Monday, August 21, 2006

Your House Is Not An Investment

An accomplished real estate investor once told me that,

"A house is like a gold mine on the moon... impossible to harvest."

If a house is an investment, then for many of today's home buyers, it should at least be qualified as a highly leveraged one. I know that over long periods of time homes have appreciated enough to justify a mortgage, and that may offer solace to some, but I can't get over the notion that if you need an 80%-100% mortgage, then common sense seems to be hollering that you can't afford the house you are buying. Would you invest in the stock market with 10-to-1 leverage?

Seriously think about that for a second. If you have to borrow 90% of the cost, consider that maybe the house is out of your budget. What if you don't get paid for 3 months? What about six months? Can you still cover your expenses? Isn't assuming that your income won't fluctuate or stall for 30 years a reckless egotistical gamble?

I know many people that were earning a few hundred grand 15-30 years ago and now work for 40k and 50k. As a self-employed securities trader, my income has always been all over the place so I am used to it. But I fear for some people that I know who have made decent income every year and have recklessly parlayed that presumption into expensive lifestyles. Imagine your career takes a dive, you have to sell your house at a loss, and move into a smaller place perhaps in a less desirable neighborhood. To most people, this would be unthinkable - not to mention psychologically devastating.

Last year I linked to some alarming articles about the high usage of adjustable rate mortgages - particularly in California. Well today, still roughly 25% of mortgages are opting for the adjustable (or interest only) route. Unless these people have a wad of cash in their bank accounts (or their mortgage is small relative to their income), I certify them as insane. I'd say this 25% is a big reason why home prices haven't crashed yet as well. As I mentioned in a recent post,

The worst case scenario is playing out for real estate. Instead of a quick 20-25% correction, the market is just stagnating, staying overbought, and sucking more buyers in at these nosebleed prices. It's most certainly going to make the eventual correction more severe.

Incidentally, my hometown of Newton, Mass heads the Ziprealty Price Reduction Index. They obviously don't have a presence everywhere, but nevertheless, as of this week, 54.3% of Newton homes have reduced their sale price.

Remember I have been tracking for home listings in Newton.

April 26, 2006 704
May 18, 2006 724
June 21, 2006 776
August 15, 2006 685

Why are the listings down after that springtime uptick? Are homes selling? Or are people taking their houses off the market?

Who knows? But regardless, I think it is safe to say that prices are dropping in Boston as well as everywhere else. I am still in Southampton, NY and let's just say that if I had a nickel for every "for sale" sign I drove by, I would likely be able to buy a house on Dune Road in East Hampton.

In the past I have done the math on Rent versus Buy and Invest for my apartment but I would like to extend that a bit. As I said above, there are tons of homes for sale in the Hamptons (because there still is plenty of farmland for development) and always plenty to rent for the summer months. Some quick and dirty math has revealed to me that it's almost always better to rent a house for the summer than to own one - and that is at every price point. I'll spare the details of the analysis but after factoring in lawn care, insurance, pool maintenance, realtor rental fees, the risk of not being fully rented, and the short rental season, I have come to the conclusion that a Hamptons house really is a luxury. Summer renting is far and away the wiser choice (and much less hassle). The same likely applies to your local vacation destination.

Seemingly everything is cheaper to rent. Consider jet-skis. Paying $50 to rent one for 30 minutes may seem like a rip, but do the math on how many times you have to rent one to outspend a jet ski purchase (and remember as well upkeep, storage, and the fact that you'll feel obligated to use it a lot, just to justify the original purchase). Renting, rather than owning, a car is also a mathematical no-brainer for Manhattanites who could spend $4,000-$5,000 a year just on parking.

Almost every house I look at screams "maintenance costs" right back at me. I am so happy renting, not having to worry about leaky pipes, new heating systems, lawn sprinklers, landscaping, getting the roof done, paying an exterminator, paying a 5% real estate commission to move, or worrying where interest rates go. (Also not to go unmentioned is my outright apathy towards local politics. I simply don't have to get involved, I can easily move when my son comes home from kindergarten and starts talking about civil unions.)

Given my druthers, I think I'd rent forever.

Remember, borrowing at 6% to buy a house implies that after the income tax deduction, your home has to appreciate around 4% per annum, JUST TO BREAK EVEN on your "investment". Now that rates are more like 6.5%, you need appreciation a half point higher, ANNUALLY, FOR THE LIFE OF THE MORTGAGE, JUST TO BREAK EVEN. If mortgage rates climb to 8%....never mind.

Another savvy entrepreneur once told me,

"Real estate is the ultimate investment...because it has a yield and is protected for inflation."

Theoretically he seems to be right. But practically, today's yield on real estate, i.e. rental income, is paltry (less than 4%). As for inflation protection, owning real estate is a hedge ONLY against real estate inflation. Owning a house won't help you pay escalating healthcare inflation, college tuition inflation, local tax inflation, and its value will actually decrease with energy cost inflation. Mark my words, the next cold winter's heating bills will decimate real estate in New England.

Speaking of real estate and Massachusetts Morons, look at this rich headline.


Now who would want to halt a "boom", especially in your own town?

This bespeaks of the gross economic illiteracy in Boston. The fact that an elected representative can publicly clamor against the development that has likely made more money for South Bostonians than anything in decades tells you all you need to know about how economically illiterate not only he is, but also his supporting constituents.

Whenever dunderheads talk about the housing market, they bandy about terms like supply, demand, and investment. Allow me to interject a more germane one - valuation.

Mostly valuation is used to talk about stock prices in terms of multiples of earnings. Google is trading around 37 times this year's expected earnings. Its PE ratio is 37.

For financial assets, valuation is the most important price determinant. The example I like to give is this,

Imagine a stock of yours climbed up to $100 per share. Clearly demand was outstripping supply for your stock and the market was pushing its valuation higher. It could stay highly valued for a long time, perhaps even go much higher. But one day, your stock may open at $50. For some reason, slowing earnings, a competitor's innovation, deleterious legislation, a market crash, natural disaster, accounting irregularities, etc. all of a sudden the market decided to value your precious stock at a much lower number.

This may seem like a circuitous, if not over-nuanced, way to simply say that the stock got ripped but bear with me.

Owning shares of a stock gives you nothing more than a sheet of paper. House ownership is nothing but a plot of land and some wood and cement. Unlike gold, these are soft assets whose values really are derivative in nature. The only part of a house that approximates a hard asset is the potential rental income which offers a floor for prices.

As I have said in prior posts, rental yields are less than money market rates. Real estate prices would have to fall near 35% for new real estate investors to be able to cover their cost of capital with rental income and that is with rates at the still benign 6-6.5%. If mortgage rates hit 8%, you'd need a 50% decline in real estate prices for the rental business to become cash flow positive.

Okay enough of my impending doom screed.

The last five years have been a boon for contractors as anyone who has tried to get some house work done cheaply and quickly can readily attest to. In fact I read somewhere that two-thirds of job growth in the last 3 years was in the construction biz (so much for Bush not creating low end jobs). It's been a perfect storm for contractors with the real estate boom, low interest rates, spread of home equity loans, and overall speculative investment. But one of the most favorable variables for them is the new mass of novice homeowners.

Just as real estate agents have been able to slide their "non-negotiable" 6% fees into the back pockets of inexperienced first time sellers, contractors also are in the fortunate position of servicing an entire generation of rookie homeowners who haven't the slightest idea how to manage a contractor.

One simply can't pay a contractor in full upfront. Too many people do this. Pay half upfront and don't pay the other half until well after the work is done and stood the test. Also, definitely have any "handy" friends check out the work.

Though I have many, I'll give just one anecdotal example. Three people I know just put new fences up - and all three got jammed. One just didn't shop around and got bamboozled on the price. The other two had the same little trick pulled on them. A price was agreed upon, the contractor said they would cement the fence posts in, but in both cases the contractor "couldn't" cement them in when the job was actually done. In neither case did the contractor lower the price for a fence that will be uneven in no time. He is under no obligation to "lower" it for you, you must ask him to.

Here is the crux of the econo-illiteracy problem. Most people don't understand the realities of an economic transaction, i.e. that self-interest also has its grip on the person they are paying. Just don't forget that everyone from a cab driver to your financial adviser to the mortician who's going to bury you, is actively trying to separate you from your money.

The lumpen masses think that because their homes have recently appreciated that they are "investments". It reminds me of a common stock market trap. Many times a trader will buy a stock that's dropping - but just to trade a bounce. But what happens all too often is that the beat up stock drops further and the trader decides to hold the position for a while, ergo a "trade" has turned into an "investment". But it is no investment, just a losing trade contorted by ego. It's really depressing to think how much money I have squandered on this familiar story.

So again, since you have to live somewhere, your house is necessarily not an investment - it is a sunk cost and perhaps a liability.

Devil's Advocate - Yeah, but who wants to piss away money on rent?

There's no difference between pissing away money on rent and pissing it away on mortgage interest? At today's prices I'm opting for the one year commitment over the thirty year one.

Right before the Nasdaq peaked in 2000, I was taking a cab at 6am to the train station in Philly. The driver, making small talk, upon hearing that I worked in the market asked me what I thought about Qualcomm (a darling of the tech bubble). If that wasn't a sign of the market top, then I don't know what was. It certainly smelled like the shoeshine boys giving stock tips before the 1929 Crash.

Back in the tech bubble, I couldn't so much as get out of a doctor's office. All the docs wanted to run their stock tips by me. Thirty minutes would run by and I'd interject, "Hey doc, what about my back?"

One guy I knew, an experienced professional trader, asked me if he should buy JDSU because he was getting a tip from a neighbor. I asked him, "What does JDSU do?". He said he didn't know (they are in fiber optics). Now here was a professional thinking about investing in a stock based only a tip and he hadn't even taken 10 seconds to research what the company did. Hindsight crystallizes everything, but the signs of an impending bubble burst were all around.

Six years later, real estate is playing out the same tragic script. Ask people about the relative costs of renting versus buying - they don't know. Ask them how much their mortgage deduction really saves them - they don't know. Ask them when the last real estate bull market ended - they don't know (1988 and it took until 1998 to make a new high). Ask them how much money they should be saving for future repairs like a new roof - they don't know and definitely aren't doing it. I am not exaggerating at all when I say that NOBODY is armed with this basic information. Forget about asking them about the solvency of their town or state - that's way too advanced of a question. States like New Jersey and California are bankrupt now - how do you think they are going to perform in a recession? People and businesses move quickly these days. Is your state or town headed for a tax death spiral (rising taxes, shrinking tax base)? Remember New York City was essentially bankrupt in the 1970s. There will be bumps again, and that is when I will buy.

Just like the last bubble this one is going to end with lots of pain. Soon there will be an army of unemployed mortgage brokers and real estate agents trolling for jobs. They will be the day-traders of five years ago.

And a lot of real estate investments will look awfully like previous ones made in the Munder NetNet Fund.


Tax Shelter said...

why all the doom and gloom? It seems to me that everything is fine (although not perfect). The persistent weakness of the dollar is troubling though...

CaptiousNut said...

It's a generalized gloom and doom - at least for real estate.

Adjustable mortgage usage has been pervasive. This variable has never been in the housing market before. I liken it to buying bulletin board stocks on your credit card.

My brother-in-law went to get a home equity loan recently. He only needed 50k, but the banker tried to get him to take out 200k. The anecdotes never end.

Also, I see impending doom because of the ignorance of the buyers - as I mentioned towards the end of the post. The parallels with the tech bubble are clear.

I don't worry about the dollar simply because the euro and yen have much worse fundamental stories. In any case, there are a myriad of ways to hedge dollar weakness: shorting the dollar, buying gold and silver, buying mining companies, etc. The only way to hedge against a declining real estate market is by renting - an option not available to many.

The billion dollar question is how would a real estate implosion affect the overall economy. This of course is a tougher call. There wasn't an economist on the planet 3 years ago that would have said the global economy could survive $70 oil.

CaptiousNut said...

I started this site with the intention of giving financial advice. I just got sick of telling people the same stuff (portfolio allocation, etc.) over and over again. I wanted a reference to point free-advice-seekers to. Obviously I have take some license with that original plan.

In the last few months, two people have personally told me that I talked them out of real estate investments via my blog arguments. I insisted that maybe they were thinking about backing out anyway and that I merely encouraged their decision. But both of them said "No", it was my blog that singularly changed their mind.

It's funny because "Doom and Gloom" is actually what my mother-in-law has been known to call me. Nonetheless, I am still offering very practical advice.

Remember much of my negativity is enhanced by having to move back to Boston.

RamtaJogi said...

Wow. You nailed the real estate craziness! I am going through all your past posts and there is tons of things for me to learn.

Thanks for sharing all the knowledge,

David said...

would you could buy a house and pay it off in 20 years or you could pay rent for the rest of your life?

CaptiousNut said...

First off...

Kind of hard to buy a house unless you know you want to and will most likely be in that area for a good 7-10 years.

Who among us has such confidence?

I'm indifferent to renting and buying. I'll do whatever's cheaper. For years it's been *renting*.

Note that once a house is *paid off* there is still upkeep and taxes. And the owner is still responsible for big stuff like roofs, new appliances, paved driveways, heating/AC systems, septic,....that will inevitably need to be replaced.