By The Tim on November 9, 2009
Here is your open thread for Monday November 9th, 2009. You may post random links and off-topic discussions here. Also, if you have an idea or a topic you’d like to see covered in an article, please make it known.
Be sure to also check out the forums, and get your word in the user-driven discussions there!
Posted in Open Thread | Tagged open_thread
Tim Ellis is the founder of Seattle Bubble. His background in engineering and computer / internet technology, a fondness of data-based analysis of problems, and an addiction to spreadsheets all influence his perspective on the Seattle-area real estate market.
To: One Eyed Man
Ok, I have given some more thought to the whole rent versus buy problem, and I think the first step we need is to agree on the accounting.
I propose the following categories:
Operating Costs:
Utilities
Insurance
Maintenance and Repairs
Property Tax
Financing cost:
Opportunity cost of the money/Interest/Rent
Terminal value
The financial costs will need to be carefully handled in the analysis. There is the whole concept of that is something like, “Your rent payment is more than your house payment, so it’s cheaper to buy.” This type of thinking needs to be avoided, as that does not incorporate the acquisition costs, such as the down payment. Additionally such claims do not consider the selling expenses.
There seems to be another problem related to the finance category. When someone puts a down payment of 20% on a property the opportunity cost of the money is often forgotten. The easiest way to avoid this trap is to assume that the home is purchased with cash. Thus we start with two people with the same amount of cash. For the Seattle area, maybe we start with two people each with $500,000 cash. Clearly this has its limitations too, as some people who rent don’t have the cash to buy, but I think this gets to the crux of the whole situation: There are people who have a personal desire to buy but don’t have the financial resources. Personal desires and other fantasies are clearly irrational, and thus, we cannot go much further with those situations. It’s no problem if you want to buy a home based on some irrational basis, like I buy my favorite Starbucks drink, but we cannot go much further.
We will need to price the value of the money. This is going to be a bit of a problem too. Clearly the money has a value greater than zero, yet if the value of cash is too high, then the cost to buy goes up, based on opportunity cost.
There is always a problem with how to cost maintenance and repairs. It’s quite simple for the renter, as the maintenance and repairs are included in the rent. We will need to come up with something in this area too. Most of the time people just want to suggest that it’s a certain percentage of the purchase price per year, but the roof doesn’t always know when it was scheduled to fail, and so on. Thus we might have some accrual versus cash methodology issues.
In any event, once we get some of the basics down, we can take the above categories and fill them in by the year. While I do many computations by hand, sometimes with the assistance of a simple electronic calculator, I suggest we use a spreadsheet with the rows labeled with the categories and the columns labeled with the years.
Then hopefully we can agree on some end conclusions.
I wonder what some of the readers here think of Denninger’s theory regarding IMF / carry trades:
MHO: There is no doubt that our society will change. Homes a distance from employment centers will drop in value. Oil for home heating will convert to other fuels… if not natural gas then propane. As a result furnaces will be replaced. Trucks can be converted to natural gas or propane.
The writer behaves as if this is earth shaking… hey, I remember when my parents heated our home with sawdust and other homes were heated with coal. We wore sweaters in the winter. They had one car and we used public transit. People will adapt.
T. Boone Pickens plan calls for all trucks to be converted to natural gas. Some taxis, small and large trucks run on natural gas in quite a few countries.
Changing topic – 2 Washington plates here in FL this weekend. Both in parking lots (lowe’s and local groceries store). Got to talk to both. From Seattle and recent arrivals 2-3 months; both ladies that “love it so far”, “love the sunshine”. I could not stop thinking, “you just love the fact you paid $175K for a 2500 sq.ft. home with a pool in a middle upper class neighborhood”.
RE: Cheap South @ 4 – You asked them a few days too early, if Ida is of any real consequence…
RE: AMS @ 1 –
I guess I’m in if your sure you want to do it after reading my comment. But you should know that I view what you suggest as a large, and time consuming undertaking. And further,that I view the discussion as a collaboration not a competition or a debate, per se. That doesn’t mean we shouldn’t present and advocate opposing views when we disagree as to the items that go into the analysis and how to model them, etc. It just means that I’m not going to advocate a postion just to try to prove a given hypothesis. I’m as egotistical as the next guy, but I value coming to a good conclusion more than the pursuit of personal accolades. I should also probably disclose that I hold both a real estate license and a WSBA membership and my veracity and motives should therefore probably be viewed with a high degree of skepticism.;-)
Second, I’m not sure that we should use a Seattle Bubble Thread for this without The Tim saying he likes the idea. After all, it could take a lot of time and comments to reach some conclusions. Although what we are talking about may fit what many Bubble readers want to see, we could alienate some of Tim’s readership as Kevin mentioned this weekend. Maybe a large part of this should be an email conversation that could be posted in part at The Tim’s discretion rather than dragging everyone thru each step on the Open Thread. Email would also give us the ability to attach and share work on a spread sheet which I don’t think we could easily do on Seattle Bubble. Then again, maybe Tim doesn’t care if we use this open thread for a couple of weeks because it will be replaced by a new Thread in a couple of days for those who aren’t interested in actively participating or following along.
You should also know a couple of things about me. First, I’m slower than the average person and unfortunately probably lazier. I also have other commitments that I will have to give priority at times. It might be irritating if I don’t keep pace with your expectations when you post a comment and are waiting for a response in order to reach a conclusion on an issue. I don’t think I’m really retarded, although opinions vary on the subject. Second, even though I’m slow, I often come up with some quality answers. That may make up for some of my short comings. If after reading this you don’t want to go forward, don’t worry about it. I’ve learnd to handle rejection without too much further damage to my psyche.;-)
As to how to set things up, I really think it needs to be an excel (or similar type) spread sheet with a number of variables that can be changed, including but not limited to the Gross Rent Multiplier, the Inflation Rate, the Down Payment, etc. I looked to see if I had an old spread sheet program around for rent v. own but I don’t. I would assume that there is a spread sheet available either commercially or thru real estate consultants in a proprietary form. I know at least one real estate consultant who might have a proprietary one but it would probably cost me a few bucks to get it (maybe more than I’m willing to spend). Although I could probably teach myself to develop an excel spread sheet to do this (as I assume you could) I don’t know that I’m willing to do it. My guess is it would take me more than 10 hours because I don’t commonly use excel (and I’m slow), but that’s a guess.
Does anybody have a rent v. own spread sheet already (and the documentation to show what it calculates) or know where we can get one so we don’t have to reinvent the wheel on this one?
Also, there’s an old Post from a couple of years ago by Eleua that is at least a good starting point for the various issues in rent v. own. If I recall correctly, it doesn’t go as far as doing a spread sheet analysis, but it does do a good job of listing and discussing many of the issues that need to be analysed. I’m sure we can find it if we look (and if we can’t, I know The Tim can).
Finally, just one comment on a specific issues you raised in your comment. First, I agree with your point about consistency but I don’t think I agree with your conclusion that we should use a model where both parties start with 500K, at least not without stipulating a number of items that will vary for each party. The problem I see is this. The average person with 50K to 100K to put down wouldn’t be able to come up with 500K with any other investment except the purchase of an owner occupied single family home. That’s part of what makes leverage through home ownership such a powerful tool for the average person (assuming an inflationary environment, etc.). Nobody is going to loan someone 400K unsecured, at least not at an interest rate comparable to mortgage rates. A margin account account is limited to 50% of the account balance and will never generate the leverage unless the account holder has substantially additional assets. There just aren’t other ways for the average person to come up with 400K if they don’t have it.
I grew up in Spokane in a big old colonial home heated by coal. The truck would come and deliver several cubic yards of the stuff through a basement window. One chore as a pre-teen was going down every couple of days to load the feed hopper for the furnace and remove the “clinkers” or waste ash from the burner unit. It was eventually changed out to an oil burner, but natural gas will work well too.
One other as consideration of the dollar as carry trade is what happens when we raise our interest rates- if we ever do. there’s a lot to suggest we’re pretty well locked into this pattern for years to come.
I saw that Obama has killed funding for future nuclear waste storage, effectively eliminating that as a future power source. A bit short sighted to my way of thinking.
Drill, baby, drill! If it’s good enough for Brazil and Mexico, it should be good enough for us.
RE: One Eyed Man @ 6 – In regards to using this forum, yes, if The Tim does not want us here, then so be it. However, I am going to guess that he’d rather see the discussion here where it can be followed. It is clearly real estate related.
My personal opinion is that this is central to the whole “bubble” issue, by the way.
That said, before we even get to the spreadsheet, or any other assumptions, computations, and the like, I think we really need to agree to the situation. This in particular is problematic:
“The problem I see is this. The average person with 50K to 100K to put down wouldn’t be able to come up with 500K with any other investment except the purchase of an owner occupied single family home. That’s part of what makes leverage through home ownership such a powerful tool for the average person (assuming an inflationary environment, etc.). Nobody is going to loan someone 400K unsecured, at least not at an interest rate comparable to mortgage rates. A margin account account is limited to 50% of the account balance and will never generate the leverage unless the account holder has substantially additional assets. There just aren’t other ways for the average person to come up with 400K if they don’t have it.”
If we cannot agree about this particular issue, then we are doomed from the start.
The problem is that “the average person with 50k to 100k” might be buying for other reasons. DrShort made an observation that home ownership is “the American dream.” I am not disagreeing, but dreams and finance often conflict.
What I propose to avoid this situation on the onset is to equalize the cash, so both could buy with cash. I am going to go one step further and claim that if our analysis does not show that a cash buyer is better off buying, then how could someone financing the deal by borrowing be better off? (This gets to the opportunity cost of the cash.)
In other words, my strategy is to start with the cash buyer, if the situation suggests that one is better off renting, then it would only be even better to rent if you didn’t have 100% of the cash to purchase.
Once we get the cash buyer down, then let’s move forward with further assumptions to get the financed situation down. My strategy for that would be 100% financing, so we don’t have to worry about the lost opportunity on the cash.
Finally we can look at capital structures, where the financed part of the purchase is a material amount between 20% and 90%, or so. Much more than 90% and it’s starting to look like that 100% financing. Much less than 20% and it’s starting to look like a cash purchase. I have a friend who financed $20k on a $350k purchase. I’d call that a cash deal, but he did borrow $20k (<10% of the purchase price). I am guessing he wanted the $20k for some other reason; I didn't ask, nor does it really matter.
In summary,
Case 1: 100% cash purchase
Case 2: 100% financing
Case 3: Other capital structures
I do agree, however, that we are going to need to assume some purchase price-to-annual rent multiple. The end results will be sensitive to this. We are also going to need to work out the terminal value, which is yet another problem. Then there is the whole opportunity cost of the money, or interest rates on borrowed money.
I have no idea what the end will be, as we have not set the situation up yet in terms of the critical inputs. The idea of paying cash does not measure the cost, but rather avoids creating financing fallacies. I will remain open along the way to adjustments, but simpler is better at first. For example, I suggested the categories above without any end conclusion about the underlying questions. I only seek that we are on the same page regarding the basic accounting before we move forward.
“Those who live in suburbia, who are primarily middle-class Americans, will find themselves faced with commute costs that are double or more what they pay now. ”
I always wonder about this one… There are a lot of people who live out in the suburbs. Who’s to say businesses won’t move out that way, too, or new businesses will locate there to begin with? Cheaper office space, generally better schools, more one-parent-working families (a stay-at-home parent cuts down on employee sick days and other “distractions”). Throw some buses in there, maybe the suburbs will just reinvent themselves.
RE: The Tim @ 2 –
Deficits Cure Short Term Ills and Cause Horrifying Long Term Problems
I hear the G20 has agreed to dig into their savings account to keep the world economies afloat, albeit without any supports for the US dollar. American stocks shot up with the wonderful news, but is it really wonderful?
China may have a 8% increase in their GDP, but IMO its all smoke and stimulus mirrors there too. They dig into their savings account until its dried up. China is urging America to control its deficits….LOL….yet, if we did, who’ll buy the Chinese stuff???? The Chinese themselves? LOL, they can barely feed themselves.
Who’ll buy the $29K Mercedes subcompacts when they sky-rocket to $60K with dollar devaluation? The Europeans? LOL, they’ll be lucky to still be making Mercedes, if we stop buying them.
There were many that predicted inflation with lower dollar rates and guess what, yes, oil is now $80/bbl [and supplies are snow-balling] ….but a little birdy is telling me, remember a stronger dollar a year ago, with $30/bbl oil…..yeah, gas was still $2 something a gallon like today. So what happenned, why didn’t the inflation monster get us by now? Even when oil was $150/bbl, we didn’t see $10/gal gas, inflation adjusted from $30/bbl $2/gal gas…..what the Hades is stopping the inflation monster?
Wages, lower wages my friends. The elite don’t want to talk about it, no, they say household incomes rise every year [yeah right, and so does the number living and working in each house].
I’ll repeat myself again….RE will never rebound in price unless per capita wages go up and that just ain’t gonna happen my friend.
By softwarengineer @ 10:
If I recall correctly, there was a period, probably in the early 80s, where used German cars appreciated in value, because the new models cost so much more than the earlier models had.
Maybe I should sell the 89 Ranger and buy something German? That might be a good plan, but I’m not sure I could tolerate all the extra trips to the shop. ;-)
RE: The Tim @ 2 –
While I have been concerned about the potential of a Dollar carry trade for the past 9 months (because the capital needed to grow the US economy, and created jobs, moves outside the US) a growing Dollar carry trade isn’t the root cause of petroleum price problems for the US economy. The carry trade is IMO, one of the biggest, if not the biggest, risk that the inflationary policies of the Fed and Treasury will fail with the end result being Snigletville USA. That’s not a slam on Sniglet or Scotsman or any of the other deflation forecasters. It’s an acknowlegment that there is a real risk that the liquidity created in the system will leak beyond our borders at a rate that stiffles investment and job growth in the US. But for the time being, the Fed is more concerned about making banks artificially profitable with cheap money than about the potential carry trade. It’s the save the financial system first with cheap money strategy.
As far as the risk of being another Japan is concerned, the good news is that our real estate bubble never approached the over valuation based upon fundamentals that they reached in Japan.
“Prices were highest in Tokyo’s Ginza district in 1989, with choice properties fetching over 100 million yen (approximately $1 million US dollars) per square meter ($93,000 per square foot). Prices were only marginally less in other large business districts of Tokyo. By 2004, prime “A” property in Tokyo’s financial districts had slumped to less than 1 percent of its peak, and Tokyo’s residential homes were less than a tenth of their peak, but still managed to be listed as the most expensive in the world until being surpassed in the late 2000s by Moscow and other cities.”
http://en.wikipedia.org/wiki/Japanese_asset_price_bubble
While the carry trade is a risk to our economy, and to oil prices and other commodity prices, the bigger risk is much simpler to understand. ITS PEAK OIL PRODUCTION! I use this phrase to refer not only to the long term peak production described in Hubbert’s theory of Peak Production, but also to the short term limits on world production capability based upon current wells available for operation. Sorry for the shouting but stopping the Dollar carry trade won’t change the fact that as world economies heat up, the demand for oil will exceed the world’s ability to produce oil very quickly. I think National Geographic devoted an entire edition to peak oil production a couple of years ago. (I never read it so I’m not sure I’m right.)
My recollection is the current daily peak production capacity is about 85 million barrels and even in this time of world economic recession, the daily usage is about 80 million barrels of which the USA uses 20 million. 18 months ago, world usage was starting to bump up against the 84 to 85 million barrels a day number. In addition to the peak oil production issue, the oil yet to be discovered and/or put into production is much more expensive than the oil produced previously because it’s off shore, or at great depth, or in the arctic, or embedded in shale, etc. It takes more time to get into production and it costs more per barrel
Regardless of the Dollar carry trade, we have to replace a good percentage of our oil usage very quickly or when the world economy recovers, we will be crushed by the high price as daily demand exceeds daily oil production.
Yes we should drill and produce more oil. BUT DRILL BABY DRILL IS LIKE DRIVING FASTER DOWN A DEAD END STREET. IT’S NOT A QUESTION OF IF YOU WILL HAVE TO TURN AROUND, ITS WHEN. (I thought that the Democrats would come up with a slogan like that to use against Palin. I thought it would win the energy issue for them if they also embraced the Picken’s Plan as part of the platform. I still can’t believe that the Democrats didn’t come up with it or if they did, they didn’t use it.)
As to what oil prices mean for real estate. Planning for high oil prices is a large part of what the Growth Management Act in Washington State is all about. Perhaps not on the surface, but certainly in spirit. Of course the Growth Management Act is also about preserving open space, clean air, clean water and affordable housing, etc. But in the final analysis the Growth Management Act favors increased development density in confined urban growth areas with multi use development and mass transit. The Growth Management Act is designed to combat suburban sprawl. In essence the Act’s policy is that we want to be Manahattan, not LA. When there’s no gas left, you’ll live in a high rise condo and ride the train to work and shop at the supermarket in the ground floor of your building. If that doesn’t sound like the future you want, you better start thinking about a public investment in alternative energy or be ready to retire.
RE: One Eyed Man @ 6 – I wrote a comment, but I suspect it went into the spam box. The Tim will need to clear it.
[rescued -The Tim]
RE: Kary L. Krismer @ 11 –
I’m with You Kary
My sister’s husband finally got rid of his “money pit” 1972 Mercedes….even when they hardly drove it all, it was in the garage more than in their garage…LOL….
RE: One Eyed Man @ 12 –
The problem is the definitions of recession and GDP. Since a recession ends when GDP begins to grow again, even if it’s from a much-reduced level, then by that measure the recession is likely to have ended when 3rd quarter GDP is announced. Want to end a recession? Easy. Just pour buckets of money into the economy. GDP goes up. The recession ends. Everyone is happy except workers and the families who depend on their incomes which, after deducting them, leaves almost no one.
GDP is a very poor measure of the health of our economy. For example, if GDP rises 0.5% while our population rises 1%, everyone has gotten poorer, not richer. Secondly, GDP is totally dependent on how inflation is calculated. Fudge the Consumer Price Index calculation a little and, presto!, you have GDP growth. Finally, most GDP growth is due to a rise in productivity. When wages fail to keep pace with the increase in productivity – and they never do – then increasing GDP actually masks declines in real income.
There’s really only one economic measurement necessary to gauge the health of the economy – unemployment. The balance between the supply and demand for labor tells you everything you need to know about the economy. And if the demand for labor is getting slack compared to the supply, the first place we should look for the culprit is our non-petroleum goods trade deficit.
RE: softwarengineer @ 15 – And to that I present the following CR entry, a cartoon:
http://www.calculatedriskblog.com/2009/10/cartoon-recession-is-over.html
RE: The Tim @ 2 – So you are suggesting that it will cost more for real estate that is closer to urban centers. If you are you have changed your mind with what you have put in past posts.
By mikal @ 17:
You’re certainly seeing prices and volume holding up better in city compared to the suburbs. Downtown condos are a different story with their own problems.
By Elizabeth @ 9:
I agree about this, when I lived in silicon valley this is exactly what you find: low rise office buildings all over the place, mixed with various types of residential and other commercial. The nearest “downtown” was San Jose, which was a handful of buildings most of which were hotels. As most knowledge-based work becomes more decentralized, place is less important and you will see more and more businesses moving to be closer to workers, not the other way around.
RE: AMS @ 8 –
I think I’m in agreement with you although I can’t say that I’ve thought of all issues that might occur to me later. I guess from the stand point of personal curiosity, I’m the most interested in a scenario that uses variable close to the historic norms over the last 50 years or so, perhaps with a variable or two changed at times to reflect current values for King County.
As a practical matter, I think the situation where both parties initially have 500K to spend is effectively reduced to a situation where both have the amount of the buyer’s down payment and closing costs because the investment yeild for all remaining cash would be the same for both the buyer and the renter.
Intelligent life on earth?
http://www.youtube.com/watch?v=EALYveaLctU&feature=player_embedded
RE: softwarengineer @ 15 -
I’m pretty much in agreement softwarengineer. I’m a big advocate of the importance of employment opportunity as a gauge of a societies economic health. In addition to the humanitarian reasons to support high employment, there is a defense and security related issue. Without sufficient employment opportunity, you have individuals with no stake in the system who will gravitate toward illicit and underground economies and who may become a large disruptive influence in the society if they can’t meet there families survival needs.
But in fairness to the more right wing who may be stronger believers in markets and economic and/or social Darwinism than me, wages and employment don’t happen in a vacuum. Just as the wage offered for that employment has to be a reasonable wage capable of sustaining survival for employment to be a meaningful gauge of economic health, the productivity of labor must be sufficient to justify that wage and the employment opportunity. I heard an interesting saying once about employment in the former USSR. It said “We pretend to work, and they pretend to pay us.”
RE: One Eyed Man @ 6 – “The average person with 50K to 100K to put down wouldn’t be able to come up with 500K with any other investment except the purchase of an owner occupied single family home.”
Couldn’t agree more. You both have your work cut out working on your collaborative common ground. Look forward to seeing your discussion.
RE: One Eyed Man @ 20 – Ok, we have the first issue to work out, and we have not even begun.
“As a practical matter, I think the situation where both parties initially have 500K to spend is effectively reduced to a situation where both have the amount of the buyer’s down payment and closing costs because the investment yeild for all remaining cash would be the same for both the buyer and the renter. ”
Issue #1:
There is the “discount rate,” which has various definitions in finance depending on how it’s being used, but because we have $500k and we are also considering borrowing money, this presents a problem. Often in corporate finance the discount rate can be computed based on expected profits (converted into some percentage based on some theory–there are different ways to look at this, see below), but there is also the rate that capital can be obtained. In this case we have the discount rate, d, and the interest rate, i.
Discount rate, d = expectation of equity investors
interest rate, i = the cost of borrowing capital, expectation of lenders
In our case we have to ask the basic question, what’s the opportunity cost of the cash? In other words, what kind of return on the cash can the renter expect? When we get to case #2 we will have another question to answer: Is the opportunity cost of the cash equal to the rate at which lenders will lend.
Bankers like to have a “positive yield spread;” in other words, they lend money at a higher rate then they borrow money. Thus if you have cash you are paid a lower rate than if you borrow cash. This observation is exactly why I suggest that buying had better be cheaper for the cash buyer. Otherwise the person who borrows will be paying more. Specifically the opportunity cost of the money is lower by the positive yield spread of the lender.
NOTE: If a banker lends money out for a lower rate than depositors are paid, people will borrow and deposit the funds right back in the bank. Essentially the situation instantly corrects itself. This is over-simplified, as we have not added the issue of duration, but for now we will assume that the durations of borrowers and lenders is exactly the same. This is a minor assumption for our rent versus buy discussion.
This does, however, quickly get to the terminal value of the home. You suggest using “historic norms over the last 50 years or so.” That might be fine for the expected terminal value of the home. However, the interest rate is not quite that simple. The discount rate of the buyer, that is the buyer’s expected return on cash, is not that simple either. Computing some 50 year norm on the yield spread is essentially impossible.
All that said, let’s take a look at what the cases are. There are exactly three cases that we will need to consider in most situations:
Take two numbers, such as the 1. historic increase in market value of the property in the area and 2. the current interest rate.
Exactly one of the following is true:
1. The historic increase in market value is greater than the current interest rate.
2. The historic increase in market value is less than the current interest rate.
3. The historic increase in market value is equal the current interest rate.
(This follows from the fact that the set of rational numbers is an ordered field. The set of real numbers is an ordered field too.)
Exactly one of the above is true, and there are no other possibilities. With this in mind, we can consider many classes of specific situations.
So before we get too deep, what’s a reasonable rate of return on cash (the opportunity cost to the person who holds the cash)? What’s our interest rate (what lenders charge, for cases 2 & 3)? What’s a reasonable rate of return on the property (50 year historic value, I guess)?
I am going to propose that we begin with a purchase price-to-annual rent multiplier of 20. I am not sure about the 50 year historic average. This is more what one will find today. Some here have suggested well-above 20, such as 25. About the lowest I have seen suggested for the Seattle area is 15. Also 20 is a ‘nice’ number, as 20 divides 100 evenly. It’s well-known that 19 is prime, 17 is prime. Numbers like 6*pi (a little under 19) really doesn’t do it for me in this situation, but there is nothing to say that the multiple isn’t 6*pi.
These four items should provide enough to discuss before we get to our accounting issues, and that’s before we get to our underlying question of rent versus buy.
1. Opportunity Cost of Cash (how much the holder of cash values his cash in annual percentage terms)
2. Interest rate that lenders charge (annual percentage terms)
3. Market value changes of real estate (annual percentage terms)
4. Purchase price-to-annual rent ratio. (Multiple)
RE: S-Crow @ 23 – I do not doubt that the average buyer is not paying 100% cash. The question is not answered by the majority’s behavior, however.
By AMS @ 8:
Because the 100% financed buyer is risking nothing but their credit score. And if they already have marginal credit, they’re risking very little. If the market goes up, they reap big rewards. If it goes down, they can always walk away and take a hit on their credit.
RE: DrShort @ 26 – The interest rate should, and I know there are problems with this, have a risk premium. I know that the risk has been under priced in recent history. When money is cheap, it does favor borrowing.
The other consideration is the future cost of the credit score hit. When borrowers no longer care about that, it has little, if any, future value to them.
RE: AMS @ 24 –
If you trust the GSE’s, they’ve already done the heavy lifting and we can just plug in numbers and take their word for the calculation. ;-)
http://www.ginniemae.gov/rent_vs_buy/rent_vs_buy_calc.asp?Section=YPTH
I haven’t tried to check the validity of their calculator and don’t know how well it applies the necessary factors.
The 4 items in your comment are all variables for which we can plug in multiple (or perhaps at least a couple) different values to get some idea of whether there is a break even point (in years) for those values.
I have the following comments as to what values we choose for the 4 variables you’ve mentioned.
For number 1, historically, in my experience, people with moderate amounts of savings invested primarily in short and middle term CD’s. The current interest rate for a 2 yr CD is about 1.6% for under 50K and 2% for 4yr under 50K. I think the historic return on mutual funds which is probably the other most likely investment, would probably be around 7 to 8% per annum. Assuming a mix of the two, I would suggest that somewhere in the range of 4% to 5% is reasonable.
For item 2, the current 30 yr fixed rate is in the low 5% range, and is appropriate when using a GRM or 20. But the 40 yr historic average is more like 7.5% +.
For item 3, the average CPI increase since 1925 is about 3.1%, but the 2008 increase was 4%. The expectation for the next couple of years is probably below the long term trend with the long term forecast subject to significant difference of opinion.
For item 4, there is a site that gives GRM’s and there are various areas around Seattle in the 20 range, although the King Co average may be higher. From a practical standpoint, I don’t think vary many people would invest in rental real estate if the GRM were commonly in the 20 range. Investing with a 20 GRM only makes sense if you expect appreciation significantly above historic inflation rates. I think the historical averageGRM nationally and in King County is less than 20.
RE: AMS @ 24 –
This analysis is very similar to how dividend paying stocks are valued (such as utilities). Housing pays a dividend in terms of a rent and may have some capital appreciation in the future as rents rise. There are nice, simple valuation models, but the flaw in all these models is that they heavily depend on the “beta” or expected market change (your item #3) and growth rate of rents/dividends. Estimating those is just a guess.
However, because future expectations play such an important role, you can’t really dismiss irrational housing attitudes as irrelevant. In fact, they might be the most important variable.
By mikal @ 17:
Well first off, it already does cost more for real estate closer to urban centers than it does for more rural homes. That is a given already, and I don’t see that changing.
Second, I was not suggesting anything other than that I thought it was an interesting post and that I wondered what others here thought of it.
RE: One Eyed Man @ 28 – I don’t trust the GSE. First of all, I don’t see any discount rates.
Let’s start with number 1, the opportunity cost of the cash. Using CD rates and mutual funds is reasonable, but I want to comment that many people are willing to borrow and spend at higher interest rates, but if we don’t have the rate lower than item number 2, then we have other problems. The 4-5% is very near the current 30-year fixed, but far below the 7.5% historic average. Using 7.5% will make the purchase much more expensive.
A rate of return of 3.1% to 4% we can just take, even if it is not adjusted for current market conditions, risk and so on. This may need some further discussion later, but ok for now.
The multiplier is obviously a big problem. I have no historic data, so I offered up 20. Maybe we could consider a number like 15?
With that said, let’s look at the situation, even before we get into the accounting, and we have not even discussed taxes yet.
If you value your cash below 5% and interest rates are more than 5%, then aside from the risk factors that DrShort points out, borrowing money is more expensive than paying cash, but not by much. It’s very, very close if we consider net of tax cost.
That said, let’s note that cash is actually returning more than the real estate. At this point I am going to look for a very small home, rent or buy, and keep high returns on my cash. Here we go again with the tax problems. If I invest in real estate, then I don’t pay taxes, within certain parameters, but I don’t get paid for many years. With cash I get paid right away, but I must pay taxes. If I invest in a retirement type account, I don’t pay taxes, but the limits are different. In any event, cash does pay more than real estate given the numbers listed.
Cash pays almost as much as the rent (GRM of 20 -> 5% rent initially), but the rent would be going up because of the market value changes. The rent is going up slower than the rate of return on the cash, as noted above.
The interest is actually more than the rent. The rent is 5% of the purchase price, but the interest is “in the low 5% range,” with a 40-year historic average of 7.5%.
Even before we get into much more, if the interest cost is more than the cost to rent, does it make sense to buy? That said, note that the rate of return on cash is a little lower than the rent.
If the annual rent were 7% of the purchase price (GRM = ~14.3), the buy decision gets a little easier. At 10% (GSM = 10), the buy decision is much, much easier.
With all of that said, all the rates are fairly close to each other. Essentially everything is 5%, with a little spread here and there.
Without getting into how long one would live in a place, and switching problems, and required moves, and so on, this seems very close. Since we are so close to critical points, it would be very easy for decisions to swing with little change in any one assumption.
This I think we can agree: “Investing with a 20 GRM only makes sense if you expect appreciation significantly above historic inflation rates.” Going further, if you don’t expect market appreciation significantly above historic inflation rates, then you should not invest–that is you should sell and rent.
Also why would I invest in real estate when so many other investments, historically speaking, produce better returns? If the argument is that one must live somewhere, then live in a small place. We still have not considered the operating expenses of the ownership.
At this point, I am seeing real estate produces the lowest return (3.1%-4%), has the highest operating cost (the owner pays the taxes, repairs, and so on.), is illiquid, and has a fairly high degree of risk. If you have to borrow, then you are borrowing above 5% to earn that 3.1-4% return. If you are a very, very high tax rate payer, especially if you must pay state income taxes too, then that 5% might be under the low rate of return, bringing the situation into the positive leverage area-it’s tight.
=============================================
I have to be at the airport by 6:00 am, so I am signing off for the night. I think this needs more on the “your mortgage payment is cheaper than your rent.” This claim need to be discussed in relationship to the above discussion.
RE: DrShort @ 29 – The black swan is always around when Beta is discussed. LTCM is the classic example. The crystal ball assumptions, however such might be determined, always have problems.
RE: The Tim @ 2 –
If oil goes to $300 per barrel all carry trade, equities, and derivatives will cease and cash will go into gold, just like it did when oil hit $150 per barrel.
The middle class will grow and traders will be out of business.
Warren Buffet bought a rail road to ship coal. That’s how forward thinking that guy is. We should think twice before hitching our wagon to his recollections of the good old days.
Today I was thinking about the Segway. It has been tossed in the corner like a Christmas toy at the first of the year.
There are innovations that no one wants to look at. People want to live in fear, that unless we do what has always been done our lives will fall into an apocalyptic chaos of revolution. We are already there.
So if oil goes up in price we will move south, ride motorcycles, and adapt a lot easier than Warren will.
Please tell me this is a typo:
A house selling for $928K
http://www.zillow.com/homedetails/6900-SE-33rd-St-Mercer-Island-WA-98040/49130677_zpid/
That can be rented for $1850 a month
http://seattle.craigslist.org/see/apa/1458678296.html
A ratio of 41, no friggin way
By AMS @ 27:
The problem in the recent past was the best rates were offered as teaser rates on variable rate or option payment loans. I could use a different descriptor, but let’s just say those loans appealed mainly to the people with the worst credit, so the lowest rates were offered to the highest risk people. The people investing in this thought it made sense because they thought real estate never goes down.
RE: buystocks @ 34 –
The rent option is great just because of their flexibility; note:
cats are OK – purrr
dogs are OK – wooof
Anyway; one more admission that prices are completely out of whack.
This is a great discussion. It’s bringing up all of the issues that surround building a Real Estate.
RE: AMS @ 32 –
I was at a memorial ceremony last Thurs and ran into one of my old high school pals and a former housemate off Eastlake in the early 1980’s. He was the roommate at MIT with one of the LTCM guys named Eric Rosenfeld. Unfortunately my friend is a geophysicist and not really into financial modeling etc. so I’ve never gotten a great inside story out of it. LTCM is pretty far out of my limited knowledge base anyway. I guess that’s two degrees of separation from infamy or something stupid and irrelevant like that.
RE: AMS @ 31 –
Clearly in the current market place, real estate is a high risk investment. But historically (post WWII) that wasn’t generally the case. Residential real estate generally had a very low but fairly steady rate of appreciation (outside of the boom and bust markets like CA, AZ, Houston in the 1980’s, FLA and of course the bust market of Detroit). And historically, the pricing of real estate was more in line with fundamentals related to rents and incomes.
It is interesting to compare GRM’s to 30 yr fixed interest rates as you’ve done and I think it helps give some idea of what is historically reasonable based upon fundamentals. For example, a 20 GRM would be 5% which corresponds to a very low historic 30 yr fixed rate. 15 GRM would be 6.7% which is still a very low historic 30 yr fixed rate. But, 13.3 GRM would be 7.5% which is about the average 30 year fixed rate over the last 40 years.
You’ve stated:
“This I think we can agree: “Investing with a 20 GRM only makes sense if you expect appreciation significantly above historic inflation rates.” Going further, if you don’t expect market appreciation significantly above historic inflation rates, then you should not invest–that is you should sell and rent.”
I can agree with these statements subject to the following caveats. First as to a 20 GRM, the appreciation rate may only need to be say 1% or 2% above inflation for buying to be reasonable, which is historically approximately 30% to 60% above the norm and therefore significant. Keep in mind that 2% on a 500K house is 10K per year compounded or more than 50K after a 5 yr holding period.
Second, although one probably wouldn’t want to buy in a 20 GRM market for financial reasons alone, the high transaction costs in real estate make a sell decision more difficult. If prices are stable or rising, it may not make sense to incur an immediate cost of about 8% plus moving costs unless one believes they will be renting for at least several years.
I took a look at some of the other rent v own calculators and Yahoo has one that I’m going to run some numbers on to see if it gets the present values and amortization numbers right. If it does, I may suggest we use it to run numbers that we can adjust if we believe the calculator has only minor limitations that we can compensate for. If we can find something that can get the basics right it will save us a lot of math and allow us to run far more scenarios.
http://realestate.yahoo.com/calculators/rent_vs_own.html
I won’t get a chance to check it out until this evening.
Horizon Bank now ‘Critically Undercapitalized’
http://www.bellinghamherald.com/602/story/1151561.html
RE: The Tim @ 2 –
This is typical King dollar rhetoric. All of his points are simple supply/demand dynamics that are curtailed to his strong dollar thesis. The true culprit is the limited supply of oil AND the 2+ billion people in India/China that are going to upgrade from bicycles to gas guzzling SUV’s. That is much more detrimental than a weak dollar. It’s inevitable the mighty $ drops once these nations develop a middle class and their standard of living increases in the next decades.
I wouldn’t worry too much about the free fall of the dollar, Obama has much more mojo than his predecessor so he should be able to negotiate another Louvre/Plaza type accord. Weak dollar is killing exports for Japan and Europe so they will willingly intervene at a certain point.
I’m going to try to up my post count so I can break into the Top 100 posters next time, since I’ve lived here for 1.5 years and have been reading this blog ~ 4 years. I want to warn you folks that I am a housing bear but a selected equity/bond bull. I also plan on making the next get-together and buck up for a donation.
1) Does anyone know why the ‘Firenza’ condo building, by the Bellevue Library on 108th St., has been seal-wrapped for a year? I could find no info by googling it.
2) Why do so many of you folks hate condos so much? If the price is right, taxes and fees reasonable, then why the venom?
3) When is Bellevue going to hold Seattle-type condo auctions?
Keep up the good work Tim and posters…….
Tim – Do you have a snail mail address where I can send a donation? I have my credit card on ‘hold’ to prevent a rate increase…I used to to purchase an ATM machine a few years ago, no kidding.
RE: One Eyed Man @ 39 – As to the 20 rent multiplier and investment, you write, “First as to a 20 GRM, the appreciation rate may only need to be say 1% or 2% above inflation for buying to be reasonable, which is historically approximately 30% to 60% above the norm and therefore significant. Keep in mind that 2% on a 500K house is 10K per year compounded or more than 50K after a 5 yr holding period.”
This is ok, but it must be placed in context. First of all, I’d rather not invest in something that is producing a return 2% or less above inflation. This is my personal expectation, philosophy about investing. I would rather invest in higher rate of return items. This is where DrShort’s discussion of Beta comes into play. I am going to suggest, without supporting the claim, that historically, c. pre-2005, there was an expectation that housing was a safe investment, in that one could reasonably expect it to appreciate. The rate of appreciation, over time, was expected to produce a good return without much risk. That said, let’s get to the whole idea of held-to-maturity and duration risk, which I have discussed a bit in this forum.
First the concept of held-to-maturity applies to something that has a maturity, and thus has a fixed end date. A 30-year fixed mortgage has a specific end date at the start. If prevailing interest rates rise, then the value of the mortgage falls. If prevailing interest rates fall, then the value of the high-yield mortgage rises. (A discussion of how this applies to mortgage broker pay and the wholesale rate sheet might be something to examine later.)
Why do I bring this up?
If you have the expectation that housing generally goes up at a rate that is above what you expect, given the risk, then short-term fluctuations in price do not impact you. The bond market goes up and down daily, but if you have a US Treasury bond that you are going to hold until paid the principal back from the Treasury, then you don’t care what happens from one day to the next, or one week to the next. In fact, if you are really going to hold until maturity, you don’t even care about market value changes, as you expect full return of principal from Treasury. Other entities have a default risk, and that must be considered, but if you expect that the principal will be fully repaid, you will get the Yield to Maturity that was computed on the day you purchased the bond. Thus what happens in the housing market is the prevailing attitude that the market generally produces positive returns, even if there are some bumps along the way. So what if the market is down this year or next year, as it will eventually bounce back, and since the owner is holding long-term, a good return is expected by the owner. It’s only a matter of time before an acceptable return is realized. I fully realize that the housing market does not have fixed dates to sell, but there are parallels in the way the owners think about the two investments.
As suggested above, I also wanted to discuss the whole idea of “it’s cheaper to buy than rent based on your mortgage payment.” You suggested that cash should have an expected return of about 5%. (All the numbers were 5%, especially relative to where I am headed–credit card debt of 20%++++. I realize that some credit card debt is less than 20%, but it is still generally 10%+, which is a far distance from 5%.) The whole idea that a person will save $100, $200, or whatever, amount per month, and that it will free up cash for a much better life is very interesting. First the demand for the $25, $50, or whatever, per week is amazing. I am going to suggest that the demand for cash is way beyond 5%, and all those credit cards in the buyer’s pockets demonstrates just that. Their discount rate for cash is beyond 5%. They value cash today at 20%+, so an extra $25 per week today and worry about the other expenses of home ownership, such as repair and maintenance, in the future is a great deal. Then when that water heater fails, it’s the end of the world. “OMG, like, how could that happen?”
Then there are those who match their income exactly to fixed mortgage payments. The basic idea is that if the payment is fixed, then one can budget. While I believe this speaks to the inability of the person to actually budget and save, the problem starts when some small event happens that was not anticipated. Job change? “OMG, like, now I get paid on the other Friday, which landed on the 6th of November rather than the 30th of October.”
All of the above does not really get to our underlying question, but it still sets the stage up for the many issues that should be covered.
With all of that said, what would you suggest to someone who purchased at the peak of the Las Vegas or Phoenix market?
I offer this as a data set. This is asking prices, but in my opinion it does not really matter. Just about everyone seems to agree that those two markets are down 50%+. Some suggest more, and others suggest less. But the point is that these two markets are down more than just a little blip, and the time to recovery could be 10 years or more, and that’s does not include a decent rate of return.
Vegas: $345k median to $140k median over 3.5 years, or so.
http://www.housingtracker.net/asking-prices/las-vegas-nevada
Phoenix: $330k median to $185k median over the same period, or so.
http://www.housingtracker.net/asking-prices/phoenix-arizona
If you purchased a median valued place, by asking prices, for $345k about 3.5 years ago, then clearly you have an unrealized loss (remember the held-to-maturity idea is here) of 50%+ (~$200k on a ~$345k investment). I am not going to try to predict the future for Vegas, but how long will it take for the property that is essentially the same next door that just sold for $140k to sell for $345k? How many years and governmental bailouts will this take? What does the owner of the $345k place do during the recovery period? If you were holding the note (i.e. the lender), and you expected to hold it to maturity (i.e. you don’t care about interest rate fluctuations), how much are you at risk of not being paid your principal back?
In our rent versus buy analysis, how should we handle the risk of failed assumptions about market value changes. The rent will always be competitively priced, as will the market value of the property, but the point that the losses/gains are realized are clearly different from renter and owner. An owner can delay the loss/gains, but the renter must pay the prevailing market rent.
RE: The_Dude_Abides @ 42 – If you post like some, alright at least one, then you could be in that top 100 list in about a week. lol
By The_Dude_Abides @ 42:
1) I know nothing of this building, but often when they’re wrapped up like that its to replace the faulty siding. Is the building 5 – 15 years old? You have to be really careful with those fake stucco siding condo complexes.
2) I don’t think people here hate condos. It’s more that the condo market has been overbuilt and treated as a get rick quick scheme by developers, flippers, and investors. I think it’s quite possible prices for single family homes are approaching the bottom. I don’t think that’s the case for condos — there’s still a ton of supply. If I were looking, I *might* consider buying one at auction with at least 35% off, but nothing else.
By The_Dude_Abides @ 43:
Hey, thanks! I do indeed have a post address:
RE: The_Dude_Abides @ 42 –
1) Don’t know anything about that condo. I tried to look it up, but didn’t find one by that name. Are you talking about the “Villa Firenze”?
2) I don’t personally hate condos, but I don’t likely see myself ever buying one. My reasons are high HOA dues that are not fixed, essentially negating a primary benefit of owning (having a mostly fixed payment) and the fact that not owning any actual land means a lower real value. The only possible way I would ever see myself buying a condo would be if they ever really turn the skinny floors in the Smith Tower into condos, and I somehow have money to burn.
3) Good question. They certainly had plenty of crazed building during the boom years, but how much of that was commercial vs. residential? I’m only familiar with a small handful of Bellevue condo projects that have come online in the last few years, all of which are fairly large. So far I have only seen relatively small buildings in Seattle go to auction. Nothing like Olive8 or 1521 has gone to auction.
RE: Kary L. Krismer @ 35 – Duration–those “teaser” rates are about duration.
If you were a lender, what would you rather do:
1. Make some fancy computation over a 30-year period where you guess what the future of interest rates, inflation, and so on will be.
-or-
2. Offer a note that adjusts to the current market conditions
During a period of falling rates, the lender would rather have the 30-year fixed instrument, but the borrower would rather have an adjustable note, and similar reversal for the case of rising rates.
(See also the discussion on “held-to-maturity.” We are getting really close to duration risk and duration based inflection points.)
If you are interrested in knowing a bit more of what some say is powering the stock market now, the so called “dollar carry trade” here is one persons take on it. Seems like he has done some studying but i’s only one source so take it for what it is:
http://www.financialsense.com/fsu/editorials/willie/2009/0923.html
‘Home Prices Sank Further In Most Parts of US in 3rd Quarter’:http://www.cnbc.com/id/33826643
“The decline in the national median price has moderated recently, and a shrinking supply of unsold inventory suggests we are getting closer to price stabilization in many areas, ” said Lawrence Yun, the group’s chief economist, in a statement. “But we need a steady stream of financially qualified buyers to further reduce inventory and get us to a self-sustaining market.” Prices in Fort Myers, Fla., plunging 40 percent to $98,000 from a year ago, were the worst in the nation. Las Vegas saw its median price tumble almost 35 percent to $138,500 year-over-year.
RE: patient @ 49 –
More discussion here:
http://market-ticker.org/archives/1611-FedSpeak-Translation-There-Is-No-Recovery.html
The carry trade became a huge issue for Japan, limiting their central bank options. I was wondering why no one thought it could happen here too, although I think one reason it was off the radar screen was the time difference. Japan has a 20 year history of low interest rates, while the U.S. has only had that environment for a year or so. But now that it has set up and is growing, our options going forward are similarly limited. We were dead anyway, but now there can be no doubt, as there is one more mechanism to ensure it. As interest rates rise and the trade unwinds, the equity markets will again collapse and deflation set in.
RE: Scotsman @ 51 – Thanks for the link Scotsman, pretty good discussion going on there.
RE: The Tim @ 47 –
Yes, Villa Firenze is the full name.
Dr. Short – I think the building was built in 2001, so I think you’re on to something about the stucco/siding. And that 35%…that’s a good start. :)
By buystocks @ 34:
Maybe the value is all in the land, which is not what a renter wants to pay for in general. The descriptions says “This home is a fixer so bring your ideas to redo or build your dream home.” The house has been on the market since summer 2005, so it is not yet a house selling.Reply – Quote
RE: kfhoz @ 54 – Oops, I meant summer 2008.
RE: The_Dude_Abides @ 53 – It’s not just the fake stucco. Be very very careful about buying a condo in Seattle. The rate of water intrusion problems in this city is downright disgusting.
RE: AMS @ 44 – RE: One Eyed Man @ 39 –
In Real Estate, aside from the rent mulipliers and cap rate carp, a cash return on a cash investment is all that matters.
If I pay $100K for a property I want a 10% return.
That should set the value of Real Estate, the price, pretty low.
Now you are telling me that I can only get 5%. On a $100K place the rent is $416. plus i have a 5% vacancy factor, which will be going up soon, maintanence, taxes, and insurance so I need to charge $600 per month.
When you do the math from this perspective you can see how over priced property actually is.
Then take into account that the 4% appeciation rate is now deflating at 5%, by Steve Tyler’s estimation, and you are in negative territory for owning.
So, in conclusion, even if you are borrowing at 0% interest you are losing money.
RE: kfhoz @ 54 – According to Zillow, the house was purchased in 2005 for 900k. Four years later the asking price is $928k.
I looked at a place that had a purchase price to annual rent multiple of 100 based on the initial asking price. If I remember right, the taxes were about 2/3 of the rent. Recently the owner sold at a loss of about $300k.
MLS#29027154
Asking price, December 2007 was $2,400,000. Advertised rent $2,000 per month.
Final sale price, July 2009: $1,545,000
Original Purchase Price, May 2007: $1,822,500
Average loss per month of ownership: A little over $10,000! (About $350 per day, every day of ownership)
That’s just the change in recorded purchases prices divided by the difference in time. It does not factor taxes, utilities, maintenance, interest/opportunity cost on the money, sales expenses, and so on. It also does not consider if it was ever rented for the $2,000 per month.
The rental terms included allowing the owner to show on short notice, and it was subject to sale at anytime. Another problem was that the owner was only offering a 6 month lease. It was clear that this deal came with problems, as the low rent was far from costs.
RE: Flying Ape @ 41 –
Really good comment.
RE: David Losh @ 57 – That’s not how it works, and I hope you know it.
What if you can rent it out for 5%, but you can borrow money at 1%?
Since the lender only requires a down payment of 30% cash, you have a 13% return on your cash.
4%/30% = 13%
(cash-on-cash analysis)
I was looking at rentals on Mercer Island last month, the rent prices there are definitely out of whack in favor of the renter.
Likely cases of people believing the market will come back and being able to afford to put their money where their mouth is. As also demonstrated in The_Tims graphs breaking down the individual area’s months on market. MI has been has not been selling much…
RE: AMS @ 44 -
Sorry its taking me so long to reply, but I warned you I was slow. In comment 44 you asked:
” In our rent versus buy analysis, how should we handle the risk of failed assumptions about market value changes. ”
I don’t think that you handle failed assumptions in the rent v buy analysis except by modifying the variables used in the calculation to account for what you anticipated is most probable. If there appears to be a high risk of deterioration in the housing market, the “appreciation rate” should probably be lower than the historic average if not negative, depending in part on the length of your anticipated holding period. If the economic outlook is for recession, the rate of return on cash should probably be lower than the average historic return. And the value chosen for each of the variables probably has to be affected by the expected holding period. If you have a short expected holding period, then the value of the variable should probably be closer to the current market rate for that item. If the holding period is longer, then the variable should probably more closely reflect historic long term values for that variable.
As to the issue of the rate of return on owning a home being low, like say 2% or less, it’s important to remember that that return is actually measuring a profit above the return that was anticipated to be made on your cash if you paid rent and invested in something other than a home.
Just to be clear, I don’t think I have a financial prejudice in favor of owning rather than renting, other than that I think a normal rate of inflation rather than deflation will most likely return in a year or two and when home prices come closer in line with historic fundamentals, home prices will likely follow close to inflation or a little above in the long term. I currently own a home but I rented in SoCal for 7 years in the 1980’s when that market was on fire because my holding period was limited and I thought there was a reasonably high risk that market was over valued. I own a personal residence currently, but it took 10 yrs of looking to find this house I’m in now and I don’t want to spend another 10 yrs finding another one. That’s a function of being married than any financial issue.
As to a sell decision if you think that real estate will return to a value above the current price within a few years, then it doesn’t make sense to sell and possibly rebuy later unless you think the additional drop in price plus rental term savings will exceed the transaction costs. In addition, because of the high transaction costs, you have to time the market pretty well to get the maximum out of a sell decision, which most people are unable to do. A lot of people acknowledge they thought the market was fundamentally over priced several years before the peak and sold several years before 2007. And a lot of people sold well after the peak in 2008 or 2009. If they intend to buy again, you have to subtract the round turn transaction costs of about 8 to 10% from the amount of the loss they avoided. But in any event, the sell decision is a separate issue from the rent v. buy decision and I don’t really see it’s relevance here.
I ran a couple of number sets on the Yahoo calculator and I think it may be usable if we identify it’s flaws and correct for them. It says it reduces cash flows to present value (I haven’t checked to be sure all items are properly handled) but it still appears to favor the buy decision in at least one way. It looks to me like it doesn’t subtract the standard deduction from the interest and tax deduction in calculating the tax savings. If this is the only problem with the calculator, it’s an easy item to estimate and account for separately with a reasonable amount of accuracy.
There are still several other things I wanted to check on, including the following:
1. The calculation and handling of the interest and principal payments.
2. The handling of transaction costs on purchase and sale. There isn’t a place to input them, although it’s possible that the calculator just uses an estimated percentage of the purchase price and sale price and does it automatically. If we can determine that the calculator doesn’t account for them at all, we can easily estimate and account for them separately.
I’d like to be able to run a number of scenarios for several reasons. One is that I’m still curious as to how short a holding period one can have before it’s nearly always best to rent. And second, I think if the return on cash is high enough, the rent v buy decision may change in favor of buying during the middle term of the loan and change back in favor of renting in the later years of the loan when the buyer has cash tied up in low yield home equity.
RE: One Eyed Man @ 62 –
This is easy: “2. The handling of transaction costs on purchase and sale. There isn’t a place to input them, although it’s possible that the calculator just uses an estimated percentage of the purchase price and sale price and does it automatically. If we can determine that the calculator doesn’t account for them at all, we can easily estimate and account for them separately.”
Let’s talk net of all sales expenses. In other words, when you say a sale price of $94,000, that’s actually $100,000 (or whatever) less transactional costs. Also, in general, the terminal value is only the cash that the owner walks away with, so the terminal value might be more like $50,000 ($100,000 less sales expenses = $94,000, and then $94,000 – $44,000 loans = $50,000 cash paid to former owner.) I am not sure how the Yahoo calculator handles these things, but let’s just use net of sales expenses for simplicity.
#1 is not as easy. Amortization schedules will always be a problem. Options include negative amortization, 15 year fixed, 30 year fixed, interest only, and so on. Then you have the how to handle the principal portion of the loan payment.
My strategy is to start simple: Interest only. The principal balance is fully paid at the end. See #2 above. This is only a simplification of the many options available, and it also avoids needing to compute amortization schedules. The interest computation is simple, 12% on $100,000 = $12,000 per year. Then to make things even simpler, I don’t worry about compounding or the small time between the months and the end of the year. $12,000 per year = $1,000 per month. I don’t care that the interest is actually paid in month 6, I consider the interest rate to be 12%. This is a simplification, but if you run all the numbers, I think you’ll agree that it really doesn’t matter much. At least we can discuss the bigger issue, and then go back and examine these simplifications.
(If you want a positive amortization, then use interest only with some extra cash in savings–this is tough to, as what do you do with the extra cash. But a positive amortization loan has a higher payment than an interest only loan. Let’s put that aside.)
If you were to look my work over carefully, you will find all kinds of rounding, simplifications, and the like, but overall the bigger issues holds.
My post #60, above, is one such example. If the down payment is 30%, then the borrower only needs to pay interest on 70% of the purchase price, so there is an error of 0.3% in the 1% interest paid. In this case it only increases the return, but does it really matter? I think we ran into this same issue when dealing with rent multiples that are 18, 20, 25 or whatever. When I am looking for a number closer to 10, all those others seem about the same, but if you were looking for a number like 20, then there is a big difference between 18 and 25. The place discussed above, with a multiple of 100, is so far out that it would make little difference if it were 100, 125, 75. One does not need to be very precise in these cases.
I have not used at that Yahoo calculator yet. I did look for some details, but I didn’t find much. I suspect that the calculator is accurate, given the assumptions made. I am willing to take a good look at it.
The last week I have been able to post quite a bit. I have posted about 20 to 25 posts per day. It does not appear that I will be able to maintain that over the next few days, but this issue isn’t going away.
Finally, the whole failed assumption risk is not a question of adjusting expectations, but rather, it’s a question of what happens when the assumptions do not hold. No one purchased in Vegas thinking that the market values would go down by 50% or more. No one. Not one of those buyers could have possibly thought, “What happens if the market goes down by 25-35% per year for multiple years?” This is obviously an extreme example, but there are plenty of business adventures that fail. No one invests in a profit venture to lose money, yet it happens all the time. A good business plan has an exit strategy for many unexpected events. The unexpected is thus expected. One thing is for sure, renters are not taking the heavy losses that buyers are, but similarly, renters don’t have a chance to enjoy market gains.
RE: cheapseats @ 61 –
Several multi-million dollar estates for sale/rent out here in the country with asking rents about 1/3 to1/4 of what PITI would be. But even at those prices they aren’t renting. I used to think sellers were waiting for the market to come back. But now maybe they just want to slow the bleeding as much as possible. Several of the formerly $1.0 million homes have sold (short) in the $600-700K range. None of the $2-3M stuff has moved at all.
RE: AMS @ 60 –
Sorry, but that’s exactly how it works, but the discussion is great.
Real Estate is the lowest common denominator, it’s cash in, cash out, that’s it.
In todays market place i did cover the interest rate as being 0% and it is still a money losing proposition.
The leverage is gone, that’s the point. The only hope of contolling a Real Estate with leverage is to pay it off with future dollars, inflated future dollars.
There is no inflation on the distant horizon that interest rate hikes can’t fix.
RE: The Tim @ 30 – That at some point the price of gas will destroy far out suburbia. Some, not all buy their solely because they can’t afford the same size house to the close in urban areas. Higher gas prices will only make it more difficult for them. They will end up buying less to live closer. That is our future unless we as a country can develop something beyond what we now have. Drilling will help in the short term. Then what? I believe that in fifty years people will be pissed that we burned it instead of saving what was left. Much of suburbia will be ghost towns.
RE: AMS @ 63 –
As a practical matter, I think the majority of home buyers don’t have an exit strategy. They don’t treat the purchase as a business decision. IMO most first time real estate buyers don’t even consider the following: From a financial standpoint, they are down about 10% the moment they close escrow on their purchase. They may realize that they are down a point or two for their closing costs at purchase. But they almost never consider that there is effectively a back end load to real estate equal to 8% to 9% for those using full commission brokers. A high percentage of first time buyers didnt’ put 8% down and don’t have the funds to get out even if the property’s value remains equal to their purchase price.
If they did have an exit strategy, the financial component of the decision to implement the strategy should be based upon the principal of marginality. My recollection is that the principal of marginality says that the decision would be based upon the best use of their next dollar and not some emotional response or concern over previously expended funds that they might not recoup. If they truly believe that the market for the property is going up, then the best use for their next dollar is probably to preserve their investment. If the market value of the property is declining with no reasonable likelihood of creating a profit for many years, their best choice is probably to cut their losses, sell and move to a rental.
From a financial standpoint, the decision would be based upon a revised analysis of all their financial alternatives including a new rent v own analysis that incorporates the revised values for all the variables that may have changed. For example, if their time horizon is 7 years and the anticipated appreciation in the property has changed from 4% per annum to -2% per annum during that period, then the rent v own analysis would tell them to cut their losses and sell now. They will lose money, but they will lose less than if they hold the asset for the 7 years originally anticipated. If the analysis says they may loose money for a few years but never enough to equal the lose caused by the transaction costs of selling, and that they will come out ahead by owning at the end of the 7 years, then they should hold the property (assuming there is some reasonable importance to the 7 year period besides finance, such as waiting to move to a new school district or a retirement community, etc.).
In essence, one needs to rerun the analysis anytime there is a substantial change to any of the important assumptions. The result of the new analysis should control the decision at that point (if the decision is purely financial). But even if the financial component is extremely important, there are numerous other factors that may be of greater importance and take precedence for most people, such as the personal time needed to move, disruption of the family, emotional attachment to their current house and neighborhood, etc.
I’ll try to run some variables on the Yahoo calculator this evening, including use of interest only financing, and maybe some one yr holding period scenarios to hopefuly make any preprogrammed assumptions in the calculator easier to spot.
Speaking of exit strategies…
Back when I was working at Genie, they hired a guy from Chicago into my team. All his relocation costs were paid for, including paying rent at a furnished apartment for somewhere between three and six months.
During this time, he was selling his old home in Chicago, and I suggested that he might want to rent for a while here, for two reasons. 1) To give him and his wife time to learn what neighborhoods they like and don’t like. 2) I felt strongly that prices were likely to begin falling soon.
This was summer of 2007. He went under contract on a house in Brier in July 2007, the peak price month here in the Seattle area. They put 20% down ($84k) on a $420k house, resulting in a $336k loan.
Fast-forward to summer 2009: It turns out that he and his wife aren’t that fond of Brier after all, and changing work circumstances allow them to move closer to the city, which will allow them to ditch one of their cars and live in a more densely-populated area more to their liking.
They listed their home last month. Asking price: $365k. Dropped the price $10k this week to $355k. IF they get their current asking price, after agent fees, excise taxes, and likely buyer concessions, they will pocket around $323k—$13k less than their original loan amount, and around $4k less than their loan amount is likely to be today assuming they made no extra payments.
Their entire $84k down payment, flushed down the toilet. Just like that. So I guess their exit strategy is “burn our down payment.”
Their PITI monthly payment on the place has been in the ballpark of $2,750 a month. They probably could have rented a similar 3-bed, 1.75-bath, 1,900 sqft. place in that area for $1,750 a month or less. Had they sat on their down payment and simply paid themselves the $1k a month savings from renting, they would be house shopping today with a $110k down payment instead of a zero dollar down payment and a likely $4k+ liability on the previous mortgage.
Just thought I’d share that little anecdote.
RE: Scotsman @ 64 – Yep. When I went ‘rural’ I found I could rent as low as 30 cents on the dollar.
RE: The Tim @ 68 –
The seller got 20% more than they would have at any other time. The thing many agents were talking about was to sell, sell, sell, kind of like what is going on right now.
Those people who sold and rented are looking pretty smart and the agents who approach them next year will find willing participants in another buying cycle.
RE: AMS @ 63 –
Unfortunately the Yahoo calculator isn’t set up to allow interest only loans. I took a look at a bunch of the other calculators that the search engines pull up but I didn’t find any others that appeared to do a present value calculation. Nor did I find one that allows for the choice of an interest only loan.
There were 2 calculators that looked really interesting because they allowed for lots of input items and they produced graphs with the performance of the rent v buy comparison over time, but it didn’t look like they reduced the cash flows to present value (although I’m not entirely sure. These are the links for those two calculators if you want to look at them. I thought the first one would have present values for sure because the name of the company is “Timevalue.”
http://www.timevalue.com/tcalcextras.aspx?CALCULATORID=HF05&TEMPLATE_ID=www.timevalue.com_2&HIDEFORMTAG=TRUE
http://www.nytimes.com/2007/04/10/business/2007_BUYRENT_GRAPHIC.html#
The NY Times calculator allows for a lot of modifications in the advanced settings but when I ran a scenario, it didn’t seem to reduce the cash flows to present value. I looked to see if there was an option that would do present value, but I couldn’t find one.
I may try some additional scenarios on these two calculators to see if they actually do present value and I just didn’t get it because maybe they use the inflation rate for the discount rate so the present value was cancelled out by appreciation or something like that.
I’m not sure how much difference the present value will make, except for the discount needed to be applied to the sale proceeds at the end of the ownership term. It’s probably just as easy to do a modification to the Yahoo final number for the transaction costs and the standard deduction as to do a modification to the final numbers on one or both of the other calculators. I didn’t check to see if either of them accounted for the standard deduction in the value for the tax deduction.
RE: One Eyed Man @ 71 – If we are going to include tax benefits, then the present value of the tax benefits needs to be considered too. So many calculators want to to give $$$$$ in tax savings over 30 years, but that’s not a discounted value.
Maybe we could start with the rental costs. That is probably easier. Then we could compare that to some purchase deals.
RE: The Tim @ 68 –
I’m used to seeing people lose lots of money in real estate, but they were commonly builders and developers, not families trying to find a place to live. Ironically, the builders and developers usually don’t have an exit strategy either. They just have a business plan with a pro forma financial that they gave to the lender as part of the loan application. It always shows everything selling for a profit with no consideration for the possibility of an unforeseen down turn in the market.
RE: AMS @ 72 –
If the only problems with the Yahoo calculator are that it doesn’t deduct the standard deduction and it doesn’t deduct the buyer/owners transaction costs, these are items that can be easily estimated with a high degree of accuracy and subtracted from the result given by the Yahoo calculator for the buyer’s side.
For example, the correction for the standard deduction could be as follows for a married couple:
11,400 X (number of years held) X (tax rate) = estimated value of deduction to be subtracted from buyers side
Arguably we should increase the deduction for estimated annual inflation and decrease it to a present value, but these factors would arguably just cancel each other out because one increases the result by the compounded rate of inflation and the other decreases the result by what is arguably the inverse number (if one uses the rate of inflation for the discount rate to calculate present value).
The correction for the estimated present value of closing costs to be deducted from the buyers side could be as follows:
(Purchase Price + (Purchase Price X Inflation rate X number of years held )) X 10% X (1 – (inflation rate X number of years held)) = estimated present value of total closing costs to be subtracted from buyers side
As with the value of the Standard Deduction, this number would also be deducted from the buyers side calculation given by the Yahoo calculator.
The portion of the correction for closing costs in the first set of parentheses is the calculation of the sale price. fNote that for purposes of simplifying the calcultaion the calculation is done without compounding of the rate of inflation.
10% is the total of an estimated 1.5% closing costs at purchase and 8.5% closing costs at sale. Obviously, the closing costs at purchase are already at present value so lumping them together is wrong, but it comes out to an even 10% that way which makes the calculation easy.
1 – (inflation rate X number of years held) is the estimated factor to reduce the closing costs at sale to present value. I think this number is slightly low because it doesn’t compound the discount rate. That makes up a little for including the transaction costs at purchase in the total of transaction cost.
The renter should also arguably get a return on the transaction costs incurred at the purchase but as long as the holding period isn’t too long and the rate of return on cash isn’t too high, this amount would be less than 1K per year and probably could be considered diminimus. If the holding period is over about 10 yrs and/or the rate of return is over about 5%, we might want to include an estimate for the renters return on the transaction costs at purchase. It should be noted that the renter is getting a return on the cash equal to the buyers down payment included in the calculation by the Yahoo model.
I haven’t checked enough scenarios on the Yahoo calculator to be sure that the above modifications are the only ones needed to obtain an estimate of buy v. sell costs that has reasonable accuracy.
I don’t know that it makes any sense to try to get a calculator that’s more accurate than a plus or minus say 5% estimate. I think we would probably both agree that the real limitations of this kind of estimate are primarily in the assumptions contained in the appreciation rate, inflation rate and other factors used for the calculation.