Deficit Commission: How Mortgage Deductibility Affects Housing Prices

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The Market Flash submits:

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 = InterestPaymentWithoutDeductibility

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 mortgage deductibility.

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. ( NVR ), D.R. Horton ( DHI ), and Toll Brothers ( TOL ), 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 ( NLY ) and Anworth ( ANW ) 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 estate group.

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.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

See also Why I See the Dow and Disposable Income Going Lower in 2011 on seekingalpha.com



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Economy

Referenced Stocks: ANW , DHI , NLY , NVR , TOL

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