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EScroogeJr (< 20)

Why housing bears are wrong (Part 5)



October 02, 2007 – Comments (11)

Part 5. People don't sell unless they absolutely have to.

Let me continue with my answer to fransgeraedts. Apart from the fact that a large outflow of capital is unlikely as housing remains a very attractive investment vs. stocks, there are several psychological reasons discouraging such an outflow:

a) The sale usually involves a 6% commission plus thousands of dollars in relocation expenses. This factor is sufficient to discourage active trading. In other words, if you anticipate a 5-10% dip in prices, there's no point selling to buy back later. It is very seldom that the seller will anticipate a drop big enough to justify this attempt at market timing.

b) Most people have very low tolerance for stock volatility. People will prefer to make less money but without huge peaks and troughs.

c) Homeownership is attained at a relatively advanced age, so homeowners with substantial housing equity tend to be older than the average population. For many of them, moving housing equity into stocks is impractical because stock investing requires a 10-15 year time horizon, and they're not sure if they have that much time left.

d) The decision to sell a primary residence always involves the risk of never going back. You can miss out on a stock and still buy back half of a position later. But if you sell a house and don't fare too well with your wonder stocks, the decision could prove irreversible. They won't let you buy back one half of your old house.

e) There is also the psychological factor. People, especially at the old age, tend to stick with what has worked for them. For a homeowner who has substantial equity in the house, real estate investment has obviously worked well. He is unlikely to change his investment approach without a very compelling reason.

Reason #5. Bears are wrong about capital mobility because they underestimate redeployment costs - both real and emotional.

11 Comments – Post Your Own

#1) On October 02, 2007 at 7:51 PM, camistocks (50.45) wrote:

Good posts, but I believe you are too bullish on housing. I will add the recent comments from Richard Russell of a veteran in the stock market.

"The news on housing gets "worser and worser." How bad can it get? Look, the simple fact, and I've been saying this for a long time, is that housing is just plain overpriced. Do you know when housing is reasonably priced? Housing is reasonably priced when you can buy a house, and then turn around and rent it out, and the rent will cover your costs, and I mean all your costs including mortgage, repairs, taxes, utilities, loss of interest on the money you put up to buy the house.

My father was in real estate all his life. He knew real estate backwards and forwards. And he had a formula. No matter how you cut it, no matter how you finance it, when you buy a house it's going to cost you an average of ten percent a year to hold that house. I've revealed this ten percent formula to a lot of people. They're usually skeptical at first. After a few years they tell me, "Yeah, Russell, you were right. The house is costing me an average of 10% a year including all expenses.

Today you buy a house for say $400,000. How you finance it is your business. Can you rent that house for $40,000 a year? Are you kidding? You're lucky if you can rent it for half that amount, which means that you're paying double what the house is really worth. A lot of seasoned old-timers are predicting a 40% to 50% drop in home prices. I don't know if we'll see anything near that drastic, but home prices in real estate bear markets tend to head south slowly, and I believe this decline in home prices could take anywhere from 18 months to two or three years. 

OK I know this sounds like a super bear, but that's not the case. It's just a thought...

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#2) On October 02, 2007 at 8:43 PM, EScroogeJr (< 20) wrote:

Yeah, I've heard that many times. House for 10xrent, let tenants pay all the expenses...The supply of fools is running out. Nobody is going to buy you a house out of his own pocket any more. By the way, remember the last time we had S&P available at a PE of 7? Ahh, those good old times...

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#3) On October 02, 2007 at 9:58 PM, MakeItSeven (31.22) wrote:

Look at this chart.

 The fools are those who are about to fall flat all their faces after exhausting their life savings feeding that big bubble which resembles Nasdaq 2000.

 Yes, the supply of fools are running out and that's why it's difficult to find any buyers now.

 Just take your  topic "Part 5. People don't sell unless they absolutely have to.".  That's patentedly false.  It's only true for investors and it's only true when their investments are not bleeding them to death. 

For people who need to sell a house, since they can't afford it or due to job relocation, it's not a choice whether they sell it or not.  For recent RE "investors", sure, they can try to hold on with the big negative cash flow but once their savings are gone, they will have to take a loss, or a foreclosure.  For people who want to upgrade/downgrade their houses, if they don't sell then they don't buy either so it's a wash.

 It wasn't just Richard Russell's comment.  I read books on RE investment back in the 80's and the advices were very similar.   A bubble is not a new paradigm, whether you look at the Nasdaq 2000 chart or at the recent home price chart/gain.  Americans have not been stupid for over 100 years until you discover the new paradigm and tell them so.   And sitting right at the top of a bubble and teaching the world how good it is comparing to everything else is a silly excercise.

 Talk about RE investment, I just took a week off from work to look at an ocean front lot in a gated community with a yacht club/berth, man-made lagoon, fishing pier, near tourist attractions in a location shielded from all tropical storms by a chain of mountaineous islands.  In that lot, if I decide to build a 3500sf villa (by hiring an architect and design my own villa, not too fancy of course), the total will come up to be around 350K.  I figure that the villa will double in value in about 5 years.  The potential yearly rental income from that is around 10% of the cost of the villa.  That would be a good investment.

 I decided against that investment (and forfeiting my small deposit) though since, comparing to my other investments, I can most likely more than double my money in 5 years.   Worrying about a RE investment in another country until I decide to retire and move into it is also not a hassle I want to take.   Maintaining an illiquid RE investment is a pain in the butt.

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#4) On October 02, 2007 at 10:20 PM, EScroogeJr (< 20) wrote:

Thanks for the link, MakeItSeven. This is the graph I was referring to in Part3. I had seen it before on, but lost the bookmark.

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#5) On October 02, 2007 at 11:23 PM, MakeItSeven (31.22) wrote:

Really.  Anyway, I read some of your responses and your whole logic seems to be based upon the insistence that home prices will not go down, and are extrapolated to move up from this bubble so potential home buyers who wish for home prices to go down will forever be locked out of this infinite wealth creation.

Sitting atop a bubble and making comparison is prone to mistakes.  At one time (1998-early 2000), Warren Buffet was called a fool since he did not compare well to other investors.  To that his only defence was "It's only when the tide goes out that you learn who's been swimming naked.".  The stock tide went out a few years later.

AFAIK, the housing tide is still moving ...  

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#6) On October 02, 2007 at 11:48 PM, EScroogeJr (< 20) wrote:

The dot-com bubble was unsustainable. When has a negative PE and no hope to become profitable, and right next to you is a house for sale whose PE is 20, sooner or later people will choose to buy the real thing. In contrast, the housing rally is sustainable, and the set of tools to spur growth is very well known. I would never make a bullish call on housing if we were at the same stage as Japan in 1990. But for now, we're not even in the same zip code.

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#7) On October 02, 2007 at 11:52 PM, EScroogeJr (< 20) wrote:

The dot-com bubble was unsustainable. When has a negative PE and no hope to become profitable, and right next to you is a house for sale whose PE is 20, sooner or later people will choose to buy the real thing. In contrast, the housing rally is sustainable, and the set of tools to spur growth is very well known. I would never make a bullish call on housing if we were at the same stage as Japan in 1990. But for now, we're not even in the same zip code.

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#8) On October 03, 2007 at 12:36 AM, MakeItSeven (31.22) wrote:

The stock bubble was not caused by alone so please save me the silly representative example.  At its worst, its main drivers (the 4 horsemen of the internet: Cisco, Sun Microsystems, Intel, EMC) were still making a profit, even if the PEs were high.  The total capitalization of all the minor players didn't even add up to 1% of the market capitalization.

Right now, the housing investments are bleeding its participants dry with negative cash flow, i.e. grossly negative PE, based on commodity products which anybody can create at any time.  There is no shortage of land or of timber in the US, and there's no intellectual properties required in building yet another house.

Stock movements, as well as home prices movements, are speculation.  People who ignored 100s of years of history and make projection of price movements based on a few years of bubbles are always wrong.  Period. 

At some point, you might even wish that the US has shortage of land like Japan to justify and support the high house prices.

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#9) On October 03, 2007 at 1:48 AM, Imperial1964 (95.18) wrote:

I can't imagine many people selling their home because it will lose a little value for a while.  I believe what I'm concerned about is called a buyer's strike.

Thinking inductively: Some people buy their first "starter" house.  Many of these were called subprime.  From there people "upgrade."  But without someone else to buy the old house, people can't "upgrade."  If first-time buyers are priced out of the market because they can't get/afford a loan, it could eliminate many potential buyers on up the chain.

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#10) On October 03, 2007 at 1:56 AM, EScroogeJr (< 20) wrote:

"At its worst, its main drivers (the 4 horsemen of the internet: Cisco, Sun Microsystems, Intel, EMC) were still making a profit, even if the PEs were high."

To an absurd degree. I remember looking at valuations back then, when I didn't know a thing about the stock market and was wondering if I should buy like everybody was doing, and I said to myself: this is crazy, I'll have to wait 80 years for that investment to pay off. For all practical purposes, the PE was infinity.

"Right now, the housing investments are bleeding its participants dry with negative cash flow"

You can call it that. I'll call it the initial investment amount. There is always a period of negative cash flow for the first few years after a leveraged purchase. The trick is to keep the creditor away for these few years. Then rental rates go up, reducing the bleading, and by the time you break even on cash flow, the house already costs 30% more. 

"i.e. grossly negative PE, based on commodity products which anybody can create at any time. "

The only commodity is bricks, cement, wood, plasterboard, and whatever else construction workers use. Nobody would invest in that. The product you're investing in is called "construction permit", and nobody can create that at any time. This product is manufactured exclusively by your local officials. Otherwise houses would most certainly cost like cars.

"At some point, you might even wish that the US has shortage of land like Japan to justify and support the high house prices."

Japan has no shortage of land. It's an artificially organized shortage that supports house prices. Natural supply of land  is always more than sufficient. As to "justifying" the house prices, I don't care about moral justification; I'm just saying they will keep growing for such and such reasons. Example: being bullish on HAL and supporting the war in Irak is not the same thing (even though I'm sure many shareholders view it that way).

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#11) On October 07, 2007 at 8:28 AM, fransgeraedts (99.77) wrote:

Dear Escrooge,

i find this exchange a pleasure.

Let me first recapitulate where we agree.

(1)There has been over the last years (decade?) a mountain of money looking for a profitable home. ( I would call it overproduction of capital leading to and made worse by cheap and easy credit; you have called it funny money and liquidity)

(2)That has lead to asset-inflation and bubbles. (We agree on calling the run up in info-tech that ended in 2000 a bubble.) (I would count four bubbles so far (info-tech; creditrisk; housing; china)

(3)There still is (a lot of)(new) money looking for profitable ways to invest. (I would say that the overproduction of capital persist; cheap and easy credit is gone, but FED actions worldwide counteract that somewhat)

(4) The market in actual brick and mortar houses is special; to compare it with other assetmarkets like the stockmarket is not very helpfull.

Your spirited defense has forced me to think deeper about that strange market in what we should call homes instead of houses. I am gratefull for that!

Now let me list where we do not agree.

1. When you talk (denie the existence of) about the bubble in housing and its ongoing deflation you narrow your scope to much. You "stare" at the market in homes ..and "overlook" the homebuilders and developers, the real estate agents, the mortgage-lenders, -resellers and -insurers, the home retailers. Looking at that wider housing-related market the existence of a bubble and its bursting is undeniable.

2. You could however agree with me on the point of the wider housing-related market and still defend the position that there is no bubble in the market of homes -or even if there is, that it will continue to expand. In other words, even if you concede that there has been a deflation in housing-related assets you could still hold on to the idea that there will be no deflation in the prices of homes. I disagree. I think that the prices of homes will go down. I have made you a wager that it will be somewhere between 10 and 15%. I have also wagered that in some vulnerable regions it could be as bad as 50%.

3. I have made the general point that in times of asset-inflation bubbles will form and then deflate and that the next bubble will form elsewhere. Capital i said is mobile and it is (the change in) riskperception that gives that movement its direction. If i understandly you correctly you do not deny this general point but argue that it doesnt apply to the market in homes. You then begin to list the reasons why capital invested in homes is much less mobile then capital invested in other assets. You and I agree on this point (see above and other posts) and have agreed upon it from the start. ((I enjoyed for example very much that you reminded people of the existence of the building permit and then proceeded in your example in demonstrating how a community can use it to maintain scarcity)(I would add along those lines that the existence of urban infrastructure is also necessary before homebuidling can be seriously undertaken.)) You, however, seem to conclude that because of that relative immobility the bubble in housing cannot and will not deflate - and therefore is not a bubble. I disagree. The relative immobility will mean that the homes market bubble will deflate in slow-motion. 

Let me try to explain how i see this playing out.

1. Lets begin with the more mobile parts of the market in homes. Homebuilders that produce homes without having buyers lined up. Developers that do the same. Private investors that buy a home not to live in it, but to resell it for profit at the first opportunity. All of the above of course have been investing in homes in the "hottest"regions in the country. The regions where homeprices were rising the fastest. That has produced a glut in homes, at the same time as a growing amount of potential buyers have been priced out of those markets. The result of that is inevitable. Prices of homes will come down, invested capital will be destroyed, even the underlying capital structures will get damaged.

In those markets the buyer now already is king. And he can pick up a home at a much lower price then say a year ago. I would suggest that he wait a little longer. Prices will drop further. (I will come back on this wait-and-see effect later.)

2. A lot of people (a whole lot of people!, mortgage-production 2001-2007 has been at a historic highs) have taken out a mortgage in the last couple of years. Either refinancing an existing home, buying a bigger one, moving home, or buying their first. Many of those have opted for mortgages that have adjustable rates.The long downtrend in interest rates is bottoming out. In many a place in the fixed income markets (including some mortgage-classes) a rise has already begun. That will mean that some homeowners will no longer be able to afford to stay in their homes. Under normal circumstances, at this point in the cycle that would only be a trickle, of course, because people, as you rightly point out, hold on to their home as long as they can. (What that says about consumption in the next couple of years is another matter.) Their selling would put the market under pressure - but just a tiny bit.

3. Circumstances however are not normal. There has been a collusion between mortgagelenders and homebuyers in the last years that has resulted in people buying homes they cannot afford. Subprime loans, ARM's, Jumbo's, you name it, they all resulted in unaffordable homeownership. The lenders and homebuyers basically counted on a rising homes market to bail them out. For that house of cards to crumble the only thing that needed to happen was that the market stopped rising. Which it then, naturally, did. The resetting of the ARM's is the trigger that will bring this segment down. Much more people then would be normal at this point of the cycle will be forced to either sell their house with a loss or go into foreclosure. The trickle will turn out to be a a steady stream of sellers. That will put the market in homes under real and sustained pressure  -and not just in the hot spots of yesteryear, but across the US.  

3. The flip-side is that that collusion of lenders and buyers has been broken up. Cheap and easy credit is gone from the mortgage market. That means that the group of (first-time) buyers that effectively is priced out of the market by the high prices reached in the recent past, grows rapidly. You could say that the fraudulent collusion masked the fact that they could not afford to buy at these prices for a while -but now reality stares them in the face. That is compounded by the damage done to the mortgage-lending industry and their unwillingness to take more risk on. Mortgage-production will shrink. So even people who could afford to buy will have problems getting a loan. This shrinking of the buyers pool plays out across the US.

4.  You rightly point out that homes are not normal investments. People live in them. That is the main reason why it is as a capital market so immobile. We, from the beginning,agree on this point! (I never suggested that people would sell their homes and move the money in to the stock-market because of the hope of better returns... .That is the Jim Cramer stile of hyperbole. Your arguments against that proposition are all sound..but do not touch mine.) However, the other side of that is that people have to sell their homes if their lives take them elsewhere. That mobility of lives produces a constant mobility of capital in the homes market -however unwillingly. (Death being the most important and the most unwilling form of this mobility)

5. In none of the arguments above the effect of the already ongoing lowering of prices has been factored in. That effect is of course the most important one when a bubble bursts.  It makes all of the above worse. When prices begin to drop mortgage-lenders become even more unwilling to lend. People that have sold a home at a loss, cannot afford to spend as much next time. Others drop out of the market altogether; they will not be able to afford to buy a house again in this generation. And the most important effect of course is on the side of the buyers. They will begin to expect prices to drop further. So the imbalance will get worse: the amount of sellers grows, the pool of potential buyers shrinks; a part of the potential buyers will go on strike.

6. All of this will of course play out against the background of a large mass of homeowners that (1) can afford their home and mortgage and (2) do not want or need to move. They will simply stay put.  One can even predict that that immobile mass of homes will grow a little bit. Paople will choose to stay because they do no not want to sell at a loss. But that immobile mass doesnt influence the price. Only the buyers and sellers do that.

7.If we look at what will happen from an investment standpoint, the picture is grim. A house is usually a very leveraged investment. Lets say that you have put up 30.00 dollars in buying a 300.000 dollar home. If you are forced to sell that home with a 10% loss, your investment will have been wiped out. Your loss is a hundred percent. If your in a market where the drop is more, you lose more then what you have invested. Your savings will get a dent, you could go into debt. (if we put that against the backgound of the low saving rate and the high debts of households...) If we assume that you will stay put, that is, you do not need to sell, that loss is of course just on paper. But it will take a long time before the price has recovered. Shall we call it dead money for maybe 10 years?

8. I particularly enjoyed reading your arguments re investing in your home compared to investing in the stockmarket. I agree with many of the points you make. In general buying and holding a home is a profitable proposition -much underrated. However there is of course an exception to that rule  -and that is buying at the top of the market.


Frans Geraedts 




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