Conversion Risk of Real Estate Equity

Have you ever experienced a time where you had a deeply held belief and then, suddenly, exposure to a new idea caused you to question that belief? It happened to me, (again!) last night, at a Snider Investment Method™ information session in Scottsdale, AZ.

 

I believe that borrowing money to invest is a bad idea. There are, of course, exceptions. But I am just saying - as a general rule - I think it’s a bad idea. But then, one of my guests, Bob Kennedy, said something that put the idea in a totally different context, and suddenly I am thinking differently about the topic.

 

I talk a lot about what I call conversion risk. In fact, it was part of my program last night. Conversion risk refers to the idea that if your strategy is to hold an asset over the long term and you suddenly need money, because of some unanticipated event, and the market value of the asset is depressed (think 2003), you're screwed. When you HAVE to HAVE that money, you are in a weak position. You have no choice but to sell at the current market price. The value that is lost - is lost permanently. You no longer own the asset so there is no way to get it back.

 

We know from studies that financially disruptive events occur far more frequently than most people are aware. I haven't seen any studies that speak to rate of change specifically but I have to believe the frequency of financially disruptive events is increasing, not decreasing. Which means conversion risk is increasing.

 

So here is the Aha! from last night. Studies tell us, what little net worth Americans have, is tied up in the equity in their homes. It certainly isn't in the bank or their brokerage accounts. According to this year's Retirement Confidence Survey, done annually be EBRI, 52% of workers saving for retirement report total savings and investments, not including the value of their primary residence or any defined benefit plans, of less than $50,000. The large majority of workers who have not put money aside for retirement have little in savings at all: 75% of these workers say their assets total less than $10,000.

 

So let's give ourselves the benefit of the doubt and assume that there is some amount of equity tied up in our homes. Isn't there a conversion risk there as well? And isn't it even greater because there is less liquidity?

 

What if there is some catastrophic medical issue and the equity in your house is the only money you have? That is not the time to be trying to get a home equity loan! Who is going to give it to you? It certainly isn't the time to try to sell your house.

 

If a loved one is sick and dying and the only way to pay the bills is to sell the house, what kind of price are you going to have to accept to dump it? Finally, real estate is an asset with fluctuating market values just like paper assets. What if the price is down when you need to tap that equity?

 

So the question Bob got me to thinking about last night is, "Doesn't prudent planning REQUIRE you to separate the equity in your house somehow, probably through the strategic use of mortgage products, so that you can better manage the conversion risk? Hmmm.

 

It kind of casts my old thinking about never borrowing money to invest in a whole new light. I had always thought of the question, probably because it was the way it had always been posed, as a speculative strategy. Can I borrow from my equity in my house, invest it, and hopefully make more than I pay in interest?

 

But Bob turned it around as a risk management question. Don't I have to separate the equity in order to manage the risk? Wow! I love it when that happens: instant insight just from having a conversation with someone who has thought about something differently than I have!

 

Clearly, I am going to have to do some more research and thinking to wrap my brain around this idea. I think you should too. In the meantime, any thoughts you might have are welcome. Leave them below.

 

Kim Snider, Kim Snider Financial Communications, Chronim Investments and/or Snider Advisors make no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk including possible loss of principal.