I went out to lunch with a friend of mine that I hadn't seen since music college. Since then, both of us had moved away from music and on to other things. He was telling me about his plan to get rich. He had bought an apartment which he was going to rent out. His plan, over time, was to accumulate more of these until he had enough rental income to live on. Because he didn't have much money, he had large mortgages on the place where he was living and the new rental property. He didn't see this as a problem because of "there is only so much land" so over time the price of property must appreciate. The leverage of the mortgages meant that with only a small appreciation in property prices, he could double his capital.
Since then, there has been a boom in buy-to-let property investment in the UK, with huge media interest. A lot of people seem to think that it's a free lunch financed by cheap money from the mortgage providers.
In the normal world we know that if you need to shift a weight, you can use a lever. The heavier the weight is, the longer the lever you need. The leverage is the factor by which the lever multiplies the force you apply. In finance, leverage is borrowing money to invest. The borrowed money acts as a lever because you gain exposure to the risk (and hopefully reward) of investing the entire amount (the debt plus the original equity) and thus multiplies the "force" (volatility) of the investment. Asset managers and other professional investors often use leverage as a way of increasing returns from investments they are very confident in. If they have less confidence in a particular position, they will use less leverage.
A mortgage on property is a leveraged investment in property. For example, say I have a mortgage of 10% on a house with a market value of £100000. If the value of the house goes up and I am able to sell it for £110000 after all my costs, then I have £20000 so I have doubled my original equity. If, however, the price goes down by £10000, then I have lost everything. If it goes down by more than that then I cannot sell because I would not recoup enough from the sale to pay off the £90000 debt on the house. This is the so-called negative equity trap.
As well as the additional risk, there are also costs associated with leverage. These are the cost of the transaction (taking out the loan) and the interest charges. The interest charge in its turn introduces a further risk which is not present in non-leveraged transactions, the interest rate risk or the risk that interest rates will move adversely and make it more difficult to finance the loan. This is particularly important for property loans- when house prices depreciate and people are stuck in negative equity, they often find that interest rates on their loans rise when they are unable to sell and pay the loans off. Also, the interest is charged on the full amount of the loan, regardless of whether the property has gone down in price in the meantime.
If you buy a house or apartment to live in, it is different in many ways to if you are buying it with the intention of renting it out. Whereas a rental property generates income (a yield), the house you live in seems like a non-yielding asset. For this reason, many people think about their residence and the associated mortgage as separate from any savings or investments they may have.
Thinking about these things as being separate, however, does not help to make the best financial decisions. Instead you could consider that everyone needs a place to live and that there is a cost associated with that need. If you chose not to own your own residence then you would need to pay rent. Therefore if you choose to own your own home or apartment, it is reasonable to assume that it is yielding notionally the amount that you would otherwise have had to pay in rent because as we have said you have to live somewhere. This is helpful because it eliminates the unnecessary distinction between property that we own to live and property we might own to rent out, and also between property and any other investments we might have.
So what is happening when we take out a mortgage? Consider that two people, Alan and Bob, are both going to buy identical properties worth £100000. Alan is going to use all of his £100000 savings to buy the house for cash whereas Bob is going to take out a £90000 mortgage. Beforehand, Alan has £100000 in cash and after he has £100000 in property so it's pretty clear that he has sold £100000 of cash for property. Bob has done the same. He now has £90000 in cash, -£90000 in debt, and £100000 of property. This makes a big difference if Bob now decides to invest the remaining £90000 in some way.
Now the only cost Alan has is the cost of having foregone the gains he might have made if he had kept some cash, taken on some debt, and invested the rest. However, he has no interest rate risk. However, any investment that Bob makes now is leveraged. If interest rates change, he will be heavily affected, and he has a negative cash position so if asset prices move against him he may find himself in a position where he cannot sell because if he did he would not be able to pay off his loans. By selling cash and buying property, Bob is betting that the returns he can make from his investments will outpace any rise in interest rates. This is an outcome that most people would not be good enough investors to be sure of achieving.
Since everyone needs somewhere to live (built-in demand) and there is only so much land (restricted supply), the market in property seems to be structurally biased so any investment in property must work out ok if held for the long term, right? Well, maybe. In practice there are several problems with this line of reasoning. Firstly, the costs of holding on to the investment (maintenance on properties etc) could force someone out of the investment at a time when prices are depressed. This is even more likely if the investment is leveraged. Secondly, there are numerous inefficiencies in the housing market in general. There is little price transparency (it's hard to know what the going price is before you actually sell or buy), transaction costs are very high, and each house and area is different so property as a whole could make tremendous gains but the sort of property you are holding in the places you hold it might prove disastrous. Because it is so expensive to buy property very few people can afford to diversify by owning several properties of different sorts in different areas. Like everything else, there's no free lunch. The property market seems full of ill-informed people and ill-informed money and greed has overcome fear. If there is a crash a lot of people will lose a lot of money, and a lot of them will have taken on much more risk than they otherwise would have because they don't really understand leverage.
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Last modified: Thu Jun 1 15:09:36 2006.