real estate - the elephant in the (PP) room

[atrchi]

I've known about the Permanent Portfolio concept for years but only heard about the "orthodox" 4x25 HB PP a few days ago, and I've been eagerly reading about it since. In order to fully understand the whole philosophy, there is one finer point which I would like clarified:

How are you supposed to treat rental investment real estate, or your own home, when these assets are the same size or even larger than your financial investment portfolio?

Do you simply say they're in the Variable Portfolio and then proceed to ignore them?

After discovering the PP principles, I now feel inadequately overweight Inflation/Prosperity assets and underweight Deflation/Recession assets!

If I were to setup a 4x25 HBPP in my investment accounts today, but then turnaround and look at all my assets together, I would be 60% real estate and only 10% each in stocks/cash/bonds/gold, minus 40% short fixed-rate debt  (is that the same as being short USD?).

[clacy]

I've known about the Permanent Portfolio concept for years but only heard about the "orthodox" 4x25 HB PP a few days ago, and I've been eagerly reading about it since. In order to fully understand the whole philosophy, there is one finer point which I would like clarified:

How are you supposed to treat rental investment real estate, or your own home, when these assets are the same size or even larger than your financial investment portfolio?

Do you simply say they're in the Variable Portfolio and then proceed to ignore them?

After discovering the PP principles, I now feel inadequately overweight Inflation/Prosperity assets and underweight Deflation/Recession assets!

Bingo. I would tend to invest mainly into LTT and STT as a result.  Maybe some gold sprinkled in, but not at these prices.

[melveyr]

I've known about the Permanent Portfolio concept for years but only heard about the "orthodox" 4x25 HB PP a few days ago, and I've been eagerly reading about it since. In order to fully understand the whole philosophy, there is one finer point which I would like clarified:

How are you supposed to treat rental investment real estate, or your own home, when these assets are the same size or even larger than your financial investment portfolio?

Do you simply say they're in the Variable Portfolio and then proceed to ignore them?

After discovering the PP principles, I now feel inadequately overweight Inflation/Prosperity assets and underweight Deflation/Recession assets!

If I were to setup a 4x25 HBPP in my investment accounts today, but then turnaround and look at all my assets together, I would be 60% real estate and only 10% each in stocks/cash/bonds/gold, minus 40% short fixed-rate debt  (is that the same as being short USD?).

Here is how I see this situation...

Firstly, I would throw as much taxable money at the mortgage debt as possible. I don't see much sense in being short debt via your mortgage, and then being long debt in the PP. It is basically the worst arbitrage trade ever Maintain liquidity for bill paying purposes of course, but try to conceptualize paying down your mortgage as a killer investment because it is. There is no better risk adjusted return in the market.

Now, let's assume you get that rental fully paid off at some point. You still are overweight prosperity to a great extent (Real Estate) with a smaller tilt towards inflation (Real Estate). Here are some options.

Option A:
I like the idea of viewing your Real Estate as a VP. I think having a pure PP, cordoned off from the rest of assets, to be very comforting as well as closing the Pandora's box of PP tinkering (oh no!). So, conceptualize your rental business as its own entity and think of yourself as its treasurer. To balance out your business cycle a bit, invest some of the rental's cash flow into some 30-year Treasuries, while holding some cash in the businesses savings account for liquidity/interest rate protection.

Option B:
You could attempt to integrate real estate into your PP. This could get messy really fast. It will never be the PP as advertised, but so be it. In this scenario, you probably wouldn't hold any equities because your real estate is such a huge component. You could think of your real estate as representing half prosperity and half inflation. Thus leaving you with loading up on Treasuries. If you decide that you really want a lot of deflation protection for cheap, consider buying 30 year STRIPS. They have the coupon payments stripped out, leaving the principal payment as the only cash flow getting discounted back to the present value. A percentage point move in interest rates will result in a 30% move in the present value of these bonds.

Whatever decision you make, try to make it organized. Sometimes I conceptualize myself as writing a contract to myself. It is not an unbreakable one of course, but it prevents me from flip flopping at the beck and call of the markets. I used to hate when that happened  

[Storm]

Firstly, I would throw as much taxable money at the mortgage debt as possible. I don't see much sense in being short debt via your mortgage, and then being long debt in the PP. It is basically the worst arbitrage trade ever Maintain liquidity for bill paying purposes of course, but try to conceptualize paying down your mortgage as a killer investment because it is. There is no better risk adjusted return in the market.

I appreciate your insights, but assuming the real estate is in a VP, completely separate from PP, what would be the advantage of paying the mortgage down, rather than investing in the PP?  The mortgage note is probably only around 4%, and the PP is returning 9%+.  Wouldn't it be to my advantage, while borrowing costs are cheap, to carry as much mortgage debt as possible and put all excess funds into the PP?

[moda0306]

I wouldn't count on 9+% PP returns going forward.  I don't want to get in a huge spat over why but it's my general belief we'll likely have a modest decade of PP performance going forward.

But it is worth pointing out that for those in higher brackets and bigger mortgages, the tax-benefit of the mortgage can be considerable.  So with a 4% mortgage, you're at 2.4% if you're in the 35% tax bracket and a 5% state.

Further, paying down an existing mortgage carries liquidity risks that I don't like.

[Tyler]

At what point does a mortgage / investment property violate Harry Browne's principle to never invest on margin?

[moda0306]

Tyler,

I tend to think that debt is often reasonable IF and to the degree that the asset you are purchasing "services the debt."  Obviously, "services" should mean something far beyond simply just barely servicing the interest.  The value should be significantly greater so you avoid going under-water.  I think any long-lived asset purchase, even a car or an education, have to be viewed very carefully, moreso because of the nature of the cost of the asset than the debt associated with it.  For instance, somebody who bought their house with cash in 2006 isn't really necessarily better off than someone who took out a 80% LTV mortgage, all else being equal.

I don't know if HB would agree with that, but that's my take.  I do tend to think, though, that if you DO own a home with a mortgage, you have taken a relatively big chunk of your life's expenditure that is subject to inflation (housing) and locked it up somewhat well.  I'd tend to think it wouldn't be a bad idea at all to take this into consideration, and veer your hedging towards deflationary recession.

[Storm]

At what point does a mortgage / investment property violate Harry Browne's principle to never invest on margin?

Harry Browne said that housing is a consumption item, not an investment, and shouldn't be treated as such.  I generally agree with him.  In general, however, I think a mortgage is a reasonable amount of leverage, provided you are not buying more house than you need, and plan on living there for quite some time.

People that get into trouble with leverage and housing generally tend to be in the "keep up with the Joneses" mindset and are trying to live beyond their means.  The term "house poor" comes to mind - people that buy a huge McMansion with 105% LTV mortgage, and immediately take out a 10% second mortgage to furnish the place.  People who have a monthly payment that is 50% or more of their income.  People that bought on an interest only loan.

I think most of us that invest in the PP are smart enough not to take out a non-conforming loan (80% or less LTV, standard 15 or 30 year, monthly payment less than 25% of income).

[moda0306]

I find it interesting that the general smart-finance thought is to buy the price, not the payment.  I generally agree with that on cars and furniture... short-lived asset... but much like the nature of long-term bonds, long-lived assets hold a lot of implications LONG into the future.  The nature of cash flows of 95% of households fits a payment system well, and trying to compare the price of a home to the monthly cost of an apartment without something like a 30-year mortgage is almost impossible.

I think with homes, when you can lock in for 30-years, it's important to look at payment more than price... with all the other factors in too (repair & maintenance, hassle, duration of residenc, etc).  For instance, where I live we happen to have both a pretty strong economy (5.5% unemployment) and VERY low price-to-rent-ratios... So I can buy and have a tax-adjusted payment in a place at MUCH cheaper than it is to rent.  Even if my house drops in value slightly for the next 10 years, that loss is having zero affect on my cash flows during that period, and if rents have also been rising during that period, I could very well have benefitted, not lost, from buying a home in terms of its affect on my net worth.  I think if people would have looked at comparitive payments in 2003-2006, it would have become much more apparent that housing simply couldn't be a good deal unless the game of greater fools continued.

[craigr]

I've known about the Permanent Portfolio concept for years but only heard about the "orthodox" 4x25 HB PP a few days ago, and I've been eagerly reading about it since. In order to fully understand the whole philosophy, there is one finer point which I would like clarified:

How are you supposed to treat rental investment real estate, or your own home, when these assets are the same size or even larger than your financial investment portfolio?

If it's rental investment it's speculative. If its your home it's a consumption item.

I've personally felt that way for years before reading anything about Harry Browne.

Do you simply say they're in the Variable Portfolio and then proceed to ignore them?

You don't ignore them, but yes they are part of your variable portfolio. The house where you live is not. IMO. Because you need somewhere to live so it's not easily accessed like other investment properties if you wanted to sell it to raise cash, etc.

If I were to setup a 4x25 HBPP in my investment accounts today, but then turnaround and look at all my assets together, I would be 60% real estate and only 10% each in stocks/cash/bonds/gold, minus 40% short fixed-rate debt  (is that the same as being short USD?)

If you are borrowing money to finance a home you are betting on inflation (paying back in cheaper dollars). If you own your properties outright you are leaning towards deflation by not carrying debt.

Personally I dislike debt and prefer to pay off mortgages. There is a argument you are tying up your money doing this, but at the same time you have more peace of mind in case of a lost job, etc. and being saddled with mortgage payments. However, if you need to get equity out of the house in an emergency that is normally the time nobody will loan you money (don't have a job, etc.). So you take your licks there.