Do you own too much house?

Posted by on September 23, 2009 in Real Estate

If you are a regular reader of the money gardener, you will notice that his monthly net worth updates include the ratio of house value/total assets. In essence, he is attempting to assess whether he’s overly exposed to real estate. After all, one of the lessons from the credit crisis is that too many people relied upon the paper gains of an appreciating real estate marketĀ  and got over-confident. But the question is, if you don’t want to make the same mistake twice, do you own too much house?

First, let’s deal with valuation. I asked money gardener how he valued his home and he indicated he made a “conservative” valuation based on comparative sale prices of his neighbors’ homes. I understand that he lives in a neighborhood that is relatively homogeneous in terms of size of lot, square footage etc. with sales in regular intervals. Thus, he was more or less conducting an apples to apples comparison with current data.

The issue always is what happens if you live in a unique (not in your own mind but to the buyer’s) house/property or the comparable data is quite dated (i.e. more than 12 months ago). At that point, you have a couple of possible options: (i) find the last comparable sale price and add in appreciation based only on the rate of inflation (unless your area got wiped out when the housing bubble burst); or (ii) find a comparable as close as possible and use that valuation. The point is never to “add” anything to what the market shows you and to aim low rather than high if in doubt. For example, in the event you have an upside down mortgage, I would, sadly, use that appraised rather than acquisition price.

Assuming your valuation skills are a little bit better than how rating agencies rated corporate debt circa 2005-2007, what is an ideal ratio of house value/total assets? In the abstract, both money gardener and I agree that anything in the 75%-80% range and above would be over-weight in real estate and is simply too many eggs in one basket.

I would add two wrinkles though. If you are a first time home buyer or have bought your house less than 2-3 years ago, a high house value/total asset ratio is simply a reflection of your reality that you used a lot of your assets to purchase your home. The key in this situation is to make sure the ratio is not extremely high (90% plus), you didn’t buy the best house in the worst neighborhood and, post purchase, to ensure that your house value/total asset ratio continues to decline steadily year over year.

Typically, this would mean adding assets which generally move opposite to housing values. Since housing is considered by some as a consumer discretionary purchase, one would try to balance it out with consumer staples, assets that don’t decline as much in a downturn (gold may be a possibility but its value as an investment is up for debate), plain old cash (since house valuations are paper gains), dividend yield stocks not in real estate (again, dividends are cash in the bank).

The second wrinkle is to add REITs and real estate stocks as part of your house value since, to state the obvious, REITs and real estate stocks tend to mirror the real estate market as a whole (even though the commercial REIT market tends to react about 12-18 months after the residential housing market as seen by rising commercial vacancy rates in North America).

The notable exception to a high house value/total assets ratio is if you hold many real estate investment properties. In this situation, a higher ratio may be warranted (emphasis on “may”) assuming the properties are in the aggregate cash flow positive, the local vacancy rate for the type of investment property is relatively low and there is a sufficient cash reserve built up to weather against vacancies. In this case, one would assume that the real estate investor is quite competent; expertise and positive cash flow management would mitigate against a diversification strategy.

Special thanks to money gardener for contributing to this post.

6 Comments on Do you own too much house?

By moneygardener on September 23, 2009 at 11:29 am

Interesting post and thanks for letting me work on it with you.

By Sampson on September 23, 2009 at 12:12 pm

So in your discussions, did you guys come up with any concrete values. As you mention, the point in your life will play a big role for certain.

Too bad these metrics aren’t measured by Stats Can. I’d be interested in mean and median values of fellow Canadians broken into age categories and net worth categories.

By admin on September 23, 2009 at 12:29 pm

Sampson: I am not sure what you mean by concrete values? You mean for our own places?

For a comparison, I would check out Money Sense’s wealth test if you have not already:

By Sampson on September 23, 2009 at 12:39 pm

Sorry – I meant to ask if you guys determined ‘safe’ levels for a (home value)/(total asset ratio)

By Return To Questrade Deal, Blog Highlight and Last Linkstuff on September 25, 2009 at 5:07 am

[...] My Wallet questions – do you own too much house? Along with the Money Gardener, he tries to figure out how much house is too [...]

By admin on September 28, 2009 at 9:55 am

Sampson: I cannot speak for MG but anything in the range of 50-70% would be “safe” to me. Although we did not address it, if you went too far the other way (i.e. you owned a lot of stock relative to real estate), you have the opposite problem of over-allocation into equities.

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