Gold - Inflation - Rental property - mortgage

[captain3d]

Hi All

I have been a happy PPer for  two years but I have not quite worked out how to think about a rental property in this mix. HB has written about it somewhat and has suggested reducing the amount of gold if you have a disproportionate amount of net worth in property...I think (must check Best laid plans again). I have been thinking like this...

A rental property could have several components.

Equity
Mortgage
Income

Equity:
A house has a value that, I think, tends to go up during prosperity or inflation. This would put it somewhere between stocks and gold as an asset (seems closer to stocks if you look at recent house price info). But prices also go up when borrowing money (mortgages) gets cheaper which would also tie it to falling interest rates to some degree.

Mortgage:
The Long Bond (30 year loan to the gov) does well during deflation as you have locked in your high rate as the current interest rate falls. A mortgage must be the complete opposite as you borrow for 30 years (from the bank) at a locked rate which would remain 'high' if deflation caused the current rate to fall. Of course a mortgage is not an asset in the first place but it would be a financial benefit during inflation if the current interest rate rose above your mortgage rate.

Income:
Rents = cash. Something I can understand :-)

My gut feeling would be to equally split the home equity value between the stocks and gold portion (prosperity and Inflation). In good times house prices generally go up and high inflation would likely accelerate that increase. If inflation went above 4.5% in this example the mortgage would start to become another source of value as the loan would be paid with ever cheapening dollars.

So how would you account for home equity if you HAD to include it in your PP allocation?

Prosperity (stocks) = 50%
Inflation (gold) = 50%
Deflation (Long Bond) = 0%
Recession (cash) = 0%

or is it more...

Prosperity (stocks) = 25%
Inflation (gold) = 75%
Deflation (Long Bond) = 0%
Recession (cash) = 0%

or

Prosperity (stocks) = 75%
Inflation (gold) = 25%
Deflation (Long Bond) = 0%
Recession (cash) = 0%

or something else.

And do you already do this?

thanks...phil

[MediumTex]

I would think of a rental property as a pure VP asset.

I wouldn't complicate it any more than that.

It's not a rule that the VP has to be more speculative than the PP.  A very cautious person could have half of their assets in a PP and have the other half in a VP consisting of nothing but bank CDs (or perhaps rental properties with a stable stream of income).

[Bob]

As a rental property owner for the past 14 years, there is another aspect to owning rental property and that is the aspect of liability.  One large expense such as a roof repair, sceptic tank problem, or other such unforeseen event can "eat up" all of your yearly profit in an instant.  While I have a positive cash flow at times, at other times a rental property can really wallop your wallet.  I agree that it should be in the VP.  I only say this to consider all the consequences of including a rental property in either the PP or VP.  There is much more to it than mortgage, loan, equity, and taxes.

[l82start]

As a rental property owner for the past 14 years, there is another aspect to owning rental property and that is the aspect of liability.  One large expense such as a roof repair, sceptic tank problem, or other such unforeseen event can "eat up" all of your yearly profit in an instant.  While I have a positive cash flow at times, at other times a rental property can really wallop your wallet.  I agree that it should be in the VP.   I only say this to consider all the consequences of including a rental property in either the PP or VP.  There is much more to it than mortgage, loan, equity, and taxes.

  a property manager i know has seen a new roof, two AC units and a steady two or three empty apartments in the last year, so i tend to agree. i would be likely to count it as your career/job first, VP second, and PP... probably not at all....

[captain3d]

Ha yes I know what you mean.

I re-read HB's section on Real estate in 'Why the Best....go wrong'

The main points were.
1. Real Estate has no place in the PP - get rid of it.
2. A mortgage is negating the bond portion as it is opposite.
3. Do something to try and balance things.
4. Real Estate with a mortgage is generally good during inflation.

I guess it is true to say I would probably not buy the rental property today if I had it to do over again but now that I have it I don't mind seeing how it works out. I dont want to pretend it does not exist when looking at my PP allocation as it is too big to be pushed off in to VP in my mind.

I am thinking like this...

The fixed rate mortgage will be good during inflation but bad in deflation. In the worst case you can walk away from the mortgage removing it from the equation (I live in a non recourse state but there could be taxes). So with that in mind I am choosing to ignore the mortgage aspect for now.

The equity of any property is an asset that will only do well during inflation. In this case it will likely do Better than cash, not as good as stocks and be way behind gold...I think. If the equity is acquired in combination with a mortgage then it is leveraged making its performance more similar to stocks...I think.

So I have now decided to split the home equity value and merge it into my PP spread sheet as...

Prosperity (stocks) = 60%
Inflation (gold) = 10%
Deflation (Long Bond) = 0%
Recession (cash) = 30%

This will hopefully...
Match stock performance quite well
Keep gold 90% intact for the worst inflation.
Force more bond purchases to balance and help in the worst deflation where I could walk away from the mortgage
Not hurt cash too badly if I lost the property

Any thoughts?

Has anyone decided to sell property to make a better PP?

cheers...phil

[amp]

Couple of thoughts...

1.  How I'd look at rental RE would depend on the debt to equity ratio.  Also, deflation may not be a terrible thing in the short run as you may be able to exploit lower interest rates by refinancing... then pray for inflation. 

2.  Transaction costs of selling real estate are so high that you'd need to figure them in when comparing the return vs. other assets.  They may eat a significant portion of your equity, depending on how much you have at this point.

3.  PP is one way to invest and there is certainly some commercial RE exposure in owning stocks.  I don't think of my personally owned RE as  having anything to do with my PP assets, they are in a completely different basket.  Don't know how or why one would want to include it in the PP spreadsheet/calculations.

4.  I haven't read HBs info on real estate, but I don't see how having a mortgage negates the bonds in PP.  Value of the bonds fluctuates with rates, value of my mortgage is constant (ignoring principle reduction).  Also, as rates go down, the value of RE typically goes up as would the value of existing bonds.  I must be missing something here.

Again, just some passing thoughts... might not be what you were looking for.

-Drew

[captain3d]

Thanks Drew

I would like to be 100% in the PP.

To be 100% invested in the PP I would need to sell the rental property. I don't want to do that...yet, but I still want to aim for the closest there is to 100% split per PP. My aim was to work out which of the four I should cut back on and which I should increase to try to balance things out. Your are correct to say that they are really a different asset but I am going to go and force it in anyway :-) Luckily it only makes up about 15% of the total value so it will not bend the rules too much.

I have now found the section in the book and reread things...HB writes in 'Best Laid Plans...' about the mortgage offsetting the bonds

Pg 367
"The other problem is that a large mortgage can cancel out your holdings of long term bonds...that makes you vulnerable to deflation"

This makes sense to me. If I have a $100k, 30 year fixed, 5% mortgage and then I buy $100k of 30 year bonds paying 5% they do more or less cancel each other out.



HB recommended several hedges against the mortgage problem (from 1987)...

1. Switch to a variable rate mortgage as "a fixed rate mortgage is a bet on rising inflation and higher interest rates...while a variable rate mortgage is neutral"

2. Longest duration, Zero Coupon Bonds - As they are about three times more volatile that the regular 30 year bond (HB says)

3. Gold: Although HB doubted the ability of real estate to react to inflation to the same degree that he expect Golds value to increase he did say having both Gold and real estate was likely to over protect against inflation. Suggesting the gold budget could be reduced. He also suggested call options, in extreme circumstances, on a even smaller part of the smaller gold portion.

The bottom line though, was that he did not like tampering with the gold portion to accommodate real estate as it was not as reliable or powerful as the gold reaction to inflation. Gold also does well in other situations like war or unrest that may devalue a property. eg you cant run away with your house in your pocket. Tax rules were another concern as real estate is what it is thanks to tax breaks to a large degree and those could change at any time.

It seems HB struggled with this a lot as he really wanted to make it fit but really could not find a good way to add it to the mix. He recognized that it was important to try as it is often the single largest investment that people own.

The one thing he recognized was that a house with a mortgage was not as fixed as the other categories eg you can walk away from the house and loan, or refinance, or get a loan modification etc which reduces the risk some what.

OK..for what it is worth I have decided on a final split to mix my rental property equity into my PP holdings.

Cash = 15%
Gold = 20%
Stocks = 65%
Bonds = 0%

I did not want to dilute my Gold power too much as it is the only saviour during hyper inflation and therefore felt house prices (amplified with the leverage of a mortgage) would most closely match stocks performance under normal economic conditions. I spread the burden into cash a little as well.

Boosting the other three means I will have to buy more Bonds to balance. This should help offset the negative effects of the mortgage if deflation ever occurred.

At least all of this made me happy and gave me a better understanding of the role of each quadrant.

cheers...phil

[amp]

Well, I'm not usually one to question HB's wisdom, but the RE info you quoted seems a little naive.

Still don't get the cancelling out unless you're only looking at cashflow (mortgage payments & bond interest).  And if it does "cancel out" the bonds, which I'd dispute, then why would you go to 0% bonds instead of increasing bonds beyond the mortgage value? 

In a deflationary environment one would expect rates to drop, which would increase the value of existing bonds, might decrease the value of the property (lower rates usually prop up prices) , and do nothing to the mortgage value.  However, deflation may provide a refi opportunity.

As for the fixed rate mortgage, it just puts a ceiling on your interest payments.  You can refi if rates drop, assuming you've got some equity.

So, how about a free & clear house... how would you work that into the PP?  Would you change your allocations if you had a free & clear rental property? 

Again, I see the ownership of RE as separate and distinct from the PP.  Perhaps it's part of the variable portfolio (VP) people type about around here?  I still think rental real estate has a lot going for it, if purchased, financed, and maintained correctly.  Future taxes are uncertain for everything, not just RE, so that argument doesn't go too far for me.

Anyway, just some random thoughts...

-Drew

[l82start]

i may be way off base or over simplifying here, but it seems to me it is far easier to calculate a rental property as a part of your carrier/job than it is to compare it to a bond or some other pp asset, it seems to have more in common with being a doctor with student loans for example.  your mortgage is the student loans, operating expenses and office costs for the doctor are the same as property taxes and repair costs for the rental owner, he builds equity by building his practice and paying down the loans  you build equity by keeping your building in good shape and paying down the mortgage, both do bookkeeping to track the income they generate, each of you make a profit (most of the time hopefully) which you can reinvest in the business or property, or live off of, or move into a investment/retirement portfolio...   if you retire you can sell the building, he can sell the practice...  

do the small business owners with a pp calculate their business as a part of their PP usually?
if so the calculation for including any small business in the PP, and including a rental property should be pretty close...    

[captain3d]

HB did talk about owning a business and how it relates to PP as well but I don't have time to look it up right now.

As to why bonds and mortgages cancel each other out...Well he said it puts you at risk to deflation while biasing too much toward inflation protection.

Deflation and falling interest rates would increase the value of your Long Bonds, but it would also increase the burden of the mortgage payments as they would remain fixed and presumably higher as everything else dropped. In the case of a rental property the monthly income could drop below the mortgage payments etc. He did say if you were confident that you could always make the payment no matter what then it was less of an issue.

I guess if your property is dropping in value, your rents are dropping while your payments are fixed you run the risk of losing the investment completely. The rising Bonds could not offset this loss.

A free and clear property is different as the value is no longer leveraged by the mortgage. it would be less volatile but still do well during prosperity and low inflation I think.

The zero coupon idea was for the situation where the mortgage value far out weighed the value you could afford buy in bonds. Which is common for many people. With limited money available for bonds you could get more volatility out of zero coupon to help make up the difference. Kind of leveraging your investment.

phil

[RickV42]

I have a rental property and exclude it totally from the PP.   I just include any estimated (realistic) equity in my net worth.  In hindsight, I'm glad I did this as it allowed me to carry the full amount of TLT in the PP, which on it's own has returned more than the rental.

I am also a couple years (roughly) into the PP and am seriously thinking about selling the property.  I don't think the property will do as well as the PP going forward, especially as I am now un-leveraged.

Versus the PP, the un-leveraged return on my rental does not cut it considering:
-Potential liabilities (like someone slipping/falling)
-My time and energy
-Non diversified
-Real estate taxes might increase more than in past
-Possible removal of interest rate deduction at some point in future
-Flat or falling real estate prices going foward (my crystal ball only)
-Relatively un-liquid

[captain3d]

I am still well leveraged and will stay with the rentals for now just to see how things work out. I am underwater to some degree but with positive cash flow so going to let it tick away as is. I may also sell down the road to remove it from my assets.

phil