is why your average super fund's portfolio invests in the index, and not micro-caps. 

Diversification is meant to be the one “free lunch” in economics. It’s the one time you really can walk along the street and pick up 100-dollar bills.

Since the circa 7-8 million property owners out there do not get the benefit of a national portfolio comprising millions of assets, understanding and managing individual asset-level risk (ie: your own home) is of great importance.

Regrettably, there is very little research on the economic hazards faced by single family homeowners. Rismark's team has, however, spent a lot of time thinking about this subject. 

Applying one methodology developed by professor William Goetzman, a leading financial economist at Yale, we found that the total risk of an individual home is about 15-20% per annum depending on the holding horizon. If we take a seven to eight-year ownership period, the individual property volatility is about 15% per annum. The chart below illustrates the results of this research based on all purchases and sales of Australian homes between 1990 and 2009. 

Based on this analysis, owning a home outright is slightly less risky than owning every company listed on the ASX, which has exhibited historical volatility of nearly 20% per annum over the past 30 years.

The next diagram shows a simulation of the risk profile of an individual home compared with capital city and national house price indices between 2004 and 2009. For the purposes of this analysis, the team used RP Data-Rismark's Hedonic Home Value Index. Importantly, we have also assumed that the individual property owner, which is represented by the red dotted line, has no mortgage debt. You can see that the value of the individual asset varies strikingly through time, compared with the capital city and national indices. 

To highlight these differences further, here are approximations of the expected return ‘distributions’ attributable to both a national portfolio of housing and a single family home. 

Observe how the individual property’s return distribution, which is proxied by the blue bars, has far 'fatter' tails and a lower peak. This tells us that the prospect of realising positive or negative capital growth outcomes is much higher than a nationally diversified portfolio, which is represented by the comparatively narrow red distribution. The latter demonstrates that the dispersion in the range of possible outcomes is very tightly wound around the average, or expected, capital growth rate. 

This is just one way of saying that a national housing portfolio has exceptionally low risk of just 3-4% per annum. If you had this holding, the value of your investment would have fallen only 2.5% in 2008. If, on the other hand, you had a single, million-dollar-plus property in Sydney or Melbourne, it probably fell by about by 10 to 15%.

The final chart illustrates the monthly returns attributable to a simulated Australian home between 2004 and 2009. Critically, we have created both 'geared' and 'ungeared' capital growth profiles. The blue line denotes the value changes associated with a homeowner with 70% mortgage debt. The red line represents a homeowner with no debt (they own the property outright). The impact of leverage is vivid: it amplifies the probability of loss, with the blue line dipping far below the zero% (ie, no change in value) axis with disturbing regularity.

So, what is the message from all of this? Over and above simple portfolio diversification, one take-away is that households have a profound (latent) desire to deleverage their balance sheets. This is an obvious statement today – but it was not something that many folks focused on back in 2003, when I first made it.

The only way to reduce debt is by boosting equity. This brings us to an economic puzzle: equity markets for housing finance don’t exist. While listed and unlisted companies raise debt and equity every day of the week, homeowners are stuck with debt. So, whereas a company with 90% gearing would be punished by the market for being excessively risky, we happily allow first-time buyers to leverage up to the tune of 95% against far riskier underlying assets.

The principal value of equity finance, as opposed to debt, is that the equity provider wears the risk of loss alongside you.

When times get tough, equity costs you nothing. In comparison, you always have to service your debt. Equity only has a positive cost when things go well, and you can afford to pay. This is precisely why financial markets and regulators like to see companies with more equity and less debt. 

The Bank of England's Andy Haldane recently arrived at this conclusion: policymakers need to revisit the housing finance paradigm and promote the design of smarter instruments that help households better mitigate their risks. Of course, real change is an awfully difficult thing to implement.

Christopher Joye is a leading financial economist, and works with Rismark International. Rismark and RP Data provide house price analytics products, and solutions that enable investors to go long and/or short the housing market. The above article is not investment advice.