Leverage Epiphany

[legion]

A comment on the RE thread got me thinking...

When one can buy an asset with leverage, does that allow the price of the asset to become detached from its intrinsic value?

Some examples:

Stocks. The intrinsic value of a stock is the net present value of future dividend payments. Based on a quick scan of PE ratios, most stocks trade for many times their intrinsic value.

Homes. The intrinsic value of a home, adjusted for inflation, and barring some change in circumstances (like a toxic dump is built next door), should never change. Yet on the coasts, home values have doubled, tripled, quadrupled or more in the last ten years.

Education. The cost of college should be less than the net present value of future earnings to be worthwhile. I don't think this is true of all colleges anymore.

Does the fact that these are commonly financed with someone else's money mean that people are more likely to speculate with their purchase? The are more tolerant of price increases that depart from intrinsic value because they anticipate future gains will go up even more?

In all three examples, I think if financing the purchase of these assets was impossible, then prices would be both stable and lower. If people had to spend real money (and not borrowed money) on them, then their costs would be more closely weighed against their intrinsic value.

[jluetjen]

I'll jump in. Leverage is like anything else (including guns) -- it can be used for good, or bad. Some examples...

1) The Good: For most people, owning a house is a long term thing. They live in it for 20 or 30 years, then sell it when the kids have moved out and they don't need the space after which the built up equity gets added into the person's retirement savings. In this case, borrowing is a good thing since it allows a person to pay for the house "as they consume it" (in economic terms), and this allows it to be a better deal then renting. Compound that with the fact that most 1st time home buyers don't have the cash to buy a house outright. The only people who have that kind of value built up will be the people selling their house, and they're generally not interesting in buying a bigger house. So without leverage, everyone's house values would be in the tank because the market would be tiny since lots of people couldn't afford to buy a house.

2) The bad: Some people buy houses merely as investments (not bad in itself) and then leverage themselves to the hilt with OPM (other people's money) on a bet that the value of the real estate will go up. That's all well and good as long as a) the property values go up and b) the buyer can make the payments. If either of those two things (not even both, but either) happens to go south, you've got big problems.

As long as the people in case 2 are a relatively small portion of the market, it's not a big deal. But if a large portion of the market invests in such an unwise fashion, then the whole economy will have major problems.

Just my (and not someone elses) $0.02...

[on-ramp]

Unless you downsize when you sell or you become homeless, your primary residence is never a good investement. It's a huge liability.

Your house is not a profit-maker , it's not about losing or making money.
it's about enjoying the neighboorhood and living there, and enjoying all the amenities it has to offer, like a garage to park your beloved 911 instead of leaving it out in the street all night.

[berettafan]

Originally posted by on-ramp
Unless you downsize when you sell or you become homeless, your primary residence is never a good investement. It's a huge liability.

1-it's no more a liability than the rent payment you will need to make the rest of your life in order to have shelter.

2-unlike renting there is a correspondingly 'huge' asset on the books as well.

[on-ramp]

"asset" is misleading. sure your house is an asset. but you can't sell it. if you do, where will you go? back to rent?

[berettafan]

No, it isn't misleading.

Tell you what, you rent for the next 20yrs and i'll own. After 20yrs i will have r/e taxes and insurance to pay. The rest can go towards a GT3RS, track time and a built in lift in my garage. You, on the other hand, will still be paying rent to 'the man'.

Oh, and my son will have something to inherit other than funeral expenses.

Oh again, i won't have to worry about a landlord deciding to sell and leaving me looking for a home to rent.

Oh and i might just say ef' it when the final payment is made and greet people at walmart as my retirement job.

Mind you, i am operating under the assumption that my mortgage cost, net of tax benefit, is comparable to your rent cost. The rent you are paying builds -0- equity. The mortgage i am paying builds something greater than -0-. There is no opportunity cost given those assumptions so it's a pretty simple scenario to examine.

[berettafan]

Almost forgot, in answer to your question about where i will go; if i have accumulated any equity i will have cash that you do not have which i could presumably use to pay my rent whilst i sit home in my underwear watching Law and Order reruns.

[on-ramp]

Originally posted by berettafan
No, it isn't misleading.

Tell you what, you rent for the next 20yrs and i'll own. After 20yrs i will have r/e taxes and insurance to pay. The rest can go towards a GT3RS, track time and a built in lift in my garage. You, on the other hand, will still be paying rent to 'the man'.

Oh, and my son will have something to inherit other than funeral expenses.

Oh again, i won't have to worry about a landlord deciding to sell and leaving me looking for a home to rent.

Oh and i might just say ef' it when the final payment is made and greet people at walmart as my retirement job.

Mind you, i am operating under the assumption that my mortgage cost, net of tax benefit, is comparable to your rent cost. The rent you are paying builds -0- equity. The mortgage i am paying builds something greater than -0-. There is no opportunity cost given those assumptions so it's a pretty simple scenario to examine.

I agree with everything you said above.. I would rather own a home than rent. I guess I didnt do a good enough of a job explaining my other post about your home not being a good investment... I was trying to make a point that it's not a good investment from a point a view that yo ucan realize a gain and bank your profit...it's not like a business where you post net profit, etc..

[Bill Verburg]

Originally posted by legion
A comment on the RE thread got me thinking...

When one can buy an asset with leverage, does that allow the price of the asset to become detached from its intrinsic value?

No, leverage is just buying an asset w/ a relatively small cash deposit and hoping that the asset will appreciate in value. If it does you still only owe the contract price less downpayment and interest expenses. The 100% subsequent appreciation is realized when the asset is sold. Your cost becomes only the subsidized interest on the loan.*

Leverage works both ways
buying a house is generally good leverage because you get to live in it and get the benefit of the appreciation
buying a car is generally bad leverage because even though you do get the use of it, it is a depreciating asset which becomes a realized loss when it's sold. Here your cost is the principle amount less interest(if any) and depreciation.*

*ignoring maintainance and taxes

W/ stocks it works the same

buy a $10 stock w/ $1 cash and $9 loan*
if it appreciates to $20 sell, you get $20 - $9 - interest on the loan(say $1) = $10 net on a $1 investment thats 1000% gain as oposed to a 100% gain if you paid cash for the original $10 stock.

Of course if it depreciates then you are in trouble.

*ignoreing brokerage fees and taxes

[berettafan]

AHA! The idea here is that one doesn't spend additional monies on a home just on the thought that the appreciation MIGHT be better than on a home that has everything they 'want'.

I agree with that! Good to be on the same page!

[jluetjen]

Bill; To make the point clear (because people always ignore the possibility of a bear market), you really need to spell out the downside of leverage. Using your example it goes like this...

buy a $10 stock w/ $1 cash and $9 loan*
if it deappreciates to $5 sell, you get $5, - ($9 + interest on the loan(say $1)) = -$5 net on a $1 investment. So now you've lost your dollar, and you owe $5 to the bank.



In the absence of an effective diversificiation strategy to help you ride out market swings like that, being heavily leveraged is a very risky bet -- as many homeowners are finding out who bought too much house without ample cash flow to make effective payments, and with too much money down on 0 interest loans that are starting to convert.

[jluetjen]

Originally posted by legion

Does the fact that these are commonly financed with someone else's money mean that people are more likely to speculate with their purchase? The are more tolerant of price increases that depart from intrinsic value because they anticipate future gains will go up even more?

Personally I think that it's more a case of people not understanding the liabilities and risks that they are signing up for when they borrow money. Look how many people run up massive credit card debts, just because someone's willing to give them a card. They don't stop think about how they can pay for the 997GT3 that they just borrowed money for. They figure once they get the money, that they'll be able to sort it out. But then before they really start to feel they payments they buy 240 inch, hi-def TV. Then there's the trip to the Europe. One day they wake up and discover not that they've bought something that they couldn't afford, but that they've bought about 6 or 8 things that they couldn't afford.

[Moneyguy1]

Ups and downs of house values should not be a factor. Gains and losses are on paper only until the property is actually sold. But one should consider the "reverse mortgage" concept although. If the house is paid off, one can, if necessary, tap into the value, assured of a place to live until either death or move to an assisted living facility. Retiring with a mortgage is unwise if it can be avoided.

I wonder, with all the emphasis on "leverage" and the vagaries of real estate and commodities, how many people will find themselves at 60 or so, unable to retire and God forbid their health goes south. I am very conservative with money and for me it has paid off in the long run. Retired early for 6.5 years now and haven't touched a nickel of investment money. Think it was easy? Instant gratification ain't for the long haul!!

[on-ramp]

the problem with "retirement" is that life doesnt begin at 65... people make 30 and 40 year retirement plans but fail to make 5 and 10 year plans. how silly.

[berettafan]

Originally posted by on-ramp
the problem with "retirement" is that life doesnt begin at 65...

And that's where simple math fails us i guess. quality of life and living in the 'now' changes everything, or at least many things.

[jyl]

Originally posted by legion
A comment on the RE thread got me thinking...

When one can buy an asset with leverage, does that allow the price of the asset to become detached from its intrinsic value?

Some examples:

Stocks. The intrinsic value of a stock is the net present value of future dividend payments. Based on a quick scan of PE ratios, most stocks trade for many times their intrinsic value.

Homes. The intrinsic value of a home, adjusted for inflation, and barring some change in circumstances (like a toxic dump is built next door), should never change. Yet on the coasts, home values have doubled, tripled, quadrupled or more in the last ten years.

Education. The cost of college should be less than the net present value of future earnings to be worthwhile. I don't think this is true of all colleges anymore.

Does the fact that these are commonly financed with someone else's money mean that people are more likely to speculate with their purchase? The are more tolerant of price increases that depart from intrinsic value because they anticipate future gains will go up even more?

In all three examples, I think if financing the purchase of these assets was impossible, then prices would be both stable and lower. If people had to spend real money (and not borrowed money) on them, then their costs would be more closely weighed against their intrinsic value.

This is a really interesting question.

I think more leverage would tend to mean higher prices. For a couple of reasons.

First, think about how prices are determined. For most assets, the "value" is a matter of opinion, and among reasonable people there will be a range of opinions. The people who think the value is higher (call them the optimists) will buy from the people who think the value is lower (call them the pessimists), until the price reaches some equilibrium. But some of the optimists don't have enough money, so they can't act on their opinions, i.e. can't buy. If the optimists have easier access to money, more of them can buy, so there's more upwards pressure on the price.

Second, just looking at history, rising asset prices and price bubbles often tend to be associated with easier access to money. In the stock market, one thing people look at is how much margin buying is going on.

Third, in finance theory, the "intrinsic value" of an asset is the net present value of the future cash flows - discounted cash flow (DCF) valuation. The discount rate is determined by the riskiness of the future cash flows and the current risk-free interest rate. So when interest rates are low, discount rates tend to be low, and NPVs tend to be high. (Look at a long-term chart comparing the PE of the SP500 to the 10-year interest rate, the inverse correlation is obvious.) Well, periods of low interest rates also are often associated with easier access to money.

There might be other reasons too. More leverage means more ability for speculators to buy (since they can borrow). More leverage can also mean the reward-risk looks asymmetrical (house price goes up, your profit is magnified by leverage; house price goes down, you hand the bank the keys and walk).

So basically I agree w/ you.

I might disagree on a couple of details.

On stocks, I would not say prices are many times intrinsic values. Curious how you are calculating this. If you do DCF valuation on the market, you won't find a 2X over-valuation.

On houses, you have to look at the long-term price trend. Over the past 40 years (as far back as the OFHEO data goes), the increase of home prices in California have roughly matched the stock market, roughly 8%/yr. Home prices boom and bust, so trough to peak (boom) looks like a huge increase but don't forget the peak to trough (bust). If you consider the growth in incomes, wealth, and rents in the coastal cities of California over the past 40 years, 8%/yr doesn't seem unreasonable to me. (If you go far back enough in this thread, I think I've posted on this.)

On education, I dunno. I know a Harvard MBA opens te door to a hell of a lot in future income (assuming the diploma-holder does his part), but I doubt a Harvard Masters in Medieval French Literature is worth much (financially speaking). No idea how to do the valuation.

[alf]

Originally posted by legion
A comment on the RE thread got me thinking...

When one can buy an asset with leverage, does that allow the price of the asset to become detached from its intrinsic value?

My epiphany with debt is that it is better to be the lender than the borrower. As Einstien said, the most powerful force in the universe is compound interest.