Getting Real About Real Estate

from Fidelity.com

Getting Real About Real Estate

For more than a decade, many homeowners have grown accustomed to a booming U.S. real estate market that has allowed them to routinely tap their home equity to pay for new cars, home renovations, and even vacations. Some homeowners have come to think of their house as a personal piggy bank that magically refills after every withdrawal. That's understandable, given that real estate values skyrocketed 56% from 2000 to 2005.1

Thanks to rising real estate values, home equity today represents the largest non-pension asset that retirees can draw on to create lifelong income, according to the Fidelity Research Institute. Some financial experts have gone so far as to dub home equity as a new "leg" that can help to stabilize the traditional three-legged retirement income "stool" of Social Security, pensions, and personal savings.

Although this may give comfort to those near or in retirement, a study2 from the Fidelity Research Institute suggests that Americans should not count on home equity as a significant retirement funding source. The study suggests that overinvesting in a home can absorb financial resources that might be invested elsewhere to produce higher returns.

Home $weet Home?
Previous generations of Americans treated home equity as an illiquid asset, what Phillip Cook, a certified financial planner in Torrance, Calif., calls "the hole card -- the last card that's played." However, the Tax Reform Act of 1986, which gave personal residence debt significant tax advantages over all other forms of personal debt, opened the floodgates of home-equity lending.

Because of increasingly low-cost and convenient refinancing options, millions of Americans have tapped hundreds of billions of dollars a year from their homes through second mortgages, home-equity lines of credit (HELOCs), or "cash-out" refinancings. Such refinancings hit a record $243 billion in 2005, as reported by the Fidelity Research Institute. This routine use of home equity as revolving credit is a new development that marks a generational change in the way Americans think about their homes and the debt that goes along with them. As a result, future generations may be destined to carry much larger mortgages into their late middle age and even deep into their retirement years.

The experience of Steve and Mary Horan (not their real names) demonstrates the appeal -- and the danger -- of tapping one's home equity. In the 12 years since they bought their four-bedroom Victorian in Chicago's well-to-do suburb of Oak Park, they have watched its value more than triple. But when Steve, 52, tallies up their retirement savings, he doesn't include the house in his calculations. That's because, having taken out home-equity loans to pay for his older daughter's college tuition and to fund a $100,000 kitchen renovation, "we're at a point where we're pretty leveraged," he says. "If we were to sell, I don't think we'd be walking away with much of a nest egg."

Questioning lofty gains
Since 1963, median new home prices in the United States have risen by an average of 5.9% annually.3 At a glance, this might seem like a great investment return. Keep in mind, however, that this remarkable climb has been punctuated by sharp corrections that came at roughly 10-year intervals from the early 1970s, early 1980s, early 1990s, and, to a lesser extent, over the past year. These are the types of price drops that could do serious financial damage to those relying on home equity as a significant source of retirement income.

"Real estate has the same types of cycles that stocks and bonds do, and there have been plenty of busts in the real estate market where home prices have declined 20 percent to 30 percent," says Van Harlow, managing director of the Fidelity Research Institute. "Given that we're at the end of a 10-year real estate boom, it's easy to forget some of the downturns of the past."

For those on the cusp of retirement, being forced to sell into a falling real estate market can put a significant dent in their retirement dreams. Sometimes, however, there's no other choice. That's exactly what happened to some clients of Steve Davis, a certified financial planner in Mansfield, Mass. Having signed a contract to purchase a home in a retirement community, Davis' clients put their house in the Boston suburbs on the market, assuming it would be snapped up for the listing price of $1.8 million. After the property sat for six months, they dropped the price to $1.5 million, but by then, Davis recalls, the market had already slumped further. They finally sold the house for about half the original asking price. "They couldn't wait for the market to rebound and ended up chasing it all the way down," Davis says.

For a reminder of how real estate values can decline, consider that median new home prices dropped 10.7% in the third quarter of 2006 alone. According to the National Association of Realtors (NAR), prices for existing single-family homes slumped 2.7% in the fourth quarter of 2006 compared to the fourth quarter of 2005. Out of 149 metropolitan areas examined, 73 experienced price declines. In addition to weaker sales and declining prices, many economists are betting that the decline will continue as a glut of unsold new homes drives down the price of existing homes.

According to a Fidelity Research Institute report, The Equity You Live in: The Home as a Retirement Savings and Income Option, the inflation-adjusted returns on real estate (as measured by prices for new homes) were only 1.35% between 1963 and 2006. That means that a dollar invested in residential real estate since 1963 would have grown to only $1.79, just slightly better than low-risk Treasury bills. Conversely, a dollar invested in stocks would have grown to $12.36. Even the highest appreciating regions of the country, the Northeast and the West Coast, realized returns of 2.35% and 2.49%, respectively, which were lower than the 2.74% return on bonds.

When broken down into rolling 5- and 10-year periods, home values have underperformed average annual returns for stocks and bonds over every 5- and 10-year period from 1963 to 2005, according to the Fidelity Research Institute report. Real estate did provide slightly better downside risk protection during the worst periods for the stock market. However, it also forfeited significant upside returns when the stock market soared.

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