EScroogeJr (< 20)

don't count on cheap housing

June 27, 2007 – Comments (3)

It is hard to argue with TMFBent, but I'm afraid he completely misunderstands the housing market. 

http://www.fool.com/investing/general/2007/06/25/housing-slumps-whos-surprised.aspx?source=iflfollnk0000003

To be sure, his lambasting of the NAR is pleasant to read, but ultimately it belongs to the category of if-only-it-were true. Here is the harsh reality: with the alleged 2.1% price "drop" and a stream of rental income that exceeds 5% in all but the most overpriced markets, homeowners can survive such a "housing recession", crying all their way to the bank. Especially if they were never going to sell anyway and for this reason could not care less about this fictitios drop. However disgusting its marketing tricks are, the NAR's message is essentially correct: it is in the business of selling an asset that pays a 5% dividend, increases that dividend year after year after year, and drops by 2.1% during what is called a "market crash". What should one do if he finds a stock exhibiting these characteristics? The answer: buy, buy, buy, go on margin and buy again.

Now, what does one make of this 2.1% drop?

Remember the saying: "there are lies, there are big lies, and then there is statistics"? Well, the number in question clearly belongs to the latter category. The median price is indicative of only one thing: the relative popularity of expensive vs. cheap houses.

Suppose a small town has 2 houses available for sale - one wooden shack for $100,000, and one brick mansion for $1,000,000. Both listed prices are well in line with sales data from the previous years.One year, a millionnaire arrived into the town and negotiated the purchase of the brick mansion for $950,000. What was the median house price in this town that year? Correct, $950,000. Next year, a local farmer went to the realtor, inquired about the $100,000 house, was told that the new price is $150,000, and for the lack of  cheaper alternatives, had to take what was available. What is the new median price? Correct again, $150,000. On the one hand, the median price has declined. On the other hand, while the first buyer has obtained a discounted price, the second buyer unfortunately had to overpay.

This is not to say that the average price should be used instead. Averaging the two houses in the example above is equivalent to the observation that the average human has one breast and one testicle - just as insightful and just as useful. Instead, I am saying that the only method that makes sense is to compare the prices in each market segment. And even that comparison will be incomplete without the asking price index. I am well aware that compiling such an index is a nearly impossible task: after all, we all know that most house ads are either fictitios or they don't represent the actual expectations of the seller. Still, if you want to assess the state of the market, you MUST look at the asking prices. Why? Because if one buyer was able to find a distressed seller and get a 10% discount, while two other potential buyers have seen the asking prices spike 20% and left the market, the transaction price statistics will be hiding the fact that actually, it has become harder to afford a house.  And it is by gauging the elasticity of  these asking prices that you predict the future housing trends. Without this comprehensive data, one has to rely on his qualitative analysis and intuition.

So, what have we seen in the past? Easy credit and a plummeting stock market suggest the right course of action: go the bank, apply for the largest loan you can get, and buy the most expensive house in the town. The expensive house makes a better investment, because as the liquidity on the market expands, the house with the best location (that's why it is expensive in the first place!) will stand to collect most of that new liquidity. Naturally, the median price goes up. And then, suddenly, conditions change. The stock market is going up, interest rates also go up, albeit very slighlty, and buying that $1 mln house with lake frontage on margin is still attractive, but not as attractive as before. Big investors take a break. The smarter ones are now counting on rental income, rather than capital gains, and buying up the cheaper houses that offer higher yields. Meanwhile, the small fry are stretching themselves to buy poor-quality houses in slums as desperately as they always did. The median price goes down! Unfortunately, the price of that wooden shack that constituted the supply of "cheap housing" keeps going up.

 This is how I view today's market. Prices keep growing as they always did. Three years ago, most of the growth took place in the luxury segment. Today, this growth is taking place in the cheaper segments. Homebuilders are feeling some pain, because they build only luxury homes as a matter of principle (and it's hard to blame them in view of the fact that urban planning departments ban any other construction). The overall market is stong, with pockets of weakness in the luxury segment. If you can't afford that ultimate prize - the $500,000 house on a $300,000 lot, it is time to buy homebuilder stocks.