Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Modernizing real estate finance

I believe that real estate finance today is where corporate finance
was a hundred years ago, and the current global financial turmoil is
the beginning of its transformation into something similar to modern
corporate finance. About a century ago, corporate finance adopted its
modern form where equity is owned by large diversified pools of
capital with low levels of leverage. Real estate as an asset class is
of the same size as the equity market, but it is still dominated by
small undiversified owners with large amounts of leverage.

Most houses are owned by individuals who finance them with mortgage
debt. A high quality mortgage might have a loan to value ratio of 80%
while very few modern businesses are run with 80% debt to total
capitalization. In lower quality mortgages, the loan to value ratio
could be in excess of 90%. This is a prescription for financial
fragility. While modern economies can easily absorb the stock market
dropping by 50% in a year, their financial systems are devastated by
even a 20% drop in real estate prices.

This is also a problem from the investor view point. Since real
estate is as large an asset class as equities, an institutional
investment portfolio should ideally have a large holding of real
estate, but this cannot be achieved because ownership interests in
real estate are not available in sufficient quantity (see for example,
Hoesli, Lekander and Witkiewicz, “Real Estate in the
Institutional Portfolio: A Comparison of Suggested and Actual
Weights”, Journal of Alternative Investments, Winter
2003.) Almost all real estate is user owned and therefore the only
exposure that you can buy to real estate in the financial markets is
mortgage debt (residential or commercial).

Corporate finance was also like this centuries ago. Bond markets
existed long before stock markets, and for the first couple of
centuries of their existence, stock exchanges like the London Stock
Exchange traded bonds more than stocks. Apart from their own money and
that of their friends, businessmen had to rely largely on debt to
finance their businesses. But all this changed in the late nineteenth
century as Mitchell has described in his fascinating book The
Speculation Economy: How Finance Triumphed Over Industry
, BK
Currents, 2007. The joint stock corporation meant that anybody
anywhere in the world could own a piece of any business.

The equivalent transformation in real estate has yet to happen. For
most individuals today, their home is the most undiversified
investment that they have (even more undiversified than their human
capital), and it is a heavily levered investment. If an individual
were to buy shares worth several times his annual income on margin, we
would doubt his sanity. But when he does the same thing in real
estate, governments encourage the imprudence by giving generous tax
breaks.

This fragile financial structure where everybody buys real estate
on margin with a downpayment of only 10% or 20% is a prescription for
huge systemic risk. By contrast, in the equity market, pension funds
and mutual funds have negligible levels of leverage; very few
individuals buy stock on margin; and corporate investments in stocks
(strategic investments) are also financed with relatively low levels
of debt.

The fragility of real estate finance is less of a problem so long
as people irrationally keep paying mortgages even when they have
negative equity in their homes. Standard valuation models of mortgage
securities (whether it is prepayment modelling or default modelling)
assume that the home owner is irrational and will neither exercise the
prepayment option (call option) optimally nor exercise the default
option (put option) optimally. As financial systems get more
sophisticated, these assumptions are bound to be falsified. As this
happens and jingle-mail becomes more prevalent, the business of
selling near money put options on real estate (which is what mortgages
are all about) is bound to be less and less viable.

In the period of transition, large portions of the financial
system will doubtless lose much of their capital. This is what one is
seeing in the global financial turmoil. It is a necessary part of the
process of creative destruction through which hopefully real estate
finance will be transformed just as corporate finance was transformed
a century ago.

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