Dear Readers: This article is the second in a three-part series, taking a closer look at the process of buying a house with the intention of protecting yourself from future financial losses. Since purchasing a house is typically the single largest financial transaction most people make in their lifetimes, I highly recommend taking the time to read all the articles in the series, especially for those considering buying a house for the first time.
Welcome to the second article in the Super Frugal Duo’s guide to buying a house in the most financially savvy way possible. In the first article, we explored the emotional side of buying a house, and how you need to eliminate emotions in order to make the best purchase possible. Today, we will be taking a broad look at financial markets, and how they play a role in the value of a house when it comes time to buy or sell, and how we can approach these milestones defensively, in order to protect ourselves from large financial losses.
Know That What You are Buying Is An Asset That Is Subject to Market Forces
Without getting bogged down in pedantry, when it comes down to it, your house is an asset. In accounting, an asset is something that provides a future economic benefit, and so for the sake of argument, we’re going to use this framework. And as an asset, much like stocks, bonds, gold, etc., every house is subject to market forces. Supply and demand of houses is key, but so is supply and demand of credit, as most purchases of homes aren’t made in all cash. Homes are also subject to low liquidity, high transaction fees, changes to interest rates and informational inefficiency. These forces are in play at all times, and help to determine the price of a house at the point of sale. The commonly believed fallacy before the great financial crisis was that prices of homes always go up, but since then, we’ve discovered that prices can indeed come down. Whenever one of these forces acts to bring the prices of all homes down, that is called market risk.
The value of individual homes are subject to specific risk, as well. Specific risk in real estate simply means that something bad can happen locally, without affecting the value of the entire housing market. A tree falling on a roof is an example of extreme specific risk playing out to just one house. While the value of the home has been diminished somewhat, at least until the roof is repaired, the values of its neighboring houses are no affected. In a broader context, a local issue can cause property values in a community to decline. Take a look at Flint, MI, where the municipality chose to provide polluted river water to the residents, rather than treated water. Or, look at what happened in East Porterville, CA, where the California drought that peaked in 2014 caused the water table to drop, and homes to be unable to get water. Even if housing prices are rising nationally, specific risk can manifest and cause a drop in the value of a particular house.
As a personal example, Mrs. SFD and I once put in an offer on a house, and only afterwards discovered that it had an elevated radon level. We caught it early enough in the process that that we came back to the sellers requesting $5000 be taken off the asking price, and in exchange, we would accept the property as-is, and ultimately pay $2200 for radon mitigation. This is an example where a specific risk was shifted to the sellers, costing them $5000.
Why Liquidity Matters
Let’s talk strictly financial assets for a moment. If you were planning a retirement entirely using stocks and bonds, then your financial advisor might recommend that when you retire, you pick an asset allocation of 60% stocks and 40% bonds. Why? Because while stocks provide a superior expected return in the long run, the are volatile in the short run, and by holding bonds, you are protected from having to sell stocks during a market downturn, and ultimately put your hard earned capital at risk. Consider that during the 2008-2009 market crash, from peak to trough, stock investors experienced a drop of about 58%. Subsequently, the market rebounded 67% in short order, and a continued bull market to this day makes the previous market high in 2008 seem like a distant memory. I say all this to point out that the greatest risk to a retired investor during the worst market crash in a century wasn’t the crash itself, it was being forced to sell stocks at rock bottom prices.
I’m sure you’ve heard the investing platitude “Buy low, sell high,” right? Well, if you were retired during the market crash, an allocation to bonds would have kept you from completely wiping out your capital, because you could have sold bonds to fund your living expenses in the short term, rather than “selling low” your stocks.
The important lesson here isn’t so much to tout the benefits of bonds, but to point out the benefits of liquidity. Bonds provide liquidity and stability to a portfolio of financial assets, and keep you from being forced to sell at the worst time possible.
Because we’re not thinking of buying a “home”, but rather buying an “asset” when we purchase a house, thinking in terms of asset allocation, and thus liquidity, is important. During the financial crisis, a lot of homeowners were forced to sell at prices much lower than they purchased them for. While hindsight is 20/20, if homeowners had enough liquidity, they could have weathered the market downturn, and sold at more opportune times, rather than being forced to sell at the worst time.
As a prospective homebuyer, there are a few ways to protect yourself. One is to employ the same strategy as the stocks and bonds illustrated above. Save enough bonds or cash to cover mortgage payments for a lengthy period, so that in a situation where you would otherwise be forced to sell low, you’re able to continue making payments until market conditions improve. We’re not talking your typical emergency fund here, but are instead focused on being able to make your mortgage payments for an extended period of time. You could also consider putting your house up for rent, thus increasing your income and decreasing your debt to income ratio. There may even be situations where putting your house up for rent, even if that rent is less than the mortgage, would make sense – if you only lose $200 per month, as opposed to $1200 if you couldn’t rent the property for $1000, then you would only need to have $2400 saved in order to make it an entire year without defaulting on payments. There are other, far more complicated options, such as shorting housing futures, but that is something I would not recommend, as it is both overly complicated, and does not entirely protect against market risk. For example, a situation where your house value falls, while the housing market appreciates overall, would leave you poorer than if you simply didn’t deal with options contracts at all.
Don’t get me wrong. The market usually goes up, but not always. The value of the home you ultimately purchase is likely to go up, but not always. However, appreciation of your house is never guaranteed, and if you don’t have a defensive plan in place to keep yourself from selling your house at a low price, then you could very well be subject to tens, if not hundreds of thousands of dollars of losses in the future. And financial success is more about the losses you avoid, than the home runs you hit.
Now it’s your turn. Have you ever thought about your house as an asset, and how the ebb and flow of financial markets might affect your home value? What steps have you taken to protect yourself from losses that might stem from a poorly timed sale of your house?