HOFFMAN,
WHITE & KAELBER FINANCIAL SERVICES, LLC
Investment
managers & Financial Advisors
October 2, 2004
This is the October 2004 monthly Wealth Management newsletter from Hoffman, White & Kaelber Financial Services, LLC. If you do not wish to be included in our circulation, please reply indicating your desire to be removed and we will be happy to oblige. Alternatively, any of your friends or colleagues may receive this on a regular monthly basis by sending their name and email address to info@hwkfs.com. Feel free to forward this to any of your friends who may find it useful. Thanks for your interest and I hope you enjoy the letter.
How can we tell whether a house is likely to be profitable
or not? Residential real estate is
usually valued by looking at “comps” – the prices paid for recent transactions
involving comparable homes. Comps can
help us judge whether the price of a particular house is high or low relative
to the prices of other houses in a given neighborhood, but they tell us nothing
about whether housing prices are high or low in an absolute sense.
Some clients ask questions about housing prices. First time buyers might ask if now is a good
time to buy; while clients who already own may ask if trading up is a good
investment or if downsizing is a good financial move. We have also had clients ask if we are in a
“housing bubble” and if they should sell their houses and rent until sanity
returns. All of these are great questions. In fact, shouldn’t a transaction this large
be analyzed with at least as much care as other investments?
This month’s letter will discuss some critical questions to
ponder for anyone considering buying, selling or remodeling a home and a
methodology to help guide you toward making better decisions. Lastly, and as always, we will finish with an update on our
investment activities.
The Rent Versus Buy Alternative
Most real estate experts realize that renting is an alternative to buying a
house, but often they simply list the pluses and minuses of buying versus
renting rather than help guide your decision to buy or not. So how do you decide what to do?
The best way to answer the question of whether a house is a good or bad investment is to think of houses the same way we think of stocks. When financial analysts consider buying stock, the proper question is not whether it is a good company, but whether the stock is cheap or expensive. Is it worth the asking price? When we consider buying a house, we should ask the same question – not whether it is a good house, but whether the house is cheap or expensive. Again, is it worth the asking price?
It is widely believed that the intrinsic value of a stock
depends upon its expected future cash flows.
The same holds true for a house, with the wrinkle that one of the
financial benefits of owning a home is not having to pay rent to someone
else. Therefore, the primary cash flows
from owner occupied housing is the rental payments a homeowner would otherwise
have to pay.
In this letter we will discuss a
well established procedure that is widely used to value bonds, stocks, business
projects and commercial and industrial real estate transactions. It can also be used to value owner occupied
houses.
One effective way of addressing this issue is to determine
the net present value of anticipated cash flows from owning a house. The intrinsic value calculations for a house
are a little involved, but lets begin to walk through some of the
considerations.
Consider the unlikely case where you pay cash for a house,
similar to how you might pay for a stock.
Just like a stock, your rate of return consists of both income and
capital gain. The income from a stock
comes from the dividends. If you pay
$100 for a stock that currently pays an annual dividend of $1, the income is
1%; if the stock price increases by 6%, your total rate of return is 7%.
For a house, the income is the rent you would pay reduced by
the expenses associated with owning it.
For example, as a renter, lets say you would pay $33,000 a year – or
$2,750 per month – for a particular house.
Home ownership would implicitly provide $33,000 that you would otherwise
pay someone else. On the other hand, as
a homeowner, you will have to pay real property taxes, insurance, maintenance
and some utilities that would ordinarily not be paid by a renter. If these expenses are $15,000 per year, then
your annual net cash flow is $18,000. If
the house is priced at $450,000, then your return on net cash flow provides a
4% return ($18,000 / $450,000 X 100%).
Now lets consider the capital gain component. To make this simple, assume that housing
prices will be expected to rise commensurate with inflation. If inflation is expected to grow by 3% per
year, then you might assume that housing prices will rise by 3% a year
too. Adding a 3% capital gain to the 4%
income gives a total return of 7%.
Although this analysis is for a single year, it works year
after year if income and home prices increase at the same rate. However, since over the last five years
housing prices have risen substantially higher than net cash flow (income), we
might actually expect that either housing prices will grow at a much slower
rate or rents must rise at a faster rate going forward. Maybe it will be some combination of the two.
For many, it is hard to assume that anyone would purchase a
home without taking out a loan (using leverage) and incurring mortgage
payments. We will soon discuss how this
impacts the analysis. The general rule
for using leverage is that your financial success depends on whether your
investment return from the house – income plus capital gain – is greater than
the mortgage rate. If it is, the
extraordinary leverage involved in most home purchases can make a house the
most profitable investment you will ever make.
If it isn’t, it can be one of the most costly mistakes you’ll ever make.
We’ve now discussed two issues that are crucial to
understanding the financial implications of home ownership: (1) the return on
your home is the net rental savings plus the capital gain, and (2) leverage
works in your favor if the total return is greater than the mortgage rate.
A more complete analysis is complicated by several other factors:
·
Unlike other expenses, fixed rate mortgage payments
don’t grow each year;
·
Most mortgages have a finite life;
·
Part of each mortgage payment includes a principal
pay down – which builds equity;
·
The interest portion of every payment is
tax-deductible and declines each month.
Now, with these concepts behind us as the “building blocks”,
you can now begin to assess whether a particular house is likely to be
profitable or unprofitable – cheap or expensive. This assessment can be accomplished by
calculating the net present value (“NPV”) with after-tax cash flows being
discounted by the homebuyer’s required rate of return. There are plenty of calculators to help you
accomplish this via the internet; or if you’re uncertain about going it alone,
we’d be happy to offer our services to help.
In this calculation, the initial cash flow is equal to the
down payment and other closing costs.
The following net cash flows, until the expected sale of the house,
consist of each period’s rental savings net of the mortgage payments and other
expenses associated with home ownership.
The final cash flow is the home’s expected sale price net of broker’s
commission, other selling expenses, remaining mortgage balance and any
prepayment penalties. Because the cash
flows are guesstimates, it is generally sufficient to work with monthly or
annual assumptions. Don’t be sidetracked
by accounting labels. All we really care
about here are dollars coming in and dollars going out.
The homebuyer’s required rate of return can be determined
from rates of return available on investments.
The initial down payment ties up funds that could otherwise be invested
in stocks, bonds and other assets; and, as the years pass, the net rental
savings free up funds that can be reinvested elsewhere. The required return can be based upon current
interest rates, but since there is considerable uncertainty about the net cash
flow from a house, you may want to use a required return similar to that
applied to stocks and comparable risky investments.
After you’ve done your NPV calculations, or had someone do
them for you, you’ll need to interpret the results. A positive NPV would indicate that the house
is not too expensive and you should buy; alternatively, a negative NPV would
indicate that the house may be too expensive and you should rent –
generally. Why generally? Because a negative NPV could turn positive
depending upon how long you plan on keeping the home!
Confused yet? Let me
explain.
It’s not uncommon for the after-tax cash flow from buying a
house to be small or negative for the first few years. But as time passes, with growing net rental
income and fixed mortgage payments, the after-tax cash flow can become
positive. In addition, the homeowner’s
equity is growing, but can easily be dissipated by substantial selling costs if
the house is sold soon after purchase.
These transaction costs underlie the sound advice that most people
should not buy a house unless they plan to keep it for a while.
Don’t be dismayed by the fact that you cannot provide exact
values for future cash flow data. We
actually don’t need to know input values to the last penny. The best way to handle imperfect knowledge is
to try a range of values to understand your best and worst case scenarios.
For most households, emotions play a significant role when
involved in decisions relating to home ownership. Yet making the wrong decision can certainly
cause a significant hardship down the road.
·
How do I know if I'm ready to buy a home?
·
How does
purchasing a home compare with renting?
· Should I sell my home and rent until sanity returns?
·
Is the home I’m looking to buy a good value or too
expensive?
·
Is an older
home a better value than a new one?
·
In my locale,
is one neighborhood-school district-etc. a better value than another?
· Should I renovate my existing home if I’m going to sell it soon?
·
How can I keep
track of all the homes I see?
·
How large of a
down payment should I make?
We’re At
Your Service
At Hoffman, White & Kaelber Financial Services, our focus is to help our clients achieve a more certain future. As such, our wealth management clients gain comfort in our conservative strategy of seeking to control risk while carefully and methodically growing their investments.
Hoffman, White & Kaelber Financial Services Investment
Performance Update
According to a recent Wall Street Journal article: “To the amazement of many investors, Treasury bonds have been among the year’s best investments. Despite three consecutive interest-rate increases by the Federal Reserve since June 30th, Treasury bond prices have been rising and their yields falling amid concerns about the economy’s strength. One reason for the bond market strength has been that people are using bonds as a parking place for money they are reluctant to risk in the stock market.” We believe this to be only so because investors see Treasury bonds as the lesser of all potential “evils”. We too are positioned defensively these days, but haven’t “put all our eggs in one basket”.
For the month ended September 30, 2004, our one-month
performance is down 0.11%, our three-month return is down 0.18%, our one-year
return is up 4.65%, and our average annualized return since inception is up
10.32%. While volatility (risk)
continues to increase in most market sectors, our (since inception) risk profile has edged downward further to +/-
6.85%. This
risk level remains conservatively low and is consistent with our strategy. With our expectation that this statistic
gains increasing importance, our Sharpe Ratio remains a very respectable 1.35.
Investment pros borrow a tool from the statisticians—standard
deviation—to measure investment risk. It
shows the range of
returns that investments are likely to earn over a given period of time and it
has two sides, the out-performance and the under-performance of an average rate
of return.
The Sharpe Ratio is a commonly used measure of portfolio earnings quality. In short, the Sharpe Ratio is a measure of return achieved per risk taken. Sharpe ratios can be better than just looking at performance because it incorporates the issue of risk. Some would say it is a measure of a manager’s ability to perform consistently. The number by itself, however, is hard for many to understand without comparing it to something.
Let’s take a look at the S&P 500 Index for a quick
comparison. The Standard & Poor's
500 Index is usually considered the benchmark for
Are you familiar with Morningstar, Inc.? They are a Chicago-based, global investment research firm, providing information, data, and analysis on the mutual fund industry. They say that a Sharpe Ratio of over 1.0 is "pretty good" and outstanding funds achieve something over 2.0. Using this “yardstick”, we are more than pleased with our accomplishment to date.
For most
investors, the Sharpe makes good intuitive sense because they not only hate to
lose money but they often compare the returns to risk free investing. You owe it to yourself to understand and
consider this measure when making investment decisions.
Is a comfortable retirement or preservation of wealth important to
you?
Want better long-term results from your investments?
Choose Us As Your Investment Manager!
Research us on the web at www.hwkfs.com