Present value is how all investments are valued, what the investment is worth right now. This is called mark to market, and is how the value of a stock portfolio and even the stock of a company is determined, even though if all of the shares were sold these sales would not receive the amount of the last trade of course.
Where prices may be headed is also factored into the current price of stocks, for instance a company which may be looked upon as having a favorable outlook in the future will see people pay more for the stock and this will be included in the present price, together with all factors currently known that may affect its future price.
Real estate is even more connected to its present value, as all real estate valuations are an approximation of what a property may bring if it was sold on the market today. Like stocks, the value of real estate tends to increase over the long term, and also fluctuates quite a bit in the shorter term depending on market conditions.
The amount that real estate is expected to appreciate in value is one’s expected return on the investment, and the amount that it may decline in value represents the risk involved. Just like when we invest in the stock market, both potential return and potential risk needs to be properly considered.
There are many investors who seek a long-term view of their stock investments and will simply ride out any and all fluctuations in order to seek to capture these expected long-term gains. Historically, this has always turned out to be the case over the very long-term, and while this doesn’t mean that this is guaranteed to continue, people still bet on this remaining the case far into the future.
Real estate also has always appreciated over the long-term, at least overall. While one may invest in stocks with a variety of strategies, from the very short term to the very long term, real estate is far less liquid and those who invest in it do generally intend to keep the investment for a number of years at least.
How Time Frames Affect Risk with Real Estate
There is a perception among stock market investors that a long term view represents less risk, and while this isn’t exactly true, holding one’s investments over the long term does seek to take advantage of long term trends and the real risk is that they won’t continue over the long term, rather than the short term.
It is more likely that a longer term trend will continue, so this part of the reasoning is sound, although due to the fact that stocks are very liquid, one may time one’s positions in a way that may end up reducing the risk of holding stocks even further than the buy and hold approach.
With real estate though, given the lack of liquidity and the time and costs involved in trading properties, we cannot really time real estate in quite the same way as we can time securities, due to the impracticality involved. It’s not that people will sell their home if they expect a decline in the real estate market in their area, because they will generally want to buy another home in the area which will be subject to the same market forces.
If one decides to ride out the bear market in real estate by renting, that might work, but this would involve paying a premium to the landlord as well as other factors and this is not generally seen to be a viable or desirable option.
Real estate also tends to be more bullish than other investments, with the trend toward increasing values predominating and pullbacks being less frequent and even exceptional. While there may be situations where one may still want to seek to time the real estate market, this is generally limited to commercial real estate ventures, and isn’t even that widely practiced in this field.
Some people look to time positions with real estate securities, which are much more liquid, but people who invest in them do tend to take a longer-term view generally and not look to time them that much.
This leaves those who prefer and have the means to own their own home committed to the real estate market, for the duration of their lives typically. This has us exposed to the long term risks of the real estate market, although these longer term risks are generally quite small should we decide to remain in the same home over the long term.
Shorter Term Considerations and Risks
This isn’t always the case though, as people do sell and re-buy for various reasons. Perhaps they are looking to upsize or downsize, perhaps they have been relocated for business reasons, maybe they just want to relocate, or maybe they just want a different house.
So, while one may be fully invested in real estate for a long time, this does not mean that one will be invested in the same property for this long. Whenever we buy and sell real estate, we are exposed to the risks of the real estate market, and this is what sets the true time frame of our real estate investments.
Many people end up selling their homes for much more than they paid for them, realizing a handsome profit, but there are others who are not so fortunate, and even may end up selling at a loss.
If one borrows a certain amount to buy a home and ends up selling for less, they may walk away from the property with simply a debt, and sometimes a pretty large one. The consequences of this are not pretty, and are considerably more grim than most people realize when they take on the risks of home ownership.
If, for instance, you have lost $50,000 on a home, and are looking to buy another home, even if you are able to come up with a sufficient down payment on a new home, the equity you will have will be limited to this amount. It’s not that you can just throw this $50,000 on your mortgage, as you would then owe more than the home is worth.
Lenders will only allow you to take a mortgage on a property for a certain percentage of its value, with the entire value of it being the maximum. People do move mortgages to new properties but do so without leaving behind a big debt after their home is sold, and instead have money left over after the sale which they use as part or all of their down payment on the new home they purchase.
This situation occurring, where a significant loss is incurred on the sale of a home and this loss results in a large amount of debt being owed is a terrible situation to be in. This is in itself a financial disaster. One either needs to obtain alternate financing to handle this debt and still afford to get a new mortgage, or one is in dire straits indeed.
Seeking To Manage This Risk
Poorly timed real estate sales resulting in financial losses and leftover debt is therefore an extreme risk that simply needs to be avoided. The risk is a function of timing, where if one is exposed to the risk of needing to sell when the market is down, then one has a real problem.
When property owners have the option of selling or not selling, one is not going to choose to sell when doing so would lead to disaster, although this does not mean that there is no risk here if one simply does not sell.
There is still a risk involved of not being able to sell if one wants to or needs to, which can have a number of unwanted consequences. This can range from simply wanting to live in a new home but not being able to, to not being able to live in a larger home as one’s family expands and this need is created, to not being able to move to a new city to get a promotion or as a job requirement, as well as other issues that may arise.
While these consequences may or may not involve financial considerations, they do involve practical ones, and not all risk can be measured in dollars and cents.
There is also the risks of not being able to manage your financial affairs by not being able to borrow the money you need against your equity, when this equity diminishes or evaporates due to the value of your home decreasing. It could be years before the value increases enough so that you are in a position to create enough equity to be used to assist you with managing your finances if the property value has dropped enough.
We do not of course have a crystal ball to predict the future with any investment, and while real estate investments may be the most reliable ones that anyone can make generally, there still is at least some uncertainty. The shorter the time frame we are looking at, the more uncertainty there is.
In order to do our best to manage these risks, we should prefer longer time frames over shorter ones when it comes to home ownership, and look to plan around this goal, where we’re looking to try to avoid the need to be placed in a position where we need to sell or even to avoid wanting to.
We also need to be paying attention to the real estate market in our area and especially in large urban areas where the market may be hot and overpriced. Urban real estate tends to be more volatile, and while fortunes are made, prices do come down as well and you want to make sure that you are not on the wrong end of these trends.
We also want to ensure that we don’t over borrow and over extend our personal finances, where we may need to be bailed out by our home equity. If that equity is no longer there, we don’t want to have this lead to a financial crisis from our not being able to meet our obligations otherwise.
A lot of people buy first and ask questions later so to speak, and take on way more debt than they are able to manage, and end up needing home equity financing to set things straight. While it’s fine to use the value of your home for borrowing, taking on too much unsecured debt is the undoing of many and should always be avoided.
Owning real estate need not be too risky, provided that one is prepared and understands that dropping property values can be very nasty if you need to sell.
Monica uses a balanced approach to investment analysis, ensuring that we looking at the right things and not confined to a single and limiting theory which can lead us astray.