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The impact of mortgages on real estate investments
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Most real estate is not purchased with cash. Almost all buyers need to borrow a portion of the money that is used to transfer ownership of the property at closing. During the massive run-up of real estate prices, mortgage lenders satisfied the demand for homes by offering so-called "no money down" or 100% loan-to-value mortgages. Interest only, low initial rate, and other creative mortgages were created to help people qualify. But why did so many people want to buy real estate and create the demand for all of these creative mortgages?
Real estate is a very appealing investment. Unlike stocks and mutual funds, you can see land, walk on it, live on it, because it is tangible. Real estate has numerous tax advantages which were covered in the previous article in this series. Greed on the part of investment banks who developed complicated products based on mortgages was matched by the greed of buyers and sellers who believed that they could make fast profits in real estate. The banks and mortgage companies began to move from holding mortgages in their portfolio to simply originating and servicing mortgages that were quickly sold to keep them off the bank books.
Leverage is available on many investments, but only real estate allowed borrowers to leverage the entire purchase. Even when buyers borrowed only 80% of the purchase price, they still gained more leverage than someone who margined equities with a brokerage firm. Leverage increases the rate of an investments return. Recently, we learned the hard way that increasing return is not necessarily a good thing, particularly if the return is negative. Let's look at an example of the impact of leverage on the average home buyer.
This chart shows the impact that leverage can have on the return of the purchase and sale of a home when the buyer pays cash, borrows half, and borrows 80%. For simplicity, the costs of carrying the mortgage, maintaining the property, and the commission and closing costs are not included. The blue line the value of leveraging home purchases that we enjoyed for many, many, years. Many investors used leverage successfully to dramatically increase their wealth.
The red line illustrates the problem of the past few years. The example is the same, but now the house loses value and falls from a purchase price of $200,000 to $160,000. It is easy to see that the benefits of leverage also increase the risk.
The collapse of real estate prices for those who leveraged their investments in real estate caused an increase in the loss. As real estate grew rapidly in value up until 2006, investors and homeowners may have forgotten the risks of leverage. Some of them moved beyond home purchases to real estate investing and leveraged additional homes. In the examples, we ignored the costs of holding real estate. When those are considered, these mortgage payments, property taxes, maintenance, and utilities suddenly become very relevant. In many cases, it was the carrying costs that resulted in people simply walking away from their homes triggering foreclosures and in some cases bankruptcies to avoid the ongoing drain on their income.
Leverage is one of the biggest problems with the housing crisis. Until these mortgages are handled and the properties that are secured by them sold, we will not see an increase in real estate prices. The final article in this series will look at the role of government in the crisis and on the solutions that are needed to end the worst real estate crisis in decades.
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