Our asset allocation in the past was based strictly on our retirement funds that I can control at a 88/12 stock/bond asset allocation [1].
Then I worked on adding phantom bond [2] allocations to incorporate the net present value of our pension plans and analyzed the impact of including the same for possible social security benefits.
The next step is finding a way to account for something that has always troubled me – the exclusion of real estate in our portfolio. Our house [3], our rental [4] properties [5], and now our cottage.
Until now, real estate has only ever showed up on our balance sheet, but never was included in our portfolio.
The Debate on Adding Real Estate to Asset Allocation
As the real estate we’re accumulating approaches the million dollar mark, every time I rebalance our portfolio, I’m left thinking that by ignoring it, I’m doing myself and our portfolio a huge disservice by ignoring the entire asset class and the accompanying risks; it’s finally time to add it.
However, I’m sure I’ll be met with some resistance from readers on adding the real estate to our portfolio. Here are some of the most prominent arguments (and the two that I’ve struggled with myself):
Illiquid assets. Since all of the real estate is illiquid (especially compared to stocks), it’s hard to rebalance like you can with stocks. However, just because it’s illiquid and carries a different risk doesn’t mean we should ignore the investment all together.
You need a place to live. While it might make sense to include the true rentals and the second home with vacation rental income, many argue you should exclude your primary home because you need a place to live. However, if you consider that you can rent out your home to earn income, and consider your housing requirements as personal spending, you can derive a value of “implicit rent” on your primary home by “renting from yourself”. You can then separate the real estate investment from your need for housing. I can demonstrate this point with our own house, our true cost of needing a place to live (if I’m being totally honest) is actually less than the amount we pay to rent our current house.
Accounting for the Mortgages with Negative Bonds
Once I convinced myself I wanted to add the real estate, I began researching ways to account for the mortgage. Do you include only the net asset value (fair market value – mortgage)? Or include the entire fair market value since that is the value subject to market fluctuations?
The solution is negative bonds. After using the entire value of the real estate as an asset, use the value of the mortgage as a negative bond [6]. Essentially, a fixed rate mortgage acts like a bond with fixed payments. Of course the exception is that you are the one issuing the bond instead of buying it, which makes it a negative holding.
What Real Estate and Negative Bonds Do to Your Portfolio
Let’s put it into numbers to wrap our brains around it. Here’s an example of the real estate and mortgage as a negative bond on a hypothetical $500,000 portfolio:
Stocks: $350,000
Bonds: $150,000
Allocation: 70/30 stock/bond
However, the person also owns a $200,000 home with a $150,000 mortgage; allocate the mortgage as a negative bond of $150,000 and your actual portfolio is 100% stocks, and 0% bonds:
Stocks: $350,000
Bonds: ($150,000 – $150,000) = $0
Allocation: 100/0 stock/bond
Result: You are now actually 100% invested in stocks.
What about if your mortgage is larger than your bond holding? Consider the example above with a $500,000 home and a $400,000 mortgage, now your portfolio looks like this:
Stocks: $350,000
Bonds: ($150,000 – $400,000) = -$250,000
Result: You now have a negative fixed income holding, and are more than 100% invested in stocks.
Obviously, including these calculations takes your portfolio to a whole new level, but one can argue it’s a more appropriate assessment of what you are actually doing with your money.
Where I’m At
I’d love to tell you that I have this all figured out, but I don’t yet. Here are some of my obstacles, that I’d love to get your input on:
We are personally liable for the rental mortgages. Even though our rental properties are in a partnership at a 50% ownership, we are personally liable for 100% of the commercial mortgages, so there is an extra component of risk to sort through. It needs to be included, but how do I account for the mismatch in liability?
Other debt factors. If I include the bank mortgages, how do I handle the fact that I used credit cards instead of a traditional mortgage [7] on the cottage? With the use of credit cards, student loans, and other unique loan sources, many of our assets are not tied to the typical collateral, which appears to be skewing some of my calculations.
How do tax benefits impact results? There is a tax benefit of the deductible mortgage interest that isn’t factored into the negative bond. Do I need to account for this to make the asset allocation valid? I would argue yes.
How do ARMs factor in? One of the reasons for valuing a mortgage as a negative bond is because of the similarity to bonds, but since I have an adjustable rate mortgage [8], it’s not going to behave in the same way a fixed rate mortgage behaves like a bond; and it loses an inflation [9] hedge that a fixed rate provides. Is an ARM now a short term negative bond?
It’s not maintainable. Even if you can argue for inclusion of real estate and mortgages in a portfolio, you cannot continually add to a mortgage, which means the asset allocation will continually move. This isn’t necessarily a drawback, but it is something to be aware of.
Action Plan
So here’s what I’m planning to do to our portfolio, although it’s turning out to be a bigger project than I envisioned (I know this because I’ve already started working on it and ran into the obstacles above in my calculations):
Real estate fair market values: Adding as assets to the portfolio in a separate asset class.
Mortgages: Subtracting as a negative bond holding from bond and phantom bond allocations.
Do you include real estate and mortgages in your portfolio? What did it do to your portfolio?