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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.

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.



3 Comments – Post Your Own

#1) On June 27, 2007 at 3:51 PM, TMFEldrehad (99.99) wrote:

First let me applaud you for not only arguing with TMFBent, but for doing so in such a thoughful manner.

I too have been reading some of Seth's take on the 'housing bubble', and I'm not so sure I agree with him either.  To be sure, easy credit and low interest rates make houses more affordable, increase demand, and therefore drive prices up across the board.  To the extent that these factors are going away, one would naturally expect housing prices to stagnate or fall.

I completely agree, however, that the best way to look at the data is market by market and segment by segment.  I live in California - one of the states that has been referred to as one of the biggest 'bubble' states by at least a few Fools around here.

When I look at California, or at least the part of California I happen to live in, I am hard-pressed to see any 'bubble' at all.  There isn't a whole lot of land in the L.A. area left to build on and the population keeps growing rather consistently.  Couple this with rising fuel and commuting costs, and there are a whole lot of factors working counter to changes in interest rates and lending practices.

Might home prices soften somewhat?  You bet.  They have already.  Houses are on the market longer here than they used to be.  Might home prices stagnate for a time while the market readjusts to the changes and absorbs some of the rather steep appreciation we've seen over the past few/several years?  A very distinct possibility.

But a 'bubble'?  Like the tech crash?  I just don't see it, especially over a longer period of time.  So long as the population keeps growing, housing prices will have some pretty solid support - especially over the long term.  A lot of the appreciation we've seen hasn't been 'froth' or 'bubble' at all (though some perhaps is) - its foundation would seem, at least to me, to be much more solid than that.

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#2) On June 27, 2007 at 8:04 PM, QualityPicks (56.34) wrote:

Yeap. Median house price is a pretty bad metric, I agree. And housing markets are local. Agreed too.

But in general I have to agree way more with TMFBent. Specially in my area. Let's review some facts for my area: 

I live in Irvine, Orange County, California. There is plenty of raw land around Irvine. A house that sells for $600k I can rent for $2,300.

The mortgage payment with a 10% downpayment would be $3,500, add $200 or so for PMI, and $120 association fees. That takes you to $3,800. Then, property taxes are 7k a year, but you get a nice tax break, so that is a wash out.

If I get 7% return on my $1,500 monthly saved I should have $1,700,000 after 30 years. I'm not sure the house will be worth that much in 30 years, but maybe, who knows. :)

Anyway, I think there is hardly a good risk reward here. Prices are overinflated in my area by some 30%, that is for sure. Will the market correct that much in my area? I sure hope so, but maybe it won't. I still can't believe people making $120k a year cannot afford to buy an entry level 3 bdr/2 bath attached townhome. Amazing.

I guess most people arguing there is a bubble are trying to buy a house. While people that believe bubble claims are an exaggeration, own their house at 30% to 50% lower prices than current levels. No bubble? Yeah sure. Just try to buy a house without using all the huge equity in your current home.

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#3) On June 28, 2007 at 9:21 AM, EScroogeJr (< 20) wrote:

Hi QualityPics,

Glad to hear this report from Irvine. As a former UCI student, I have a special partiality for this town. Guess you're not talking places like Turtle Rock, though. Anything around the campus might as well be made from gold, but it's reassuring to know that at least AROUND Irvine construction permits are so cheap that you can still pay merely $600,000 for a house that costs $100,000 to build ;). Realistically, however, 27K annual rental income makes for a 4.5% yield - hardly a bubble by any standard. Plus, if the tenant you're renting the house to is yourself, you also stand to gain a nice hedonic component on your investment - Irvine is indeed a fabulous place to live in, although that component will be slightly attenuated by the distance between your "American Dream" and the downtown ;)

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