Monday, July 19, 2010

Is residential property Super?

The retirement plans of working families may soon succumb to Australia's residential property mania. If Chris Joye had his way, Australian super funds would invest in the emerging residential equity market to diversify their portfolios against highly correlated domestic and global equities markets. The argument for this move is summarised below.

Investors, such as super funds, get extremely low-cost, highly enhanced and very long-dated exposures to what has, during the past three decades (including the recent calamity) been the largest and best performing of all investment classes: residential real estate. Historically, investors have only been able to access highly concentrated, risky development-style holdings comprising small parcels of properties that incur heinous transaction costs of about 12.5 per cent. By investing in a portfolio of thousands of shared equity interests, super funds could avoid all of these costs and secure the low risk diversification that they have never had before. Independent actuarial analysis suggests that about 15 to 30 per cent of all super fund capital should, in theory, be allocated to housing, in part because its returns are so unrelated to the performance of other investments. Compare the 50 per cent plus losses in shares and listed property trusts in the past year with the fact that the RP Data-Rismark Australian House Price Index has tapered by only -0.8 per cent. (emphasise added)

Is this idea worth embracing? Or to put it another way, how many people would actively choose to invest superannuation in the residential property market?

Super funds investing in residential property equity face a couple major of problems in my view:

1. decreasing the diversity of investor portfolios, and
2. moral hazard associated with residential equity finance.

To begin a proper analysis we need to take think in terms of investor portfolios, not super fund portfolios. Outside of their super fund, Australians have other investments - mainly in residential property. Already we see that most (70% home ownership) households have plenty of exposure to this apparently superbly stable market, particularly those close to retirement age.

But Joye's argument also rests on the fact that typical investments in housing are lumpy - people own just a single house rather than a share of the housing market. An individual home can be high risk due to its location, but the housing market is much more diverse and is thus far less risky. If super funds invest in residential equity schemes they are reducing risk against not only other equities markets, but from households' own lumpy property investment. It sounds almost too good to be true.

Opponents of this idea also have some fair points to make. Directing more investment at the housing market will increase market risk and fuel speculation.

There may also be severe moral hazard in the market for residential equity. Only people who view their property as below average, and whose money management is rather poor (since they are negating part of the investment benefits of property ownership yet still leveraging wildly), may take up equity finance, thus reducing the diversification benefits that were the initial selling point. Equity finance is an easy way to hedge against a falling property market.

While the residential property index has low volatility (and therefore low risk if you believe in that type of thing) it also has very low returns. Although equity finance is structured to take twice the capital gains (if you take out 10% equity finance when you buy, you owe 20% of capital gains when you sell), it misses all the 'dividend' of rent. Sellers have less incentive to hold on through a market downturn if losses are shared. They also have less incentive to maintain the property, since they take a smaller share of capital gains.

Further, those who are willing to take the risk can already invest in property via a self-managed super fund - further exposing them to residential markets.

All I see from residential equity investment is a small upside with a potentially huge downside. If, from this point on, house prices track wages, which slightly edge ahead of CPI, the best outcome for a residential equity investor is about two to three times CPI, or 6-9%. The downside is all there in the event of a residential price bubble deflating, and it may be many years before positive returns eventuate.

Because an equity mortgage typically supplements a debt-leveraged purchase, they are second in line for cash upon sale. People taking out equity finance will probably not fully understand the downside risks of having this funding arrangement.

For example, if you borrow 60%, equity finance 20% and put up 20% of your own, in the event of a 40% drop in the value of the home which forces you to sell, you will still owe the equity financier 12% of the home purchase price and the mortgagee 60%. The equity mortgage is not real equity – it does not share in leveraged losses. The possibility that a proportion of equity mortgage holders will default on the balance owed, was not recovered from the sale price under such a scenario, adds to the downside risks.

In the end, if owning an equity share in the housing market as a whole provides such benefits, why would anyone buy their own home in the first place? Wouldn’t they simply want to lend to others under this fantastic scheme? Some people may, and some people do. But the significant moral hazard problems may mean that the diversification benefits so loudly promoted are not all there. Furthermore, super fund investments in residential equity will divert an even greater proportion of the typical retiree’s funds into the housing market, negating the apparent diversity benefits.


  1. shares in the sydney harbour bridge

    like hell houses are uncorrelated with other asset classes, what do people borrow against to make big investments?

  2. Great analysis Cameron. I am not surprised the spruikers are pushing this type of financing. Having exhausted traditional forms of mortgage finance, the 'innovative' financeers are now desperately trying to reinvent the wheel in order to keep ever-increasing amounts of credit flowing into housing.

    No doubt the property industry and government will soon be heralding equity financing as a breakthrough affordability initiative, even though it is obvious that the additional credit will soon get capitalised into higher house prices and would make housing even less affordable.

  3. There is nothing wrong with equity finance in isolation if it just a voluntary agreement between parties who all understand the risks. Linking it in a positive way to housing affordability is a gross misrepresentation.

    The features of equity finance mortgage make them very similar to mezzanine finance. Have we learnt nothing? Bundling together sub-prime debt/equity as diversified and low risk has been done before.

    But in this case there is also a moral hazard issue, as risk are shared, and rewards for housing upkeep and smart timing of a sale are decreased.

    Stephen, I also tend to agree that housing is correlated to other asset classes (maybe not to the degree of say domestic and internationaly equities), and that the returns on a individual home are very closely correlated to the market as a whole. Thus, the individual who owns their own home on retirement already has plenty of exposure to the residential market.

  4. Leith - I'm still waioting for a reply.

    Cameron - Mezzanine Finance is used for high rise residential developments etc when the construction has reached a stage where values have been added to the point that another lender can come in and provide sufficient finance to complete. that finance lasts only a short time until sales clear both the mezzanine finance and the first lenders debt.

    You draw a very long bow when you say that that an EFM is similar to Mezzanine finance.

    I beg to differ on that point.

  5. Mezzanine finance is used more broadly than you make out Peter, and can often include a stake in equity. It fills the middle ground between senior debt and equity - but it also increases risk for the home buyer who is now even more highly leveraged. The EFM is not actually equity (otherwise its losses would be leveraged), so it falls in this middle ground mezzanine area of finance.

    Traditional mezzanine lenders are book-and-hold investors, generally focused on cash-flow lending, looking for a minimum term (call protection) and equity participation to generate longer term results.

    Where is differs is the timing - EFM is marketed as a very long exposure to the residential market, whereas tradionally mezzanine finance is used to cover funding needs in the short term.

  6. Cameron - Mezzanine finance is NOT cash flow lending. I don't know where you got your definition from. I have only seen it used in developments for office towers, residential developments, or land developments.

    It is used in the very final stages when the development is close to being finished in a structural way, but needs the finishing touches. For example the fitout in a multi-residential construction - kitchens, bathrooms, lining, floor coverings, painting etc etc.

    It is never used for housing except at the wholesale level. refer this link to a local mezz funder

    I've had a quick look on Google and it appears that in the USA they also use it for IPO's and startups, but it just ain't available to you and I unless we get involved in multi million dollar apartment developments. It is wholesale funding only.

    If you have some references or links showing alternate uses I would like to check them out. I'm happy to learn something everyday.

  7. I meant "Mezzanine finance is a term used more broadly than you make out Peter". My use of mezzzanine is the umbrella term for types of lending that fall between senior debt and equity, including various hybird securities.

    EFM appears to fall under this umbrella.

    Representing that the risks surrounding property prices are similar to the risks of this security is somewhat misleading.

  8. Ah well I can't possibly counter a definition that is completely unique to you Cameron.

    Many private lenders have provided individuals with short term second mortgage funding for years. But none have ever referred to that as "mezzanine funding"

    You're on your own with that definition Cameron.

  9. This comment has been removed by the author.

  10. Not so unique I thought, but happy to use any term that you think covers these middle layers of financing.

  11. Hi Cameron - I guess it really doesn't matter what definition you apply. My point was really that in finance mezzanine funding is considered high risk and wholesale only, and EFM would never be considered as such. But you can use whatever term you wish, that's fine. Sorry if I pressed too hard.

    I actually think the Rismark 20% product is a responsible level of involvement, and I suspect (but of course I have absolutely no evidence) that it would help stabilise the housing market. However I do concede that like everything it can be overdone, especially if more lenders get involved, competition heats up, and creativity comes into play. Picasso was a conservative when compared to Wall St.

    If you get time one day please post an OP on what elvel of EFM lending would be responsible, and you could also look at Sharia finance which is a whole new ball game.



  13. There are plenty of reasons why Listed Property Trusts issue is such a dismay for many. I guess, not only with it but on most investment around the world. The slowing down of the economy is such a slap.

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