Real Estate: Bubble or not? How does it affect our Divorcing Clients?
By Howard I. Goldstein and Steven A. Branson
There is a lot of talk of a real estate bubble bursting. It looks like we are at least in a slowdown. Even if real estate returns to “normal” how should we be advising our clients regarding their ownership of real estate? What does the volatility in the real estate market mean for clients going through a divorce and for their lawyers trying to advise them? As lawyers, we are not generally trained or licensed to be investment advisors. Nonetheless, our clients often look to us for this kind of advice, which is especially tricky, or so it seems, in the current investment climate.
For many of us there is a common cookie cutter approach, which is infrequently challenged: In a divorce the wife gets the house and the husband gets the investment and retirement assets. If the house is worth more than the investment assets the difference is made up out of the proceeds when the house sells, upon the emancipation of the children.
However, careful analysis of investment returns over time suggests that keeping the house is not always the best idea, whether we are in a bubble or not. In the end, what you get out of your house rarely matches what you get from your retirement plans or other investments.
To put the issue one way, before you decide that you want to keep the house in a divorce and give up retirement plan accounts, ask yourself if you plan to sell a bed room when a child needs money for college tuition or when you need money at age 65. Holding the bulk of your assets in your home means you have your net worth primarily in one location, which is not diversified, and that asset may not offer the best investment return.
Psychologically, people assume that homes have been appreciating so they will continue to appreciate over time. However, you do not get hourly quotes on CNN for the value of your home. In fact, house prices have fluctuated over time. For example, if you purchased a house in the late 1980s, the value went down and did not return to what you paid until the early 1990s.
If you compare the price change over most 10-year periods in recent years, real estate does not usually match the returns of the S&P 500. The following chart shows the increase per $100,000 invested in 1980:
The return on real estate investments will look better when you consider the financing or “leverage” that you get with a mortgage. However, if you are paying attention to leverage, you have to also pay attention to carrying costs: For example, a house purchased in 1992 for $350,000 might be worth $700,000 today. If you put 20% down, $70,000 in cash, the equity today of more than $350,000 (depending on how much of the mortgage was paid off) is a 5-fold return. However, when you account for the costs of the after-tax mortgage and the property taxes, the cost of repairs, maintenance and any improvements, the return is lower. Thirteen years of mortgage payments, even with the tax advantages, and property taxes alone could be over $180,000, assuming a 30% tax rate, maintenance could be another $20,000 or more and, to keep the value, home improvements could be as much as $100,000. Now the cost is $370,000, including original down payment, and the current value of the equity is $350,000. This return is actually negative, while the stock market, represented by the S&P500, produced a 4-fold return during the same period. If your property paid you rent to cover the carrying costs, it would behave more like an investment. However, because you live in it, and pay the costs for that comfort, a house is really a “lifestyle” asset rather than an investment.
With this in mind, consider a situation where a couple is preparing for divorce. Take an example where the marital house is worth $1 million, with a mortgage of $350,000. The husband wants to keep his 401(k) plan, which is worth $550,000. Assume that total home equity and retirement plan, $1.2 million, are to be divided in half. Should the wife keep the house, increasing the mortgage by $50,000 to pay off the husband? She may say, “But property values of all my friends have quadrupled and the stock market is too risky.” However, she has increased her carrying cost for the property and reduced what she will have for retirement. If she does not want to move now, she would be better off agreeing share the house proceeds on sale at a designated date and keep some portion of his 401(k) plan. This way, she would have investments to support her later.
Even in the best of times, real estate is not as liquid or as diversified as a portfolio of stocks, and it is burdened by carrying costs and risk. This controverts the conventional wisdom that “you can’t go wrong with real estate.” Very few of our clients can afford to have their entire net worth in their home. It may be many years before real estate will have the spectacular gains it has had in the last number of years. Recent events make this more compelling: fuel, insurance and interest rates are all likely to go up in the near term, all of which makes owning real estate riskier and more expensive than it has been. We owe it to our clients to suggest a careful review of all of their choices. Factors such as their age, health, earning capacity and other investments have to be carefully weighed in order to come up with an appropriate mix of assets after a divorce. As lawyers we should be recommending that they consult with a qualified “fee based” financial planner who will not try to sell them products, but who will be able help them think through these decisions and come to the right conclusion for their particular circumstances.
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