Can Home Owners Benefit From Falling Real Estate Values?

by Mike Holman

Welcome to Money Smarts! If you're new here, please read the "About" page to find out more about this site. If you would like to receive updates by email then sign up here or you can subscribe to the RSS feed. Thanks for visiting!

Real estate values have been holding up in Canada reasonably well, but the American real estate market is down 33% from the peak in 2006 as measured by the Case-Shiller index.

Most people view falling real estate values negatively and would prefer to see their houses increase in value. The net worth of an average person is largely influenced by their debt (including mortgage) and their house value. If their house value go up and their debt level goes down, net worth goes up and they feel good about themselves.

But what about the person or family that wants to upgrade from a starter house to a larger, more expensive family house? Do they also benefit from rising real estate values? Sure, their starter house is worth more, but the more expensive house they want to buy probably increased by an even larger dollar amount, which means they might not be as well off compared to if real estate values had fallen.

In the investing world, it is said that an investor in the accumulation phase should be happy when markets fall so that they can buy more stocks on sale. They shouldn’t desire higher markets until they get close to retirement.

When you upgrade from a starter house to a family house, you are accumulating more real estate for your portfolio and should therefore want lower, not higher prices at that time.

Don’t believe me?

Let’s look at a couple of scenarios:

Martin bought a two bedroom condo several years ago and has seen the value drop by 25%. Now that he is married and has a young daughter, he would like to upgrade to a three-bedroom single family house.

He’s not happy about losing money on the condo, but he understands that three-bedroom houses are also cheaper after the market dropped.

I’m going to make a number of assumptions to simplify the calculation. These assumptions are not true, but the errors are not significant to the analysis.

  1. A three-bedroom single family detached house in Martin’s city is always worth twice as much as a two-bedroom condo in the same location.
  2. No transaction or insurance fees of any type.
  3. Martin has an interest-only mortgage and makes no payments to principal.

I’ll run two scenarios – one scenario involves the real estate market dropping 25% from the time he bought his condo, so both the condo and three-bedroom house drop 25%.  The second scenario involves the market increasing by 25% from the time he bought his condo and both the condo and house go up by similar amounts. Then I’ll compare and see which scenario is better for Martin assuming he sells the condo and buys the house.

Real estate market drops 25%

      • Initial condo value = $160,000
      • Initial down payment = $50,000
      • Current condo value = $120,000
      • Current Mortgage = $110,000
      • Cash remaining after sale = $10,000

He buys a three-bedroom house for $240,000 (twice what the condo is worth). After using the $10,000 left over from the condo sale as a down payment, Martin is left with a $230,000 mortgage.

Real estate market increases 25%

      • Initial condo value = $160,000
      • Initial down payment = $50,000
      • Current condo value = $200,000
      • Current Mortgage = $110,000
      • Cash remaining after sale = $90,000

He buys the same three-bedroom house for $400,000 (twice what the condo is worth). After using the $90,000 left over from the condo sale as a down payment, Martin is left with a $310,000 mortgage.

Which scenario is better?

When the market dropped, Martin ended up with a mortgage of $230,000. In the scenario where the market rose, his mortgage was $330,000. Clearly, from a debt and monthly payments point of view, Martin benefited from the dropping real estate market.

However, it should be noted that in the rising market scenario, Martin has $90,000 of home equity which is $80,000 more than in the dropping market scenario.

Which is better – higher debt and more equity or less debt and less equity?

In my opinion, the scenario which provides less debt is the more desirable scenario. The home owner will have smaller monthly payments which will allow them to build wealth quicker by paying down the mortgage sooner or using the difference to invest.

If he was planning to sell the house in the near future, then he might be better off with more equity and more debt.

Which scenario would you prefer?

More real estate articles

Why you shouldn’t trust your real estate agent

How to deal with bidding wars

11 things to think about when buying a house

 

Be Sociable, Share!

Want to learn more about RESPs? Buy The Book:

Resp-Book

The RESP Book: The Simple Guide to Registered Education Savings Plans

Everything you need to know about RESPs.

See it on Amazon now

Welcome to Money Smarts! If you're new here, please read the "About" page to find out more about this site. If you would like to receive updates by email then sign up here or you can subscribe to the RSS feed. Thanks for visiting!

{ 6 comments… read them below or add one }

1 Sudip Adhikari

Nice perspective but simplistic.

Debt is looked at from future yield (return) point of view.
Future servicing cost of debt should be a part of the math. (not only the mortgage but also the interest rate)

Anyways, I like the analysis. Thanks and keep it up.

2 jesse

Buy low sell high. Is it so hard? ;)

3 Traciatim

Now slow down just a second. You’re saying when prices go down it’s better for people who are looking to buy things? You just blew my mind!

4 Echo

Hi Mike, this was exactly what I was thinking before we bought our new house. If everything dropped 10% while we were trying to upgrade our house, it would work out nicely for us in the long run.

We waited for a year and a half while saving up our downpayment and seeing what happened with the market, but the problem we faced was the value of our house had dropped by 8-10% (as did the rest of the existing homes on the market) but unfortunately the prices on new homes kept rising.

Even now when we go to the show-home office of our builder, I hear them quote an additional $10k more than we paid.

Oh well, on the bright side I won’t have to do any renovations for a long time :)

5 Jake

unfortunately transaction fees should be included as well as minimum down payments. $240K you need $12K. martin is left holding the bag if his condo price drops because he can’t afford to buy that bigger home and would probably rent OR keep his home until values turnaround.

I understand what you’re trying to say, however.

6 Mike Holman

You got it – buy low and own high. :)

@Echo – The reality is that there isn’t much you can do to time real estate. It’s not like you can just sit out of the market for 8 years waiting for something to happen.

I guess the article was more of a “look at the bright side” for people who have seen decreasing house prices.

Leave a Comment

Current ye@r *

Previous post:

Next post: