In asset allocation strategies, the ‘dividing line’ is home equity

DETROIT — As ripples from the imploding subprime-mortgage market spread across the broader home lending industry, financial advisers might have to start helping clients reposition their mortgage and home equity exposure.
This has the potential to unearth the bold line dividing two distinct financial planning philosophies that dictate how the industry views home equity and residential real estate.
Many advisers don’t acknowledge even the existence of home equity or a client’s primary residence, regardless of market value, when developing and managing an asset allocation strategy.
“I rarely look at the home as part of an asset allocation strategy,” said David Mendels, director of planning at Creative Financial Concepts LLC in New York.
Mr. Mendels, who is also president of the New York chapter of the Financial Planning Association, subscribes to the “use asset” theory, which places a client’s home equity beyond his focus as an adviser.
“Most clients will say their home is the best investment they ever made, but they’re not really looking at it as an investment, because they’re not really willing to sell it,” added Mr. Mendels, whose firm oversees $40 million.
Potential malpractice?
In stark contrast to the Mr. Mendelses of the financial planning profession, some advisers suggest that disregarding home equity borders on malpractice.

“Ignoring the value of a client’s home is like picking up the decision-making process at a different point,” said Frank Corrado, chief executive of Lighthouse Financial Advisors Inc., a Red Bank, N.J., firm that oversees $70 million.
“It’s no different than saying you won’t look at 401(k) assets just because you’re not getting paid for it,” he added. “I have to believe that any adviser worth his salt, even if he’s not being paid for it, should be thinking about a client’s equity in real estate along with any other real estate investments.”
According to the latest data from the Bureau of Economic Analysis in the Department of Commerce, home equity in 2005 represented $12 trillion of the $51.8 trillion worth of total private wealth in the United States.
The real estate equity measurement, which is calculated net of mortgage debt, compares with $9.6 trillion held in publicly traded stocks and equity-based mutual funds.
A 2005 Harvard University study, “Housing Wealth and Retirement Savings: Enhancing Financial Security for Older Americans,” determined that residential real estate has grown to become the largest single asset class held by households with heads aged 65 or older.
More than 80% of senior citizens owned a home, and residential real estate accounted for 30% of the group’s aggregate asset holdings, according to the study. By contrast, only 21% of all households with heads 65 and older owned stocks.
The study also found that real estate equity was more widely distributed across all income levels than were stock market investments.
“Stock market wealth is especially concentrated in the hands of the highest-income households, while home equity is an especially important source of wealth holding for those in the bottom fifth of income distribution,” according to the Harvard study.
Despite the significant presence of home equity as a contributor to overall private wealth, it is often those advisers that include residential real estate as part of an asset allocation strategy who are seen as the rebels.
“In a lot of ways, I know I’m considered a maverick, but to ignore real estate is a serious oversight — it’s the elephant in the living room,” said Bert Whitehead, president of Cambridge Connection Inc. in Franklin, Mich.
In Mr. Whitehead’s book, “Why Smart People Do Stupid Things with Money: Overcoming Financial Dysfunction” (Sterling Publishing Co. Inc., 2007), he dedicated a chapter to the tax advantages and investment opportunities that come with owning a home.
“When advisers ignore the real estate, they’re not only doing a disservice to their clients, but they’re missing a tremendous opportunity,” he said. “I think the equity in your house is an asset like any other asset, and it’s more accessible than other illiquid investments.”
The reason more advisers don’t consider their clients’ home equity, he said, often boils down to a lack of training and sophistication with regard to real estate and tax planning.
But perhaps the biggest and most sensitive road block with regard to real estate inclusion, Mr. Whitehead added, is that “advisers don’t get paid or don’t know how to get paid for managing a client’s real estate.”
But planners like Mr. Whitehead who calculate home equity in their fee structures are opening themselves up to losing clients, said Theodore Feight, president of Creative Financial Design in Lansing, Mich.
“We end up getting a lot of their clients who don’t think it’s fair to be charged for the value of their home,” Mr. Feight said. “We decided we don’t want to charge an assets-under-management fee for the value of the home, because we can’t do enough with that home to make it right.”
While excluding real estate could help advisers steer clear of sensitive conversations about fees, depending on a client’s specific home equity position, such exclusions could also push a portfolio wildly out of whack.
“If a client has enough equity in their home, we will trim other allocations to real estate investments,” said Seth Pearson, president of Pearson Financial Services LLC in Dennis, Mass.
“Our job is to be realistic with people,” he added. “If an adviser doesn’t include the house, I would question how they’re recommending real estate in the rest of the portfolio.”
Even in areas of the country where home values can represent significant proportions of a client’s net worth, there are advisers who justify keeping home equity outside an asset allocation strategy.
Excluding residences
“I will include the principal residence when I’m doing a net-worth statement, but I exclude it when I’m doing the asset allocation,” said Bernard Kiely, owner and president of Kiely Capital Management Inc. in Morristown, N.J.
“A home is a lifestyle choice instead of an investment. Besides, you can’t sell off your front porch to buy groceries,” Mr. Kiely added.
“I only look at the financial assets even though we are here in New Jersey where we’ve got the highest property taxes in the world.”
It was an aversion to personal real estate holdings among advisers that three years ago drove Peter Benda to launch PortReal LLC, a Glen Allen, Va.-based firm that develops software solutions to help financial planners analyze risk and return characteristics of real estate equity.
“By and large, planners don’t factor in real estate, and the financial services industry in general has no answers, or fairly misleading answers, for how to account for real estate ownership,” he said.
Mr. Benda, who said his business venture has yet to gain much traction among the hard-core “use asset” crowd, described the exclusion of real estate as a missed opportunity for much of the planning community.
“We know that homeownership is blessed by the government for having certain social qualities, which will naturally lead to lower risk and higher growth,” he said. “For a reasonably sophisticated investor or planner, there’s room to do much better.”