Why 'The Second Half Of Your Home May Be The Worst Purchase You Ever Make...'

January 2019

I posted a teaser at the end of 2018 for a post on why economists from some of America’s top universities say that, “the second half of your home may be the worst purchase you ever make.” That’s a direct quote from Housing Partnerships, a book written by Andrew Caplin, Sewin Chan, Charles Freeman and Joseph Tracy. I was introduced to it a couple of months ago and in under 240 pages the authors are able to pretty effectively detail the housing finance system in the United States — its history, inner workings, strengths and weaknesses.

For the last year and a half, I have been pitching and then more seriously working on a project in the housing finance space. The data around “homeownership” tells two different stories. While both originate from the same viewpoint that owning a home is an important determinant of wealth, it’s the bottom 90% of households in America for whom this can have adverse effects. One perspective is that the franchise of homeownership has been successful avenue for building wealth, therefore maintaining it is important. However, the other perspective is that. American households are too financially reliant on this one asset, for both physical and financial shelter. Both positions are a result of the all-or-nothing, all debt market structure.

I found validation in Housing Partnerships, because it almost completely aligned with these ideas. Furthermore, my thoughts that the housing finance system as it exists stands to be improved and equity financing could be one of path. While, I was pleased to see there was a group of very intelligent individuals who shared my sentiments, I’ve been diligently working on a way to. give momentum to this conversation. This post is. giving me a venue to express thoughts as it relates to housing in hopes to get more people thinking about the shortcomings and the potential for innovation.

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Key Takeaways:

? The current housing system is based on an all-or-nothing, all debt model. If you want to make the leap from renting to owning it means jumping from 0% ownership to 100% ownership all upfront. Essentially, there is no way to divorce housing investment from housing consumption.

? The result is a significant funding gap. A mortgage is the most readily available bridge today.

? The mortgage market for Main Street is beholden to the capital markets of Wall Street.

? Most mortgages are not held on the books of banks, but rather are packaged and sold to investors. This is why the mortgage industry is as robust as it is.

? Examining the factors of utility and risk between these two groups presents an opportunity to innovate on the current system structure.

? What is Utility?: Is buying a home consumption or investment? In the ideal scenario it is a bit of both but the current system structure doesn’t support it and this erodes affordability.

? What is Risk?: Overextension on debt and over exposure to a single home makes homeownership today a risky proposition.

? Investors have a different utility function and risk profile when it comes to housing. This creates an opportunity to solve the issues in the consumer market.

? Innovation in housing finance has been limited to figuring out how to make a mortgage cheaper or more accessible. That’s a reasonable goal, but no thought has been given to whether there is something other than or in addition to a mortgage that could help.

? I put forward the idea of fractional ownership as a potential solution to turn the binary tenure choice into more if a sliding scale. Either through a new type of lease that allows equity building or a new type of debt-free home purchase financing.

? A version of both does exist — rent to own and down payment assistance — but neither are perfect and do not have a scaling machine behind them like Fannie Mae.

? A solution is just the first step. Product education will be crucial because the concepts of renting and owning are so entrenched.

Second Half??

So back to the question at hand: why might the second half of your home turn out to be one of your poorest purchasing decisions? It’s well regarded by many in America that homeownership is the most important factor in determining a household’s wealth. We as humans are not wired for saving, and a mortgage essentially turns one of your largest, most consequential expenses each month into an opportunity to do just that. In fact, homeownership via mortgage is empirically the most effective individual forced savings program to exist. Beyond that it’s heavily promoted in our society, so it has to be “good”, right? From the tax policy to social and economic status signals — owning a home is encouraged over renting.

Therein is the crux of the problem. Housing tenure is an all-or-nothing choice — buy or rent. The current market does not allow a household to separate its housing investment from its housing consumption. If you want to buy or just don’t want to rent, you have to buy the entire home today. And that’s typically done with debt. The problem baked into this market structure is that consumers cannot act in the best interest of their utility for and risk to housing choice. I will devote a section below to each.

The idea at the root of this article’s title is that you should be able to consume the entire home from day 1, while making the investment amount in said home of your choice. Furthermore, making additional investments incrementally. For example: you find a $300,000 home today that you personally invest half and get outside investors to buy the second half (which you could always buy from them at a later time). That other $150,000 that you are not sinking into the home is therefore, freed up for other things like paying down debt, borrowing to start a business, or building a portfolio of stocks and bonds.

Mortgage Industry: The Cliff Notes

The mortgage industry is kind of boring and esoteric, but some of this context in this blog is necessary to appreciate the necessity for change. Buying a home is a large purchase, so unless you have a bucket of cash sitting around it requires financing. Financing comes by way of a mortgage for most people. A mortgage is a massive personal piece of debt, secured by a lien on the home. Let’s break that down: personal = it’s in your name and bankruptcy is the only way to remove the effects of the liability outside of paying it off, massive = a multiple of your annual income (2.0x in cheap markets and up to 12.0x in some expensive markets), debt = a fixed payment, due every month no matter what, and lien = first claimant on the home, which is why a foreclosure can happen in the event of non-payment.

A mortgage is sold to consumers by a lender. There are a bunch of lenders, and the categories are defined across two main dimensions — bank vs. non-bank and portfolio vs. non-portfolio. Wells Fargo and your community bank are clearly banks, while a company like Rocket Mortgage is a non-bank lender. Both make mortgage loans to give prospective buyers the cash they need. That’s the primary market in a nut shell.

In the case of non-portfolio lenders, they have a limited amount of capital, so in order to keep making these loans they typically sell a big chunk of each loan to a secondary player like Fannie Mae or an investment bank. These “secondary players” then bundle a bunch of these loans together (a process known as securitization) and resells them to investors like pension funds and insurance companies. Portfolio lenders on the other hand raise money directly from these investors and in some cases do their own securitization. Large investors have an appetite to participate because these investments are only marginally more risky than government bonds while providing a better interest rate. Also, they are pretty uncorrelated to the stock market.

In either scenario, your home purchase (read: your mortgage) on Main Street is made possible by Wall Street investors who have a different utility and risk profile when it comes to housing. It is that mismatch on these two characteristics between these two stakeholder groups that I believe has not been adequately explored.

Utility Factors

Housing is a very unique item. Not only is it unlike other commodities because homes are completely heterogeneous (meaning it’s virtually impossible to find two homes that are exactly the same), but a house falls into an interesting debate between consumption item (is it a consumer durable good?) or an investment (is it more like a capital good?). My opinion is that a primary home (i.e. the home you live in) purchase is really a little bit of both.

It’s shelter that is used over time, but one could make the argument that the housing services and storage of wealth that it provides can increase the productivity of the owner-occupant and generate a financial return. The problem is that the current market doesn’t support a home efficiently serving as both, because it doesn’t support the disaggregation of housing consumption from housing investment. Essentially, if you want to invest at all you must invest at least as much as you consume.

In terms of utility this is in most cases a mismatch. This becomes clear when you think about household size. The amount of home that is useful to you as a single person vs. a married couple vs. with children varies. Other preferences factor in too, such as property type (single family home vs. an apartment) or location (downtown vs. suburbs). These parameters can substantially change the the amount of house you need to consume and more importantly the cost of said home. The influences on your consumption needs are clear, but the same cannot necessarily be said for your investing appetite for housing. People generally have to constrain their consumption needs by their investing budgets when it comes to housing. This is fine but imagine how equity financing could loosen that constraint.

Next, I believe it is important to consider whether there should be a distinction made between an investment and a storage of wealth (i.e. savings). Through a mortgage and the paying down of the principal over time it becomes a literal piggy bank that stores your cash and does much better to keep up with inflation than a typical savings account. It is this feature that keeps the consumption versus investment argument alive. I think a home is a reasonable storage of wealth, but things get muddy when the expectation is to make more than a nominal profit from your home.

This brings me to a related point on the current system structure. It fundamentally pits two concepts we constantly are talking about when it comes to housing at extreme odds — affordability and invest ability. There is an article from City Lab, that discusses how housing cannot be both a good investment and affordable. Their point is that in order for it to be a good investment, it must increase in value over time more than inflation.

That works only if the subsequent purchaser is able to afford this higher price. The article’s authors refer to homeownership as a “Ponzi scheme” predicated on a cycle of “massive up-front transfer[s] of wealth”. While I think that goes too far, the logic is reasonable. If incomes are not keeping pace with inflation or home prices are outpacing inflation, or as the situation stands now — both of these things are coinciding, it’s easy to see how homeownership can quickly become unaffordable. To this point, more than the “buyer culture” in America I fault stagnant wage growth for homeownership inaccessibility. We shouldn’t be asking people to take on more and more debt that their incomes do not support to purchase a whole home. I will discuss more about incomes in the risk section.

This all coincidentally lines up well with the utility ascribed to housing assets for large institutional investors. Unlike occupants an investors utility is entirely financial. This creates the perfect opportunity for partnership with occupants that have both a utility for consumption and less so one for investment. Though their utility is purely financial, housing investment offers a very particular set of benefits.

Large scale, investors like pension funds and insurance companies have long-term liabilities which are linked to inflation. Owner-occupied housing is the perfect asset to match those liabilities. US Housing is a more than $30 trillion sector. It makes up a significant portion of GDP (read: the economy) and the CPI (read: inflation). But it is largely inaccessible in any efficient way. The only way to get scaled and diversified exposure is to become America’s landlord — finding, acquiring, and then operating the properties. The cost of search, acquisition and operation of a single property let alone a portfolio is expensive. For this reason the investment in the second half of your home provides more financial utility to investors than to you, presenting an opportunity.

Risk Factors

The other category of factors that make the second half of your home a not so great investment is “the risk”. There is a massive wealth gap that exists between owners and comparable renters. The gap is mostly made up by the value of the home. This implies the primary residence is overwhelmingly the most significant component of a household’s wealth. This also means the household’s financial future is very tightly linked to how their home performs. A financial advisor would never tell their high net worth clients to put the bulk of their financial wherewithal into a single, illiquid and highly volatile asset, but this is precisely what the average American is doing when they purchase a home in the current system.

Starting with the topic of illiquidity. When one purchases a home it does create a sort of piggy bank, where each month as the principal on your mortgage gets paid down, you build equity. To ensure that everyone is on the same page, home equity = home value — mortgage balance. Home value increases and mortgage balances decreases result in more home equity. This is your wealth as a home owner, but unlike your savings account that you can freely access, this savings is tied up. That’s what is meant by illiquid — it is difficult to convert to cash.

Today, there are three pathways to liquidity. The first is to sell the home, repay any outstanding mortgage and keep the rest of the cash. The second is to get partial liquidity by taking out a second mortgage in the form of home equity loan or line of credit. Thirdly, there is something called a reverse mortgage. Method #1 requires you to find a new home to rent or buy. Method #2 creates a new monthly expense. And method #3 can only be employed once your mortgage is almost entirely paid off, and results in losing ownership in the home at the end. Additionally, all three of these methods are potentially time consuming and definitely costly. Also, the intended benefit of pulling equity out of the home in any of these ways, is dependent on a good market and good use of funds.

There is definitely some benefit to the liquidity barrier. People struggle with savings partly because they never set aside the funds to begin with, but also because they are equally as undisciplined in “keeping their hands out of the cookie jar”. This illiquidity keeps you from leaking funds out of your savings over time. However, it also creates bigger barriers to accessing that savings — which I have discussed is the biggest component of household wealth — in the case of emergency.

Next, is the overexposure that has historically resulted from the franchise of homeownership. If you think about all your assets as your household’s financial portfolio, overexposure is having that portfolio over weighted toward a particular asset or asset class. Portfolio diversification (even at the household level) is important because it’s a way to reduce risk when things go sideways. You can imagine if all your wealth is tied up in Facebook stock and something goes wrong at the company and the price drops dramatically. Your wealth would be wiped out. This is the equivalent of having all your wealth tied up into a single home.

The issue is something called idiosyncratic risk. Idiosyncratic or unsystematic risk can be defined as the risk which affects a particular asset (e.g. a Cambridge Analytica scandal for your Facebook investment or the discovery of a sink hole in your backyard for your home investment). It can be almost eradicated through diversification, something that is not accessible in homeownership today. This tends to be the case, because in order to purchase you must invest in the whole home and that investment is massive compared to any other purchase you’ll make. And we are naturally undisciplined savers.

According to a working paper by economist Edward Wolff, the primary residence makes up approximately two-thirds of the average American’s household wealth and roughly 30 percent of households have zero or negative non-home wealth. The ideal scenario is to have a mix or stocks, bonds, real estate, cash, etc. that match your lifestyle and future goals. This is the strategy employed by wealthy individuals, but it shouldn’t only be reserved for them.

Many people cite leverage as a positive aspect of using a mortgage. I do not disagree, but gearing is something that should be done responsibly. Making a small down payment and taking on a high loan-to-value mortgage can amplify your returns if everything goes right, but the scenario less often considered is what if home values stay the same or go down? In that case, a high LTV mortgage becomes a major liability. This is because the likelihood of negative equity increases greatly.

Negative equity is when you owe more than what the home is worth. Negative equity has a few major implications: (1) some people choose to strategically default and walk away instead of repaying a loan that’s more than the value of the thing it is securing, (2) it can prevent you from being able to refinance, and (3) it can prevent you from being able to move because if you sell, you will either owe additional cash to the lender or in a best case scenario breakeven with nothing to show for your time in homeownership.

This brings me to my final point about risk. It is linked to the topic of overexposure. Essentially, housing like all other real estate sectors is very localized. Buying a home is to take a massive, potentially hard to liquidate position in a single local economy. You are betting on that economy, and the wager is very consequential. A person needs to understand, and examine the relationship between incomes and housing. The price of housing (either to purchase or rent) is highly correlated with incomes. This means that as the cost of housing trends up or down, income is likely trending in the same general fashion. This is easy to understand considering the following: well paying jobs bring more people, and without an increase in supply (which always comes with a lag) the increased demand drives up the cost of housing and just the reverse if good jobs leave an area. In an upward trending market, homeowners benefit while renters lose. Homeowners’ monthly cost of housing is locked in and they can sell their home for more than what they bought in at, while renters have their housing costs subject to increase at the discretion of their landlord based on the market rate. In a downward trending market, renters benefit while homeowners lose. As the market softens, renters have the ability to reset their monthly rental payments while homeowners have their fixed payment. If a homeowner wants to sell they would likely have to do it at a loss.

Institutional investors have the financial wherewithal and incentive to invest small amounts across a portfolio of homes. This is in contrast to an owner-occupant who is making a very large investment in a single home, for which its most important purpose should be shelter. The portfolio approach, diversifies away the majority of the idiosyncratic risk of a single home. These fractional ownership investments also offer price exposure that is uncorrelated with the equities market. This altogether means an investment in the second half of your home is in theory financially worth more to investors than to you on a risk-adjusted basis. An arrangement could be made whereby owner-occupants can sell a small investment in their homes into a portfolio for investors. Selling that chunk means less exposure to that single home, provides the financial bandwidth to get exposure to other assets, and a lower loan-to-value.

The Challenge

Most of the innovation to make financing a home purchase safer, cheaper and more accessible has happened entirely on the investor side of the mortgage process (e.g. the government sponsoring FHA and VA loans, the establishment of Fannie and Freddie, securitization, etc.). However, housing finance on the consumer side hasn’t seen any major innovation since the Great Depression with the invention of the mortgage as we know it today. Before the Great Depression homeowners were forced to refinance every year. Now we have mortgages that feature variable interest rates, short matures, and low down payments but the only product category we still have is…the mortgage.

Make no mistake, the mortgage is important. It has granted working class households access to the franchise of homeownership. The side effect has been having the wealth of the middle class entirely propped up on it. We’ve all heard the expression, “don’t put all your eggs in one basket”, but that has become the “American way” that has been taught to us. But the cracks in the fa?ade of the American Dream are only revealed and paid attention to in times like 2008, when home prices dropped and wealth was devastated. We need to be thinking about risk management products for homeowner at all times.

No, I’m Not Saying Don’t Buy A Home

This should not be viewed as an attack on the institution of homeownership or the mortgage. As discussed earlier it is a proven saving and wealth accumulation tool. Every month, a part of your payment for housing services is saved away in an asset that generally keeps pace with inflation (or in other words, does better than sitting in a bank account). Conversely, it is also difficult to access, which means the saving is even more disciplined. There are also the intangibles of homeownership, namely agency. As a homeowner you have the ability to make changes to the home and generally live freely in a way that you cannot as a renter. Also, you have more of an interest and say in what’s going on in your neighborhood and the local government.

When it comes to a mortgage there are things about it that make it great that should not be overlooked. One big one is leverage. I discussed the downside of debt but the other edge of that sword is leverage. A big mortgage means you can “leverage” a rather small down payment to make a big purchase which can substantially increase modest returns. For example, the average down payment is 5%, which means your leverage is 20x. In practice, that means a 3% value increase translates into a 60% return on your investment.

Other beneficial features, include the tax incentives, the cost of capital, and the simplicity and standardization. When you have a mortgage, any interest you pay on it is tax deductible. So is the amount that you pay in property taxes. If you use a traditional fixed rate mortgage, your payments are set and predictable. Additionally, the cost to borrow (i.e. the interest rate) on a traditional mortgage is generally pretty low, because the market is so robust. And finally, a 30-year fixed rate mortgage is like a scoop of vanilla ice cream. Everyone is familiar with and it seems approachable. Adding complexity to personal financial choices can be a slippery slope to predatory practices (see: the subprime variable rare mortgages a decade ago). A reasonable approach seems not to replace the mortgage but to find a complement for it.

Solutions

With everything discussed above, I think it is important to highlight what I feel are some areas of academic and commercial research to be explored. All of them aim to carry forward the conversation on why ‘the second half of your home may be your worst purchase’ and what innovations in policy or business could be made to address the roots of that question. I’ll highlight a few below.

First, is tax policy. All of the tax incentives sit with the property owner, therefore as a renter you miss out. The main difference in the occupant-investor relationship between leasing and buying a home is in one scenario you are renting the property and in the other you are renting the money. The rent payments on the money are tax deductible, but not on the property. I’m guessing a data-driven argument could be made to push a policy change here.

Second, I’ve talked about the power of forced savings. A mortgage does this reasonably well, the problem is the savings end up concentrated entirely in the home. There should be a way to tweak this feature to allow more diversified asset building at the household level.

Thirdly, consider breaking down the binary nature of the housing tenure choice. Instead of the rent or buy, there seems to be room and consumer appetite for more of a sliding scale. The first option could be in the form of new kinds of leases. Take for instance, a lease agreement with the option to build equity in the property or an individual savings account each month. The first alternative is a model that exists in the U.K. they refer to it as ‘laddering’. It has had mixed success, mainly because it is missing the forced saving element that exists with a traditional mortgage. In essence, people never opt to build up that equity.For this reason, I’m personally more inclined to get behind the idea of new financing options. What I mean by this to introduce non-debt capital as an alternative or more likely a complement to a mortgage for a household to use when financing their home purchase. I refer to it as non-debt financing, because unlike a mortgage it would not be a loan. It would likely not have any monthly payments, and the return for the investor would come via a share of future home price appreciation. Non-debt financing or in other words equity financing would also break down the all-or-nothing nature or the current housing market.

It would allow passive partners the opportunity to invest in the housing market without having to become a landlord. Combining an “equity investment” with a mortgage would preserve the owner-occupant’s tax advantages of a mortgage and ownership while also allowing them to take on less debt and risk. Essentially a home buyer/owner could sell the investment in the second half of their home to investors who have a higher financial utility for it. There is also an opportunity to pool these equity investments into a portfolio that can be sliced up and sold in order to diversify away much of that idiosyncratic risk mentioned earlier. This last piece would mean establishing an entity similar to Fannie Mae for equity investments in homeownership.

Finally, I am a proponent of exploring this route because it would finally permit a household to separate how much house they consume versus how much in which they invest. This means better diversified household portfolios, and this is particular important in neighborhoods of color. Those are areas where the valuations are notoriously depressed until gentrification begins to happen and current community members are displaced without getting to participate, nor benefit from the revitalization. Equity financing could be a tool for more equitable gentrification. In theory it could serve as a path to spatial integration on a racial or socioeconomic basis via capital investment. Obviously, these things happen in an idealistic setting but I think this presents a great opportunity to discuss the impact of the current housing finance system on neighborhoods and the racial wealth gap and how new innovations may be able to address certain longstanding issues.

About Me

I’m a concurrent degree candidate earning an M.B.A. from MIT Sloan (concentrating on entrepreneurship) and M.P.A. from Harvard Kennedy School (concentrating on behavioral economics and housing). I’ll graduate Spring 2019. I also hold a Bachelors in Industrial & Systems Engineering from Georgia Tech (concentrated on financial engineering). Between undergrad and grad school I worked on Wall Street in real estate investment banking for a little more than six years. Since high school, I’ve always prioritized finding new ways to learn and grow in subjects to which I feel personally connected and/or have interest. Before the last year, I had a difficult time drawing line through the points on my resume, but then I started working on Chord and suddenly it all made sense. I like to say that it wasn’t necessarily my plan but it was a plan made for me.