How to Cope with the Declining Value of Your Home
As the Mortgage Meltdown spills over into the Credit Crunch and recession, most of us who own homes (or at least live in homes where we pay a mortgage) have seen the value of our home decline precipitously. Where prices rose the highest and the fastest, they’ve come down the farthest and the fastest. In some areas, real estate values have dropped by over 50 percent.
Side note: If you can get a loan, start thinking now about buying a home if you don’t already own one. Prices may drop further, but not by much — if, that is, the economy doesn’t go into free fall. If it does, all bets are off.
In trying to cope with falling values, I suggest you look at your house purchase as a two-part purchase, the first being the intrinsic value of the utility a home provides (shelter), the second being the investment value.
I submit to you that in years past (prior to the run-up in house prices), the investment value of your real estate purchase was trivial, whereas the past few years it held the majority component of your purchase.
Let’s use an example. The discussion below assumes you paid cash, for simplicity. Nobody does this anymore, so the leverage is much higher, and your return on investment is considerably higher than this cash method suggests. Keep that in mind.
Say you bought your house in 1990 for $100,000. Back then, in a “normal market” you could expect the value of your house to rise by 2-5 percent (depending on where you lived). I’d estimate, then, that 95% or so of your mortgage was the intrinsic value of the shelter you purchased, and 5% was the investment component. So, if your $5,000 “investment” rose in value to $105,000, you made 100% on your investment.
Not bad. In fact, excellent!
But how much did your “shelter” component rise? Let’s say rents rose by 2% in a year. In a market where rents and mortgages were in line (we’ll call it equilibrium), the value of your shelter, by definition, rose 2%. That is to say, if you could rent out your house, you could rent it out for 2% more this year than last.
So, in fact, the gain on your $105,000 house was $3,000 investment and $2,000 intrinsic value.
Still, a 60% gain on your “investment.” Not bad at all.
Fast forward to 2005.
Your $100,000 house is now $500,000. If you bought it in 2005, I’d estimate that your investment component was around $390,000! In other words, at 2% per year growth in rents, your shelter component is only worth about $110,000!
That leaves a lot of room for investment losses!!!
In fact, if house prices fall by 50%, it is my contention that your shelter component barely moves. If anything, it has risen, simply because rents should be increasing as everyone moves out of “too expensive” homes to apartments — the demand for rentals has risen dramatically through this mortgage debacle.
So, if your house declined in value by 50%, down to $250,000, I am suggesting that all of it was comprised of the investment component.
But, the intrinsic value of your house has risen.
I know, money is money. And you’ve lost a lot. But if you felt that your house was worth $500,000 in 2005, what makes you value it any less today?
Your loss is only on paper. If you truly believed that your home was worth the half a million dollars you paid for it, then it truly has gone up in value since then.
Of course, you cannot realize that gain right now. Or for quite some time for that matter.
Think of your house for a moment as you would the purchase of a stock. There’s the future cash flow (dividends) and the capital appreciation. If the stock does not rise in price, but keeps paying out the same dividends, it’s still worth what it was when you bought it.
It may be worth more to somebody else right now, or it may be worth less (this is all based on price). But to you, it is worth just the same.
If the price falls on the stock, yet the dividend remains the same, then isn’t the stock intrinsically worth more?
That’s what I’m saying about your home.
On paper, you may be suffering a “wealth effect.”
But in real life, your home is providing the same utility today as it did when you bought it. In fact, it may be providing more. Rents have not fallen, they’ve only gone up in the real estate “collapse.” Therefore, the shelter component of your purchase is worth more today than yesterday.
It is only the investment portion of your purchase that has taken a beating. Try to set that aside for a while. In time, you will recoup your investment, and then some.
Especially with the rapid inflation the Fed is building into the system. Don’t be surprised, if in 5-10 years, your investment will be reaping positive returns!
Enjoy life. Spend time with your family.