Does the drop in home prices we have seen so far make the current real estate market affordable? Do prices that have dropped ten percent represent a great buying opportunity? Long-time Seattle Bubble regular Eleua takes on these questions and more with his “House Valuation Workshop,” using his native Bainbridge Island as a working example. Follow along by using home prices, rents, and incomes for your own neighborhood.
by Guest Poster Eleua
Original posted at Clearcut Bainbridge
At the Institute For Economic Reality, we are always trying to help people out of their self-imposed, colo-cranial economic impairments. Judging by the volume of chatter on how the real estate market is suddenly “affordable,” it would appear that we have our work cut out for us.
When home prices have gone up 150-200% in a decade, a 15% rollback isn’t exactly a buying opportunity. Keep in mind that during the run up, the “experts” all predicted that prices would not decline, but would level-off and allow incomes to catch up. When confronted with a slowdown, these same experts said that a 10-15% rollback would represent the “worst-case” scenario.
The delusion is understandable. Bainbridge Island is populated with Babyboomers, and Boomers have seen property prices increase for the bulk of their life. In fact, real estate is the one “investment” that Mouseketeers think they know well. The prospectus for a Boomer’s investment in real estate goes something like this:
Property prices have gone up, so they will continue. My real estate agent said this is the “bottom,” and I had better buy now or be priced out forever (they would never tell me something that is self-serving and against my interests).
Is there an objective metric to value a home? Should you jump all over a home that has been reduced in price $10,000, or wait for a better value?
(Click below to read the rest…)
As we like to say at the Institute For Economic Reality, the difference between a good home and a good investment is the price you pay for it. There are many good houses on the market, but we have yet to find a good investment.
For example, if we have a house that represents the median home and is located in a neighborhood where the median household income is around $75K (the Bainbridge median), what would the value be? Let’s say that it rents for $2,100/mo, with property taxes of $3,600/yr.
Why is the rental rate important? Given that all but the truly clueless believe we have been in a credit bubble, and that bubble distorted the prices of things purchased with credit (homes), we should expect to see a difference between the bubble value (price), and the non-bubble value (rental value). This is because rents do not move up and down in a credit bubble, as easy credit terms are not available to renters like they are to home owners. Put in another way, you never heard advertisements on the radio, or TV that told renters that they could reduce their payments and get more house, with cash back, and no credit checks. These programs were only available to people that were buying or refinancing homes. Renters had to rely on good, old-fashioned income ratios to qualify for their leases, and the rates they pay reflect the true value of the property.
After all, the only “dividend” the mortgage throws off is not having to “throw your money away on rent.”
The difference between the rental value and the price is the speculative premium. That is the amount of money that you are committing to attempt to capture a rising sales price of the home. Given the recent national obsession with the concept, it should be no wonder to people that people have committed lots and lots of money to chasing higher resale values.
$2,100/mo equates to $25,200/yr in gross income. That’s all you get. That is the absolute maximum amount of cash the home can generate. That also presumes that you keep all of it, which is of course not true.
- The county assessor still gets her chunk.
- The property manager gets her chunk (unless you do your own management).
- The property still needs maintenance, and that comes out of the owner’s pocket.
- The house will likely be vacant from time to time.
- If this is your biggest “investment,” then you need insurance.
If taxes consume $3,600/yr, and property managers get 10% (likely 15%), the house is vacant 10% of the time, while you are dumping $500/yr into maintenance (optimistic), and your insurance is $900/yr, then your net cash generation before income taxes is $15,160/yr. This presumes you paid cash for your house and there is no mortgage.
That is your return on investment. What yield are you seeking? Are you going to accept a yield that is below that of US Treasury debt? If so, why are you risking so much for an investment that yields less than the safest investment on earth? You have to command a higher interest rate than that of a T-Bill, or CD at your local bank.
How much of a premium do you need? That varies by individual, but given that real estate is actually somewhat risky (vacancy rates, tax hikes, bad tenants, unforeseen maintenance expenses), you should ask for a few hundred basis points above Treasury debt. If the 10 year T-Bill is yielding 4%, and a bank CD is yielding 5%, one would think that an 8% ROI would not be unreasonable. If I am only going to get 5%, why would I even bother with all the fuss and hassle of putting up with renters and a home that needs maintenance, when I can take my money to the bank and spend my time golfing?
At 8%, your yield goal multiplies your net cash by 12.5 to arrive at the value of your “investment.” $15,160 / .08 = $189,500.
YIKES! Can anyone find a Bainbridge home for this price? If so, does it rent for $2,100/mo?
If we raised the rent to $2,200/mo, did our own property management, and lowered our yield to 6%, we still arrive at $312,667. This presumes that with the orgy of building that has taken place, the amount of rentals on the market would command such a price. Keep in mind that $2,200/mo is 35% of the median income for Bainbridge Island. Home costs have historically capped-out around 28%, and the renter will normally carry his own insurance.
If that house has a current market value of $650,000, then the speculative premium is $460,500 (or 71% of the price) for the realistic example, and $337,333 (or 52% of the price) for the delusional “investor” that is content to take large risks and expend a lot of effort to barely beat the local bank’s CD.
In order for the rental value to equal the speculative/market value of the property, the “investor” would have to be content with a 2.3% ROI in the managed property, or 2.9% ROI in the unmanaged property. Just for perspective, a 120 day CD at American Marine Bank goes out at 2.45%, and I’m guessing you don’t have to worry about fixing a roof, replacing a water heater, or scramble to find tenants when September comes around.
The above example is EBIT (earnings before income taxes and interest), but the overwhelming majority of “investors” will carry a mortgage. This begs the question, “Does it cash flow?”
Let’s see. If we have a 6.5% mortgage and a 15% down payment, then our payments on a 30 year-fixed run $41,944/yr. That’s an annual cash-flow loss of $26,784, assuming there are no further hikes in taxes, maintenance, or any prolonged vacancy period. Remember, our rental assumptions were fairly optimistic.
At the end of 10 years, the total cash outlay was $267,840 in direct cash-flow losses, plus the original 15% down payment of $97,500 for a grand total of $365,340, or $3,044/mo (average).
You should have $182,144 in equity, but you still have to pay approximately 7% in closing costs and real estate fees to get at that money, which reduces your equity to $136,644, assuming you broke even on your house price (sold it for what you paid). Remember, we are not calculating speculative premium, but are merely looking at the value of the investment without the idea that home prices will perpetually escalate. Prices can go either way.
So… our “investment” cost us $228,696 over 10 years. That is money that we flushed away. It would be more if that original $365,340 was earning 5% in a CD, but for our comparison, we assumed the “investor” kept his cash in his mattress.
In order to beat the 5%, our home price would have to appreciate to offset the amount our negative cash-flow would have grown to at 5%, which is $508,619. That is the amount the owner would pocket at the closing. If the “investor” owes the bank $467,856 at the 10 year mark, then the property needs to sell for $976,474 AFTER REAL ESTATE FEES AND CLOSING COSTS! In order to pay Cookie and Candi, we need to sell our “investment” for $1,049,972.
Good luck with that.
Is this scenario reasonable? Look at the price/income ratio.
Currently, the median household income for Bainbridge Island is $75K/yr, which puts our $650K median house at 8.67X income. If we assume an above-trend line income growth for Bainbridge of 3%, then in 10 years the median income will be $100,700, which puts our price/income ratio at 10.4X income. You would have to assume that we would get an above-average income growth (after a spectacular 25 year bull market), and that future buyers would wish to buy your tired rental for an 10.4X ratio, when you only paid 8.67X.
Keep in mind that prior to the credit bubble, a 4X income ratio was considered very exotic and the normal range is from 2.5-4X income. Sub-2X incomes are not unheard of in some parts of the country with high incomes.
What would the value of the median Bainbridge home be if ratios were in historic norms?
$187,500 to $300,000. (Didn’t we see $189K earlier in this example?)
What if we overshoot in the correction to 1.75X? After all, we have lots of new inventory with a population that can’t even keep schools open. If a major Seattle employer gets wiped-out in the credit crunch for writing zany loans and playing fast-and-loose with their accounting, that will be a gut-punch for Bainbridge incomes. What Might that business be called?
Also, how many new Bainbridge residents have been selling real estate for a living? How many write loans, do appraisals, home repairs, additions, and speculative building?
Had enough? I have not. Let’s look at sustainable lending, as the unsustainable lending is what got us in trouble in the first place.
If we assume that the only debt our prospective home buyer has is the mortgage on his house, and that historical, sustainable mortgage debt loads have topped-out at 28% of gross income, then how much house can we buy at 6.5% and $75K/yr gross income? They can afford $21,000 for principal, interest, taxes, and insurance (we will assume no HOA), which equates to $217,343 if we still have the taxes and insurance listed above. If we drop the taxes to 1.5% of purchase price, then the house value goes up to $221,136.
Remember, other debt (student, plastic, auto, personal) will start to weigh on a bank’s ability to fund your mortgage. Our example was a “debt-free” person seeking a mortgage. How many of those people in the median income range do you know?
All the above examples presumed that we are not in a massive economic downturn and that interest rates remained at 6.5%. Both of these assumptions are not realistic. Run the numbers with mortgage rates at 9% to 14% and you will likely get a feel for what the next 10 years will look like.
I hope you enjoyed our workshop. The Institute For Economic Reality seeks to push back the frontiers of economic cluelessness. By now, you should be familiar with the amount of speculative premium that exists in Bainbridge Island real estate. Your homework assignment is to calculate the value of a second/third/vacation home with people laboring to make their payments under the above mentioned conditions. Remember, the latest “bailout” from Hank Paulson removes the tax write off for the “2 in the last 5″ provision of a secondary home.
Stay solvent.
Jump to the bottom to add your comment. ↓
232 responses so far ↓
1
Sniglet
// Aug 21, 2008 at 11:23 am
I am not so sure that rents correlate so smoothly to income ratios. The confidence level potential renters have for their personal economic prosepects can have a major impact too. For example, we have recently been seeing more articles about how people are deciding to double-up, live with parents, or find other shared housing situations to reduce their expenditures EVEN thought their incomes haven’t fallen.
If people become concerned about their future job prospects they might decide to cut spending to the bone (including their housing needs) even though they hadn’t been laid off. You can even have situations where some people continue to rent, but decide they can do nicely in a smaller home (e.g. having kids double-up in rooms, etc) in order to save money.
2
TheHulk
// Aug 21, 2008 at 11:25 am
Wow, I am speechless. I never ran the numbers myself. Like I said, speechless.
Mikal and Harley, I would still like to see how you run the numbers against this, and justify someone buying a house TODAY as an “investment” property where you generate “positive” cash flow out of it. Houses bought before 2000 in Seattle don’t count since they have seen tremendous increases in paper values (which are coming down as we speak).
3
Jon
// Aug 21, 2008 at 11:28 am
Now, can you account for the benefits of the tax write offs, please?
4
vboring
// Aug 21, 2008 at 11:31 am
don’t forget rising lending standards.
with ALT-A basically gone and lenders actually using lending standards again, it’ll be a lot harder for speculators to get loans for houses they could never afford, even if they are crazy enough to want to.
5
Eleua
// Aug 21, 2008 at 11:36 am
Jon,
If you think the tax bennies can offset this kind of capital loss, you are very special.
Unless your income is very high, the tax writeoffs on real estate don’t have nearly the benefit that most people think.
6
Cheapseats
// Aug 21, 2008 at 11:38 am
I would suspect that as all things tighten, 10% for a property management, or paying someone else to manage at all would be a fat target.
7
Eleua
// Aug 21, 2008 at 11:42 am
Cheap,
If you live locally and have the time, you can do your own management. Many of the Island rental properties are owned by Californians or people from the Eastside, and there is no real way for them to do their own managment.
Yes, if you manage your own properties, your value goes up, but that is extracted from your own efforts.
8
Eleua
// Aug 21, 2008 at 11:43 am
Property management goes for 15% in most of the cases that I am familiar.
9
Eleua
// Aug 21, 2008 at 11:50 am
On my CCB blog, Ardell reminded me of the “1% rule of thumb.”
Monthly rents are typically 1% of the value of the property, which means that the house in my example needs to rent for $6500/mo, which is 104% of gross income, or the price of the property needs to come down to the low $200K range, which happens to be right where all the other metrics are pointing.
10
vboring
// Aug 21, 2008 at 12:19 pm
if rent is historically 28% median income and houses historically cost 100x the rental rate, that comes to houses historically costing (.28/12*100) 2.3x median income.
that sounds low for all but the cheapest areas to buy. one of those rules of thumb has a problem. my guess is that the 1% rule of thumb is the victim of a rounding error.
11
Eleua
// Aug 21, 2008 at 12:25 pm
I think 2.3 is low for today, but not without precedent. I am predicting a total paradigm shift away from speculation in real estate, and 2.3X income is going to be about right when you calculate in a higher interest rate, and economic recession/depression.
People are not going to have the appetite for speculation like they used to.
Highland Village, Texas - about 30mins north of Dallas. Median income is $105K with home prices just over $200K.
Bainbridge Island, Washington - Median income is $75K with home prices in the high $700s to low $800s.
People are not speculating in HV, but they are in BI. That is the difference.
12
vboring
// Aug 21, 2008 at 12:27 pm
glad to see you back, Eleua.
you bring a much-needed sense of unmitigated doom to the blog.
yes, even for those of us who chose to stay away from RE. if half of what Eleua says is true, we’re in for a deep and prolonged international depression as unwinding financial systems bring every modern economy to a near standstill.
we should all just be glad we’re in the US, where lenient bankruptcy and lien laws allow us to shed our bad debts rapidly, go through a few tough years, then get on with things.
imagine being underwater and incapable of making payments on a house in the UK, where personal bankruptcy is the only way out. and sometimes you get stuck with bad debts for life.
13
Ira Sacharoff
// Aug 21, 2008 at 12:38 pm
As a former landlord, I’m very familiar with the 1% rule, and never gave it any thought, but my rents were usually about 1% of the value of the property.
taking the median BI house valued at 650k, I’m guessing the typical rent right now would be about 2700 dollars per month…Maybe there’s a little room for increase, but it’s not going to go more than another 20% anytime soon, because people won’t spend all their income on rent ( or mortgage), so either home prices will continue to come down, or incomes will rise substantially. If you go with the hyperinflation scenario, that’s a possibility, but I’m a Pollyanna: I’m guessing we’ll see home prices continue to fall, rents continue to rise, and incomes go up a bit, but home prices continuing to fall seems the most probable.
14
Sniglet
// Aug 21, 2008 at 12:42 pm
To play devil’s advocate for a minute: aren’t there regions where prices are PERMANENTLY higher than median incomes? Regions that have a high appeal to the wealthy can sustain higher prices just because people WANT to own homes there. Retirees with huge nest-eggs can move in, for example, (who may have low incomes currently since they no longer work). You can also have rich people decide to buy second homes (e.g. because the LOVE the Bainbridge Island ambiance), but never actually “live” there, and rent the properties out for most of the time. Lastly, if there are lots of restrictions on building then this could also lead to prices that exceed the median (i.e. because there is little supply).
In short, isn’t there a case to be made that prices can remain higher than medians justify due to the desirability of a given area and restrictions on building new supply?
One possible retort to this argument is that if it truly was the case that a given region justified higher home prices than median incomes allowed, then the rental rates should ALSO be high (i.e. because there is high demand for rentals). I might be able to understand a situation where BOTH rents and home prices were above what one could expect the median wage to afford.
15
Eleua
// Aug 21, 2008 at 12:43 pm
Ira,
The median price on Bainbridge is about $100K over what I used in my example, and I assumed that the median income was going to live in a sub-median house, just to skew the numbers TOWARD increasing values.
At $2100/mo, the median income is going to strain to meet that obligation, and the rentals for median homes on Bainbridge reflect this.
I don’t see incomes rising over the next few years as the credit crunch gains steam. With that, rents will also drop on the income and rental supply issues. This will weigh on home prices.
We had too much building and the job base was more phantom than reality. The REIC and credit community were the growth areas, and they will lead the charge down hill.
16
Eleua
// Aug 21, 2008 at 12:59 pm
Sniglet,
IMAO, I dismiss the “special” areas argument. If prices are higher, it is because incomes are higher. Yes, in a few examples, people can buy-down their mortgage with a large down payment, but if we are truly getting a deflationary credit contraction, then that phenomenon will become even more of a rarity.
Second homes are a luxury that people are not going to afford for some time. You are proposing that “rich” people will be glad to rent out properties at a loss. I reject that in all but the most rare of circumstances. The nicer the house, the less you can recover on rent and the less likely somone would be willing to rent it out. Do you know of any rentals on Rockaway Beach with 120′ of waterfrontage?
I will be the first to admit that the further you go above the median, the larger amount of income that can be applied to luxury housing, as other costs of living are fixed, regardless of income, so studies at the upper end need to take that into consideration.
For the median, which is more representative of “normal” than the upper end, prices of housing (rent or owner-occ) needs to be what they can afford. If the prices are well above that level, we find it to be unsustainable (as is our current situation). The only reason it was possible was an ever-expanding, irresponsible credit bubble that temporarily confused debt obligations with genuine income.
In fact, the aftermath of such unsustainability is likely a prolonged overshoot of normal, sustainable income ratios.
17
Sorin
// Aug 21, 2008 at 12:59 pm
Seems pretty well reasoned to me. I have a friend that bought a house about 4.5 years ago partly because it only cost him about 10% a month more than renting. You can’t come close to doing that today in most areas around Seattle. It’s difficult to imagine how the economics of housing wouldn’t revert back to very close to parity.
Even if you compare median income to entry level house prices (rather than median), the numbers are still way out of whack.
18
Cheapseats
// Aug 21, 2008 at 1:02 pm
Sniglet,
I think that your argument is valid. I also think that more people believe this to be the case for their hood than is realistic.
19
B&W Nikes
// Aug 21, 2008 at 1:22 pm
Awesome run down Eluea, really eye opening. There are a few elements or variables that seemed to be missing in the ten year forward time machine. I’m not suggesting any crystal ball or fantasy what if’s, but am curious if or how they could be accounted for. In general terms how does CPI inflation, or real inflation, or the purchase power of the US dollar influence the picture over time? Looking backward $100 had very different purchasing power 20 years ago compared to now, even more so for $100,000. Not all of that change is accountable in product or service demand or value.
Also, there is also the location and demand thing that makes averaging difficult. One also has to ask themselves why a place like Bainbridge is and has always been so much pricier than nearby Suquamish or Poulsbo. Something else along with baseline numbers is seasoning the stew over there. Maybe the fertilizer from golf courses is getting into the water supply?
20
Lake Hills Landlord
// Aug 21, 2008 at 1:56 pm
Ugh. I feel nauseous. Anyone want to buy a Bellevue rambler with tenants in it that (negative) cashflows -$750 / month?
21
Eleua
// Aug 21, 2008 at 1:59 pm
B&W,
If by “inflation” you mean a general monatary inflation (the ratio of dollars to the underlying economy rises), then home prices could get a lifting component, but it is uncertain if the boost would outgun the post-bubble effects.
I would say that kind of inflation has about a zero chance of becoming reality. We will likely get the opposite.
If by “inflation” you mean that certain commodities will rise in price due to supply issues or input costs (oil based war), then that is decidedly DEFLATIONARY for home prices, as money for that has to come from somewhere.
Why is Bainbridge pricier than Poulsbo or Suquamish?
The people and what they do.
Suquamish is largely tribal, who without the state granted gaming monopoly, would be a basket case if they could produce a basket. Crime, drugs, meth, and a failed culture make this so.
Poulsbo is just a blue-collar navy suburb, which has many of the same problems as Suquamish, but no casino or legacy of entitlement.
Bainbridge has always had the better schools. This was the case when my mother attended schools here in the 1950s, and that has survived the years. People tend to have a higher education level, and they don’t want to live on the Kitsap Peninsula. Also, on Bainbridge, you don’t have the risk of having a full-service meth lab open up in your neighbor’s house. Not so with North Kitsap.
That being said, Bainbridge is still WAY overpriced. Poulsbo and Suquamish are even worse.
22
Jon
// Aug 21, 2008 at 2:06 pm
Eluea,
You still haven’t taken into account the fact that you do get some write offs. Care to share that with us…
Let’s take me for example:
Single Guy, one income, making $225k a year.
I own my home, but I need a tax shelter. I invest the maximum I can into my 401k.
I then invest into stocks and bonds, but I am paying taxes on that.
Now, let’s say I purchase a property that I can now reasonably pick up fro $450k, and get $2200 a month in rent. I can put down 20%.
I pay a point on my mortgage, and I have typical closing costs of about 6% on the purchase side. My monthly costs are close to $2800 a month, inclusive of taxes, insurance, and maintenance.
I find a tenant that leases the property for a one year lease, but I screen quite a few and make sure that I am picking a great tenant that wants to be there for a long time, maybe even a bubblehead.
What are the benefits of the following:
The tax write off that year?
The fact that I lower myself into a completely different tax bracket? (Let’s say 33% to 28%)
The neg cash flow is $600 a month, which is a deductible.
The taxes are all deductible, and let’s assume they are near $4k a year.
Am I better off? I would argue, that in my particular case, I am.
Also, I don’t buy that rents are going down… I think that is a crock statement that has no merit.
23
NotaBull
// Aug 21, 2008 at 2:10 pm
“IMAO, I dismiss the “special” areas argument. If prices are higher, it is because incomes are higher. ”
You yourself gave an example of an area with incomes at $100K but median house price at about $200K. Shouldn’t the house price there be much higher? Why isn’t it?
Why is the median house price in Mercer Island higher than the median house price in Sammamish, but the median income in Sammamish is higher?
I don’t disagree that prices will keep going down for a while, but I think your argument is missing something. What that “something” is, I’m not sure, but it seems to be missing it.
Data from city-data.com:
http://www.city-data.com/city/Mercer-Island-Washington.html
http://www.city-data.com/city/Sammamish-Washington.html
Mercer Island was in 2005 at about 8X median income.
Sammamish was at about 5X.
Sammamish median income is actually *higher* than Mercer Island. So shouldn’t the house prices be higher if it’s all about income? Obviously there are other factors at work here.
24
Sniglet
// Aug 21, 2008 at 2:15 pm
Every region that is experiencing significant price declines and large numbers of foreclosures is also seeing a drop in rental rates.
We’ve been talking about this in the forums (notice the links to articles about declining rents).
http://seattlebubble.com/forum/viewtopic.php?f=2&t=1321&start=15
You could claim that the Seattle area has already hit bottom, and that foreclosures won’t increase any more than they already have, but that’s an altogether different debate. If you believe Seattle area home prices will decline significantly, then it only follows that rents will likewise decline.
25
Jon
// Aug 21, 2008 at 2:22 pm
Again, no merit.
Rents decline, purchases go up… it’s a cyclical market that we are seeing an anomole to.
Of course, I don’t expect that 100 years of previous data would convince you otherwise, so I will leave it alone and let the dead dog lie.
26
Eleua
// Aug 21, 2008 at 2:24 pm
Jon,
Your example seems to be cherry-picked. As I said in post #5, absent an unusually high income, the tax bennies are not that significant.
Your example is 300% of the median household income. It is certainly doable, but not representitive of the typical “investor.”
You are also saying that you are picking up a home for just over half the median price, which is the point of my entire article. In order to get the numbers to work, you need dramatically lower prices.
Yes, you do get some tax write offs, if your income is high enough, and in your Mr. $225K who buys a house at $450K with $90K down, it would have some advantages. These advantages don’t offset the risk of entering into a $650K house with an joint income in the low 6 figure range, which is the current reality.
27
Sniglet
// Aug 21, 2008 at 2:27 pm
Huh? Sales have been plumetting in many cities at the SAME time that rents have been falling (e.g. San Diego, Miami, Las Vegas, etc). It is absolutely possible for over-all demand for housing to decline (both rental and purchased dwellings), even without population declines.
28
Jon
// Aug 21, 2008 at 2:28 pm
So you have eliminated the speculators… which is a good thing.
Let’s focus our conversation on speculation - Wheat, Corn, Oil buyers… they are the real issue at this time.
29
jon
// Aug 21, 2008 at 2:29 pm
Mercer Island was built out several decades ago and now is home to a lot of retirees. I don’t know how they report the income for someone who is living off of savings, but the main factor is those people just don’t want to leave their friends of 30+ years. The fact that younger people having driven up price of homes to high levels doesn’t matter to them. I suspect the same is true of Bainbridge Is, where many long term residents are not interested in the cash value of the family home.
For some people, a rented house is an equivalent product to a owned houses, but for many people, I suspect most, they really are different. Over recent decades people haven’t even been tempted to consider what ownership is worth in comparison to renting. Clearly that may be changing, but it does affect the calculation. To me, knowing that you won’t be forced out of the home you or your kids grew up in to meet the changing preferences of a landlord is worth a lot to one’s long term quality of life.
30
Eleua
// Aug 21, 2008 at 2:29 pm
Jon,
What do you mean by this statement?
Rents are capped by income, as renters don’t have the ability to “exotically finance” their leases. With the credit contraction, we are seeing joblessness rise, and the number of vacant homes rise. Remember, the entire supply of housing units expanded in the bubble.
Rents are going down, just like every other part of the country that has busted.
31
TJ_98370
// Aug 21, 2008 at 2:30 pm
Hey Eleua,
.
Bainbridge real estate values made the local news today -
.
Skyrocketing Housing Costs Islanders’ Top Social Concern
.
………The lack of affordable housing ranks as the island’s largest social dilemma, according to a recent human services survey. The community’s efforts and ability to tackle the issue of shrinking housing options for middle- and low-income renters and would-be buyers also scored rock bottom marks……
.
……..According to the HHHS, the median home value on Bainbridge has doubled in the last eight years to almost $700,000, which is three times higher than Kitsap County’s median……
.
32
Sniglet
// Aug 21, 2008 at 2:33 pm
A slight correction… Rents will be going down. Rents have definitely been rising in the Puget Sound area over the last year or so (my landlord has certainly been raising mine). That said, this is almost certainly a short-term phenomena, as has been extensively covered in our forum discussions. Many other regions saw their rents rise JUST as their market was turning the corner at the peak, only to come crashing down as the local real-estate market really began to tank (which hasn’t happened here yet, although we are on course for it).
http://seattlebubble.com/forum/viewtopic.php?f=2&t=1321&start=15
33
Eleua
// Aug 21, 2008 at 2:34 pm
Notabull,
Yes. The price of homes is a complicated one, but it is manifestly about income and the ability to pay.
Trees and water are nice, but if the incomes are not there to drive prices, then all the trees and water in the world won’t bouy home prices.
Detroit once had the highest incomes and most expensive homes in the country. Today, it has among the lowest. The same can be said for Pittsburgh.
San Jose, Seattle, and New York are not special. They are just where a hot (and highly speculative) job market exists.
Seattle was the Cleveland of the West Coast until the Microsoft experience.
34
Civil Servant
// Aug 21, 2008 at 2:38 pm
I love this post and I am glad to have learned the great term “speculative premium” and to have been reminded about the 1% principle. More Eleua please.
With respect to another kind of premium, here are two condos for sale in my neighborhood.
6557 4th Ave NE #9, a one-bedroom at $300K and $453/sf that was built in 1974: http://www.redfin.com/WA/Seattle/6557-4th-Ave-NE-98115/unit-9/home/74000
… and 413 NE 70th #212, a brand-new studio at $340K and $588/sf (also with HOA dues that are 60% higher): http://www.redfin.com/WA/Seattle/413-NE-70th-98115/unit-212/home/17165032
How many renters would pay 23% more per month for zero bedrooms and less space in exchange for living in a fancy new building with even shinier granite? I am sure someone somewhere could be talked into it, but that’s a hard sell. I have often been flabbergasted at the premium people are willing to pay for new and prestigey and tricked out vs. older but solid. I just don’t think that is most renters’ priority.
35
Eleua
// Aug 21, 2008 at 2:41 pm
TJ,
Thanks. I might have to do an entire blog entry on that. I just need to get in a snarky mood to write it.
36
Garth
// Aug 21, 2008 at 2:54 pm
It seems like a lot of people here believe that every property is overpriced if you can’t rent it on craigslist the day after you purchased it for the same price as your mortgage.
Apartments have to be converted into condos before they are sold, and mansions have to be converted to rentals to get a decent cap rate (4-6% in Seattle zips right now, not really a good return for individuals as mentioned above, but perfectly acceptable to REITS and trusts and such with a larger portfolio that provide dividends), because they are different products appealing to different groups and the amenities demanded by purchasers are not cost efficient for property managers.
Most multifamily property owners use median class A (in Seattle zip codes this basically means above ~$1200 a month) apartment rental prices and compare that to the median house payment using normal financing to calculate a rent / buy spread and try and gauge how many of their tenants they will lose each year to buying a home. Many people here seem to be comparing Class B or C apartments or month to month rentals for single family homes from craigslist to median home prices and expecting there to be a very small spread between the two.
37
Sniglet
// Aug 21, 2008 at 3:05 pm
Does this “normal” method of determining the rent/buy spread show that buying rental properties in the Seattle area is a good business with today’s prices? Does it require the assumption of some sort of appreciation on the property in order to pencil out?
38
Angie
// Aug 21, 2008 at 3:20 pm
Eleua, that was quite an effort. I hope you feel better now that you got that all out of your system.
I guess I don’t get the sense that great droves of people are trying to make their fortunes by buying rental properties on Bainbridge. But, you know, party on.
39
Sniglet
// Aug 21, 2008 at 3:22 pm
Garth,
I would love to see an example of how you work the numbers in a rent/buy calculation. It would be very interesting to see how the variables you think need to be considered differ from Eulea’s suggestions.
40
Eleua
// Aug 21, 2008 at 3:29 pm
Angie,
Why, thankyou. I do feel better.
The point of my post was not that people are trying to make money as landlords in the Great 98110, but that there is a tremendous speulative premium that exists in all homes, both owner-occ and rental. If the party is over, then I expect to see that speulative premium vanish, and possibly become an “owner’s discount.”
The present value points to the median home on Bainbridge hitting around $250K, which is quite a gut-punch for the typical Bainbridge home-debtor. This presumes that incomes remain stable and that we suffer no meaningful economic downturn. Given that this premium is the entirety of the economic wave in both jobs and structure, you need to assum that we will get a declining job base and incomes.
At the end of the day it is called DE-flation.
Glad you enjoyed the post
41
jon
// Aug 21, 2008 at 3:51 pm
“The difference between the rental value and the price is the speculative premium. That is the amount of money that you are committing to attempt to capture a rising sales price of the home. ”
So when I go to the bookstore and buy a book instead of renting it for free from the library, am I speculating on the rising price of the book? Why are the prices off waterfront homes in the millions when anyone can go to one of the large number of fine beaches during any daylight hour?
We each have a certain amount of money that we can spend as we wish. Some people scrimp on some things to own a great house or condo, and others make do with an older unit and go on great vacations or whatever. It’s much more complicated that just comparing dollars.
The reasons why a median income cannot buy a median house in an established area are so numerous that I just can’t understand why someone would write a whole article that presupposes that it should.
42
Eleua
// Aug 21, 2008 at 4:24 pm
Jon,
Honestly, I don’t know where to start.
Your library analogy is flawed. Libraries lend books for free, whereas rental homes are not freebies. If you moved into government housing and paid nothing, then I guess you analogy would survive.
Waterfront homes are more expensive because people with more money outbid those with less money. At the end of the day, they are driven by incomes (current or past as represented by savings).
I’m not saying that one family can’t put a higher premium on housing than another with the same means. I’m saying that the aggregate can’t pay above a sustainable amount for any meaningful time without dire consequences. This is sufficiently represented by the median, as the outliers in income and price are thrown out of the equation.
Do tell us how home prices can have a sustained dislocation from incomes. It would be best not to use creative financing or irresponsible borrowing in your example. We are seeing how that ended.
43
jon
// Aug 21, 2008 at 4:37 pm
“Do tell us how home prices can have a sustained dislocation from incomes.”
I buy house and retire.
44
Jillayne Schlicke
// Aug 21, 2008 at 4:48 pm
rental rates will also be driven down when the foreclosures start hitting the rental market. We have too much inventory which will drive prices down. Downward pressure on prices (among many other factors) will send foreclosures up.
More foreclosures mean more REOs hitting the market. Banks will have to eventually mark the prices down and take the loss.
At that time the investors will re-enter the market: When the prices are low enough to make the transaction pencil.
Lots of choices for renters mean downward pressure on rents.
How did I do, teacher?
45
Cheapseats
// Aug 21, 2008 at 4:56 pm
Jon,
Honest question, because I have not seen this addressed elsewhere. The “norm” that is often quoted for median income vs median price is usually around 3 X income. My assumption is/was that this norm, when it was followed factored in retirees, rich people etc… they are not a new phenomena…
The question being, what has changed today, versus when this norm was in line, that allows for the variance. I could speculate that it is people living longer, more retirees, or other factors…
46
Eleua
// Aug 21, 2008 at 5:03 pm
Jon,
Great. You retire.
What portion of the population does that represent in middle to upper-middle income neighborhoods?
I thought so.
Also, how do 70% of Boomers think they are going to fund the bulk of their Golden Years?
Yeah, that McMansion they “own.”
They still have to pay for Jennifer and Jason to go to college.
77 million people don’t have a viable exit strategy.
47
Eleua
// Aug 21, 2008 at 5:06 pm
Jillayne,
Gold star.
If renters are experiencing pressure on their income while having more options when looking for a place to live, I’m going to go out on a limb and say that rents will be decreasing.
48
Eleua
// Aug 21, 2008 at 5:09 pm
Cheap,
While you did direct your question to Jon, allow me to take a swipe.
Cheap, unaccountable credit origination is what did it. This put extra money in the hands of the Great Unwashed and they all went to the REIC casino and let it ride.
12-15X income was beyond insane.
49
fancypants
// Aug 21, 2008 at 5:12 pm
How about I give you guys a real world example to break down?
400K in a CD at 3.5 percent (money set aside for downpayment on a house)
2400 mos rent on 3000 sq foot very fancy house with 1000 sq foot finished basement on 5 acres (Viking appliances, etc. etc.)
Equivalent Houses for sale: 775k (needs 75k in repairs) - 1 million.
220k annual income, and I always hit the AMT.
Likely 6.5% interest rate on a loan.
If we purchased a house my guesses are:
Insurance: $1500 a year.
Repairs costs this year to the rental that I didn’t have to pay for: $2600.
Property tax: $8000
Our income is extremely unreliable. Our floor income is 120k. (Self-employed).
Should we buy or keep renting?
50
Ira Sacharoff
// Aug 21, 2008 at 5:16 pm
I read a couple of years ago that the historical average of home prices to monthly rent in the Seattle area was 150x rather than 100, so even if that was true, and even if we put as positive a spin on it as possible, and say that the 650K Bainbridge house currently renting for 2700 goes up about 10% to 3000, and we revert to the 150x, then the house is 450,000. That’s still about a 30% drop, and one that I see as more realistic than the 60 something percent drop that Eleua is envisioning, but I’ve been wrong before.
51
Eleua
// Aug 21, 2008 at 5:20 pm
Ira,
That $650K house is renting for $2100, and it took 5 months to fill it.
52
Garth
// Aug 21, 2008 at 5:29 pm
Sniglet,
I know a couple of multifamily unit owners with a couple hundred units each and they use a regular cap rate to pencil cash flow when buying or selling, but when they are calculating their rental increases and projecting tenant loss to home purchases they use the median conventional financing payment - median class A rent number to get a monthly spread.
It is not a rent to buy calculation so much as an estimate what percentage of their tenants are going to be lost each year to new home purchases. Appreciation in single family homes increases the spread generally and leads them to assume that fewer of their tenants are going to leave to purchase.
53
Ira Sacharoff
// Aug 21, 2008 at 5:35 pm
In your 2100 per month rent example, how’s you arrive at that figure? Was it based on BI median income? Or was it an actual home?
I don’t know, it just strikes me that a 650,000 dollar home would fetch more than 2100 in rent.
I know a woman in Sammamish who had her house on the market for a few weeks at 480,000 dollars, and it was “fairly” priced, she probably would have gotten close to that had she not pulled it off the market and rented it out. She rents it for 2000 per month, and it was only vacant for a few weeks. who knows? Maybe she just lucked out and found some sucker who loved the cul de sac.
54
Flotown
// Aug 21, 2008 at 5:38 pm
Eleua -
Great analysis for those who have not seen it before - We had heavy numbers such as this on the blog a year ago so it nice to see a refresher.
to the “3x income” rule of thumb, however, could some of the rapid rise in prices above “historical” sustinable levels be attributable the population and incomes of people buying homes beiong substantially different from those living in the area as a whole? for example, in Ballard, the neioghborhood asa whole is much older and of more humble means, I would wager, than the average homebuyer. Because only say 10% of stock rolls in a given year, and because the market price is only what the last idiot was willing to pay, the sales value are much higher than what could be supported by the local incomes statistically. Because home prices are sticky, people are not necessarily able or willing to sell immdeiately, so it would take many years of transactions before the incomes catch up to prices in tredny locations. What we really should be looking at is the ratio of incomes of the buyers over x period with the value of the homes sold over the same period, correct?
55
Eleua
// Aug 21, 2008 at 5:40 pm
Ira,
It is an actual example that I think fairly represents what is happening with homes that are just below the median.
In Kitsap, if you go over $1500 in rent, your options mushroom as the higher end homes can not command rent that is anywhere near what it costs to carry them. Remember, rents are driven by income and not subject to creative financing.
People that can throw around $2500/mo are likely to be “owners” of homes and not looking to rent.
56
Cheapseats
// Aug 21, 2008 at 5:46 pm
Eula,
My point about the median income to house ratio was where the new ratio should be. I do believe that it is artificially high, but I accept that the new normalcy point for it may be higher than say 3x median income. If one considers factors that differ from the previous norm. More retirees, boomers etc would seem to change the dynamic, but I have no proof of that, I just threw that out there as an example.
57
jon
// Aug 21, 2008 at 5:51 pm
“What portion of the population does that represent in middle to upper-middle income neighborhoods?”
Your article seemed rather focused on Bainbridge Island. In 2003, there were 2850 social security recipients, out of a population of 21000 or so. Of that number 4280 are in school, presumably in their parent’s house, leaving 16720. Take out another 1000 for too young for school and you have 18% on SS. I suspect there are quite a number of people on Bainbridge who have retired, but not yet reached 65 years. To show how significant that number is, it it were to hit 50%, the reported median income would be essentially $0.
Retirees are the people who have been there the longest, for the most part, and have the best locations, probably. On an island, location has a huge effect on price. So you have a large group with high priced property and no income, which is going to skew the medians.
A ratio of 3 years income to buy a house is fine for an individual. For a group it has problems, but for a special case, like Bainbridge Island, it is near meaningless.
You have a large group of people with current income, no mortgage, and a nice house. You have a large group of people who bought their houses before the run-up and have been paying their mortgage with a very low rate of defaults. And you have a small group of people who recently bought at a very high price. Those people probably have an income that is well above the median. (We discussed earlier how the average recent sale price for BI is $200K higher than the average price overall.) If you are waiting for a large number of one of these groups to be forced into distress sales, you may have a very long wait.
58
Eleua
// Aug 21, 2008 at 5:56 pm
Flo,
You bring up good points. Yes, as a neighborhood is infested with greedy yuppies, the incomes will rise, but probably slower than prices at the margin. The longer term residents will likely have lower incomes, but we are talking about the median, not the average.
Gentrification is difficult to grasp by looking at the median, for the reasons you state. However, as more yuppies move in, they become the median and you see the price/income ratio come back in. Even if we go to the 75th percentile, my numbers would still show a large contraction. At some point, the yuppie has to live on his income and not his debt, and the income isn’t nearly as high as we might think.
Ask yourself if the way that yuppies were able to afford their Ballard craftsman was sustainable. If not, then you will likely see a contraction in prices. Those older Norwegians will be able to comfortably undercut the yuppies when they want out.
The only way for the income ratios to be sustainably high is for the outlying income brackets (who have more disposable income). The median is much more sensitive to those historic ratios. You can see this by the rapid growth in Price/income ratios during the credit bubble.
59
jon
// Aug 21, 2008 at 5:57 pm
“I don’t know, it just strikes me that a 650,000 dollar home would fetch more than 2100 in rent.”
For a place like Bainbridge Island that sounds about right. Locations like that carry a purchase price premium because of the school system, so you aren’t getting as much house for your money. The rental market at that price is going to skew towards people with no kids, so the school has no value to such renters. So the rental value is going to be a lot less. People who are renting out their houses in places with high value school systems are doing it because they want to hold on to the house for some other reason, and are just bringing in some extra income in the meantime.
60
Eleua
// Aug 21, 2008 at 6:00 pm
Cheapseats,
I address this on another CCB entry.
http://clearcutbainbridge.blogspot.com/2008/07/better-living-by-driving-prius.html
Budgets drive spending on homes. Even if you raise the income, the realities of other spending obligations weigh on home prices. Those historic ratios are historic for a reason. We have had boom/bust periods in our past. The only thing different about today was the size of the boom.
61
Eleua
// Aug 21, 2008 at 6:02 pm
Jon,
The median income is per household, not per individual.
62
John
// Aug 21, 2008 at 6:09 pm
The grim reality of the credit crisis still hasn’t sunk in for some yet. The collapse of Fannie Mae, Freddie Mac, WaMu, Lehman Brothers (take your pick) will help clear things up. Time is on our side.
63
Markor
// Aug 21, 2008 at 6:11 pm
Great post Eleua.
In the short run I don’t see anything to disagree with. I think things could be different in the long run (30+ years) though. In the long run I can foresee that the value of a house will not be as correlated to wages as it is today. As the world population continues to increase exponentially, eventually we’ll run out of all sorts of resources, and substitutes will be more expensive. In my lifetime I expect mass starvation, like a billion+ people. The effect on house prices should be that people who inherited them or saved a lot can have one, whereas others can be homeless or living in a scrap-metal shack even if they make the median wage.
64
Eleua
// Aug 21, 2008 at 6:11 pm
Back in the mid-90s, the median price was in the low $300s, which was around 5X income. The mid-90s trough never experienced seller capitulation as interest rates were coming down, and Californians were still able to move up with all their Bongo-bucks. This kept the price/income skewed higher than would be expected without the X-Cal influence.
Today, that is NOT the case. The lending space is completely broken, and X-Cals are yesterday’s news. Without those two factors to buoy the price, I predict that the ratio will come in much further (and faster) than historical precedent.
Incomes will also come in, which only compounds the problem.
65
Alex
// Aug 21, 2008 at 6:15 pm
Great writeup, Eleua, thanks!
I am working through your calculations and this is a line I do not understand:
‘At 8%, your yield goal multiplies your net cash by 12.5 to arrive at the value of your “investment.” $15,160 / .08 = $189,500.’
Could you elaborate how you arrive at the value of the house and explain the formula you use?
66
Eleua
// Aug 21, 2008 at 6:27 pm
Alex,
To get your yield, you divide by the percentage. If your yield is 1%, then your capital outlay is 100X your EBIT income (which results in 1%). If your yield is 5%, then you need 20X income as a capital outlay. 1 / .08 = 12.5.
67
Eleua
// Aug 21, 2008 at 6:31 pm
Put another way, if I have $250K invested in some vehicle, and my yield is 8%, then I get $20K. 250 / 20 = 12.5.
Now, do it in reverse. If an investment is yielding $20K/yr, and I need an interest rate of 8% to justify the investment, then I am willing to pay $250K, as $20K / 8% = $250K. If I need a 10% yield, then I am only willing to pay $200K for the same investment. If I need a 20% yield, then I can only pay $100K.
68
mikal
// Aug 21, 2008 at 6:41 pm
My mortgages are $1350 and $1450 for duplexes. I get $2300 and $2450 in rent with water costs already taken out. I bought both ten years ago. I have 20 years and my mortgages will disappear. I have done all the work so their is rarely anything for me to do because I did it right in fixing them up in the first place. One needed alot of work while the other did not. I personally don’t care if things drop in value. It will only be temporary. Nothing goes down forever. Anyone who buys anything now is out of their mind. That said tell me there is no money to be made in real estate. Nice to see Eleau take a break from the apocalypse bunker construction.
69
Eleua
// Aug 21, 2008 at 6:45 pm
Mikal,
The bunker construction is going well. Thanks for asking. When you have Vlad invading his neighbors, you can’t be too careful.
Congrats on buying 10 years ago. We are talking about today’s prices. But while we are on the subject, what are the sales value of your properties?
70
mikal
// Aug 21, 2008 at 6:47 pm
What will they be in twenty years or more is what matters.
71
Nick
// Aug 21, 2008 at 6:55 pm
Part-time reader, but wanted to comment specifically wrt the inflation angle. Although I totally agree with the analysis, the wild card is inflation, IMHO. If we see real double-digit inflation in the next 5-10 years (which I consider fairly likely, given the 9% current rate and prospects for accelerated deficit spending at the national level), a fixed-rate long-term loan could start to look like a good idea, even with clearly inflated asset valuations at the time of the loan.
Now, I wouldn’t buy a house right now either, but I don’t know of any other way normal people can borrow money at a fixed rate for 30+ years, and if we happen to elect socialist leaders who spend our currency into the toilet, and the currency doesn’t spiral into hyper-inflation, and you can make the payments on the loan, it could turn out actually beneficial in the long run. It’s a lot of ‘if’s’, but like I said, it’s the wild card.
72
mikal
// Aug 21, 2008 at 7:00 pm
Well Nick, we have been spending our money into the toilet for the last eight years. That would be one of the causes of the current inflation mess.
73
Jillayne Schlicke
// Aug 21, 2008 at 7:43 pm
Fancypants needs our help. See comment 49
“Our income is extremely unreliable. Our floor income is 120k. (Self-employed).”
In today’s more strict mortgage underwriting climate, self-employed income must all be verified and documented. They’ll take a very close look at cash flow.
I’m assuming you have excellent credit and will pt lots of money down on your purchase. even so, lenders will look at your debt to income ratios to determine if you’re a worthy credit risk.
The bigger question to ask is, what happens when home prices continue to fall and you end up having to sell that home? If you’ve put a bunch of cash down, would you be able to accept the risk of home values going down further? If you couldn’t sell, could you put a renter in there and cover your mortgage payment?
This is what Eleua is getting at. Until mortgage payment and rent are closer together, it’s still very risky to be purchasing a home.
74
Eleua
// Aug 21, 2008 at 7:45 pm
Nick,
Accelerated deficit spending will cause the cost of US.gov borrowing to increase, which will cause all interest rates to rise. That is deflationary for homes.
I wonder what will drive inflation in the future of massive credit defaults. I’m not so sure we will see inflation.
75
david losh
// Aug 21, 2008 at 7:49 pm
The comments got me to read the post. The interesting part was the 150 to 200% appreciation in pricing.
An agent contemporary of mine made a statement to me that home prices doubled every seven years. I looked him square in the eye and said, “no they don’t.”
We both stood there for a few minutes, it was at a Real Estate meeting, and he agreed. We had the discussion for a few minutes because his claim came out so naturally, as though it was just a fact of life. In the past ten to fourteen years it has been.
Real Estate prices have been doubling. He and I as older agents knew there was something wrong with it, but it becomes a reality while you’re in it.
I just want to say that the agent I’m referring to is a good guy. Solid, salt of the earth guy, who cares deeply about the business and his clients. How his perception altered is by being overly involved. I’m beginning to see that in many of the older agents I’m acquainted with.
76
david losh
// Aug 21, 2008 at 8:00 pm
The loans already exsist. Give the lender nothing. Agree to take a nonperforming loan, with an equity position, and make payments.
If the foreclosure scenario is true, and the Real Estate Owned property inventory is as high as I think it is, the lender’s asset is nonperforming and unsalable.
In the very near future, as they have in the past, they will quietly make deals to reduce thier holdings.
We’re not in the business to make the lender feel better about the loans they are making. They are in the catch 22. They have to make loans to make money, they lost money by making loans. What to do, what to do?
77
Jillayne Schlicke
// Aug 21, 2008 at 8:52 pm
Eleua,
When will the Institute for Economic Reality be holding classes on the topic of deflation?
78
TJ_98370
// Aug 21, 2008 at 8:54 pm
Whoa! Reading this thread is like the lightening round with Cramer - only with more reliable info.