Hey that’s the poor man’s house

Everybody get a look at the poor man’s house

Everywhere they went before must have turned them out

And now they’re living in a poor man’s house

There’s nothing like poverty to get you into heaven

They got a lot of wine and fish up there

And the bread’s unleavened

They got a lot of ears that heard a whip go crack

Lots of missing toes and fingers and scars upon their backs

Daddy’s been working too much for days and days

He doesn’t eat

He never says much but I think this time it’s got him beat

It isn’t that he isn’t strong or kind or clever

Your daddy’s poor today

And he will be poor forever

Hey that’s the poor man’s house

Those kids are living in a poor man’s house

They walk to school with the soles of their shoes worn out

And come home in the evening to the poor man’s house

What are you chopping that wood for

Why are you growing that corn

Mama’s sewing a brand new shirt and

You’re wearing the one that’s torn

I guess it’s for some one elses kid who wasn’t born

In a poor man’s house

Hey take a look at that house

Everybody we’re living in a poor man’s house

Seems like everywhere we go they find us out

Find out that we’ve been living in a poor man’s house

Poor Man’s House — Patty Griffin

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What is Equity?

In simple accounting terms, equity is the difference between how much something is worth and how much money is owed on it (Equity = Assets – Liabilities.) People who purchase real estate use the phrase “building equity” to describe the overall increase in equity over time. However, it is important to look at the factors which either create or destroy equity to see how market conditions and financing terms impact this all-important feature of real estate.

For purposes of illustration, equity can be broken down into several component parts: Initial Equity, Financing Equity, Inflation Equity, and Speculative Equity. Initial Equity is the amount of money a purchaser puts down to acquire the property. Financing Equity is the gain or loss of total equity based on the decrease or increase in loan balance over time. Inflation Equity is the increase in resale value due to the effect of inflation. This kind of appreciation is the “inflation hedge” that provides the primary financial benefit to home ownership. Finally, there is Speculative Equity. This is the fluctuation in equity caused by speculative activities in a real estate market. This can cause wild swings in equity both up and down. If life’s circumstances or careful analysis and timing cause a sale at the peak of a speculative mania, the windfall can be dramatic. Of course, it can go the other way as well. If a house is purchased at its fundamental valuation where the cost of ownership is equal to the cost of rental using a conventionally amortized mortgage with a downpayment, the amount of owner’s equity is the combination of the above factors.

Initial Equity

The initial equity is equal to a purchaser’s downpayment. If a buyer pays cash for a home, all equity is initial equity. Since most home purchases are financed, this initial equity is usually a small percentage of the purchase price, generally 20%. A downpayment is the borrower’s money acquired through careful financial planning and saving or from the profits gained at the sale of a previous home. Downpayment money is not “free.” This money generally is accumulated in a savings account, or if a buyer chooses to rent instead, downpayment money could be put in a high-yield savings account or other investments. There is an opportunity cost to taking this money out of another investment and putting it into a house. This cost and its impact on home ownership costs are detailed in Rent Versus Own.

Financing Equity

Financing equity is controlled by the loan terms as described previously in Financially Conservative Home Financing and Your Buyer’s Loan Terms. With a conventionally amortizing mortgage, a portion of the payment each month goes toward paying down the loan balance. As this loan balance decreases, the owner’s equity increases. This is a substantial long-term benefit of home ownership. With an interest-only mortgage, the loan balance does not decrease because only the interest is paid with each payment. With this kind of loan, there is no financing equity. One of the major drawbacks of using an interest-only loan does not become apparent until the house is sold and the seller wants to take the equity to the next home in a move-up. Since no financing equity has accumulated, the seller obtains less equity in the transaction. This means the move-up buyer will be able to afford less. Over the short-term, financing equity is not significant because the loan balance is not paid down by a large amount, but if the house has been held for 10 years or more, or if the loan was amortized over a shorter term, the financing equity can be a large amount. This can make a real difference when the total equity amount is to be put toward a larger, more expensive home. Also, financing equity is a great reservoir for retirement savings. In fact, it is the primary mechanism for retirement savings of most Americans.

The worst possible loan is the negative amortization loan because of its impact on equity. As noted in the chart above, if a negative amortization loan is utilized, it will consume all equity in its path. It is a cash-out financing that reduces equity. This loan relies on inflation and speculative equity to have any equity at all. The negative amortization loan will only begin to build financing equity after the loan recasts and becomes a fully-amortized loan and the payment skyrockets — assuming the borrower does not default. Most people cannot afford the fully-amortized payment, or they probably would not have used this form of financing initially. Even after the recast and the dramatic increase in payments, the loan does not get back to the original balance for many years.

Inflation Equity

House prices historically have outpaced inflation by 0.7% nationally. In a normal market, this is the only appreciation homeowners obtain. This appreciation is caused by wage inflation translating into higher housing payments and the ability of borrowers to obtain larger loan amounts to bid up prices. In areas like Irvine where wage growth has outpaced the general rate of inflation, the fundamental valuation of houses has increased faster than inflation; however, there are reasons to believe that Appreciation is Dead. The related benefit to home ownership obtained through utilizing a fixed-rate, conventionally-amortizing mortgage is mortgage payments are frozen and the cost of housing does not increase with inflation. Renters must contend with ever-increasing rents while homeowners with the proper financing do not face escalating housing costs. Over the short term this is not significant, but over the long term, the monthly savings accruing to owners can be very sizable, and if the owner owns long enough or downsizes later in life, housing costs can be nearly eliminated when a mortgage is paid off (except for taxes, insurance and upkeep.) Although this benefit is attractive, it is not worth paying much of a premium to obtain. The long-term benefit is quickly negated if there is a short-term additional cost associated with obtaining it. For instance, if a property can be rented for a certain amount today, and this amount will increase by 3% over 30 years, the total cost of ownership — even when fixed — cannot exceed this figure by more than 10% to break even over 30 years. The shorter the holding time, the less this premium is worth. In short, capturing the benefit of inflation equity requires a long holding period and a minimal ownership premium.

Speculative Equity

Speculative Equity is purely a function of irrational exuberance. It has become a common element in certain markets, and capturing it is the dream of every would-be speculator who buys residential real estate. As was noted in Speculation or Investment? it is a losers game, but it does not stop people from chasing after it. The first chart in this post approximates the conditions from 1997 to now in Irvine, and extrapolates a future repetition of the same conditions witnessed from 1997 to 2007. Will these conditions repeat themselves? Who knows? Human nature being what it is, the delusive beliefs of irrational exuberance may take root and the cycle may continue. In the aftermath of the Great Housing Bubble legislators may pass laws from preventing it from happening again. Of course, such laws require enforcement, and when greed takes hold, enforcement may simply not occur. For those that purchased at the peak of the bubble, they need another bubble or they will not get back to breakeven in the next 20 years. If however, there is another bubble, those who purchased at rental equivalent value after the crash will have an opportunity to reap a huge windfall at the expense of those who purchase at inflated prices in the future. As PT Barnum noted, “There is a sucker born every minute.”

The speculators who purchased at the peak of The Great Housing Bubble who put no money down (no Initial Equity) and utilized negative amortization loans — and there were a great many of these people — they will have a painful future. The loan balance will be increasing at a time when resale home prices are falling. They will be so far underwater, they will need scuba equipment to survive. Plus, during the worst of their nightmare, their loan will recast, and they will be asked to make a huge payment on a property worth roughly half their loan balance. What default rates will these loans see? Realistically, they will all default. Why wouldn’t they? The only reason they purchased was to capture speculative profits which did not materialize. Even if some of these people hold on, and there is another speculative bubble similar to the last one, it will take 10 years or more for them to get back to breakeven, not including their carry costs. If there is no ensuing bubble, it will be 20 years. If you factor in their holding costs, they may never get back to breakeven.

Conclusion

Equity is made up of several component parts: Initial Equity, Financing Equity, Inflation Equity, and Speculative Equity. Each of these components has different characteristics and different forces that govern how they rise and fall. It is important to understand these components to make wise decisions on when to buy, how much to buy, and how to finance it. Failing to understand the dynamics involved can lead to an equity chart like the one for the peak buyer who purchased at the wrong time and utilized the wrong terms. Nobody wants to suffer that fate.

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BTW, if you want proof that speculators who bought at the peak with no equity will walk in large numbers, please watch the following video:

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Ask yourself this question:

Do you want to be rich?

I’ve got the brains,

you’ve got the looks

Let’s make lots of money

You’ve got the brawn,

I’ve got the brains

Let’s make lots of money

You can tell I’m educated,

I studied at the Sorbonne

Doctorate in mathematics,

I could have been a don

Oh, there’s a lot of opportunities

If you know when to take them, you know?

There’s a lot of opportunities

If there aren’t, you can make them

Make or break them

Opportunities — Pet Shop Boys

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Speculation or Investment?

Real estate is viewed by many people as a good investment. Realtors often use this idea as part of their sales pitch. As was described in detail in the post What is a Bubble?, this view is fallacious and it is one of the beliefs responsible for creating an asset price bubble. To understand why houses are not a good investment, one needs to understand the difference between investment and speculation.

An investment is an asset purchased to obtain a predictable and consistent cashflow. This would include things such as bonds and rental properties or even cash in a savings account. The value of the asset is based on the cashflow, and this value can be determined in a number of ways. For a “point in time” analysis simple division will yield the rate of return (return = income / investment.) Risk is evaluated by comparing the rate of return of the investment to the safe return one can obtain in a savings account or government bonds. For more complex financial structures the value can be determined by a process known as discounted cashflow analysis. The sales price at the time of disposition is often not a major factor in the investment decision, particularly if the eventual disposition is many years in the future. In fact, true investments need never be sold to be profitable. As Warren Buffet noted “I buy on the assumption that they could close the market the next day and not reopen it for five years.” In contrast to investment, speculation is the purchase of an asset to sell at a later date at a higher price (Actually, you can also speculate by selling first and buying later in a process known as “selling short.”) Speculative assets are not valued based on cashflow but instead are valued based on the perceived probability of selling later for a profit. Houses can be purchased as an investment at the right price, but most often when people purchase a property they are engaging in speculation based on the belief they will be able to sell the house for a profit at a later date.

A study by Robert Shiller has shown that historically houses have appreciated at 0.7% over the general rate of inflation since 1890. Over the long term house values are tied to incomes because people buy houses with mortgages for which they must qualify based on their income. Inflation keeps pace with wage growth because people will bid up the prices of all goods and services with their available income. Therefore, long term house prices, wages and inflation all move in tandem. There are short term fluctuations in this relationship due to variations in financing terms and irrational exuberance, but any such deviations from the mean will be corrected over time by market forces. As an investment, houses serve as a hedge against the corrosive effect of inflation, but over the long term appreciation in excess of the general rate of inflation is not possible. In this regard, houses are little better than savings accounts as an asset class, and they are inferior to stocks or bonds in the long term.

Leverage and Debt

As a speculative investment, residential real estate has the potential to make or lose vast sums of money due to the impact of financial leverage (debt.) Houses are typically leveraged at 80% of their value. During the Great Housing Bubble, this leverage was often provided at 100% by various lenders. Leverage is a powerful ally when prices increase, but leverage works just as strongly against the speculator when prices decrease. For example, if a house is leveraged 80% and it increases in value 5% in one year, the return to the investor is actually 25% due to the 5 times multiplier created by leverage. With the effect of leverage, returns generated by speculation on housing can far exceed any competing investment strategy. However, the inverse is also true. If a house is leveraged 80% and it decreases in value 5% in one year, the loss to the investor is 25% of their downpayment not just the 5% the house declined in value. Leverage magnifies both the return and the risk of any speculative venture.

One of the worst mistakes lenders made during the Great Housing Bubble was to allow 100% financing and negative amortization loans. This was a boon for speculators because it allowed them to participate in the market without any of their own capital, and it allowed them to hold the speculative assets with a minimal debt service expense. Plus, there was the implicit idea that they would simply default if the deal did not go in their favor (which of course many did.) Combine these facts with the near elimination of loan underwriting standards allowing anyone to participate, and the conditions are perfect for rampant speculation and a wild increase in prices.

Why Speculators Fail

Despite the huge price spike in the final two years of the bubble caused by wild speculation, most speculators will lose a great deal of money. The causes are rooted in basic human emotions that work against making the proper decisions to profit in a speculative market. The moment a speculative asset is purchased and the speculator has taken a position in the market, emotions are immediately in play. If the potential resale price in the market is rising, the natural reaction is to want more. Greed takes over and the asset is strongly coveted by the speculator. If possible, the speculator will go out and purchase more of the asset in question. This was common in the bubble when people would take the equity from one property and purchase even more residential real estate. The problem with this natural emotional reaction is that it prevents the speculator from selling the asset and taking profits when they are available. People who make a living participating in speculative markets have learned to override this natural instinct and sell when their emotions are telling them to buy more. The average residential real estate speculator does not have this discipline or awareness. They will hold the asset through the good times.

When prices begin to fall in a speculative market, most speculators immediately lapse into denial. They were so emotionally rewarded by purchasing and holding the asset, they see no reason to believe the first signs of a declining market are anything other than a temporary aberration. As prices continue to fall, the emotions change: fear begins to creep in, and the battle between denial and fear goes on well past the breakeven point where the speculator could have closed the position without losing any money. As prices fall further, the fear begins to take an emotional toll and the speculator starts to feel pain. The further prices drop, the more pain is inflicted on the speculator. What is the natural reaction to pain? Push it away. As a speculative investment becomes painful, the natural reaction is to want to get rid of it. This prompts the speculator to sell the asset – only after they have lost money. A speculator’s emotions always work against them. When the asset is rising in price they want more of it, and when it is falling in price they want less. This is a natural reaction, and it is the cause of all losses in speculative markets. This is why most speculators fail.

Two Kinds of Real Estate Investors

There are two types of true real estate investors: Rent Savers and Cashflow Investors. These two groups will enter a real estate market without regard to future appreciation because either the cash savings or the positive cashflow warrant the purchase price of the asset. These people are largely immune to the emotional pratfalls of speculators because the value to the investment to them is not dependent upon a profit to be garnered when the asset is sold. They will hold the asset through any price declines because they are not feeling any pain when prices drop. Since these investors will purchase houses even if prices are declining, they are the ones who move in to create a bottom and end the cycle of declining prices.

In a declining market, a market where by definition there is more must-sell inventory than there are buyers to absorb it, it takes an influx of new buyers to restore balance. Since it is foolish to buy with the expectation of appreciation in a declining market, the buyers who were frantically bidding up the values of properties in the rally are notably absent from the market. With the exception of the occasional knife-catcher, these potential buyers simply do not buy. This absence of buyers perpetuates the decline once it starts. Add to that the inevitable foreclosures in a price decline, and the result is unending downward spiral. It takes Rent Savers and Cashflow Investors to enter the market to provide support, break the cycle and create a bottom.

Rent Savers are buyers who enter the market when it is less expensive to own than to rent. It doesn’t matter to these people what houses trade for in the market in the future. They are not buying with fantasies of appreciation. They just know they are saving money over renting, and that is good enough for them. Cashflow Investors have a different agenda; they want to turn a monthly profit from ownership. For them, the cost of ownership must be less than prevailing rent for them to make a return on their equity investment. Cashflow Investors form a durable bottom. If prices drop low enough for this group to get into the market, the influx of investment capital can be extraordinary.

Buyer Support Levels

When do Rent Savers and Cashflow Investors move in to a market and create a bottom? In the post Rent Versus Own there is a detailed analysis of the true cost of ownership. When comparative rents come into alignment with the total cost of ownership, Rent Savers enter the market and begin purchasing real estate. It makes sense for them to do so because ownership becomes a savings over renting (hence the term Rent Saver.) The “return” on the investment is the hedge against inflation the Rent Saver obtains by locking in the cost of housing with a 30-year, fixed-rate, fully-amortized mortgage. As rents in the area continue to increase, these costs are not borne by the Rent Saver. Utilizing the gross rent multiplier concept from that post, the Rent Savers will enter the market when the GRM falls to 160. There will be knife catchers who enter at higher prices, but there will not be enough of them to stabilize the market. It takes a decline in prices to where it is less expensive to own than to rent before enough new buyers enter the market to create a bottom. However, there are some properties that Rent Savers do not want because they really don’t want to live in them. This includes transitory housing like apartments or small apartment-like condominiums. Prices on these properties will generally drop below the 160 GRM breakeven for owner occupants until they reach price levels where Cashflow Investors will purchase them as rental properties. Since these investors do not want to merely break even, the price must be low enough for the rental rate to exceed the cost of ownership by enough to provide a return on the investor’s capital. Historically, GRMs from 100-120 are required to create the conditions necessary to attract Cashflow Investor’s capital.

Conclusion

When it comes time to consider purchasing a house, it is important to know if the motivation is one of an investor or one of a speculator. Investment in real estate requires an accurate assessment of the revenue (or savings) and the costs associated with the property. If the cashflow from the property warrants the purchase of the investment — without regard to future asset value — then it is a true investment, and the risks of ownership are much reduced. If the property’s asset resale value were to decline, the investment value would still be there, and the investor would feel no pain and no pressure to sell. In contrast, speculation is a loser’s game, and if the motivation is to capture a windfall from future appreciation, there is a good chance it may not work out as planned because the emotions of a speculator will cause a sale at the worst possible time. A few can put their emotions aside and properly evaluate the market and trade the asset, but most who profit from speculation simply sold at the right time due to life’s circumstances. In short, they were lucky. The people who bought late in the rally and are now holding on to the asset while they drift further and further underwater: they are not so lucky…

Talking to myself and feeling old
Sometimes I’d like to quit
Nothing ever seems to fit
Hangin’ around, nothing to do but frown
Rainy days and mondays always get me down

What Ive got they used to call the blues
Nothing is really wrong
Feeling like I don’t belong
Walking around some kind of lonely clown
Rainy days and mondays always get me down

Rainy Days and Mondays — The Carpenters

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How Much a House Really Costs

A useful way to look at the total cost of housing is to evaluate the monthly cost of ownership. An ownership cost is any expenditure required for the possession of property. A working definition is important because there are many hidden or forgotten costs people overlook. These costs are borne by owners and not by renters. There are 7 costs to owning a house. Although some of these costs are not paid on a monthly basis, they can be evaluated on a monthly basis with simple math. These costs are:

1. Mortgage Payment

2. Property Taxes

3. Homeowners Insurance

4. Private Mortgage Insurance

5. Special Taxes and Levies

6. Homeowners Association Dues or Fees

7. Maintenance and Replacement Reserves

Mortgage Payment

The mortgage payment is the first and most obvious payment because it is the largest. It is also an area where people take risks to reduce the cost of housing. It was the manipulation of mortgage payments that was the focus of the lending industry “innovation” that inflated the housing bubble. The relationship between payment and loan amount is the most important determinant of housing prices. This relationship changes with loan terms such as the interest rate, but it is also strongly influenced by the type of amortization, if any. Amortizing loans, loans that require principal repayment in each monthly payment, finance the smallest amount. Interest-only loan terms finance a larger amount than amortizing loans because none of the payment is going toward principal. Negatively amortizing loans finance the largest amount because the monthly payment does not cover the actual interest expense.

Property Taxes

Property taxes have long been a source of local government tax revenues. Real property cannot be moved out of a government’s jurisdiction, and values can be estimated by an appraisal, so it is a convenient item to tax. In most states, local governments add up the cost of running the government and divide by the total property value in the jurisdiction to establish a millage tax rate. California is forced to do things differently by Proposition 13 which effectively limits the appraised value and total tax revenue from real property. Local governments are forced to find revenue from other sources. Proposition 13 limits the tax rate to 1% of purchase price with a small inflation multiplier allowing yearly increases. In California, the first half of regular secured property tax bills are due November 1st, and delinquent after December 10th; the second half are due February 1st, and delinquent after April 10th each year. If the delinquent date falls on a Saturday, Sunday, or government holiday, then the due date is the following business day. Often the lender will compel the borrower to include extra money in the monthly payment to cover property taxes, homeowners insurance, and private mortgage insurance, and these bills will be paid by the lender when they come due. If these payments are not escrowed by the lender, then the borrower will need to make these payments. The total yearly property tax bill can be divided by 12 to obtain the monthly cost.

Homeowners Insurance

Homeowners insurance is almost always required by a lender to insure the collateral for the loan. Even if there is no lender involved, it is always a good idea to carry homeowners insurance. The risk of loss from damage to the house can be a financial catastrophe without the proper insurance. A standard policy insures the home itself and the things you keep in it. Homeowners insurance is a package policy. This means that it covers both damage to your property and your liability or legal responsibility for any injuries and property damage you or members of your family cause to other people. This includes damage caused by household pets. Damage caused by most disasters is covered but there are exceptions. The most significant are damage caused by floods, earthquakes and poor maintenance. You must buy two separate policies for flood and earthquake coverage. Maintenance-related problems are the homeowners’ responsibility.

Private Mortgage Insurance

Mortgages against real property take priority on a first recorded, first paid basis. This is known as their lien position. This becomes very important in instances of foreclosure. The 1st mortgage holders gets paid in full before the second mortgage holder gets paid and so on through the chain of mortgages on a property. In a foreclosure situation, subordinate loans are often completely wiped out, and if the loss is great enough, the first mortgage may be imperiled. Because of this fact, if the purchase money mortgage (1^st lien position) exceeds 80% of the value of the home, the lender will require the borrower to purchase an insurance policy to protect the lender in event of loss. This policy is of no use or benefit to the borrower as it insures the lender against loss. It is simply an added cost of ownership. Many of the purchase transactions during the bubble rally had an 80% purchase money mortgage and a “piggy back” loan of up to 20% to cover the remaining cost. These loan pairs are often referred to as 80/20 loans, and they were used primarily to avoid private mortgage insurance. There were very common during the bubble.

Special Taxes and Levies

Several areas have special taxing districts that increase the tax burden beyond the normal property tax bill. Many states have provisions which allow supplemental property tax situations. The State of California has Mello Roos fees. A Mello-Roos District is an area where a special tax is imposed on those real property owners within a Community Facilities District. This district is established to obtain public financing through the sale of bonds for the purpose of financing certain public improvements and services. These services may include streets, water, sewage and drainage, electricity, infrastructure, schools, parks and police protection to newly developing areas. The taxes paid are used to make the payments of principal and interest on the bonds.

Homeowner Association Dues and Fees

Many modern planned communities have homeowners associations formed to maintain privately owned facilities held for the exclusive use of community residents. These HOAs bill the owners monthly to provide these services. They have foreclosure powers if the bills are not paid. It is given the authority to enforce the covenants, conditions, and restrictions (CC&Rs) and to manage the common amenities of the development. It allows the developer to legally exit responsibility of the community typically by transferring ownership of the association to the homeowners after selling off a predetermined number of lots. Most homeowners’ associations are non-profit corporations, and are subject to state statutes that govern non-profit corporations and homeowners’ associations.

Maintenance and Replacement Reserves

An often overlooked cost of ownership is the cost of routine maintenance and the funding of reserves for major repairs. For example, a composite shingle roof must be replaced every 20-25 years. It may take $100 a month set aside for 20 years to fund this replacement cost. Also, condominium associations often levy special assessments to undertake required work for which the reserves are insufficient. In the real world, most people do not set aside money for these items. Most will attempt to obtain a Home Equity Line of Credit (HELOC) to fund the repairs when they are necessary. Of course this assumes a property has appreciated and such financing will be made available.

Tax Savings

There are two other variables people often consider when evaluating the cost of ownership that is not included in the prior list: income tax savings and lost downpayment interest. When a borrower takes out a home loan, the interest is tax deductible up to a certain amount. For borrowers in the highest marginal tax bracket, the savings can be significant, and this can make a dramatic difference in the true cost of ownership. However, this benefit diminishes over time as the loan is paid off and the interest decreases. Plus, contrary to popular belief, it is never good financial planning to spend $100 to save $25 in taxes. Also, these benefits are almost universally overestimated by people considering a home purchase. A renter considering home ownership will need to remember they will be giving up the standard deduction when they itemize to obtain the Home Mortgage Interest Deduction (HMID). A “married filing jointly” taxpayer will forgo a $10,700 deduction in 2007. This reduces the net impact of the HMID. Anecdotally, even those in the highest tax brackets usually do not get more than a 25% tax savings.

Hidden Savings

This is the forgotten benefit of a conventionally amortizing loan: forced savings. Most people are not good at saving. The government recognized this years ago when they started taking money out of peoples salaries to pay income taxes because they knew people would not do it on their own. People who become homeowners during their lifetimes often have the equity in their home as their only source of retirement savings other than social security. To accurately calculate the cost of ownership, this hidden savings amount needs to be deducted from the total cost of ownership because this money will generally come back to the borrower at the time of sale. Since taxpayers in the United States get a capital gains exemption up to $250,000, this savings amount does not need to be adjusted for taxes.

Lost Downpayment Interest

Unless 100% financing is utilized, a cash downpayment will generally be withdrawn from an interest bearing account to purchase a house. The monthly interest that would have accrued if the downpayment money was still in the bank is a cost of ownership. This is perhaps the most overlooked ownership cost. For instance, if you are putting 20% down on a $500,000 property, you will be taking $100,000 from a bank account where it would have earned 5% in 2007. This $5,000 in interest comes to $417 in lost interest the moment this money gets tied up in real property. If someone chooses to rent rather than buy, they would earn this interest income. Of course, this earned income is also taxed, so 75% of this number is the net opportunity cost of a downpayment.

To establish the cost of ownership, each of these costs, if applicable, must be quantified. When the total monthly cost of ownership is equal to the rental rate, the market is considered to be at fair value for owner-occupants. In fact, this is the equilibrium in most real estate markets across the nation. In a strange way, the bubble did not upset this equilibrium. The use of negative amortization loans with artificially low teaser rates allowed borrowers to obtain double the loan amount with the same monthly payment: double the loan; double the purchase price. This is how prices were bid up so high so fast without a commensurate increase in wages. The elimination of these loans is also the reason prices collapse.

Ownership Cost Math

Below is a typical cost of ownership for a $500,000 Irvine property:

$500,000 Purchase Price

$100,000 Downpayment @20%
$400,000 Mortgage @ 80%

$2,528.27 Mortgage Payment @ 6.5%
$416.67 Property Taxes @ 1%
$104.17 Homeowners Insurance @ 0.25%
$104.17 Special Taxes and Levies @ 0.25%
$100.00 Homeowners Associate Dues or Fees @ $100
$625.00 Maintenance and Replacement Reserves @1.5%
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$3,878.27 Monthly Cash Cost

………………$2,166.67 Interest on First Payment
$(567.71) Tax Savings @ 25% of mortgage interest and property taxes
$(361.61) Equity hidden in payment
$312.50 Lost Downpayment Income @ 5% of Downpayment
_________________________________________________________________________
$3,261 Total Cost of Ownership

Notes:

• The mortgage payment assumes a 30-year fixed-rate conventionally amortized mortgage at 6.5% interest.
• The property taxes are set at the 1% limit imposed by Proposition 13.
• The homeowners insurance is estimated at one-quarter of one percent per year.
• Private Mortgage Insurance is estimated at one-half of one percent per year. It is not included in the calculation above because this example utilized 80% financing. If the financing amount required PMI, the costs would have been over $200 a month higher.
• Special Taxes or Levies (Mello Roos) is estimated at one-quarter of one percent per year. Some nieghborhoods do not have Mello Roos as the bonds have been paid off. Some Mello Roos fees are as high at 1%.
• HOA dues are estimated at $100: some are lower, and some are much higher.
• Maintenance and replacement reserves are estimated at 1.5%. This may be the most contentious estimate of the group because most people assume they will simply borrow their way around these costs when they are incurred. This certainly has been the pattern during the bubble years when credit was free flowing. This method of home improvement and maintenance may be significantly more difficult as the credit crunch and declining values make financing much more difficult to obtain. In any case, these costs are real, and failing to acknowledge them denies the realities of home ownership.
• The sum of the above costs are the monthly cash costs of ownership. A homeowner may not write a check for each of these costs every month, but the costs are still incurred, and renters do not pay them.
• The tax savings are based on the maximum interest payment at the beginning of a loan amortization schedule. This tax savings will decline each month as the mortgage is paid off. Contrary to popular belief, this is not a bad thing. Also, the property taxes are also deductable, but Mello Roos are not fully deductible (even though most people mistakenly deduct it.)
• The opportunity cost of lost interest assumes a 5% interest rate on the downpayment reduced by 25% for taxes on this earned income.

So there you have it. The actual cost of ownership on a typical $500,000 property in Irvine would be approximately $3,250 per month. Some will be higher and some will be lower, but the calculation above, when adjusted for the specific property details being examined, will yield the cost of property ownership.

Gross Rent Multiplier

So what general relationships can be inferred from the ownership cost breakdown provided above? First, notice the relationship between monthly cost and price. This property is worth 154 times the monthly cost when you fully examine the cost of ownership. This is the basis for the Gross Rent Multiplier (GRM). The GRM is a convenient way to evaluate whether or not a rental rate will cover the monthly cost of a particular property. It was developed by landlords seeking a method to quickly evaluate the purchase price of a property to see if it would be a profitable investment. When performing such an evaluation, a cashflow investor will typically look for a GRM near 100 to find a property with positive cashflow. This method can also be easily adapted to calculate the breakeven point where an owner/occupant would break even compared to renting. As you can see, when you consider the full cost of ownership — including those costs often ignored — the gross rent multiplier is lower than most think. The GRM of 154 is very close to the 160 I have been using in my posts here. The Gross rent multiplier is a convenient measure of value because it spares you the brain damage of performing the above, detailed calculation for every property you wish to evaluate.

Renting Versus Owning

Renting versus owning is both an intellectual, financial decision and an emotional one. The financial decision is first and foremost an analysis of the comparative cost of renting versus owning. The cost of a rental can be determined fairly easily as there are usually a number of comparable properties on the market to establish a realistic rental rate for any given property. Of course, it is easy to justify in one’s mind a comparative rent that is higher than the market will bear. A house someone is in love with will almost certainly rent above market in their minds. Also when looking at similar products the rental rates may not be realistic in the marketplace. It is probably a good idea to take 5% to 10% off comparable rental rates on properties offered on the market. Once you have established what you believe to be a comparative rental rate, and you have gone through a realistic evaluation of the true costs of ownership as outlined above, a simple comparison of the two figures will tell you if a property is overvalued, undervalued or just right.

This point-in-time analysis of the relative worth of a house does leave out a couple of important financial factors: inflation and transaction costs. Inflation is the erosion of purchase power of money over time, or looked at another way, it is the increase in the price of some set of goods and services in a given economy over a period of time. It is measured as the percentage rate of change of a price index. The effect of inflation on housing costs is that it tends to increase the cost of renting over time, and theoretically, it will increase the value of a house over time as well. If the cost of rent is increasing, but your cost of ownership is fixed (assuming a fixed-rate mortgage,) then owning a home becomes less expensive over time and serves as a hedge against the impact of inflation. If you are a homeowner, inflation is your friend. There is one big cost of home ownership that works against the positive impact of inflation: transaction costs. When people buy a house, they pay some closing costs, but many of these get rolled into your loan and forgotten. When people sell a house, they generally go to a realtor to help them market the property and complete the paperwork necessary for the transaction. Real estate commissions for many years have been held at an artificially high 6% in the United States, and the seller is the one who pays this commission. From the time of purchase to the time of sale, inflation (or irrational appreciation) must have increased the value of the house enough for the sales price to cover the real estate commission or the seller will lose money. This is why it is often recommended for people who are not going to live in a given area for more than 2 or 3 years to rent instead of own. Renting is freedom — freedom to move when you wish (within the terms of your lease.) As I noted in America’s Debtor Prisons, homeowners who go underwater lose this freedom of movement. This advantage of renting is nullified during a price rally as owners have this same freedom during those times, but this forgotten benefit becomes readily apparent once prices start to fall.

Some people spend a great deal of effort evaluating the costs of ownership to determine if is a correct decision, but many people do not. Some people make the decision to purchase the most expensive asset they will ever own with no analysis at all. The decision to buy a house is primarily an emotional one. Even those who go through all the analysis generally only do so to provide rationalizations for their emotional decision. During price rallies, greed becomes a powerful emotion motivating people to fudge their financial analysis in order to justify their emotional purchase. Another factor often called the “nesting instinct” causes both men and women to want a place to call their own, particularly when there are children in the family. There is nothing wrong with deciding for emotional reasons. Most people pick a spouse this way. The real challenge is to have the emotions and the intellect working together to make a decision that is both fiscally sound and emotionally satisfying. This is easier said than done.

And the hardest part

Was letting go not taking part

Was the hardest part

And the strangest thing

Was waiting for that bell to ring

It was the strangest start

Everything I know is wrong

Everything I do it just comes undone

And everything is torn apart

Oh and thats the hardest part

Thats the hardest part

Yeah, thats the hardest part

Thats the hardest part

The Hardest Part — Coldplay

Perhaps the hardest part of the housing bubble was not taking part in the rally. There was pressure from everyone and the lenders were giving away money. It was very difficult to make a conscious choice not to participate, particularly when people want to own. I felt these desires; I wanted to own again. My intellect and my emotions were in conflict. Now that the bubble is bursting and prices are coming down, I see the light at the end of the tunnel, but it is still difficult to wait. Like Archie Bunker said, “Patience is a virgin.” I will only buy once at the bottom, and I want the time to be right.

For those who participated in the bubble, the hardest part (beyond the financial problems) is yet to come. It will be accepting that everything they thought they knew was wrong. As I described in What is a Bubble? a financial mania is supported by a whole series of erroneous and fervently held beliefs. It will take time for the participants to come to the realization that they were wrong, very wrong. Accepting this truth will be even harder. Unfortunately, financial markets have a way of forcing a painful awareness on its participants. Whether they like it or not, each participant in the market will come to realize it was a colossal mistake.

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The cutting edge is sharp. Innovators often pay a heavy price for advancement. Sometimes these advances lead to quantum leaps in human knowledge and understanding. Sometimes the time, effort, and money is merely thrown into the abyss. The innovations of the Great Housing Bubble were of the latter category.

The lending industry touted its “innovation” with exotic loan products. They sold these toxins far and wide. Now that these loans are achieving the highest default rates ever recorded, it is safe to say the “innovations” over the last 5 years were not entirely successful. It is amazing that a group of intelligent bankers came up with this loan and expected a positive outcome. When you really look at the whole “innovation” meme, you see that it is nothing more than a public relations effort to convince brokers the products were safe to sell and borrowers the products were safe to use. It is hard to fathom the widespread acceptance of this nonsense, but that is the nature of the pathological beliefs of a financial mania.

Many in the lending industry think their work is like science that continually advances. It is not. It is far more akin to assembly line work where the same widgets are pumped out year after year. When lenders start to innovate, trouble is brewing. The last significant advancement in lending was the widespread use of 30-year amortizing loans that came into favor after World War II. Prior to that time, home loans were interest-only, short-term loans with very high equity requirements (50% was most common.) This proved problematic in the Great Depression as many out-of-work owners defaulted on their loans. A mechanism had to be found to get new buyers into the markets and allow them to pay off the loan. The answer was the 30-year, fixed-rate amortizing loan. To say this was an innovation is a stretch as this loan has been around as long as banking has existed, but it did not become widely used until equity requirements were lowered. The lenders were willing to lower the equity requirements as long as the loan was amortizing because their risk would decline as time went by and the loan balance was paid off.

Over the last 60 years since World War II ended, a number of experimental loan programs have been attempted. These include, interest-only loans, adjustable rate loans, and negative amortization loans among others. It is this group of loans that has consistently failed in the past for one simple reason: if payments can adjust higher, people will default. It is really that simple. The Option ARM is certainly the most sophisticated loan on the market today. It is a dismal failure, not because it isn’t sophisticated, but because it has embedded within it the possibility (probability, no — near certainty) of an increasing payment. Any loan program that has the possibility of a higher future payment will fail because there will be a certain number of people who cannot afford the higher payment.

Here is where the lenders lie to themselves and to the general public after a financial debacle like the Savings and Loan problems of the 1980s or our current housing bubble: they blame the collapse and the high default rates on some outside factor rather than the terms and conditions the lenders created all by themselves. There are still many out there who believe the high default rates and problems in the housing market in the 90s were caused by a weak economy. This is rubbish. House prices declined for 6 years. The decline started before the economy went soft, and it continued well after it had recovered. People defaulted because they overextended themselves on loans to buy overpriced housing, and toward the end of the mania, many were using interest-only loans. Whenever lenders start loaning people money with total debt-to-income ratios over 36% people start to default. Whenever lenders start loaning more than 80% of the purchase price, people get underwater and start to default. These phenomenons, which we document daily on this blog, are not new. It happened in the early 90s; it is happening again, and it is happening for the same reasons: lax lending standards.

Someday the lending community may actually innovate and come up with some financial product that has low default rates which most people can qualify to obtain — Not. Unless you change human nature, there are always going to be people who are too irresponsible to make consistent payments. This is the key to any loan program. Either people do or do not make their payments. You can reinvent new terms and schedules as often as you like, and it will always boil down to people making payments. When these fancy loan programs contain provisions that make it difficult for people to make payments — like increasing payment amounts — they will default, and the loan program will fail. This is certain.

When lenders create new, “sophisticated” loan programs that require advanced financial management on the part of the borrower, both the lenders and the borrowers fall victim to the Lake Wobegon effect. Everyone thinks they have above average abilities when it comes to managing their finances. In reality, perhaps 2% of borrowers have the financial discipline to handle an Option ARM loan. Unfortunately, 80% of borrowers think they are in this 2%. The reason for this comes from the inherent conflict between emotions and intellect. 80% of borrowers may understand the Option ARM loan, but when the pressures of daily life create emotional demands for spending money on one’s lifestyle, the intellectual knowledge that this money should go toward a housing payment is conveniently set aside. It is this 2% of the most disciplined borrowers who will cut back on discretionary spending to make their full housing payment. Everyone else will make the minimum payment, fall behind on their mortgage, and end up in foreclosure.

It seems lenders forget basic facts about lending every so often and create a new financial bubble. Perhaps they succumb to the pressure of the investment community or their own shareholders, or perhaps they just start believing their own “innovation” bullshit and forget the basics of sound lending practices. This is why we need the upcoming recession. These pathologic lending practices must be purged from the system or else they will survive to build an even bigger and costlier bubble — although it is difficult to imagine a bubble bigger than this one, it is still possible.

In the aftermath of a financial fiasco, lenders return to the practices that did not fail them in the past. Some will consider this taking lending standards back 50 years. They would be right. The only program lenders know is stable is a 30-year, fixed-rate, conventionally amortizing loan based on 80% of appraised value taking no more than 28% of a borrowers gross income (36% maximum total debt.) This is what is coming. The last vestige of kool-aid denial I see in the comments is the insistence that equity requirements will not get that high. They will, and it will be a catastrophe for sales volumes and home prices. This is why I always post the downpayment and income requirements on my posts. People need to think about Your Buyer’s Loan Terms.

Why would banks continue to loan 90% of value when there is a likelihood of a greater than 10% decline and banks know high loan-to-value ratios result in high default rates? They are doing it now because they have to to make any loans at all, but they are limiting these loans to those with very high FICO scores, and they are betting these people will not default do to moral reasons or the desire to keep that high FICO score. If they try to extend these loans to lower FICO score individuals or subprime borrowers, they won’t stay in business long. Think about the losses we have documented here on this blog. Banks can’t sustain those losses indefinitely. Large downpayments are coming back, and government assisted financing will become widely used by first-time homebuyers to overcome the high equity requirements. There really is no other way forward. The credit crunch we have all been hearing about was not caused by some unexpected or unknown factor, it was caused by the failure of lenders. Credit will continue to tighten until lenders stop making bad loans. The bad loans will not disappear until lenders return to the stable loan programs with a proven track record. That is how the credit cycle works.

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Note to Lenders:

I plan to purchase in the aftermath of your most recent failure. Please wait until about 5 years before I am ready to retire before you innovate again so I can sell my house near the top of the next bubble you facilitate.

Thank you,

IrvineRenter

I was just guessin’, At numbers and figures, Pullin’ the puzzles apart

Scientist — Coldplay

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Do you remember this post on the Price-to-Rental Ratio?

Well, Calculated Risk has done another post regarding this issue. If you are not a regular reader of Calculated Risk, I highly recommend the blog. Their latest post contains two great charts I want to share with all of you:

The chart above is the historic ratio of home prices to rent with projections for how we get back to the historic relationship between the two. From the numerous discussions we have had on the gross rent multiplier, you can see that I am a big believer in the price/rent ratio as a determinant of real estate value. If you look at the stability of this relationship over the last 48 years, you can see it never deviates much from the mean — at least until our most recent bubble. There has been a slight upward drift since the recession of the early 70s with much of this slight increase being explained by declining interest rates since the early 80s. You can also see why many were saying prices were too high in 2000 and 2001. By historical measures, they were.

The chart above is the inverse of the previous chart showing the relationship between rent and price. The over-valuation in the market in 2000 becomes even more apparent. The price bubbles of the late 70s and late 80s also stand out. Our most recent bubble is hard to miss and even harder to deny.

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The historic relationship between prices and rents will be restored, unless of course you believe we have found a way to support permanently higher prices. I think not.