Tag Archives: college

Summary The typical millennial profile (post-college graduation) has human capital as their only asset, but is also effectively short both bonds (student debt) and residential real estate (renters). Given most millennials’ desire to own a home, their largest risk exposure, pre-home-ownership, is the risk of inflation in residential real estate, which can far exceed conventional CPI. Given this, we recommend a large portfolio exposure, indirectly leveraged if possible, to various components of the residential real estate sector, until the goal of home ownership is reached. We offer a portfolio solution to implement our recommendation including specific sectors and stocks. Along the way, we explore various other issues, such as setting your goals, repaying your student debt, and the best time to buy a home. Typical asset allocation weights for millennials The popular financial planning educator, Michael Kitces, on his blog Nerd’s Eye View , wrote about the importance of taking a holistic view of the client’s assets to maximize the risk/return profile. Particularly in your early years, human capital may be up to ten times larger than your financial capital. He cites a paper written by David Blanchett and Philip Straehl of Morningstar, ” No Portfolio Is An Island ” where they create a nice graphic, shown below, of how the typical holistic capital structure changes as you get older. We are interested in looking only at the millennial age group of 25-35 and we will add to this chart further by looking at both assets and liabilities, and actual and implied risk exposures. Typical profile of millennial has student debt and is a renter While not all millennials will fit into our “typical profile” we define the “typical millennial” as having graduated college – with the help of student loans, likely renting as opposed to owning or living with parents, and a desire to someday own a home. We provide the following statistics to support our “typical profile”: From the Institute for College Access & Success , “seven in 10 seniors (69%) who graduated from public and nonprofit colleges in 2014 had student loan debt, with an average of $28,950 per borrower.” From The National Association of Realtors, Generational Trend Report (2015) Exhibit 1-10, 59% of homebuyers age 34 and younger, rented an apartment or house prior to buying their home. In their study, Zillow found first-time homebuyers are renting for six years before buying, are older and less likely to be married than they were in the past, are buying increasingly expensive first homes and spending more relative to their incomes than any time in the past 40 years. Quoting from their press release , “Millennials are delaying all kinds of major life decisions, like getting married and having kids, so it makes sense that they would also delay buying a home,” said Zillow Chief Economist Dr. Svenja Gudell. “We know millennials value home-ownership and want to buy. The next challenge will be figuring out how they can save for a down payment and qualify for a mortgage, especially while the rental market is so unaffordable all over the country. The last hurdle will be finding a home they like amidst very tight inventory, especially among starter homes.” While this describes the average millennial, there is nevertheless a significant difference in wealth levels among millennials. Courtesy of the Equifax Client Insights , in addition to average household assets, estimated household income varies from $55,000 for Mass Market, to $110,000 for Mass Affluent, to $289,000 for Affluent. Establish real exposures and risks Given this “typical profile” we can now begin to look closer at the real and implied risks as a starting point to understand the most suitable investments for the financial component of their portfolios. The chart below shows the expanded weights of the portfolio components to include the liabilities as well. (click to enlarge) The liabilities are shown as negative risk exposure, below the zero line. The student debt is easily understandable as a liability, but you may be wondering why renting your primary residence shows up as such a large liability. This point is the key idea to our whole thesis: Renting a home is very similar to being short residential real estate. Although technically you don’t have to buy the house, at some point in the future for most people, this is their goal, so the risks are effectively very similar. Put another way, being a renter exposes you to significant risk if the price of residential real estate goes higher. With this more comprehensive risk profile we can now begin to think more clearly about goals and planning. With most millennials wishing to own a home, their biggest exposure (excluding their human capital) until they reach this objective, is the risk of inflation in residential real estate, which can far exceed conventional CPI inflation from time-to-time, for many years. The first chart shows various home price indices together with the traditional Consumer Price Index. Notice that they do not move neatly together and that home price indices have been higher than inflation for most of the past fifteen years. People who live in a major metropolitan area like San Francisco, New York or Los Angeles will instinctively know this is the case without needing to look at a chart. (click to enlarge) This chart shows the year-over-year percentage change in the Home Price Index less the traditional Consumer Price Index. Unless we are going into a recession, home prices always seen to rise faster than CPI. (click to enlarge) So given your implied short position in residential real estate, and the worries of getting caught in a short squeeze, what should you do to achieve your objective of owning a home someday, and how does it fit into your big picture? Setting your bigger picture financial goals While many financial advisors or target date funds invest for retirement, thinking 40 years down the road, we believe it easier to set and visualize a 10-year goal than a 40-year goal. At age 25, it’s difficult to focus on retirement and you don’t have to – just focus on getting to the next level . We posit that a reasonable goal for millennials is to get to age 35 or 36 and accomplish the following: Be free of student debt Own a home Have an emergency fund of 6 months’ salary While the requirements to reach this goal will vary widely, in general they require two basic things, which you mostly have control over and should try to maximize: Maintain the income from your job, or similarly if you take the entrepreneurial route. Save at least 10% -15% of your earnings every year. The two biggest risks to reaching these goals are 1) losing your job/income and 2) inflation in residential real estate prices. Allocating your saving to various financial assets to reflect your goals and risk profile 1. Human Capital Don’t rely on your portfolio to protect your largest asset. Your portfolio is small in relation to your earnings at this stage so it will not have a meaningful impact if you lose your job. The study cited by Kitces involves hedging your human capital by investing in industries that are not correlated with the industry where you make a living. For example if you are in the tech industry, do you really want more exposure to tech stocks? While there is some merit to this later on in life, we think it not relevant in your early career stage. Losing your job could occur for a number of reasons beyond your control, but for the most part you are in control of this, which means keeping your skill set up to date, and make sure you are adding value to your employer – even if a recession does come along, employers will try hang on to their best people for as long as possible. 2. Real Estate The real estate inflation risks we are exposed to are out of our control, so we want to hedge this as closely as possible. We recommend a large exposure, indirectly leveraged if possible, specifically to various components of the residential real estate sector, until you own your home. We think that allocating at least 25% of your portfolio to an aggressive, inflation tilted, residential real estate portfolio of stocks makes sense. 3. Bonds Most advisors will not recommend you have much exposure to bonds at this point in your life, and we recommend you have exactly zero allocated to long bonds. You are already short bonds with your student loans so why own government bonds at 2-3% when you can pay down your student debt which earns you 5-6%. If you want to keep six months of emergency funds in short term 1-2 year government bonds that is fine. Given that real estate inflation is your biggest uncontrollable risk until you purchase your home, and given that being short bonds (i.e. borrowing) benefits from high inflation, we actually recommend paying down only the minimum necessary on your student loans, until you own your home. We also endorse getting some additional, indirect (meaning you are not borrowing directly) short exposure to bonds, by investing in companies with higher leverage ratios. It is more risky, but keep in mind you are merely balancing out your overall risk. A portfolio solution to implement our recommendations The portfolio solution we have created is designed specifically for millennials who are saving toward owning a home within a 7 to 10 year horizon. The holdings are designed to hedge against an implied short position in real estate created from renting. We invest in companies that are geared specifically toward the residential real estate market mostly through land, homebuilders, apartment REITS, realtors, and some exposure to home improvement retailers. The objective is to keep pace with or exceed the rate of appreciation in home prices. We identify a list of suitable stocks in these industries: Land – The Howard Hughes Corporation (NYSE: HHC ), iStar, Inc. (NYSE: STAR ), Tejon Ranch Co (NYSE: TRC ); Homebuilders – Lennar Corporation (NYSE: LEN ), Toll Brothers, Inc. (NYSE: TOL ), DR Horton Inc. (NYSE: DHI ), Pulte Group, Inc. (NYSE: PHM ), KB Home (NYSE: KBH ), Cal Atlantic Group, Inc. (NYSE: CAA ); Realtors – Zillow Group, Inc. (NASDAQ: Z ), Realogy Holdings, Inc. (NYSE: RLGY ), RE/MAX Holdings, Inc. (NYSE: RMAX ); Home Improvement Retailers – The Home Depot, Inc. (NYSE: HD ), Lowe’s Companies, Inc. (NYSE: LOW ); Apartment REITS – Camden Property Trust (NYSE: CPT ), Apartment Investment and Management Company (NYSE: AIV ), Avalonbay Communities, Inc. (NYSE: AVB ). If you wish to create a passive portfolio with these, you can allocate say 20% to each category – there is no magic formula, although some sectors like land are more leveraged to changes in home prices, so you can adjust the mix to suit your risk profile. In our actively managed portfolio we analyze each stock to make sure we are buying them at reasonable valuations; since we are planning on holding this portfolio for up to 10 years, and the single biggest determinant of long term returns is the price that you bought it at – do your homework here. We also consider gaining additional indirect leverage via company debt, land exposure and stock beta. Remember, with inflation, debt is your friend. Actively managing your positions If you have a nice profit and perhaps enough to make your down payment, you may want to cash out and remember the purpose of why you invested in these stocks in the first place. Lastly, it’s probably better not to try and time the market; if we go into a recession, real estate stocks will get hurt like all other stocks. But remember the purpose of this portfolio is to hedge your future down payment on your home – so if your portfolio goes down, home prices will likely decline too, and you will benefit from being able to purchase your home at a cheaper price – your hedge will still have served its purpose. When is the best time to buy a home? Lastly, let’s look at a few factors to keep in mind around the timing of buying your home. The following graph plots the Housing Affordability Index, the National Home Price Index and the Renters CPI Index on the left hand scale, and the 10 Year Treasury rate on the right hand scale. (click to enlarge) Housing affordability index It is a function of income levels, home prices and interest rates. For a given level of income and interest rates, there is a limit on how high prices can go. It’s good to know where we are in this cycle; for example in 2007 you can see the huge spread between the home price index and the affordability index – unsustainable, as we know in hindsight. Currently, prices are almost back to where they were in 2007 but the affordability index is much better than in 2007, so don’t expect home prices to come crashing down like they did in 2008. Rental Inflation Rents seem go up steadily over time. Quite simply, this means you really should try to own your own house at some point. Is it better to buy when interest rates are high or low ? While it feels good to know you have locked in a low rate for 30 years, buying when rates are low is not necessarily the best time. For one thing, low rates imply that you will pay a much higher purchase price than when rates are high. It’s generally better to buy when rates are high and declining; your purchase prices will be lower (also your property taxes may be lower) and you may have the option to refinance your mortgage if rates go down plus your home value should increase with lower rates; if you buy when rates are low, you pay a higher price (and higher real estate taxes) but have no option to refinance at a better rate in the future and your home value may also decline when rates rise. Your income level The lower your income level, the more at risk you are to rising real estate prices and being priced out of both the home purchase and rental market, creating a greater sense of urgency to purchase your own home. Non-monetary considerations may trump everything else Sometimes the timing of home purchase will likely be driven more by family considerations, or the peace of mind and sense of security of owning a home. Conclusion Hopefully this article helps you to plan toward owning a home within the next ten years by looking at your balance sheet holistically.