My Property is My Pension (because of Leverage)

Within this great country of ours we have what appears to be an eye watering level of debt.  We learnt this week that household debt in the UK, including mortgage debt, has now grown to £1.43 trillion or £28,489 for every adult. We however need to be careful when digesting this type of information as what really matters for the Average Joe is actually Wealth which is the market value of all assets minus those debts.

The Office for National Statistics Wealth and Assets Survey, published on the 12 July 2012, tells us that the total Wealth (including private pension wealth but excluding state pension wealth) of all private households in Great Britain was £10.3 trillion.  That’s £373,000 of wealth for the Average Household and even if we switch to Median values, to try and remove some of the extreme Wealth held by the 1%, it’s still £210,000, making the debt seem a little less serious on the average (I acknowledge that the poorest probably have no wealth and a lot of debt with the richest having lots of wealth and little debt but that’s for another day).  32.9% of this wealth is Net Property Wealth which is the value of the property held minus the value of mortgage liabilities and equity release.  Not everyone is lucky enough to own a property but for those that do the Average Net Property Wealth is £195,000 and the Median is £148,000.

With so much Wealth tied up in Property it’s no wonder I still hear and read of people using the My House is My Pension statement.  This is in my humble opinion is a statement from someone who really hasn’t quite understood how they have generated all that housing Wealth they now possess.  Have they really stopped to understand how with average earnings of £474 per week and a property Compound Annual Growth Rate of 5.4% since January 1995 (Land Registry data) so much Wealth has been generated by property.  There are of course a number of ways this has occurred including the more obvious time in the market and riding the rapid rise in property values between the mid 90’s and 2007 but there is also another method that all those with a mortgage are employing which I don’t think the vast majority even understand.  This is Leverage or Gearing which is a financial technique used to increase gains or losses by giving the investor the return on a larger capital base than the investment personally made by the investor.  In home owning speak the investment is the house deposit and the capital base is the purchase price of the house.  The leverage is achieved by taking on a mortgage.


Let’s demonstrate with a simple example that looks at two punters, Average Bob and Average Joe, who each have £10,000 to invest.  Average Bob understands that a mortgage is just money rented from a bank and that the interest portion is then really not much different to just renting from a landlord while the principle portion is an investment made in property.

Average Bob therefore chooses to rent a home for his family and makes a £10,000 investment in the Vanguard LifeStrategy 60% Equity Fund.  A year passes and the Vanguard Fund increases in price by 5%.  Were he to liquidate his Vanguard Fund the return made by Average Bob would be (£10,000 x 5%) / £10,000 = 5%.  Average Bob is using no leverage.

Average Joe goes in a different direction.  He heads over to Yorkshire Building Society and uses his £10,000 to secure a 95% LTV mortgage (as an aside why are people taking on the complexity that comes with a Help to Buy loan when 95% LTV mortgages are once again available...)  on a £200,000 home.  A year passes and our Average Joe’s home has increased in value by 5%.  Were he to then sell his home the return made by Average Joe would be (£200,000 * 5%) / £10,000 = 100%.  Average Joe is using leverage to generate a return that is 20 times larger than Average Joe.

Given the huge rise in property values since the mid 90’s it’s therefore not hard to appreciate how with leverage a lot of UK residents are sitting on big property wealth leading to the My Property is My Pension statements.  It’s however important to remember that past performance is not a guide to future performance.  Turn that 5% rise into a 5% fall and Average Bob still has an investment worth £9,500 while Average Joe has lost the lot.

I should reinforce that I don’t have a problem with leverage or gearing in principle.  I just wish that people had a stronger financial education and understood concepts like Leverage, Compound Interest and even more simple things like how to calculate investment return.

As always DYOR.

Note:

• I understand that the examples presented are extremely simplified and make no account for complexities including inflation, costs, duties and expenses.  I have done this as in this post I wanted to simply demonstrate what leverage is rather than get bogged down in a complicated piece of analysis that would pass over the head of many.