Introduction
Everywhere you turn today, people are blaming the international recession on ‘the sub-prime mess’. But whoa, hold them horses; a sub-prime borrower could be your son or daughter, your mother-in-law, your best friend or you and me.
Let’s first remember why we have a sub-prime lending market in the first place—it is to make more of our citizens, homeowners. There is the idea that homeowners make better citizens because—
1. They have bought-in to social norms and have a stake in their societies.
2. They benefit from owning their own homes in terms of forced savings (that part of their monthly mortgage that goes to paying off the principal).
3. They have some inflation protection.
4. They have security of tenure (they won’t get kicked out by a Landlord).
5. They can customize their homes to their own individual tastes and needs.
6. They care more about their neighborhoods.
7. They are vigilant with respect to crime, vandalism and graffiti.
8. Home equity is the number one source of capital for starting a new business.
9. Home equity is also one of the most readily accessible emergency funds.
In Canada, it has been the goal of our government since the immediate post-war years to increase the percentage of Canadians who can own their own homes. This has also been true in the US, Australia and other nations. In fact, planning for post-war reconstruction began before the end of WWII—as early as 1943 and 1944 when it became apparent that Germany would likely lose the War.
Central Mortgage and Housing Corp (now renamed Canada Mortgage and Housing, CMHC) has been in the business of guaranteeing home mortgages for sub-prime borrowers for a long time—they do this through a self-funding program that adds a point or so to the cost of your home mortgage when you are a highly leveraged Buyer (up to a 95% loan to value ratio in most cases).
Ask most people how much money they can save and, if they are honest, they will tell you: “Not much.” Even relatively good savers, once they have saved $5,000 or $10,000, can resist spending it on a new PC, laptop, vacation in the DR, downpayment on a new car, what have you.
But most people will think twice about accessing their home equity for anything other than a major crisis or to start a new enterprise.
These days with unemployment soaring practically everywhere, the thought of owning your own home and owning your own business, looks pretty good. I don’t know about you, but I wouldn’t like anyone tapping me on the shoulder and telling me: “We don’t need or want you anymore, you’re finished here, get out, you useless bugger.”
Of course, outplacement firms handle it better than this but don’t tell me that what you hear and what they say are the same. What they say is: “Due to the overall economic situation that the company faces, you will have to find a job elsewhere. We have services such as CV preparation and an outplacement office you can visit every day and we have an industry-leading severance package for your review and, if you like, the review of your counsel.”
What you actually hear is what I wrote above. It hurts, a lot. Politicians often say that they are immune to criticism. Don’t believe a word of it. They are incredibly SENSITIVE to negative stories about themselves. Employees are too.
The Analysis
Now it isn’t hard to figure out what the Internal Rate of Return, IRR is for a sub-prime borrower in normal market conditions.
Let’s say that your brother-in-law buys a $245,000 home with 5% down ($12,250), pays 4.5% for his mortgage and another 1% to CMHC for insurance because he is a sub-prime borrower. He holds onto the house for five years and then sells. Real estate inflation is 2.25% p.a. and he ‘pays himself a rent’ (this is called an imputed rent) of $1,675 per month.
You can look at the imputed rent as what he would have had to pay for a rental accommodation of similar quality for himself and his family.
Now under these assumptions, he bought the home for $245,000, he will sell it for $273,800 and he will pay some transaction fees (basically legal costs and real estate fees) of $14,492 so he nets around $259,339.
Remember he started with $12,250 and he ended up with $66,085 after five years, made up of: a) getting back his original equity of $12,250 when he sold the home, b) pay down of the mortgage principal of $37,254 (I used a 20 year amortization, which in conservative Canada is more typical than a 35 year amortization that they tend to use in the US, which lowers the monthly payments but significantly increases the total amount of interest he will pay and significantly decreases that amount of principal he will pay down in the first years of his mortgage) and c) $28,831 from the increase in the value of his home less his original equity (don’t double count!).
Now you tell me, how many of your friends can save $66,692 in five years (or $63,843 if we ignore the contribution by imputed rent in Years 1 to 5) and how many can make an IRR on their equity of 42.1% p.a.?
How about what happened to me—I gave a major private bank $100,000 in 1995 to invest for me in the Bank’s mutual funds. In the greatest stock market boom in the last 150 years (since the first days of the railroad revolution when everyone thought that there would be a RR going to everyone’s home and business and everyone bought speculative RR stock issues like they were buying a regular coffee for a nickel), the Bank LOST $8,000 of my money. I never once got the promised monthly statement and when I finally insisted on a report in 2000, I realized they had churned my fund over and over again and that they had four of the worst ten performing funds (this is out of 1,000 CDN. mutual funds). I asked for my money back—I told them I wasn’t angry, just ‘gimme my money back’. A monkey throwing darts at a chart of 1,000 mutual funds would certainly have done better. My father-in-law, Ken MacMillan, an old timer with a conservative bent, got the last laugh—he believed in CASH like most people believe in drinking rum while lying on a Caribbean beach.
I have uploaded my simple IRR model to my server and you can download it in .xls format by clicking here. I included a case where you have a more normal down payment of 25%.
In that second case, you put down $61,250 as your downpayment on the $245,000 home, your interest rate is lower (since you don’t have to pay CMHC insurance for a high ratio mortgage), your imputed rent remains the same.
Now your IRR on your equity is lower (a still respectable 19.9%) and the cash in your jeans at the end of five years is $137,503 (or $107,633 if you ignore the imputed rent).
You can see that, relatively speaking the high leverage home buyer has done better: your brother-in-law turned his $12,250 investment into $63,843 for a multiple of 5.2 while the more traditional homebuyer who put down $61,250 turned that into $107,633 for a multiple of 1.8. Both are good results but the higher leverage returned relatively more.
This points out an important fact—almost no one becomes wealthy from saving—the only way to wealth is through investing.
I also include in the spreadsheet a leverage summary—if you take your 25% down and buy 5 (rental) properties instead of one, you end up generating a ton more cash in five years: $197,307! Refer to the spreadsheet for details on how I calculate that.
Downside
Now for the downside: if the market goes down by more than 5%, you are upside down on equity. That means your equity is wiped out and banks will get very nervous. They may well refuse to renew your mortgage when the renewal comes up or will insist that you top up your equity so that, if they have to foreclose on the property or power of sale it, your equity may be wiped out but their loan is protected.
But in a market like we are experiencing now, you might find that the rental market actually ticks upward. As Banks foreclose more and more people—they have to live somewhere. Rental vacancies might go down and rental rates might actually increase.
Upside
But I like to remember what Warren Buffett has said many times over the years—“If you haven’t sold (stocks) in a down market, you haven’t lost anything. So why worry?”
This is also true in a down market in real estate. As long as your home or your rental portfolio can cashflow itself, stay with it. Real estate corrections happen but in Canada, the overall market direction is up by 2% p.a. or more over a very long period of time.
There have been many downturns in the real estate market but it is still the one, time-tested way of creating wealth for yourself and your family. Most of the great fortunes in Europe including Elizabeth Windsor, Queen of England, and the Holy Roman Catholic Church are largely real-estate based.
Types of Return
There are essentially three types of return in real estate:
a. cash on cash;
b. real estate inflation;
c. forced savings (this is a wealth effect) through the pay down of principal each month.
Cash on cash means that you are making some money from the property each month. You should NEVER buy property that is cashflow negative on a monthly basis hoping that inflation of forced savings will bail you out.
Real estate inflation and the wealth effect both accrue to the equity holder. This is why comedian and actor Chris Rock has said: “Shaq O’Neal is rich but the man who signs Shaq’s paycheck is wealthy.” If you control assets, you are wealthy or, at least, have the possibility of wealth.
Conclusion
I don’t believe that sub-prime mortgagees are to blame for the financial meltdown in the marketplaces of the global economy. They are being unfairly blamed. In Canada, we still have CMHC standing behind homeowners who can only come up with 5% down. Good for Canada!
The folks on Wall Street engineered complex financial products that practically nobody understood. They sold sub-prime mortgages as if they were prime mortgages and have done an incredibly poor job of managing those portfolios. Why should they care? They sold the portfolios and made huge fees. The suckers who bought them now are stuck with millions of mortgages, some of which they can’t even find the paper on. Try managing that.
It is always the poorest members of our society who pay for the ridiculous bonuses and fees paid to these people. Sub-prime borrowers, who can least afford it, pay the highest interest rates on their mortgages, their credit cards, on OAC financing in stores, for services they buy—everyone builds in an extra margin for risk for them.
Plus it is almost certainly the middle class, the poor and the SMEE sector who will pay for the bail out of Wall Street Bankers, Insurance Companies and major corporations who have enough political clout and can hire the best lobbyists, through higher taxes and more costly services. It has happened before—when Canadian Banks went out of their minds and loaned excessive amounts of money to Third World Nations in the 1980s (which were never paid back), ordinary Canadians and SMEES paid about two points more to the Banks for the next ten years to restore the Banks’ capital bases.
We should not allow banks to foreclose on properties where borrowers have solid payment histories just because the Masters of the Universe on Bay Street and Wall Street have gotten frightened and decided to shut down their funds and call their loans. This is counter productive, smacks of panic, craters the resale and new home markets and undermines 60+ years of efforts to turn our countries into nations of homeowners.
Prof Bruce
ps. if you want to learn more about HOW TO OWN YOUR OWN REAL ESTATE, read: