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The Dangers of Investing Too Much Into a Home

A single financial asset, a house, can become deeply tied to a person’s identity. Then, after excessive funds are committed towards the home, it is almost impossible to think objectively when it comes to wealth maximization—which can detract from increasing liquidity and funding retirement. It’s a dynamic that is especially true for early-career homeowners and causes their assets to get out of whack at a crucial time for balanced asset accumulation.

On this episode of Elementality, Reese and Matt look at why Real Estate (Rt) is included on the Elements periodic table, how to measure it, and whether a home should be included when measuring. As clients’ make decisions about their wealth, discussing where their home fits can be pivotal to their investment strategy.

 


Podcast Transcript

Reese Harper:
I think the caution that I’m looking for in early accumulation years is like, “Are we building equity and property at an accelerated rate while neglecting liquidity and qualified plans and business equity, that really need the time value of money on their side? And we can get a tax advantages for building up those other buckets, or am I just kind of emotionally rushing to build equity and property and pay off my student loans and pay off my debt? When ultimately like none of that gives me a significant financial advantage in my early years and the time value of money doesn’t go to work for me.”

[music]

Jordan Haines:
Welcome to Elementality. I’m Jordan Haines, Financial Planning Specialist at Elements. Each episode, Reese and Matt will discuss major challenges faced by financial advisors and the things they can do to navigate the complexities of delivering quality financial advice to clients. We hope you enjoy this episode.

Reese Harper:
Welcome to Elementality everybody. I’m your host, Reese Harper, in the studio with Matt Glazer, freshly flown in from Philadelphia to partake in what may be the most… I would say the most awaited podcast episode of the season.

Matt Glazer:
Wow, that’s a lot of weight.

Reese Harper:
And you don’t even know exactly why. First topic of the day that we’re really excited to chat about is probably the most emotional decision that an investor makes in their lifetime. And that is, where do they wanna live? And in what kind of place do they wanna live in? And what size of space? How much they wanna spend on it? Real estate is kind of a very emotional decision. I framed it that way, just because even if people are buying investment property, if they’re buying a building for their business or if it’s a second home or a primary residence, it’s still… There’s dimensions of identity and ego and like what they… How they see themselves, and that’s all tied up into this financial asset that people like to think is objective, but it’s really pretty emotional, even investment-related property.

Reese Harper:
So, Matt, I think the conversation today that you and I wanted to have was, in our work, we try to explore real-time sometimes, breaking apart a topic, and real estate is one that’s in the periodic table, in the elements group on the asset row. And we kind of wanna talk about why it’s important and how we might measure that and sort of grade that? Why does it make the cut for financial health? So I’m curious, even though I know you want to ask me this question… I’m curious why you think it made the cut. And I wanna see if I have anything to add to that. Why do you think it makes the cut?

Matt Glazer:
I’m gonna politic my way out of this for one second. Let’s just define for everyone real estate term for a moment. Okay?

Reese Harper:
Okay, I want that.

Matt Glazer:
So, real estate term is simple, total real estate equity divided by annual spending. So as a component… And when we look at like… If you’ve been listening for a while, we know that total term is net worth divided by spending, real estate term is really the real estate component of total term. And so I think the question just to repeat is, “Why are we separating out, real estate term as like this… ” There’s only… I should know this number, off the top of my head, but there’s only what, 12 elements? I can’t remember specifically. I mean to call out a specific element… A specific area of financial health as to say that, “This is pretty fundamental as like a domain in financial planning.” And so it’s a serious thing to call that out separately. So the question is, why is a real estate term, an area of financial health to even recognize and measure on a standalone basis? And I think that’s good for conversation. So that’s what it is. Ask your question again to me.

Reese Harper:
Yeah. Why do you think it is a stand-alone conversation topic? Why?

Matt Glazer:
I think for a lot of people, real estate term, as a percentage of total term, or more specifically real estate as a percentage of total net worth is substantial. If you’re buying, right? Not if you’re renting obviously, but if you’re buying. And for that same group of people, the investment required… The cash investment, the cash out-of-pocket today, to acquire that property is substantial on its own. So, why is it so emotional? It’s a lot of money.

Reese Harper:
Yeah, that’s a good point.

Matt Glazer:
You know, I think those are two…

Reese Harper:
Especially early on, right?

Matt Glazer:
Yeah, especially early on. And I know I’m talking… I’m being… A gross generalization here, but I think it’s a fair generalization to me. Because certainly there’s people on either ends of that spectrum where it’s much more emotional just to be able, to be able to have that conversation in the first place, of that being a possibility. And there’s other people where you’re talking about this emotion in the context of their second and third and fourth property. So, let’s focus on the happy meeting between those two, and it’s like, real estate tends to be a substantial portion of overall total term, of overall net worth, and for that reason alone, it’s expensive and it’s emotional.

Reese Harper:
Yeah. If we wanna go back to why the point of elements is to assess financial wellness and guide your advice.

Matt Glazer:
Right.

Reese Harper:
And for me like, if I look at a balance sheet, there’s four main components at the macro kind of categorical level that I wanna get oriented around first. Because it tells me a lot about the client. One of these four categories… Not all of them exist for everyone. But you could break it into 20 categories. I mean, look at like the balance sheets that are detailed right now, that coming out of the traditional financial planning software, there’s endless amounts of categorization you can create. But I wanted to distill it down to the smallest number of distinct groups.

Matt Glazer:
So you said, it tells you something about someone, that’s like a discovery context kind of situation, but as an ongoing… I think the question I really wanna get to, in this conversation, as an ongoing KPI, Key Performance Indicator to measure financial health, why is it so important, in that context, as an ongoing measure of financial health, why does a higher or lower real estate term indicate some level or any level of financial health. Or is it just continue to…

Reese Harper:
Well, I’ll politic my way around that question and go back to it. After saying yes, if assuming you already have done this upfront work, then we’ll answer Matt’s question. But the upfront work, you still have to look at these four… You have to look at the asset mix of your customer and be able to identify what weight and this kind of goes to your ongoing question. What weight of someone’s entire net worth is allocated towards real estate to begin with, and how much of that real estate is not likely to be productively turned into an income stream at some future point in time. So it’s essentially equity that’s going to be… It might as well be off balance sheet.

Matt Glazer:
How often do you think that conversation is happening today? Broadly speaking, real estate as in primary residence, as an asset class on my balance sheet.

Reese Harper:
Like most people… Most financial advisors care about two things. Getting new clients and justifying their fees, that’s the two biggest concerns. And real estate doesn’t help justify their fees in the way they normally think about their business. The way I think about their business, it does because AUMP’s are getting compressed therefore, comprehensive planning is on the rise. You have to be able to talk about a lot of other topics, you wanna justify your fee. So it’s related in my mind very strongly and to a lot of advisors who get… Who are kind of on this advice forward planning model, they get it. But I don’t think that conversation is happening ever until a client is at retirement and they realize that of the three and a half million dollar net worth they have, two and a half is still sitting in this property and they’re out of money in their IRAs and they’re out of money in their after tax brokerage accounts, and they go, Oh, well…

Matt Glazer:
What next?

Reese Harper:
“We do have two and a half million dollars sitting inside this house, and we don’t have to leave it to get the money. So now we have to make a decision how are we going to use this equity?” And the crazy thing is we never look at the balance of real estate equity as a usable asset like it’s so illiquid, there’s not a lot of financial instruments available. We have a heat lock and you got to cash out refi. Like you feel kind of constrained.

Matt Glazer:
Reverse mortgage.

Reese Harper:
Yeah, you’ve got a reverse mortgage, but then the asset leaves your balance sheet.

Matt Glazer:
Sure.

Reese Harper:
And so I would say, we have limited ways to access the liquidity, but it is liquid and there are increasingly more diverse types of mortgages that are gonna allow that to continue to expand as an asset class. So when you go and decide at age 59 to pull money out of qualified assets because you finally hit the place where you can, and you have a bunch of real estate equity in a primary residence, let’s say you’re pulling a 10% withdrawal rate out of a 401k account, and you could have left that until age 70 and a half and stuck with RMDs. But you’ve depleted and paid taxes on this 401K just because you didn’t have the conversation with the client about this asset that inevitably and in their particular case they would have to have tapped anyway at some point at age 76 or age 79 or… And you’re just like prematurely pulling from qualified assets because you’re not looking at the primary residence as a part of their asset allocation.

Matt Glazer:
So what are you trying… I’m talking about your discovery mindset, though, because you’re talking about like we’re we fast forward to the time where real estate becomes an asset I actually have to use. Let’s back up to that’s not even like in my peripheral. I’m in my 40s or 50s even.

Reese Harper:
I’m 29 years old and buy my first house.

Matt Glazer:
But I’m saying you could, 40s and 50s even, this is probably still true. What does discovery look like there?

Reese Harper:
Well, then it’s a question of how much equity are we going to build in property versus the other four assets that we have in option or the other three assets, at least we have the option of putting money into. We have after tax and brokerage accounts and liquid assets that we’ve talked about before, that’s our liquid bucket. And on the elements table, you can see the bottom left hand corner of the first row, you’ve got your liquid term score, that’s your after tax bucket, then you’ve got your qualified plans, then you’ve got real estate, and then you’ve got business equity as a contractor or a small business owner, if they are someone and most financial advisors work with business owners, a lot of them do, that customer has a chance to reinvest capital in their business, grow their topline, grow their profitability, grow their EBITDA. And so as a younger person, the tendency a lot of times is to eliminate obvious debt and acquire a real estate. That’s the most obvious kind of emotional response. “I need a house, I don’t want to stop wasting money on rent and I got to pay off my loans.” And that tendency still applies into people’s 30s and 40s.

Reese Harper:
But ultimately, you… Real estate, once you acquire that property, there isn’t like an advantage to paying it off faster. The assets are going to appreciate at the same rate, you’re going to have the purchase price locked in. You own it. You get to enjoy all the benefits of it. Having more equity in that property in an early age, that equity doesn’t actually grow, it doesn’t appreciate, the equity itself is, you had no advantage to building equity and property at an early age because it doesn’t even usually reduce your mortgage payment for a lot of people, unless they refinance it. And so I think the caution that I’m looking for in early accumulation years is like, “Are we building equity and property at kind of an accelerated rate while neglecting liquidity and qualified plans and business equity that really need the time value of money on their side? And we can get tax advantages for building up those other buckets. Or am I just kind of emotionally rushing to build equity and property and pay off my student loans and pay off my debt when ultimately, none of that gives me a significant financial advantage in my early years. And the time value of money doesn’t go to work for me.”

[music]

Jordan Haines:
Hi there, it’s Jordan. Are you on the hunt for ways to grow your book, speed up your planning process, and better serve your rising star clients and prospects? Then it’s time to find out how elements is helping advisors like you all across the country modernize their approach to financial planning. To chat with us, go to getelements/demo, and we’ll show you how elements can help futureproof your business.

[music]

Matt Glazer:
I still wanna hear a bit more about what your discovery conversation sounds like, what you’re ultimately trying to learn and understand in that… In uncovering what’s important about real estate with a client, but if we move into ongoing monitoring mode for a minute, it sounds like all we’re trying to… I mean, really, at the basic level, all we’re trying to do is remind ourselves that, yeah, it’s not as tactical as like a savings rate, which is gonna change that often year-to-year, it’s this much more longer term thing, but it’s a reminder that this is a major component of how we’re trying to build a work-optional kind of state and what independence looks like in the future, and it needs to be part of the conversation, whether it’s 1.9 or 2.5, a little less important than the fact that it’s just in the mix to begin with. Is that fair to say?

Reese Harper:
Well, yeah, it’s… For me, it’s a question of if I were to eliminate the tracking of that over time, if I get lazy to real estate, and if I get lazy to business equity monitoring, which is a related concept, if I get… These assets for a lot of people end up being their largest assets on their balance sheets, but as financial advisors, we kind of have a pretty narrow view of what we look at, and we kind of forget about these other options. I know in my experience as a financial advisor for dentists, a lot of personal financial advisors never track the business asset value on a personal financial statement, and that’s a pretty meaningful liquidity event that’s going to occur at some point in time, and then they build a lot of their asset allocation on a target income date that isn’t taking into account a liquidity event from an asset, and so you end up being very overly conservative in their asset allocation because if they would have known about this cash influx that was gonna occur at a particular point in time, they could have said, “Well, we’re not gonna tap this equity portfolio, then, until nine years after that liquidity event.”

Reese Harper:
It’s the same thing with real estate. If we know that we’re going to eventually… Let’s say I’ve got an earner, a normal earner in the 100K plus income range, or I’ve got someone in the 200K plus income range, like above median income, but not someone making a million or more, if that person continues to have an income level about that rate throughout their entire lifetime, it’s unlikely that they’ll be financially independent without the equity from property. They’re gonna need it at some point in time. They’re just like… It’s a very… You have to have a pretty high amount of lifetime earnings, like you can’t… When we talk about lifetime earnings, we’re talking about the amount of earnings, salary earnings someone would make in a lifetime. If you’re making $200,000 a year, you have 6 million in lifetime earnings. And in most major metro markets, a house is gonna be… It’s gonna take… To pay off a home, it’s gonna take a lot of that, it could be a third of someone’s lifetime earnings just to have paid off a home.

Reese Harper:
And so you’re probably… It’s unlikely they’ll be able to retire comfortably without utilizing that asset, but we don’t really caution the client against paying the property off too quickly ever, we kind of just allow their emotions to dictate that pace and then we save the difference. Or… I don’t really have a strong opinion about the rate and time in which we should pay off the property, when we have enough liquid or qualified assets to then shift and say, “Yeah, let’s pay off the house now.”

Matt Glazer:
Sure.

Reese Harper:
And that decision, I think, has a big impact on terminal wealth, lifetime wealth, and inheritance, and it also affects someone’s comfort level during retirement in a significant way, because the idea that you might have to borrow against your house or you might have to withdraw equity from property, that’s a pretty very emotional conversation for a lot of people, and then they’re not gonna be able to process it in five minutes when they’re 65.

Matt Glazer:
Let’s go back to the discovery question, what are you trying to learn then, given how you want to monitor a real estate over time, how you want that to be a conversation over time? What are you setting up initially? What are you trying to learn or guide the next five years or two years even worth of discussion around real estate on sale?

Reese Harper:
Initially, I’m trying to understand too is, what’s the median home price in their market, like how… Let’s just take an average person and let’s not try to get into investment real estate analysis for now, but what’s the median home price in the market and where do they sit in terms of their appraised value in their house relative to what the median looks like in the area. So it’s like pull up Zillow or pull up something, some other real estate program, and just look at median home price is it, and then be able to kinda see, “Okay, this person tends to skew their houses three times the median price of a neighborhood.” That tells me a lot about their spending patterns, that tells me a lot about what I might also discover in their lifestyle and the way they choose to live and vacation, and so it also tells me I can compare that to their income and say, “Well, if this person’s five times the median income or six times the median income, then it’s probably gonna work out.” If someone’s got an average income or a reasonably sized… A slightly above median income, but they’ve got a three times or four times median property value, and it’s still a single-income household, I just kind of know that I’m probably gonna have a little bit more pressure at retirement regarding this residence than I would with someone who’s maybe more in line.

Matt Glazer:
Might that also appear on the element scorecard in a way where there’s tension and red flags around another cash flow score probably?

Reese Harper:
Yes, I might see savings rate be lower, I might see burn rate be higher, and then I might also… If I look at total term and the total term of a client’s 10 and their real estate term is a seven, and they are 40, I know that at some point in time, they have depleted all their liquidity or most of their liquidity and put it into property. And they felt more comfortable with that. So quickly, if I see someone with a real estate term of one and a total term of 10, then I’m able to say, “Okay, why did they… Did they rent for a long time? Do they not really value property ownership? Do they have a high mortgage? Is this person already understand this cautionary tale, I’m gonna tell them about building too much equity inside of property? What kind of philosophy do they carry?” If someone is 60 and they’ve got a 25 total term score and I see a real estate term score of five. I’m wondering like, “Okay, either this person lives in a really modest home or they’ve never had a chance to build equity yet in property and there’s a big debt.”

Reese Harper:
I gonna know the right answer, as soon I get into more information, but I’m also not as concerned about having this big conversation with them about the importance of liquidating property. But if they’re at a 25 total term score and a 15 RT score, they might feel like they’re broke and have nowhere to go, and they don’t… They’re not gonna be able to retire, but they’re just a cash out refile away or a home equity line away or… From being just fine. But they haven’t emotionally gotten to a place where they’re willing to like, borrow money against this house that they’ve spent their whole life paying off. So it’s just… There’s a ratio that you’re looking for early on in life, you’re hoping that the ratio of real estate term to total term is less, earlier in someone’s life, because if they’re piling up a bunch of real estate equity early in their career on a balance sheet item that’s not gonna grow. I mean, you own the house… Again, the appraised value will go up whether you have equity in or not, so if we take all of our net worth and we’re concentrating it into real estate really early in our life, we’re not gonna get the compounding effects of all of that wealth. And if we don’t have a lot of wealth, ’cause we’re kind of an average earner and we try to get…

Reese Harper:
And we’re neglecting the equity markets or our business growth or qualified plan deductions because we wanna have more equity, that’s not gonna be good. So the ratio of real estate equity to total term, RT to TT score needs to be low in the first part of the career and it can get higher at the latter part of the care, but you don’t want it to become the predominant asset. Like, you don’t want real estate, primary use, especially, and even, vacation property that’s not… Like, I’ve got a cabin and I can rent it, but I don’t. Because I could tell myself that it’s a rental property, but it’s really not that efficient as a rental, I use it a lot. And so, my house and my cabin they’re kinda off balance sheet. You don’t wanna see those two items become the majority of someone’s net worth, especially at the expense of having gotten the compounding from those other groups. So that’s kind of the general theme. And then at certain ages, you can kind of grade and contrast and say, “Okay, if someone’s always below 20% of their total net worth in real estate equity for primary use, there’s probably no really red flags being raised, at any given time.”

Matt Glazer:
Yeah.

Reese Harper:
And even younger people, if they got a 50% net worth tied up in real estate, it’s okay. Because they probably just put down a big down payment and that’s to be expected. You might see it go from a high real estate to total term ratio and then decline slightly and then start growing again.

Matt Glazer:
Where it’s nice, the target score, like, where there’s some more set targets on a good healthy ranges for things like a savings rate, a liquidity term, real estate term, seems like one of those things that is more like… Outside of the allocation in terms of overall balance sheet, it seems more of like a values check, to the extent that the ratio is not in the range that you’re talking about, where like, someone’s young, but they happen to have a high ratio of real estate to total term. It’s probably worth a values conversation to make sure that we are spending accord… Like, “Okay, you’ve made a conscious decision that’s outside what I would normally recommend from a pure financial perspective, if this represents your true self and your true values and it’s in the line with what makes you happy it could totally be the right thing for you, but we should call that out and we should use this metric to monitor whether you’re living according to those values or not, whether you’re straying from that plan. So it changes more slowly for certain… It sounds like… And it’s…

Reese Harper:
There are some… It’s a constant kind of… I like to use it as a way to remind people that it’s a big part of their wealth and give them credit for that. This is probably the last point I’d like to make is, I don’t treat it like… I treat it more liquid than they treat it… Like, I like to treat it like just a part of this balance sheet and let them know early on, “We’ll probably be using that at some point and we’ll be using it then, and… ”

Matt Glazer:
I’ve noticed that. I’ve never had a conversation where someone has treated real estate as liquid as… A primary residence, as liquid as you do in conversation…

Reese Harper:
Yeah. And I just think it’s hard… It just puts a lot of other… It puts a lot of pressure on investment allocation, if you don’t incorporate it in a situation where it’s gonna be needed. And it causes people to have to develop, get off of training wheels and get right on to a fancy road bike. At the point in their life, in their 70s when they’re mentally not really ready to sort of be told that they’re… They gotta start using equity in their home. I just like preparing for that because it lets me have a more aggressive asset allocation with my other assets. And it helps me just grow their net worth a lot more efficiently. If I can get them to buy into the idea that, “This is just another asset. Don’t get attached to it. And it’s gonna rot and the roof is gonna come on, and you’re gonna have a great life with it.” Like, I love my house. I love my house. But I’m not gonna get attached to it like, “Come hell or high water, that’s the thing that I’m gonna like anchor my happiness on. If I gotta move, I gotta move. If I gotta rent, I gotta rent. Living is not house, life is bigger than house.

Matt Glazer:
But some people might think very differently than that.

Reese Harper:
And I would give them the opportunity to sort of start to come my direction slightly. ‘Cause I’m a financial advisor, and my goal is to try to help them align their values with wealth maximization, if possible. Sometimes they don’t align, sometimes people, like you’ll say, values of home did not align with wealth maximization. That’s okay, but it’s my job to at least show my bias, and the more attached we get to this thing, the more attached we get to it as an asset that’s appreciating somehow, like it’s… This is a place where we’re storing and usually inefficiently eating up our capital.

Matt Glazer:
And people are looking for that opinion.

Reese Harper:
Yeah.

Matt Glazer:
They’re coming to you for that opinion.

Reese Harper:
They want that. They’re not asking you to just be a yes man or a woman so… Alright, anyway, at the risk of offending somebody who wants to pay off their house at the first sight of a paycheck, we’ll let this one go into the airwaves and let one of you that listened to this come back and complain at me. Just kidding. I hope that there aren’t too many people that are offended by my characterization of treating the house a bit less emotionally, but I think it’s to everyone’s benefit.

Matt Glazer:
Yeah, I think it’s a worthwhile viewpoint to just to be aware of.

Reese Harper:
Enjoy your life. But your life is not your house, it’s just a part of it, and you might have several of them throughout your life, treat it like an asset, but realize that it’s one of the poorest performing ones you’re gonna have on your balance sheet. I just think that… On Twitter, I just saw this week, another person post a comment, and it was like, “How bad is the home as an investment?” And they were emphasizing kind of like how poor it is, and I do think there’s that dimension out there, too. I’m not trying to say that every dollar we put into this thing isn’t taking us backwards, but it’s… You kind of got me, I guess, thinking about this more of a risk area. I think it’s somewhat of a way to manage the risk of your overall net worth growth.

Matt Glazer:
Yeah, that’s a good lens, too.

Reese Harper:
That’s a good conversation today. We look forward to catching up with everyone next week.

Abby Morton:
Next time on Elementality.

Carl Richards:
Years ago, as I was traveling all over the world giving talks, generally for financial advice, financial advisor or financial planner audiences, but often also for clients. So a financial advisor would put together a group of clients and go talk. I sort of got this habit of asking people, if you could describe your relationship with money in one word, what word would you use? So I took a relatively unscientific poll, but it was all over the world, South Africa, and Australia, and New Zealand, and all over Europe, all over Canada, and the United States, and the word that people almost universally used and it didn’t matter where we were was anxious or anxiety.

Abby Morton:
You can learn more about the Elements Financial Monitoring System at getelements.com/demo, and schedule a time to talk with one of our friendly financial planning experts. Elementality’s executive creators are Reese Harper and Carl Richards. Elementality is produced by Abby Morton and directed by Jordan Haines. Have a good one.

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