Does my house count as my "real estate" for diversification?

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martincmartin
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Does my house count as my "real estate" for diversification?

Post by martincmartin »

Hi,

I have a 401(k) and do Index investing following the diversification strategy in "Unconventional Success" by David Swensen, which is similar one in "The Intelligent Asset Allocator" by William Bernstein:

30%: Domestic equity
15%: Foreign developed countries equity
5%: Emerging market equity
20%: Real estate
15%: U.S. Treasury bonds
15%: U.S. Treasury inflation-protected Securities

I recently bought a house, and it's worth more than my entire retirement savings. So how should I adjust the real estate portion of above?

One argument is that my house counts for that and more, so I should just remove that line and adjust the others in the same proportions to make 100%.

But then my real estate holdings aren't diversified at all, e.g. they depend on a single market. So maybe I should have some REIT ETF in addition.

Edit: The house has many bedrooms and is in a good school district. Once the kids are out of college, we plan to sell it and buy a more modest house in the same metro area (Boston), perhaps downtown.

Thoughts?
Last edited by martincmartin on Thu Jul 03, 2014 12:04 am, edited 1 time in total.
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grabiner
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Re: Does my house count as my "real estate" for diversificat

Post by grabiner »

I would not count the house as "real estate" for diversification, because you aren't using it as an investment. If housing prices go up, owning your own house doesn't make you any better off, because you still live in the same house. If housing prices fall, owning your own house doesn't hurt you (unless you are underwater and need to sell), because you still have a place to live.
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Grt2bOutdoors
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Re: Does my house count as my "real estate" for diversificat

Post by Grt2bOutdoors »

Your house isn't an investment - it's a place to live.
If the home you own is income-producing real estate, then sure, I'd count it as an investment.
"One should invest based on their need, ability and willingness to take risk - Larry Swedroe" Asking Portfolio Questions
sscritic
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Re: Does my house count as my "real estate" for diversificat

Post by sscritic »

grabiner wrote:If housing prices go up, owning your own house doesn't make you any better off, because you still live in the same house.
But your heirs will sure appreciate it when you die. I am very happy that my father's house is worth about $4,000,000 rather than $40,000. Six zeros is so much nicer than four.

Also, if you want to buy a second house as a vacation home, having $3 million in equity will make it much easier than if you are $300,000 underwater. Net worth counts for something. One of the reasons I invest is to increase my net worth. I have no idea what that has to do with diversification, but I would rather be up than down, if only for being "psychologically better off." When you are $200k underwater, my guess is that your anxiety level will skyrocket, but maybe you will be calm, cool, and collected as your house sinks. I mean, it's not like it's an investment you care about (or so I keep hearing on bogleheads).
amitb00
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Re: Does my house count as my "real estate" for diversificat

Post by amitb00 »

I don't count my primary house in my net worth calculations. I use it to live and don't consider it an investment. I also don't count my wife's jeweleries or my cars in my net worth calculation. They all have value though.
sscritic
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Re: Does my house count as my "real estate" for diversificat

Post by sscritic »

I guess none of you saw the recent thread from the person whose dream was to retire to California, preferably to a place on the coast. Unfortunately, his current house was worth only $235k rather than $2,350,000. Now he could have had an extra $2,115,000 in his investment portfolio, but he didn't. Actually, the extra $2,115,000 could have come from an inheritance but it didn't. Or, the extra $2,115,000 could have come from his home equity, but it didn't.

I know that if I need an extra $2,115,000, I would be happy to have home equity, whether you want to call it net worthable or not.

Note that you don't need to retire to CA to appreciate home equity; just get a new job in a HCOL area.
Lafder
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Re: Does my house count as my "real estate" for diversificat

Post by Lafder »

I do not buy REITs because I feel that the equity in my house is in real estate, even if I live in it. And I do not want too much of my investments tied up in real estate.

Yes the value in my house is only theoretical until sold. But I do not think it will be my forever and ever house. So it will be sold some day.

Is your equity in your house more than your investments? Or is the resale value of your house more?

lafder
ralph124cf
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Re: Does my house count as my "real estate" for diversificat

Post by ralph124cf »

Do not count the VALUE of your home, only your EQUITY in your home. The bank owns the rest of it.

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grabiner
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Re: Does my house count as my "real estate" for diversificat

Post by grabiner »

ralph124cf wrote:Do not count the VALUE of your home, only your EQUITY in your home. The bank owns the rest of it.
If you do count your home as an investment, your real-estate exposure is the full value of your home, not the equity. If you have a $500K home and housing prices drop 20%, you lose $100K of your net worth, whether you have a mortgage on the home or not.

The amount of equity limits your risk only if you will walk away from an underwater home, and either your mortgage is non-recourse or you don't have any other assets for the bank to collect. If you don't walk away from your home, your net worth is still exposed to real-estate risk even if your home is underwater; you have lost $100K if your $500K home with a $500K mortgage loses 20% of its value.

(Since you are counting your net worth in this situation, your equity is what counts there; it is a positive asset of the home, and a negative asset of the mortgage.)
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Gattamelata
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Re: Does my house count as my "real estate" for diversificat

Post by Gattamelata »

As a general principle, I don't think anything should be counted as part of your asset allocation unless you can easily take money into or out of it. If you can't rebalance into or out of something, it's not really part of your portfolio. The whole point of an asset allocation is to participate in many markets so that a precipitous drop in one or more markets doesn't wipe you out. It assumes that the rest of the asset classes are sufficiently liquid that they can perform in place of the asset classes that have underperformed. You don't have to sell low because your emerging markets tanked, because US stocks are doing fine.

So take your house for an example. You can't sell part of your house or buy more of it, so it's not particularly useful as an asset class. What's more, your house is not representative of a market. It's a single, tiny asset in a gigantic market. It's entirely possible for your house value to rise or drop in opposition to the market it's in, so it's not much of a diversification in any case.

Or let's say you owned the Pink Panther diamond. It gives security, because if everything else you had was wiped out you could sell it and still live comfortably. But it's not exactly part of your asset allocation, either. You couldn't sell part of your diamond if the jewelry market went up and use the proceeds to buy bonds.

I think it's best to consider your house on the expenses side of your financial planning. You have to pay for a place to live, whether it's rent, mortgage payments, or the sunk cost of your home equity in the case that you own outright.
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CABob
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Re: Does my house count as my "real estate" for diversificat

Post by CABob »

amitb00 wrote:I don't count my primary house in my net worth calculations. I use it to live and don't consider it an investment. I also don't count my wife's jeweleries or my cars in my net worth calculation. They all have value though.
I would include equity in primary home in net worth calculations, but, not a factor for asset allocation purposes.
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MrMatt2532
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Re: Does my house count as my "real estate" for diversificat

Post by MrMatt2532 »

grabiner wrote:I would not count the house as "real estate" for diversification, because you aren't using it as an investment. If housing prices go up, owning your own house doesn't make you any better off, because you still live in the same house. If housing prices fall, owning your own house doesn't hurt you (unless you are underwater and need to sell), because you still have a place to live.
As a continuation of this point, even if you are planning on selling in the future to buy another house, there is a strong correlation with your house value and other house values. Say prices rise by 10% over the next year, you might be thinking that you'll be able to afford a 10% larger house. Well, that future house you might buy probably also rose about 10% in price as well, so you are back to where you started.
sscritic
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Re: Does my house count as my "real estate" for diversificat

Post by sscritic »

MrMatt2532 wrote: As a continuation of this point, even if you are planning on selling in the future to buy another house, there is a strong correlation with your house value and other house values. Say prices rise by 10% over the next year, you might be thinking that you'll be able to afford a 10% larger house. Well, that future house you might buy probably also rose about 10% in price as well, so you are back to where you started.
I live in Omaha. My house goes up by 10% from 200k to 220k. The house I am moving to in San Francisco went up from $2,000,000 to $2,200,000. The $20k rise in my old house isn't going to cover the $200k rise in my new house; I will be $180k short. What do you suggest I do other than turn down a terrific job in a terrific city? No slight to Omaha, but it isn't the City by the Bay.

P.S. the house in SF is 30% smaller, so I am not even worried about your 10% larger.
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martincmartin
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Re: Does my house count as my "real estate" for diversificat

Post by martincmartin »

Thanks for all the responses! I do intent to sell, and buy a more modest house, but as MrMatt2532 points out, the cost of that new house will most likely correlate with the cost of my current one pretty strongly. And it's a good point that I can't easily rebalance into or out of it, I hadn't considered that.
Bungo
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Re: Does my house count as my "real estate" for diversificat

Post by Bungo »

sscritic wrote: Note that you don't need to retire to CA to appreciate home equity; just get a new job in a HCOL area.
Home equity is a big factor in my plan to retire FROM California, at a significantly younger age than if I insist on remaining here. :D
Sagenick48
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Re: Does my house count as my "real estate" for diversificat

Post by Sagenick48 »

You have three things to consider, your income, your net worth, and your portfolio. Those are three different things. Your income includes your portfolio income. Your net worth includes your portfolio value minus any portfolio debt.

In the end your net worth is all that counts. That is, what your estate tax return measures, your assets minus your liabilities.

In a bankruptcy the same thing is measured.

When a Bank asks for your for your Personal Financial Statement, they are looking for the same thing. Assets minus liabilities.

So, in the end, the way of keeping "score" is your net worth.

And in calculating your net worth, the real estate you own, your home, is part of your net worth. So, you take the fair market value of the home, subtract the debt and the difference is your equity, which in turn is part of your net worth.

When calculating your asset allocation you can either fuss over whether the house equity is part of your bond % or is part of the stock % or is something else.

You are wasting a lot of time and energy over nothing.

I think house equity is a separate category.

Forget the details. If you have 30% bonds, 60% stocks, and 10% real estate, does it matter if you treat the real estate as stock or bonds, really, over 40 or 30 years?
The market goes up, the market goes down.
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