The Market Flash
The Deficit Commission, chaired by Erskine Bowles and Alan
Simpson, had many interesting proposals concerning deficit
reduction. One can debate the relative merits and demerits of each
proposal and the economic benefit to the country. However, our job
as investors is to evaluate the impacts of what they propose and
take advantage of any changes in valuation before the wider market
discounts the changes. The proposal on the table is to limit
mortgage deductibility only for mortgages of 500k or less.
The purpose of this article is to examine the effect of that
proposal on houses that would have a mortgage of greater than 500k.
Obviously it is not known whether the Deficit Commission's
suggestion on mortgage deductibility will be implemented, but just
the discussion of it can affect current prices.
First things first: The U.S. tax policy of mortgage
deductibility is baked into the price of every house in the United
States, whether that house has a mortgage or not. The U.S. has had
mortgage interest deductibility since the 1950s or earlier. Each
home in the U.S. is valued at what it can currently sell for to new
buyers who generally have to get a mortgage to make the purchase.
Any buyer who is purchasing with a mortgage, takes out a bigger
mortgage than they would otherwise because mortgage interest is
fully deductible on their tax return.
So all housing prices in the U.S. now, both at the high end and
the low end, reflect the fact that interest on mortgages is tax
deductible. There is some part of the value of every house that
would fall if mortgage deductibility were taken away. There are
many countries in the world that don't allow mortgage interest
deductibility so it's not a constitutional right.
So let's establish the price of houses that will not be affected
by the Deficit Commission's proposal. This is pretty easy.
Mortgages up to 500k will still be deductible and just for the sake
of simplicity let's assume a bank would want 100k down on a 500k
mortgage. So for houses of 600k or less, it's business as usual in
terms of valuation. If the 500k is not adjusted for inflation going
forward that could raise or lower the price of houses near the top
end of the range, depending on what the decision was.
The purpose of this article is to use some
financial/mathematical techniques to guesstimate the affect of the
Deficit Commission's proposal on houses that have a greater value
than 600k, just factoring in the deductibility of mortgage
interest. Many things affect high end housing prices; elasticity of
demand, how much down payment is made for a house in a certain
price range, and the local employment market.
This article is going to focus only on the mortgage
deductibility effect on housing prices of greater than 600k. The
approach is to discount the present value of 30 years' worth of
interest payments in a world where there is mortgage interest
deductibility and a world where there is not. The difference
between those two numbers should be a rough estimate on housing
prices over 600k of having their mortgage deductibility taken away
by the Erskine/Bowles commission. Present value is a financial
concept that allows a single number in the present to represent the
value of a series of future payments. Here our future payments are
interest paid on a mortgage and the Present Value is the amount
that can be borrowed to buy the house.
So let's look at the effect of taking away mortage deductibility
on mortgages over 500k. I am going to include the Excel® formulas
used in the calculations so you can make your own calculations if
you are interested in a different price range or want to use
different assumptions. I am going to target a mllion dollar house.
600k of the value of the house is unaffected by the Deficit
Commission's proposed change.
The amount over 600k I am going to break down into roughly 300k
of borrowing and 100k more of down payment and the principal
portion of the mortgage payment. So our borrower in the current
world of unlimited mortgage interest deductions is willing to pay
$1800 of interest required to buy the last 400k of the million
dollar house. Keep in mind this $1800 is just the interest portion
of the mortgage, not the entire payment. Assuming a 6% discount
rate and 30 years of discounting, this provides 300k of present
value to buy the million dollar house:
$300,225 = PV(.005,360,1800)
Excel uses non percentage interest rate numbers for the periodic
interest rate so 6% would be .06/12 = .005. I chose a 6% discount
rate because I thought it was a more representative rate over the
next 30 years, and it converted to monthly compounding cleanly. Use
a different discount rate if you think that's more correct. Assume
30 years' worth of discounting 30*12=360. $1800 is the monthly
interest in a mortgage deductible world. The = sign and to the
right is what you put into any Excel cell.
Now what happens when Erskine/Bowles wipes out mortgage
deductibility over 500k? We need a formula that shows what monthly
interest a person would be willing to pay if the interest is not
deductible. That formua is:
(1 - MarginalTaxRate) * PaymentWithDeductibility =
The highest marginal tax bracket proposed by Erskine/Bowles is
23%. So our borrower is indifferent between making an interest
payment of $1386 in a world where there is no mortgage
deductibility for mortgages > 500k OR paying $1800 a month,
deducting an extra $21,600 ($1800 * 12 months) from his joint
income of 350k, and paying $7128 (33% joint bracket) less in taxes
because his mortgage was deductible. So now we plug this new lower
interest payment into Excel and discount to the present:
$231,175 = PV(.005,360,1386)
So we see roughly 70k less present value ability on the part of
borrowers, given that mortgages > 500k are not deductible.
Proportionally, and to get to a round number, we will take another
30k of down payment and principal payments because we can borrow
less, so 100k less to buy the house with. The rather stark
conclusion of this exercise is that the price of every house in the
U.S., ceteris paribus, will drop by one quarter of its value over
600k if the Deficit Commission's recommendation on mortgage
deductibility becomes law.
I am pretty sure most members of the Deficit Commission own
homes worth more than 600k so you can't say they were acting in
their own self interest with this suggestion. I would argue that
grandfathering the clause in (allowing existing mortgages > 500k
to keep their deductibility) mostly doesn't matter. Prices in the
real estate market are set by the marginal (new) buyer, not by the
people who already own homes, and as time goes on, existing
mortgages will bleed off.
One could even argue my estimate is low. If the law changes, it
changes for the foreseeable future. My assumption of 30 years is
probably too short, given that mortgage deductibility is removed
theoretically forever. Your buyer and your buyer's buyer won't be
able to deduct the mortgage interest. But if you increase the
discount periods to 720 (60 years) you will see it only makes about
a 10k difference. Using a higher discount rate (12% for example)
would make the price change greater than a quarter. Using a lower
discount rate (1.2% for example) would make the price change less
than a quarter.
This discussion reveals one of the problems with law and
economics. Something may be a good idea but if you have huge
existing pricing in the market built up around it, it becomes
difficult to change. I personally don't think the U.S. should have
ever have had mortgage deductibility at any level. I would go so
far as to say that the Financial Panic of 2008 would have been less
severe, or perhaps not have happened at all, if there was no
However, once bad policy is implemented, prices adjust and
change becomes problematical. In this case, people who bought
expensive homes more recently could get punished for making a
decision based on the current state of the tax law.
The investing takeaways focus on home builders, mortgage REITs,
and realtors. Of the homebuilders, NVR Inc. (
), D.R. Horton (
), and Toll Brothers (
), Toll Brothers seems to focus more on the high end market. Prices
of new homes have to be greater than 600k to depress the stock.
Mortgage REITs Annaly (
) and Anworth (
) could be affected if the size of mortgages fall, or mortgage
volume falls. High end realtors would clearly be impacted.
Sotheby's (BID) had a large high end real estate broker network but
I'm not sure what percentage of their net income is from the real
Taking long/short action now given the uncertainty of whether
the Deficit Commission mortgage proposal could be implemented, is
not warranted. If the mortgage deduction looked likely to become
law or became law, the impact in the housing market is going to be
large. As I mentioned above, even serious discussion of this
proposal could cause high end housing prices to fall. I abhor
chartism (looking at past prices to discern future prices) but I do
look at past prices when I think I have an idea the market hasn't
discounted yet. In this case you would check the price of the
stocks above or others you can think of over the last six months.
If they are flat or opposite your guess you still have time to
implement your bet that the market hasn't discounted the
ramifications of the ideas presented in this article.
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours.
Why I See the Dow and Disposable Income Going Lower