Why Boomers will still retire after the boom

This article argues that the diminished housing wealth of the Baby Boomer generation will not forestall their retirement-induced migration, and clarifies the nuances in the debate over Baby Boomer behavior in today’s real estate marketplace.

To retire or not to retire

Over the duration of this Lesser Depression, the media has continually asserted that the aging population of Baby Boomers (Boomers) has deferred retirement due to the 2008 economic downturn and real estate market crash. In media reporting, the economic distinction between diminished housing wealth and negative equity is all-too-often oversimplified and considered one and the same.

They are not!  All homeowners took a nominal dollar hit to their housing wealth after the bubble burst. But a universal drop in home value is not necessarily a death sentence for every homeowner, as many have portrayed it to be. In point of fact, the decline in housing wealth resulting from the precipitous drop in home prices has had no effect at all on the retirement expectations of seniors, as determined by economists from the American Economic Association (AEA). [For the full report, see the May 2011 AEA article, What explains changes in retirement plans during the Great Recession?]

How could this be?

Many Boomers either own their home free-and-clear or hold a strong equity position. Most purchased long before the bubble inflated and have made their mortgage payment religiously over the ensuing years – the majority without refinancing to pull out cash.

In situations where a homeowner has no mortgage debt, housing wealth from peak to trough prices is entirely relative and works out to be a zero-sum game when trading properties – relocating – in the real estate market. The purchasing power potential tied-up in a home used to purchase any other home remains the same after the crash — a receding tide has sunk all ships.

Housing wealth: real vs. nominal values

Consider a homeowner now on the cusp of retirement who purchased his home at the peak of the Millennium Boom for $500,000 and is now free and clear of trust deed liens.  At present, due to the collapse of the housing bubble, the market price of his home has plummeted to $250,000 — 50% of its purchase price.

While the nominal dollar price of the home has decreased significantly, the real value of the home has remained constant as it is comparable in price to other homes of like quality currently for sale in the real estate marketplace. Although the actual price decrease of the home has taken a severe blow nominally, the homeowner’s purchasing power for a replacement home remains the same.

Consequently, the homeowner’s housing wealth is unaffected by the loss in his property’s nominal dollar price. Thus it follows that planned retirement for the homeowner is not deferred due to this decrease.

He can still buy a replacement home of any price using the net proceeds from the sale of his house and will receive equal housing value in the other home, just as would have occurred on relocation at the peak of the market. [For more information on purchasing power in today’s real estate marketplace, see the November 2011 first tuesday article, Buyer purchasing power.]

In fact, despite the persistence of this Lesser Depression, those who own a home free and clear are poised to retire on time. Also, aside from the ill-informed and heated rhetoric, pension plans have not dropped in their dollar amounts of benefits and social security remains solidly intact. Along with their housing wealth, bruised in terms of nominal price but still fine to function on its sale to buy a replacement, there is no reason why the vicissitudes of the real estate market postpone retirement plans for the free-and-clear homeowner.

Boom-time Boomer leveraging 

Now consider a homeowner who purchased his home in 2005 by putting 3.5% down on a home priced at $500,000, leaving him leveraged up to his eyeballs with a 96.5% loan-to-value (LTV) ratio — starting off with no net resale equity, but counting on it increasing annually over the duration of the mortgage.

Three years later, after the housing bubble bursts and the financial crisis is thoroughly under way, the fair market value (FMV) of the property plummets 50% to $250,000, a return to the historical equilibrium trendline price. Accounting for the miniscule down payment and a few years of principal in mortgage payments, the homeowner is now hopelessly underwater with an LTV well above the 94% needed to avoid a short sale situation. [For more information on the equilibrium trendline, see the October 2011 first tuesday article, The equilibrium trendline: the mean-price anchor; For more information on short sales, see the September 2011 first tuesday article, You’re sure you’re a short sale specialist?]

Although nominal housing wealth has been dramatically diminished, the real loss in wealth is negligible.

Underwater? Yes. But this can be easily rectified with strategic default. The actual dollar amount of investment lost on a default depends on whether the down payment exceeded 10% of the price paid, the closing costs on a resale.

The ATM effect

We must also consider those who have taken a nominal hit to housing wealth via a cash-out refinancing (cash-out refi) arrangement during the boom.

Consider a Boomer looking forward to retirement at the height of the Millennium Boom who arranged a cash-out refi of his home based on the then grossly-inflated price. While such an owner is no longer approaching free-and-clear freedom, he extracted nearly as much cash out of the house as he would have netted by selling at the zenith of the market. If he now defaults, he is a big winner in terms of his housing wealth since the cash withdrawn from the property is in excess of both his original purchase price and present prices, leaving no loss in home purchasing power today.

Again, we are faced with a nominal vs. real scenario that bears critique. At first glance, this homeowner seems to suffer from the negative equity syndrome as his home price dropped after the crash. However, we must remember that a huge amount of his housing wealth was liquidated with the cash-out refi during the boom, effectively eliminating any loss in price homeowners suffered due to the crash.

So long as the wealth extracted was not squandered on jet skis, pickup trucks or trips to Maui, this latent retiree remains poised for his golden years with no hit to his housing wealth – he extracted it already with the refinance, and did so at peak prices.

Dissaving but still moving

Many Boomers approaching retirement age are currently dealing with just this negative equity situation. Of the 2.5 million underwater homeowners in California, most were first-time homebuyers snared by the lures of easy financing available during the Millennium Boom. However, those dispossessed by foreclosure number many. Worse, a fair deal of those spurned by the busted housing bubble were Boomers on the cusp of retirement who bought or refinanced a home and now find themselves tethered to their jobs, unable to recover their home investment due to their negative equity. [For a comprehensive account of the negative equity issue, see the February 2011 first tuesday article, The negative equity plague.]

In order to stay afloat, these homeowners approaching retirement age and faced with a real hit to their housing wealth as a result of mortgage financing have begun the fearful process of dissaving by liquidating wealth tied up in stocks and bonds, cashing in their 401Ks and stockpiling current earnings to cover rent or excessive mortgage payments for shelter during their golden years. [For more information on the phenomenon of Boomer dissavings, see the September 2011 first tuesday article, Boomers bust open doors to real estate investment era.]

It is said that a newly minted retiree must have at least $500,000 in savings at the outset of retirement in order to maintain the standard of living they enjoyed during their working years. Before the Great Recession, the vast preponderance of middle class Boomers could easily boast this amount of savings by including their housing wealth (and stock values) in their calculations.

Now that housing prices have been ravaged by the wraiths of Wall Street Banker participation, retiring Boomers unencumbered by a mortgage will still most often trade down into a replacement home in the twilight of their life, only now they will not carry as much surplus cash to their new residence. Instead, many will subsidize their retirement with what would have eventually gone as inheritance. This is an inconvenient economic reality of our times, but one that will not forestall retirement migration.

Viable local markets

Research over this Lesser Depression has shown  that Boomers who have no mortgage or who have extremely low LTVs will be virtually unaffected by the nation’s loss of housing wealth when it comes to their retirement plans for moving to greener pastures. The ultimate effect of this real estate market price downturn has proven to simply return home prices to their equilibrium, thus setting those who purchased well before the boom back on the same track they started on. [For more information on the historical mean price of real estate, see the October 2011 first tuesday article, The equilibrium trendline: the mean-price anchor.]

It bears repeating that real estate is always local — this applies to demographics analysis as well. Yes, many Boomers are underwater and suffer from the same migratory lockdown that plagues over 2.5 million families in California. However, there are a vast number of Boomers scattered throughout local markets in California who invested in their homes well before the excesses of the Millennium Boom and are now positioned to behave as retirees typically do — trade down to a humbler home located closer to the grandchildren, recreation and social services. The others with negative equities will either default or see their standard of living diminish. [For more information on migratory lockdown, see the November 2011 first tuesday article, Americans imprisoned in their homes.]

Soliciting these potential purchasers as clients will require a more sophisticated approach than the overly simple refrain, now is a great time to buy. Rather, it will take a discussion of the economists’ distinction between diminished housing wealth and negative equity ownership in order to dispel the fears that have been inculcated by media pundits.

It will require a financial analysis of the equity position they hold in their current property and the neutral opportunity cost of trading (in some cases up) to a home in a more desirable, retirement-friendly location.