As the investment world becomes more and more curious each day, it’s appropriate to look at one of the most fundamental changes taking place today – investors’ increasing preference for debt over equity.
Although not wanting to own hard assets as an investment strategy might seem counterintuitive, there are fundamental reasons why this shift is occurring.
We’ll review some of those in today’s Q2 2018 newsletter with the theme “Alice Through the Looking‐Glass”.
“If I had a world of my own, everything would be nonsense. Nothing would be what it is, because everything would be what it isn’t. And contrary wise, what is, it wouldn’t be. And what it wouldn’t be, it would. You see?”
― Lewis Carroll, Alice’s Adventures in Wonderland & Through the Looking‐Glass
The Dentist With $1 Million in Student Debt
The first reason that debt is becoming the new equity is that debt can, in fact, be turned back into equity.
Sometimes that’s accomplished with hypothecation or collateralization, other times through lender foreclosure and property seizure. In the case of student loan debt, converting debt back into equity is done by allowing the buck to stop with the taxpayer.
Mike Meru, a dental school graduate from USC, managed to accumulate over one million dollars in student loan debt – a balance that according to the Brookings Institute will never be fully repaid.
Dr. Meru converted his student debt into equity by creating a medical practice that earns $255,000 in annual personal income, a house worth $400,000, and a Tesla. USC converted Meru’s student loan debt into equity when the university received $601,506 in tuition payments from the federal government.
Because student loan payments are based on a percentage of discretionary income, over the next 25 years Dr. Meru’s monthly student loan payment will be only $1,589.97. Meanwhile, his student loan balance will have grown to over $2 million, including accumulating interest. After 25 years his debt will be forgiven, according to federal law.
“For, you see, so many out‐of‐the‐way things had happened lately, that Alice had begun to think that very few things indeed were really impossible.”
Rainbows, Lollipops, and Debt
The second reason that debt will continue to be a very attractive investment is because of the laws of financial physics.
Specifically, as interest rates continue to rise so will the preference for the underlying debt instrument that generates the interest payment. And as interest rates rise, the prices of most other assets go down.
For the time being, there’s more than enough debt available for purchase. According to the Federal Reserve, in Q2 2018 household debt grew by 3.5% to a total of $13.29 trillion:
- Mortgage debt increased by $60 billion to a total of $9 trillion
- Student loan debt increased by $2 billion to reach a record high of $1.41 trillion
- Auto loan debt increased by $9 billion to $1.24 trillion
- Credit Card debt rose by $14 billion to a total of $829 billion
It’s not just households that conƟnue to create income-generating debt. U.S. Government debt recently reached nearly $20.8 trillion. Then there are the rising levels of pension fund debt obligations, along with state and local government debt.
“Alice had got so much into the way of expecting nothing but out‐of‐the‐way things to happen, that it seemed quite dull and stupid for life to go on in the common way.”
Home Equity Wealth Creation
As mortgage debt soared to $9 trillion, homeowner equity had some pretty impressive gains as well. According to CoreLogic’s most recent Home Equity Report homeowners with mortgages saw their equity increase by 13.3% last year, representing a gain of over $1 trillion:
- Nationwide $16,300 average gain
- Washington state $44,000 average equity gain
- California $51,000 average gain
Rising equity in a home makes the consumer feel good and borrow and spend more. But the problem with equity is that it doesn’t actually turn into cash until the property is sold. And equity has a nasty habit of suddenly disappearing in a down market cycle while only the interest income generating debt remains.
It’s becoming increasingly evident that the home equity wealth effect is beginning to vanish before our very eyes as:
- Foreign buyers stop investing in the U.S.
- Home price appreciation slides to a 2‐year low
- New home sales continue to decline
- Housing starts are at a 2‐year low, plunging nearly 13% in June
“She felt a little nervous about this; ‘for it might end, you know,’ said Alice to herself, ‘in my going out altogether, like a candle. I wonder what I should be like then?’ And she tried to fancy what the flame of a candle looks like after the candle is blown out, for she could not remember ever having seen such a thing.”
Why Own When You Can Rent Instead?
Once upon a time owning a home was the Great American Dream, and one of the surest ways to build a nest egg and save for old age. But not anymore.
Housing ‘experts’ have various explanations of why more and more people in the U.S. rent where they live: Lack of supply, rising home prices, zoning restrictions, and millennial preferences.
But whatever the reason – and we think that none of the above reasons explain what’s really going on in the residential real estate market – paying rent is simply another form of debt.
And this ‘rental debt’ continues to grow:
- Single-family home rents rose 2.7% annually according to CoreLogic’s Single Family Rent Index
- Residential rental rate growth overall is increasing 2% ‐ 3% annually according to Zillo
As a result of the growing demand for residential rental property, multi-family mortgage debt used to finance property acquisitions has increased by $19.3 billion for a total of $1.3 trillion – the largest increase since the Global Financial Crisis.
“I could tell you my adventures—beginning from this morning,” said Alice a little timidly; “but it’s no use going back to yesterday, because I was a different person then.”
You’re Not Getting Older, You’re Getting Better
“You are old Father William,’ the young man said, ‘and your hair has become very white; and yet you incessantly stand on your head ‐ do you think, at your age, it is right?”
Today’s senior citizens – and by that we mean those 55 years and older – aren’t like the senior citizens of yesteryear.
In July’s article Why the U.S. Housing Market Will End Up Like Japan’s, we discussed how rising health care costs – which are another form of debt – and an aging demographic are making a significant long‐term impact on the demand for single-family homes.
While both the amount of debt and the number of renters in the U.S. continue to rise, assisted living and senior-focused housing is a bright spot for investors. In fact, while U.S. commercial real estate has largely fallen out of favor with the Chinese investor, China continues to invest heavily in U.S. senior living properties.
The National Association of Home Builders’ most recent 55+ Housing Market Index notes that all four components of the Index remain strong:
- Present Production rose 6%
- Expected Production jumped by 11%
- Present Demand gained 4%
- Expected Demand rose by 7%
With much thanks to Lewis Carroll, Alice’s Adventures in Wonderland & Through the Looking‐Glass, we’ll close this quarter’s newsletter with a final thought:
“Finding meaning, like losing meaning, involves pleasure as well as pain. But then losing meaning, like finding it, does too, as the best nonsense reminds us.”
We look forward to sharing our thoughts again in our next quarterly report. In the meantime, should you have any questions, we look forward to hearing from you.
Very truly yours,
Chief Executive and Investment Officer