From Gerd Kommer and Maximilian Bartosch
Owner-occupied residential real estate is a popular form of retirement planning. Around 45% of all German households live in their own home (owner-occupied apartment or house). According to surveys, around two thirds of all renter households also want to own their own home in the short or long term.
However, owning a home as an element of retirement provision has a structural disadvantage for many households who are about to end or have already stopped working and who do not fall into the “very rich/very wealthy” category, which we will get to the bottom of in this blog post. (We have dealt with the often overestimated profitability of residential properties and their often underestimated risk in recent years from different perspectives see here and here as well as the list of our blog posts on this at the end of this text.)
The fundamental disadvantage of real estate as an investment in the asset reduction phase
We illustrate the basic problem using the young pensioner household Luisa and Ludwig (hereinafter “L&L” for short). Both are 65 years old and both have just finished their careers. The couple has built up a fortune of 500,000 euros over the last 25 years and is debt-free. After completing their professional activity, L&L have now moved from the asset accumulation phase to the asset utilization phase.
In our first observation scenario - let's call it "Universe A" - we assume that L&L's assets of 500,000 euros consist entirely of liquid assets, namely an ETF portfolio worth 300,000 euros (a single ETF that represents the asset class Stock Global shows) and from an interest-bearing daily money of 200,000 euros. [1] This split or asset allocation is often referred to as a “60/40” portfolio, which usually works well for relatively cautious investing households. The portfolio generates current income (interest, dividends) and price gains in the equity portion.
L&L live in a beautiful three-room apartment for rent. Because their two statutory pensions are noticeably lower than their previous two salaries and they do not want to live a “frugal” life, they now have a combined “pension gap” of 2,500 euros per month or 30,000 euros per year. The two want to cover this gap with their liquid assets, their ETF portfolio and daily money account. The initial “withdrawal rate” is therefore 30,000 ÷ 500,000 euros = 6% per year.
In the case of a liquid investment, as in the case of L&L, this withdrawal rate consists of distributions and share sales in relation to the stock ETF portfolio and of withdrawals in relation to the overnight money account. L&L can flexibly increase or decrease the monthly or annual withdrawal at any time if your actual liquidity needs differ from the plan, which probably happens quite often.
Depending on what average inflation-adjusted (real) return after deduction of costs and taxes is assumed for the entire portfolio, the 500,000 euros would last on average around 24 years until fully consumed with an annual real withdrawal of 30,000 euros, but the exact duration is not significant for the purposes of the matter being analyzed here. [2]
In parallel universe B, we assume that L&L live in a self-occupied three-room apartment, i.e. in their own home. The property has a market value of 500,000 euros. It's the same apartment the two of them live in for rent in Universe A. Again, there are no other assets apart from the statutory pension insurance claims. In Universe B, the two save 16,000 euros a year in living costs due to no rent. [3] Accordingly, their annual pension gap is no longer 30,000 euros, but only 14,000 euros. Now the challenge becomes clear: Where should L&L get these 14,000 euros (around 1,200 euros per month) from if not steal them?
The capital commitment when owning real estate
The problem: The substance or “capital” in a property cannot be used little by little like with a bank deposit or securities account. “Ongoing consumption” is only possible for a property up to the amount of the net rent. The net rent is the (gross) rent less expenses for maintenance, insurance and property tax.
With a home, there is naturally no rental income, but the owner saves expenses equal to the net rent that he would have to pay if the home did not exist. On this point, there is no significant difference between an owner-occupied property and a rented one - in both cases, as an owner, you can only use the current net income, but not the substance tied up in the property, the capital.
Another unfavorable aspect of real estate in the context of liquidity and cash flow: the net rent or net rent saved (as defined above) varies significantly over time from year to year due to the irregularity and "lumpiness" of maintenance expenses. In the case of major repairs, it can even happen in a single year that as an owner you have to put more into the property than you get out of it in the form of the rent saved on your own home or real rent on a rental property. Then there is a negative cash flow. This cannot happen with a securities account (for the often underestimated amount of maintenance costs for residential properties, see here).
According to a lobby organization in the German “real estate annuity industry,” there are said to be over three million homeowners aged 55 and over in Germany who are fundamentally confronted with a liquidity problem due to the capital tied up in their own home, i.e. they have too little liquidity, but at the same time do not want to sell their property (source). The cause of the liquidity problem for these owner-occupier households may be an ongoing pension gap (too little income relative to the cost of living), as in the case of L&L. However, the “money problem” can also result from the desire to modernize the property or finance a larger lifestyle expense (e.g. a camper van or a sailboat).
We will now quickly describe ten financial solution approaches – “liquidity creation models” – for such home ownership households. In nine of the ten approaches, the aim is ultimately to at least partially release the capital tied up in the property for the owners, i.e. to make it liquid, in technical jargon to “monetize” the capital in the property so that it can be used when necessary.
Solution 1: Lower living standards
Basically, this is a non-solution to Luisa and Ludwig's problem and definitely one that they don't want. Furthermore, they see no need to leave an inheritance to their 35-year-old son Louis. Louis earns well himself, married a wealthy woman and has already made it clear that he does not want to inherit anything. Solution 1 is therefore ruled out for L&L.
Solution 2: Selling the home to buy a new, cheaper property
In modern German, this solution is called “downsizing”. However, it is not an option for L&L because they do not want to lower their standard of living. But living in a smaller or less well-located, cheaper apartment would mean exactly that. They are also emotionally attached to their current property.
Solution 3: Selling your home and renting an equivalent property
In this case, L&L would simply sell their apartment and then rent a new, equivalent property nearby. An obvious advantage of the sales solution relative to most other monetization strategies is that this approach is legally and economically very simple. In addition, the new rental property can be selected precisely according to L&L's health-related and other criteria that are important for an older couple at this time, such as accessibility or physical proximity to their son and daughter-in-law.
Solution 4: Rent out part of your home
Bringing in the proverbial “subtenant”: For many reasons, this is not to everyone’s taste and not to L&L’s either. Renting out part of the property also fails in many homes because the property is not suitable for partial rental due to its floor plan or other structural reasons.
Solution 5: Selling the home while granting usufruct rights
The property is sold. The buyer (which could be a specialized company or a private individual) grants the old owner (hereinafter “old ET” for the sake of brevity) a lifelong lease right of usufruct one that is notarized and entered in the land register. In the case of a residential property, this gives the usufructuary (the old ET) the right to continue to live in the property until the end of his life, even though the usufructuary is no longer the owner. [4] The right of usufruct is a centuries-old type of right of use for real estate (or other assets) and is regulated in detail in 59 paragraphs of the German Civil Code (BGB). Because the “encumbrance” recorded in the land register makes the property less valuable for the buyer, the selling price is correspondingly lower relative to a property without usufruct.
The old ET cannot sell, bequeath or give away its usufruct right. Who bears the costs of maintenance can be regulated in individual contracts; typically it is the usufructuary, as he has the full economic benefit from the property.
Instead of a simple purchase price payment, it would also be a lifetime payment Life annuity conceivable that the buyer pays to the old ET (usufructuary). [5] We generally advise against life annuity structures. They have several major disadvantages, including the basic problem that the payer stops paying over the following years or decades, e.g. B. due to bankruptcy. Then the pension recipient can be left out in the cold. This complex risk exists even for large insurance companies such as Allianz and is particularly high for smaller companies or even private individuals. In the case of a home annuity with a life annuity structure, there are instruments to partially reduce this “counterparty risk” (default of the pension payer), for example through a so-called “fallback clause”, but such instruments are at best band-aid solutions and only partially cure the basic problem.
Secondly, life annuities mean an unacceptably high inflation risk for the recipient, as the pension does not increase at all over time or only increases to a small, contractually fixed amount. If inflation was consistently above around three to four percent p.a., the purchasing power of pensions would fall drastically over time. In the event of runaway inflation, almost everything would be gone. [6]
Because life annuities in Germany can only be granted by private individuals, the state and licensed, BaFin-regulated insurance companies, the following “combination model” is often used in practice: Step 1: Purchase price payment by the “annuity provider”, Step 2: Payment of the purchase price into an “immediate annuity” offered by a separate insurance company. (Presumably a commission will then flow from the insurance company to the annuity provider for the placement.)
Either way, from our point of view: stay away from life annuity structures, which in principle can also be used in some of the other real estate annuity models outlined below instead of a simple purchase price payment. In practice, however, life annuity structures are rarely chosen for good reasons.
Solution 6: Sale while granting a right of residence
It is very similar to solution 5, except that instead of a usufruct, a “right of residence” (or, to put it more legally, “right of residence”) for the old ET is entered in the land register. A right of residence is similar to a usufruct, but is more limited under civil law and therefore less economically valuable. For example, a right of residence usually expires worthless as soon as the old ET moves out, which does not apply to a right of usufruct. [7] Because a right of residence is worth less, the purchase price payment to the Alt-ET for a given property, after deducting the burden for the right of residence, is higher than for a right of usufruct.
Solution 7: Partial sale to a specialized financial service provider
If the real estate retirement industry's marketing publications are to be believed, partial sales are the new star in the real estate retirement sky. With a partial sale, part of the home - usually 50%, rarely more - is sold to a specialized financial service provider. This then makes a purchase price payment to the old ET. All of this is notarized and entered in the land register. At the same time, the old ET is granted a lifelong right of usufruct (see comments in solution 5).
In principle, instead of paying the purchase price, a life annuity or a temporary pension (time annuity) is also conceivable, but these pension models are rarely offered in practice due to their legal complexity and economic risks (see again the comments on solution 5).
In the standard configuration, the old ET bears all maintenance costs, including those for the part sold. For the part sold, the Alt-ET has to pay the buyer a monthly “usage fee”, a kind of rent, even though he is not a tenant but a usufructuary. The amount of the usage fee is based primarily on the interest rate at the time of the partial sale and less on the local rent.
In the event of a partial sale, the old ET or its heirs remain involved in the potential for increased value of their share. In a typical partial sales agreement, the Alt-ET can sell the entire property to a third party or its part to the financial service provider at any time. However, under standard industry contracts, the old ET must compensate the financial service provider for any losses and even lost profits at the time of sale (regardless of who it is to) if the property has not experienced a sufficient increase in value since the original partial sale during this “second” final sale. This “value protection clause” in the partial sales contract in favor of the financial service provider is the single biggest disadvantage of the partial sales model. From our point of view, it represents you Deal killer.
Overall, the distribution of opportunities, benefits and costs between Alt-ET and financial service providers in a typical partial sale does not appear to be balanced enough. The German financial regulator BaFin also sees it that way (here).
Solution 8: Rent-back purchase
The sale and leaseback consists of simply selling the property to a private person or to a commercial real estate company. The plan from the outset is to conclude a long-term rental agreement between the old ET and the buyer a “logical second” after the sale has been completed, i.e. to rent the property back to the old ET. Typically, the buyer waives his ordinary right of termination in the rental agreement for a long term or at least for several years, including the right to terminate the lease for personal use. The amount of the future rent can also be bindingly fixed in the long term via a graduated rental agreement or index rental agreement. The new owner becomes the landlord and will bear the future maintenance costs.
In general, the leaseback purchase is legally simple and economically uncomplex. Many normal real estate agents offer the search for a buyer willing to buy back as a service.
Solution 9: Conventional lending on the property (senior citizen loan)
The most obvious solution to monetize a debt-free home that you don't want to sell or move out of is a mortgage, i.e. the "normal" taking out of a bank loan against registration of a mortgage. Because this route is so obvious and legally and economically simple, it is widespread in Anglo-Saxon countries and is even specifically regulated in the USA - expressly for owners over 60 years of age. [8] This process is called there home equity take out, the regulatory-defined loan types “Home Equity Conversion Mortgage” (HECM) or “Home Equity Line of Credit” (HELOC).
But even without its own regulatory framework, the matter in Germany is simple and straightforward: a senior citizen loan (new German “best ager loan”) is an ordinary real estate loan secured by a mortgage. The loan amount is usually limited to 50% of the market value of the property as determined by the bank. The loan, for example, has a term of ten or fifteen years and is “final maturity”, i.e. h. There is deliberately no ongoing repayment. The borrower only pays the current interest. The loan is repaid at the end of the intended term either through a sale of the property, from other means or the loan is extended again.
If an inheritance occurs, the loan can be taken over by the heirs and continued or repaid. If the heirs do not want the property + loan debt (e.g. because the value of the property has fallen below the value of the loan balance), they have the risk-free right to reject the inheritance.
What speaks against lending to monetize a debt-free home? Nothing at all, because it is the simplest and almost always the cheapest solution and probably gives the old ET the least amount of control over their existing home relative to all other alternatives. The old ET remains the owner of the entire object even after the transaction.
Strangely enough, many homeowners in this country believe that (a) taking on new debts at an advanced age is “somehow not right” or (b) that you can no longer get real estate financing from a bank “from the age of 60” - both are wrong. If these two considerations were correct, there would be no widespread home equity take-outs in countries with better developed financial markets than here. Of course, every bank wants and must carry out a credit check before granting a loan, even if the value of the security significantly exceeds the loan amount, as is the case with a best-ager loan. And yes, a borrower household with an average age of 65 needs a certain minimum credit rating, regardless of the security. First and foremost, this means that the pure interest payments (without repayment) can be made from existing liquid assets or current income. But in any case, in our opinion, a household that aims to monetize its home without selling or moving out should first examine the viability of this route.
Solution 10: Borrowing via a “reverse mortgage” (“reverse loan”)
The reverse mortgage (“UH”) comes from the USA like so many financial innovations. There it is called “Reverse Mortgage”. Since it is only offered by a tiny number of financial service providers in Germany and probably all at unattractive conditions, one could almost do without presenting the UH here.
In its standard form, UH works like this: The owner of a debt-free home, usually a retired household, takes out a loan on the property from a bank, which is secured by a first-lien mortgage. However, the bank does not pay out the loan amount to the borrower's household immediately (as with senior citizens' loans), but rather grants them a lifelong monthly pension, a life annuity. The loan debt is still very low at the end of the first month because only a single monthly pension payment has been made. The longer the old ET lives, the more the credit debt builds up. According to the contract, the loan is not repaid during the borrower's lifetime - there is no ongoing repayment and the interest is also "capitalized", i.e. added to the loan debt on a monthly or quarterly basis.
The maximum loan value of the property (the loan amount) is usually 50% of the market value of the property at the start of the transaction. This upper limit and the age of the borrower at the start of the transaction largely determine the amount of the monthly pension payment. The older the borrower is at the start of the transaction (i.e. the lower his remaining life expectancy), the higher the pension will be, other things being equal.
When the borrower dies, the outstanding debts are repaid either by the heirs of the property or (if there are no heirs or they do not want them) through a sale of the property by the bank.
We advise against the UH, especially because it is based on the life annuity model (see solution 5) and is simply too expensive.
It is not uncommon for journalists and representatives of the real estate rental industry to write that UH has not yet become established in Germany, but it is widespread in the USA. That's nonsense. To this day - over 60 years after its invention - reverse mortgages have only been able to gain a measly market share in retirement provision in the USA and are considered a failure in politics and science (see Knaak et al. 2020).
Conclusion
The “home pension” as it is marketed and offered in the German market today is a deceptive package.
It starts with the fact that the real estate retirement industry and its journalistic applause continually use the term “retirement” or “pension” for marketing reasons, [9] but essentially do not offer any financing models that include a pension element.
In our view, the partial sale (solution 7), which is the most common solution in the annuity industry, fails because the distribution of opportunities, risks and costs is unattractive for the existing owner.
The main reasons for the unattractive conditions for partial sales and reverse mortgages are the legal and economic complexity of these constructions and the fact that too many parties on the provider side want to make money: brokers, annuity providers, the annuity provider's bank and, in the case of life annuity models, a life insurance company.
With regard to the partial sale and the reverse mortgage (solution 10), we have explained on a purely factual basis why these two home monetization models are a bad idea. If you don't find our argument convincing and are interested in such a solution, we recommend getting one or, better, several offers. To find providers, the first step is to google “partial home sales providers” or “reverse mortgage providers”. We believe that a concrete offer will confirm our great skepticism in the vast majority of cases.
The sober realization remains that real estate is a structurally illiquid asset. The easiest, fastest, least economically risky, legally secure and cheapest way to get liquidity out of this asset is to sell it. The second cheapest option is conventional lending. However, the monetization effect is more limited when lending than when selling.
As we have shown, selling does not necessarily mean that you have to move out of the property. Selling and not moving out can be done using three proven, uncomplex and legally secure alternatives: selling against usufruct rights, selling against right of residence or rent-back purchase.
For all monetization approaches based on sales or partial sales, it is extremely important that the owner has a valuation report prepared by a professional real estate appraiser before the contract is concluded, who has a sole and exclusive contractual duty of loyalty to the owner and is paid solely by the owner. As a general rule, you should not consider appraisers who have been named or recommended by the seller.
Endnotes
[1] This means that the amount of L&L is within the statutory deposit insurance limit of 100,000 euros per person and bank. Above this limit, bank deposits are not sufficiently secure (see here).
[2] We are talking here about a “real” withdrawal of 30,000 euros, i.e. an amount of money that increases annually from year 1 in line with inflation, so that its purchasing power remains constant over time. But since we are investing with “low” real Calculating returns, we can save ourselves the annual “inflation” of the withdrawal. We have ignored the so-called “return sequence risk” here. If you are interested, you can read our blog post on Monte Carlo simulation (here).
[3] This saving results from a saved annual gross rent of 22,500 euros (for a property value of 500,000 euros, this corresponds to a gross rental yield of 4.5%) reduced by 6,500 euros in ongoing costs per annum for maintenance, insurance and property tax.
[4] In individual cases, a usufruct right can also be limited in time at the request of the contracting parties.
[5] By definition, a life annuity (in contrast to a “time annuity”) flows for life, just like the statutory pension. With a life annuity, the annuity payer is exposed to the “longevity risk” of the annuitant: the longer the annuitant lives, the more expensive it becomes for the annuitant.
[6] In addition to the two main risks and disadvantages of life annuity structures mentioned here, there are others, which we will not go into here for reasons of space.
[7] Housing law is regulated by law primarily in Section 1093 of the German Civil Code (BGB).
[8] The financial markets in the Anglo-Saxon countries (USA, Canada, Great Britain, Australia, New Zealand) are overall more developed, more modern and more efficient than in Germany. Private investor protection is also more strictly regulated there.
[9] For example, “home pension”, “real estate pension”, “stone pension”, “house against pension”, “additional pension from your own home”.
literature
BaFin (without author) (2023): “Partial sale of your property – where are the risks?” – link
Knaak, Peter et al. (2020): “Reverse Mortgages, Financial Inclusion, and Economic Development Potential Benefit and Risks”; World Bank – link
Kommer/Bartosch: “Increases in the value of residential properties – dream and reality” – link
Kommer/Lauterwasser: “Inflation helps me as a borrower – keep dreaming!” – link
Kommer/Schweizer: “Maintenance costs: How to gloss over real estate investments” – link
Kommer/Weis: “Are rental properties attractive investments?”– link
Kommer/Schweizer: “The risk of investing in real estate” – link
Kommer/Schweizer: “The return on investments in real estate” – link
Kommer/Großmann: “Open-ended real estate funds – illusion and reality” – link
Kommer/Bartosch: “Avoid capital consumption: Not a desirable investor goal” – link