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EScroogeJr (< 20)

Bust mythology - microeconomics

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January 09, 2007 – Comments (0)

It amazes me that some folks still believe there will be a housing bust.

Making a correct market call is usually difficult, as you have to weigh all pros and cons. Housing is one happy (or rather unhappy, if you rent) exception where the answer is obvious because there are no cons to cons to consider. Indeed, from whatever angle I look at the housing market, all signs consistently tell the same story - that the only possible direction for this market is up.

The first and most obvious indicator is relative benefits of buying a house and not buying a house.

The market is not a fool. It is often irrational in the short run, but in the long term it is always extremely rational, even the stock market. Therefore we can say with full confidence that as long as buying makes more sense than renting, there can be no meaningful decline in price.

A house buyer should expect to pay annually some 6-7% of the house cost in mortgage interest, plus insurance, plus property tax - about 9% altogether. Essentially all of it is tax-deductible. For the retired and for those making some $40,000-80,000 per household, this is obviously not a factor, because the standard deductions together with ROTH IRAs and so on is already enough to shield most of their meager income from taxation. However, as the market price is determined by the purchasing ability of the weathiest buyer, and the upper 10% of the population have never been richer than today, we can confidently estimate that the real cost of these payments for the qualified buyer is somewhere under 7% per year. In addition, there is the depreciation writeoff, which lets you get back another 0.5% or so, and repair writeoffs for rental properties. I don't count payments of principal, becuase they immediately increse your equity and therefore cannot be considered a cost. They only "cost" you if you have trouble making these payments, which is not the case for wealthy buyers. So, 6.5% is the actual cost of homeownership, and as long as rental income from the property minus maintenace (i.e. heating bill and plumbing repairs) stays above that, no landlord will ever refuse to buy another house becuase in fact he gets it for free without paying a cent. Of course, as Uncle Sam wants his cut of the rental income, it should be reduced by some 30% for abnormally honest landlords, and by a far lesser amount for normal landlords.

Of course, bargain prices that made such yields possible are mostly gone. Still, for the average $250,000 one-family house, getting a 3% yield does not take a lot of brains. You can increase it to 4% if you don't report rental income, or "rent" the place out to yourself or to a family member, but we won't go into that.

Now, the cost and the yield are not created equal. The main component of homeownership cost (mortgage interest) is fixed in dollar terms. Rental yields, on the other hand, increase with inflation. Assuming a very conservative 4% rental inflation per year, we can count on them to double in about 17 years. So, the first impression that the net expense is going to stay at 3.5% forever is wrong. In about 20 years, rental income will fully cover your ownership expences.

Meanwhile, even the most ardent bubble enthusiasts agree that with a 20-year time horizon, house prices will increase at their average long-term rate. From the past experience, this rate has been about 6-6.5%. Macroeconomic considerations suggest that in the future, it will only get higher. But there is nothing wrong with erring on the safe side and assuming a lesser number. 4% should satisfy the pessimists, 5% - the realists.

The conclusion is obvious: even under the most conservative assumptions, the time-averaged annualized gain still exceeds the maximal cash outlays in the worst and hardest first year of ownership.

The net gain will surely trail the returns of the stock market. However, the opportunity cost involved is not an issue because the initial cash outlays are very small, and the whole transaction is essentially done on margin. Surely, one can also trade stocks on margin, but this is too risky to be a viable long-term strategy. Of course, if you run a business, you will probably find a better application for your loan. But this is only for the more adventureous individuals, and anyway, it seems like most of business activity in this country is centered around the housing market anyway.

Summarizing, I sadly but confidently conclude that based on the cash flow projections, the average house is somewhere from undervalued to fairly valued. This means that investment demand for houses will not stop except as a temporary and transient phenomenon as investors hope that bubble talk might produce a slightly better price.

So, microeconomic considerations tell us that there is no objective reason for the bubble to burst. This conclusion will remain valid until we have a tax system that makes renters pay twice (first to the landlord, and then to the government so the government could write a tax return check to the landlord), and changing that system is politically impossible because both Republican and Democratic politicians own houses. Barring a complete collapse of the rental market, or an unexpected increase in interest rates, microeconomics allows for housing prices to increase by another 30% in real terms before we can call the market overbought. Using realistic, rather than conservative projections, I expect nominal prices to rise at least 50% in the next 5 years.

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