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  • Accounting for equity of house in asset allocation

    I have been thinking for a while about how to account for the equity value of a house that one lives in, in terms of AA. This is more important for people who live in HCOL regions.

    Previously, I had thought to include the house in risk assets.

    However, recently I read a bogleheads thread that changed my thinking about it:
    https://www.bogleheads.org/forum/vie...4390&start=900

    The thread OP mentions that he accounts for the house value as an asset in the AA, but as a bond equivalent in the asset allocation. This makes a lot of sense to me.

    For example: Retirement: 500k stocks, 500k paid off house that one lives in.
    AA is then 50/50 by this method.

    The paid off house in a way, is effectively bond-like in that it saves rent per year.

    This reconciles in my mind why the AA setting in the financial literature is at odds with what real estate investors do and also, what people do at a young age. Say for a young person with net assets 100k in the form of a 500k house, with 400k mortgage. If one defines the house as a risk asset, mortgage as a negative bond, their risk asset/bond allocation is: 500/-400. Which is a bit nutty to think that everyone is 500% allocated when they start out on a mortgage (although they are in respect to their equity value/net worth if one categorizes the house as 100% risk asset).

    I tend to think there is a chance of selling the house at some stage prior to death, and also the house may appreciate when you sell it, so I would apportion some of it to equity risk i.e not 100% bond. The house is an asset that can appreciate, and indeed some people invest in houses on this basis.

    I tend to also applying a risk weighting to property (depending on type [commercial, land, residential] and specific factors). Often this is guided by what banks will allow as leverage (based on net rental yield).

    As an example, say a portfolio of:
    House one lives in, paid off (no debt): 1M @ 2.5% net rental yield
    Retirement : stocks 1M in broad equity index fund
    Land : 1M @ -1% net yield p.a

    Assuming no debt/leverage in the above (to simplify):

    This is a completely subjective assessment, and I might be wrong with it, but I would weight the above as:
    House: 800k bond, 200k risk asset
    Retirement : 1M risk asset
    Land: 1.5M risk asset, -500k bond

    Where $1 risk asset is equivalent to $1 at risk in an broad equity index fund.
    Land or any cashflow negative, appreciating asset, I would consider having an appreciating equity/risk asset component and a negative bond amount (equivalent to the negative yield/cashflow amount per annum).

    Hence the AA for the above holding (to me) would be : 300k bonds, 2.7M risk assets, or equivalent to renting the house (instead of owning and living in it) and owning instead a 3M portfolio with 90/10 stock/bond allocation in terms of risk tolerance (to me).

    I have always thought of my portfolio in terms of units of risk equivalent index fund, but this is a way of making clearer the risk weightings and whether they are coherent.

    What do others think, how do you account for house value in your AA?

    I think people mentally account for it in some way, and it is part of their risk tolerance, whether they are aware of it or not.

  • #2
    I see what you are getting at, but I dont understand why. Yeah, a paid off home is an asset but it isn't an investment. If anything, my home is a consumption item; contrast with my rental property.

    Comment


    • #3
      Originally posted by G View Post
      I see what you are getting at, but I dont understand why. Yeah, a paid off home is an asset but it isn't an investment. If anything, my home is a consumption item; contrast with my rental property.
      If your paid off home is a bond, and you think your risk tolerance AA is 80/20, and your investments are 80/20, then you may be underallocated.

      As an extreme example:
      You own a 5M paid off house
      You have 500k in retirement accounts entirely in stocks
      You think your AA is 100%. Is it ?

      Comment


      • #4
        Originally posted by Dont_know_mind View Post

        If your paid off home is a bond, and you think your risk tolerance AA is 80/20, and your investments are 80/20, then you may be underallocated.

        As an extreme example:
        You own a 5M paid off house
        You have 500k in retirement accounts entirely in stocks
        You think your AA is 100%. Is it ?
        The asset allocation of my investments would be 100% equities. And my investments would be 9% of my net worth.

        Comment


        • #5
          Do what makes sense to you. If that’s a nuanced inclusion in your overall portfolio, that’s fine.

          For me, I don’t include it in my AA as housing needs are continuous throughout life and the equity for all intents and purposes, illiquid. Since it is neither an investment or part of the portfolio I plan to retire with, I don’t feel the need to find a way to categorize it.

          I guess you could say that my AA refers to my investments only. I actually don’t include my EF in my AA either. Others prefer a different definition.

          Comment


          • #6
            I consider my home equity as part of my net worth, but not my asset allocation. I think of my investable assets as a corpus from which I will live. My house, although it provides me a place to live, does not provide for my other needs. Because a house does not produce assets for me to live off of, it is irrelevant to my asset allocation. The only way I may consider it is if I was required to live in a HCOL area for work and definitively plan on immediately leaving following retirement to a lower COL area. In that case, if you wanted to count the portion above what the house in a LCOL area would be and you already have in equity as a bond, that would be reasonable (e.g. 1M house in CA with 250k mortgage and plans to move to MI and buy a 500k house, counting 250k as a bond portion) - but this is still basically irrelevant.

            Don’t overthink this. I feel like everyone in a HCOL wants to do mental gymnastics to make themselves feel better. Don’t buy too much house, save enough and invest responsibly. If you can’t afford to live in manhattan, that’s ok. I’m not saying that’s what you’re doing, but it seems like everyone has a justification - my second cousin once removed lives there so I have to, if I can’t get Thai food within a block of my house at 5AM I’ll die, if I can’t pick between 37 musicals there’s no culture!??!

            Comment


            • #7
              It's not part of my asset allocation.
              As a new house owner, I haven't even added the down payment into our net worth tracking.

              I'm a Ferri core 4, so maybe I will go down on the reits a little, but that's all I can think of.

              Comment


              • #8
                I also don’t put the house in our AA.

                Comment


                • #9
                  My house doesn't impact my asset allocation. It does impact the withdrawal rate that I am comfortable with since I do consider it insurance I can tap if my financial portfolio fails.

                  Comment


                  • #10
                    If calling a house a bond will get investors to tamp down the mindless allocation to bonds, I’m all for it. Otherwise, I’m with @G.
                    Our passion is protecting clients and others from predatory and ignorant advisors. Fox & Co CPAs, Fox & Co Wealth Mgmt. 270-247-6087

                    Comment


                    • #11
                      It's interesting.
                      Against the idea that it is a bond and against the idea that it should not be included in your AA:
                      1. Say in the example of the young homeowner above 100k equity, 400k loan, 500k house. The house appreciates 100% in a 3 year period. Their net worth does seem to appreciate like they were 500% allocated to an asset that appreciated 100%. Most people would feel this way I would think (i.e happy).
                      2. In the other example of the above person with the 5M house during the GFC, where it may have gone down 40%, it probably didn't feel like that 5M was invested in bonds or wasn't worth thinking about.

                      I think the AA is used for retirement calculation, but also to estimate risk tolerance.

                      This is a problem. Say in the example above, the person with the 5M house and 500k in retirement account has 2M debt on the house during a recession. Even if your retirement portfolio is 0% stocks, it would feel uncomfortable. So the house and debt particularly have an effect on risk tolerance. Even if you have no debt and the 5M house declines in market value by 40%, and your retirement is 100% bonds, I would argue you will still feel like your AA is not 100% bonds.

                      Also, a dollar in assets is a dollar in assets. Even though you live in your house and do not intend to sell it, you can at any stage sell your house, invest it in stocks and rent (although you choose to make the choice that you never will).

                      Thinking about it more, I think there is a case for accounting for it as a risk asset. If you do this, you would have to factor in the amount of equivalent rent you have to pay for your FI number, which would include your house in your investable assets.

                      Comment


                      • #12
                        I think of net worth as two different numbers. My total net worth includes all my regular investments (stocks, bonds) plus home (no mortgage) and household goods (have lots of antiques). My financial net worth is regular investments only. My financial net worth is the number that I use for thinking about SWR. I really do not consider my house at all. I plan to live in my house until I need assisted living. I could of course sell my house and contents to increase my financial net worth but I see no reason to do this ever.

                        Comment


                        • #13
                          I feel like it should definitely be included in net worth calculation and possibly if you were going to be leaving a HCOL to retire to a LCOL area in the short term then maybe include it. Otherwise, the difficulty I see is how to rebalance your asset allocation if you include your home equity. It’s really illiquid unless you want to move.

                          Comment


                          • #14
                            Originally posted by Dont_know_mind View Post
                            I have been thinking for a while about how to account for the equity value of a house that one lives in, in terms of AA. This is more important for people who live in HCOL regions.

                            Previously, I had thought to include the house in risk assets.

                            However, recently I read a bogleheads thread that changed my thinking about it:
                            https://www.bogleheads.org/forum/vie...4390&start=900

                            The thread OP mentions that he accounts for the house value as an asset in the AA, but as a bond equivalent in the asset allocation. This makes a lot of sense to me.

                            For example: Retirement: 500k stocks, 500k paid off house that one lives in.
                            AA is then 50/50 by this method.

                            The paid off house in a way, is effectively bond-like in that it saves rent per year.

                            This reconciles in my mind why the AA setting in the financial literature is at odds with what real estate investors do and also, what people do at a young age. Say for a young person with net assets 100k in the form of a 500k house, with 400k mortgage. If one defines the house as a risk asset, mortgage as a negative bond, their risk asset/bond allocation is: 500/-400. Which is a bit nutty to think that everyone is 500% allocated when they start out on a mortgage (although they are in respect to their equity value/net worth if one categorizes the house as 100% risk asset).

                            I tend to think there is a chance of selling the house at some stage prior to death, and also the house may appreciate when you sell it, so I would apportion some of it to equity risk i.e not 100% bond. The house is an asset that can appreciate, and indeed some people invest in houses on this basis.

                            I tend to also applying a risk weighting to property (depending on type [commercial, land, residential] and specific factors). Often this is guided by what banks will allow as leverage (based on net rental yield).

                            As an example, say a portfolio of:
                            House one lives in, paid off (no debt): 1M @ 2.5% net rental yield
                            Retirement : stocks 1M in broad equity index fund
                            Land : 1M @ -1% net yield p.a

                            Assuming no debt/leverage in the above (to simplify):

                            This is a completely subjective assessment, and I might be wrong with it, but I would weight the above as:
                            House: 800k bond, 200k risk asset
                            Retirement : 1M risk asset
                            Land: 1.5M risk asset, -500k bond

                            Where $1 risk asset is equivalent to $1 at risk in an broad equity index fund.
                            Land or any cashflow negative, appreciating asset, I would consider having an appreciating equity/risk asset component and a negative bond amount (equivalent to the negative yield/cashflow amount per annum).

                            Hence the AA for the above holding (to me) would be : 300k bonds, 2.7M risk assets, or equivalent to renting the house (instead of owning and living in it) and owning instead a 3M portfolio with 90/10 stock/bond allocation in terms of risk tolerance (to me).

                            I have always thought of my portfolio in terms of units of risk equivalent index fund, but this is a way of making clearer the risk weightings and whether they are coherent.

                            What do others think, how do you account for house value in your AA?

                            I think people mentally account for it in some way, and it is part of their risk tolerance, whether they are aware of it or not.
                            I actually asked a similar question several weeks ago (elsewhere, not on these forums) but I never got an answer. I hadn't thought to view a paid off house as a bond, but that makes some sense to me to account for it that way.

                            On the other hand, I think viewing it as a risk asset also makes some sense for purposes of asset allocation. Particularly if someone has a goal of allocating x% to particular sectors including real estate/reits, I think you could argue it makes sense to take the value of one's house into account or else you might be overallocating to real estate beyond those goals. Also, the fluctuations in market value of a house would tie in much more closely with REITs/stocks than with bonds.

                            Comment


                            • #15
                              Originally posted by G View Post

                              The asset allocation of my investments would be 100% equities. And my investments would be 9% of my net worth.
                              Say we agree to disregard the family home in the investment AA.

                              Say someone has an investment portfolio of 3 houses worth 3M in total and 2M debt on that, what would you consider to be their AA ?

                              Comment

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