Monday, June 06, 2005

Practical paranoia, part 3

The topic of this one is the housing bubble. Now it's possible that this is a false alarm. I don't think so, though.

This one's fairly easy, however. First, figure out if you're in a large or small bubble. (heh - easy. right). I've got a couple of rules of thumb for the size. First, what're the median prices in relation to the median incomes of the area. 20 years ago the ratio was 3 to 4. Heck, even a decade ago the ratio wasn't that far off. Now... in the
Atlanta Metroplex the margin is about 8.5. In Miami it's about 12. You get the idea. If your ratio is over 4 you're on the edge of a bubble. If it's double you're in a bubble. If it's triple or more start watching for the pop. I said a couple of rules of thumb, though, because that one might not be enough.

The second test is rent:price ratio. In a nominally perfect world price (monthly cost of the house) to rent is about 1:1. If it climbs over 1.1 you might have a bubble, though a lot of other factors might also apply. If it exceeds 1.25, you better have some really strange applicable factors to not have a bubble.

OK, but what happens when the bubble bursts? Here's where it gets different from other speculative bubbles. Basically you can expect two big results.

First, for the most part house prices will stagnate, not drop. That is, the price people sell a house for will be in the vicinity of what they paid for it. (Big ugly here is realtor fees. The effect will usually be a net loss. It's my opinion that realtor fees have been a big driver in house appreciation in the past decade as people want to at least 'break even' to include that cost - which is anywhere from 6 to 10 percent increase all by itself.) Oh, the top of the heap will decline, but the median will pretty much stay about where it is - at least till sales perk up again. Which takes us to the second and more significant effect.

There'll be a lot more houses on the market due to foreclosures. People won't drop their primary residence (for the most part, barring other effects). But that second house - the one for which they're paying principle and interest and taxes (especially taxes) and insurance plus utilities and maintenance - that one's going to go bye-bye. And if it can't be sold in what they consider a reasonable time, they'll foreclose. Sure, it'll hit their credit. But it'll free 20 to 30% of their regular income in exchange. Rent it? HAH - remember that price:rent ratio? They lose money with rentals at that level. And a landlord has a lot more costs and risks - more than just a homeowner even if it's a second residence.

The best indicator that the bubble is or has popped will be a large number of "stagnant homes" - 120, 180 or more days on the market for average, with some homes easily exceeding a year. Second best is a large spike in foreclosures, though this might also come in the third chicken little - something to beware, and I'll touch on it again then.

So what's the solution? The ideal solution is to rent till the bubble pops, and buy a foreclosure. The second ideal is to rent till the bursting is over (harder to detect) and buy at the bottom of the market. These ideals assume you can rent. Me, I can't.

See, I have pets - dogs AND cats. Landlords don't usually like these unless you've a special relationship, and even then there are problems. So I'm committed to buying. What's my answer? Don't buy speculatively. Instead buy on the old-fashioned spectrum of purchase solely for my residence. And do so with an eye toward staying in the house for AT LEAST five years and preferably a decade for a minimum. I'm buying for the decade and quite possibly for my retirement as it happens. The house is on the edge of being too big for the current family, and stands a decent chance of being definitely too big when the kid leaves - but it's not that much too big. I'm looking at retirement in about 22 years. I figure to pay off the house in 20-25 years. (A simple technique - I have a bit more taken out on each payment due, and that part's paid a bit early. This pays against principle which forces a recalculation of interest owed every few periods. Total result is that the house is paid off before the nominal due date 30 years from now.) Anyway, that means that if the house does turn out to be too much, the sale is unencumbered and totally equity and I can use the result to purchase something more appropriate - including assisted living if necessary.

I've hinted at this point of a critical point about all these chicken littles, and I'm going to make the point clear right now. Every one of these is a temporary problem. Peak oil - I don't know how, but we'll manage. Either we'll develop much greater efficiencies of use or we'll develop useful alternatives or both - they're there, we just don't have the incentive yet. We're lazy, but not suicidal. Same goes for housing - it may depress for a few years, even a decade, but not for a lifetime. And when I get to the next part - even if we use Japan as our example, we'll manage. The doom is not forever - it's not armageddon. I firmly believe and will plan on the assumption that the best plan gets you through the rough positioned to take advantage of the recovery. As I think the most likely chicken little is the next one, that's where you'll see me doing more positioning.

Later, all.


Blogger InigoMontoya said...

I think you may be overly optimistic about the resilience of the real estate market in the face of downward pressures.

A foreclosed property is a drag on a Lender's books. Banking regulations requires Lenders to set aside reserves against possible losses when they foreclose a property. These reserves take money out of circulation that they otherwise could be making money on by lending.

Ergo, when they foreclose a property, if homes are lingering on the market, they will price a foreclosure under the current "market" price to sell it fast. With fewer Buyers than Sellers, this becomes the new "market" price and Sellers and their agents start reducing the prices on their listings to catch up...and a vicious cycle sets in. I saw this for four years, 1991-1995.

6/07/2005 4:18 PM  

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