Seattle Bubble

News & discussion about real estate & the housing bubble in the Seattle area.

Seattle Bubble - News & discussion about real estate & the housing bubble in the Seattle area.

Entries Tagged as 'mythbusting'

Checking Up on the “Forced Savings Plan” Myth

By The Tim on August 31st, 2009 at 6:00 AM · 101 Comments

Please consider the following excerpt from a post I wrote that was originally published on the personal finance blog Get Rich Slowly (and later here):

…if home buying is like a savings plan, it’s probably the worst savings plan on Earth. Would you voluntarily sign up for a savings plan where well over half of the money you deposit in the first 20 years simply vanishes, and from which you can only withdraw money by relocating and paying a 6-9% fee (not on the amount you have “saved” mind you, but on the total sale price of the home)? Of course not. That doesn’t sound anything like a savings plan.

If your goal is to build wealth, you will be much better off investing your money in the stock market than buying a home.

In the post, I described a pair of examples using real-world homes that I had located on both the rental and for sale markets at the time: comparable 3-bed, 2.5-bath, 1,800 sqft houses in nearby neighborhoods in the Kirkland / Juanita area. The rental was $1,495 a month, and the home for sale had an asking price of $425,000.

It just so happens that I wrote this post in July 2007, the peak month for Seattle home prices according to both the Case-Shiller home price index and the NWMLS King County SFH median. As such, I thought it might be instructive to run a little comparison of how things would have turned out for the hypothetical buyer and renter / stock investor described in the original post. With home prices off over 20% from their peak, and stocks down 34%, who would currently have more equity?

Following is a chart that shows the monthly equity in each scenario. Note that the buyer adds to their equity by paying $322-$367 in principal each month (it increases slightly each month), while the renter / stock investor increases their equity is assumed to be adding the $1,161-$964 (it decreases slightly due to rent increases) they are saving each month to their investment. The value of the home is based on Seattle’s Case-Shiller index, with a slight increase in value assumed for July and August. The value of the stock investment is based on the S&P 500 index, and rent increases are based on the “rent of primary residence” portion of the CPI for the Seattle area.

Peak Buyer Equity Comparison: $85,000 Down on a $425,000 House

As of the end of August, just over two years into their respective “investments,” our hypothetical homebuyer is left with $537, while the renter / stock investor currently has $84,690 in equity. Here’s a visual of the total amount of money each would have put into their respective investments, and the total amount they have lost in the crash:

Peak Buyer Equity Comparison: $85,000 Down on a $425,000 House

At 25%, the stock investor’s loss is nothing to sneeze at for sure, but it pales in comparison to the 99% loss suffered by the peak homebuyer. Ouch.

But what if we tweak the scenario slightly, in order to stack the deck as much as we can against the renter / stock buyer? Let’s say we set the start date to October 2007, the peak of the stock market, and only run the numbers through February 2009, the low point when stocks were over 50% off their peak. The stock buyer’s losses double to 50%, but as it turns out, the home buyer is still far worse off with a 93% loss.

Of course, the $85,000 down scenario isn’t really very realistic compared to what most people were really doing in 2007. Let’s modify the situation a bit into something more reflective of reality.

Instead of comparing 20% down on a $425,000 house, let’s say the hypothetical potential buyer and renter had just $8,750, which would be a 3.5% down payment on a $250,000 house. Again, to stack the deck against the renter / stock buyer in this scenario, we’ll assume they’re still paying $1,495 a month in rent, even though that would rent a far nicer house in 2007 than $250k would buy.

Here’s the equity matchup for our more realistic scenario:

Peak Buyer Equity Comparison: $8,750 Down on a $250,000 House

Wow. The homebuyer in this scenario presently has negative $39,847 in equity, while the stock buyer has $12,820. Take a look at the invested / lost chart:

Peak Buyer Equity Comparison: $8,750 Down on a $250,000 House

The homebuyer has lost 364% of what they have put in, vs. 22% for the stock buyer.

I think this is an appropriate time to repeat the point I quoted at the beginning of this post. If home buying is like a savings plan, it’s probably the worst savings plan on Earth.

When you actually look at the present equity situation for the people who jumped into the housing market near the peak, stretching their budgets to buy a house that they didn’t even intend to live in long-term, the current record foreclosures start to make some sense.

If you bought a house near the peak thinking that it would be a great “forced savings plan,” you would probably be pretty tempted to hand over the keys, walk away, get yourself into a nice affordable rental, and get yourself started on an actual savings plan—like actually saving money every month. And who could blame you, really.

P.S. – I should add that at this particular moment, I don’t think the stock market is a very good place to put your money. With a P/E ratio on the S&P 500 somewhere in the ballpark of 150, I think stocks are primed to drop back down in the not-too-distant future, possibly by a considerable amount. That’s not investment advice, just my personal opinion.

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“Throwing Away Money”

By The Tim on June 9th, 2009 at 10:47 AM · 127 Comments

One of the reasons we would often hear people use to justify overspending on a home during the bubble was that they wanted to stop “throwing away money” on rent.

I would hope that by now most people have realized how ridiculous that concept is, but I thought it might help dispel the notion if we consider a pair of hypothetical (but completely plausible) scenarios.

Couple A is renting a 2-bedroom, 1.5-bath townhouse for $1,000 a month in Ballard. Their $1,000 pays for not only the roof over their heads, but the water/sewer/trash, any necessary maintenance, and access to shared facilities such as a pool, hot tub, and workout room.

Over the past three years Couple A have spent around $35,000 on shelter. If they decide they want to move, it’s as easy as waiting until the lease is up and collecting their security deposit.

Couple B decided in 2006 that they were tired of “throwing away money on rent.” They didn’t have a down payment, but that of course didn’t stop them from qualifying for a $400,000 loan on an adorable 2-bedroom, 1.5-bath Ballard craftsman. With an interest rate of 5.7%, their (PITI) payments are around $3,000. Of course, this doesn’t include any services or maintenance.

Over the past three years Couple B have spent around $67,000 on mortgage interest alone, and their home is now valued at around $340,000—15% less than they paid. If they decide they want to move they have three options: Come up with about $40,000 in cash to cover the difference between their mortgage and the house’s value, convince the bank to accept a short sale, or walk away.

Now, which of these hypothetical couples seems more like they have been “throwing away money” to you?

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King County NOT Running Out of Land

By The Tim on September 21st, 2007 at 10:00 AM · 58 Comments

For those that continue to insist that home prices around Seattle are high because “supply isn’t keeping up with demand,” I would like to point out the 2007 King County Buildable Lands Report.

This is what the report has to say about building activity in King County from 2001 through 2005:

  • King County gained more than 49,000 net new housing units in the UGA during the second five-year Buildable Lands review period (2001-2005). Accounting for assumed vacancy rates, this translates into about 47,300 net new households in Urban-designated King County, which is about 31% of the 22-year Household Growth Target added in 23% of the planning period. This growth occurred despite an economic recession and significant job loss during four of the five years of the analysis period.
  • During the six years from the April 2000 US Census to April 2006, Washington State’s Office of Financial Management (OFM) estimates that King County’s population grew by 98,300 persons, from 1,737,000 to 1,835,300. This increase is nearly 32% of the 2002 OFM population projection for the planning period (2001-2022), which is the basis for the Household Growth Targets, during six years or 27% of the planning period.

- Chapter IV, p. 1

Quick calculation… 98,300 people in six years is roughly 82,000 people in five years, which translates to approximately 35,650 households (assuming an average of 2.3 persons per household—2000 Census showed 2.39). 35,650 new households (county-wide) vs. 49,000 new housing units (UGA-only). Whoops. Looks like supply has actually been easily exceeding demand, just like I said it was.

Going forward, the picture looks much the same:

  • The King County UGA has capacity, based on current plans, for approximately 289,000 additional housing units accommodating an estimated 277,000 additional households—more than twice the capacity needed to accommodate the Household Growth Target of about 106,000 for the remainder of the 2000-2022 planning period.
  • At projected household sizes, the 289,000 new housing units, together with the existing housing stock in 2006, could accommodate more than 400,000 additional persons within the UGA. This is more than twice the population growth needed to meet the remaining part of the 2002 OFM projection of 2,048,000 total population for King County in 2022.

- Chapter V, p. 3

Translation: the Growth Management Act and Urban Growth Boundary have not and will not result in an artificially-constrained supply of houses in King County for the foreseeable future.

Here’s a little blurb from the P-I (which is about all I expect to see, since the facts in this report don’t back up the oft-repeated “constrained supply” claim the papers love to tout):

According to the report, King County cities and towns grew slightly faster than projected from 2001 through 2005 and still had enough capacity for twice as many households as remain in the projection for growth through 2022.

In fact — thanks to rezoning, denser construction and increasing potential for redevelopment — there was more capacity at the end of the five years, despite development of 5,000 acres during that time.

Can we please stop claiming that “restricted supply” will prop up local housing prices now? I can write articles all day long about how beautiful the pretty pink sky is, but that doesn’t and won’t make it true. It just makes me annoying and ignorant.

(P-I Staff, Seattle P-I, 09.20.2007)

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Homebuying Platitudes vs. Reality

By The Tim on September 12th, 2007 at 11:35 AM · 154 Comments

This is a post that I originally wrote for the highly-recommended personal finance blog Get Rich Slowly. As such, the style of writing is more geared toward the audience of that site. However, I felt that the post would be of interest to the readers here as well, so I am re-posting it in its entirety.

It was posted at Get Rich Slowly on July 16th, where it rapidly became one of the “Most Discussed” and “Most Rated” posts. It was subsequently bookmarked by over 350 people at del.icio.us, featured on Consumerist, and posted to Digg. If you’re a Digg user, I encourage you to “Digg it,” so maybe it can finally make it to the front page there, and get a little more attention. Enough shameless self-promotion—on to the post!

Introduction

“If you rent, you’re throwing away your money.”
“Owning your own home is a forced savings plan.”
“Home ownership is an excellent path to build wealth.”

You’ve probably heard statements like these plenty of times. On television, radio, the internet, and in casual conversation. Such sentiments are common in any discussion that involves home-buying and personal finances. It’s common knowledge that buying a home is a better financial move than renting. After all, you’re building equity instead of throwing away your money, right? Well, maybe not quite… Rather than assuming the “common knowledge” on this subject is accurate, let’s take a look for ourselves at some of the financial differences between renting and home-buying.

A Real-World Example

For the purpose of comparing renting to owning in this post, I’ll be using real-world data gathered from my area (NE of Seattle). Although most first-time buyers tend to move from renting an apartment to buying a larger, stand-alone house, as much as I can I will compare apples to apples.

For rent, I located a 3-bed, 2.5-bath, 1,840 sqft house with an attached 2-car garage, on 0.2 acres. Monthly price: $1,495.

For purchase I found a 3-bed, 2.5-bath, 1,850 sqft house with an attached 2-car garage, on 0.22 acres. Price: $424,950.

The two homes are located within two miles of each other in similar neighborhoods, and neither is located on a busy road. We’ll assume that our hypothetical homebuyer is a married couple with $85,000 in the bank to make a 20% down payment. To calculate mortgage payments we will use a recent 30-year fixed interest rate of 6.25%.

Let’s look at how the monthly costs break down (approximately) for our hypothetical potential first-time homebuyer:

  Renting    Buying   
Rent/Mortgage:    $1,495 $2,093
Insurance: $20 $163
Property Tax: - $407
Tax Savings*: - ($327)
Maintenance: - $354
Total: $1,515 $2,690

*: (less standard deduction)

Right off the bat, you see that simply trading straight across from renting to owning results in a 78% more expensive monthly bill. That’s not exactly chump change. With even a slight upgrade from renting to buying (which most first-time buyers are prone to do), you can easily see how the total monthly costs would be more than double.

“If you rent, you’re throwing away your money.”

Common knowledge says that despite today’s large premium, buying a home is a “good investment” anyway. Hey, at least you’re not “throwing away” your money, right? True, the renter in our scenario spends $1,515 every month that they will never see again. I wouldn’t exactly say it has been “thrown away” any more than money spent on any other good or service is “thrown away,” but granted, there is zero financial return on that money.

However, when you take a look at the breakdown of the homebuyer’s monthly expenses, a large amount is money that will never return, either. Insurance, property tax (less tax savings), and maintenance, add up to $517 every month that is being “thrown away.” Even worse is the amount spent on mortgage interest. Consider how much of a mortgage payment is applied toward loan interest throughout the life of a 30-year fixed loan:

Years    % toward interest
0-5 ~80%
6-10 ~70%
11-15 ~60%
16-20 ~50%
21-25 ~35%
26-30 ~10%

Homebuyers throw away lots of money, too.In the first five years, approximately 80% of the mortgage payment goes toward interest. That’s an additional $1,674, for a total of $2,191 being “thrown away” every single month by the homebuyer for the first five years. Ouch! In fact, not until the homebuyer has been paying down the mortgage for over 20 years will the amount they are “throwing away” be less than the renter.

“Owning your own home is a forced savings plan.”

As you can see above, if home buying is like a savings plan, it’s probably the worst savings plan on Earth. Would you voluntarily sign up for a savings plan where well over half of the money you deposit in the first 20 years simply vanishes, and from which you can only withdraw money by relocating and paying a 6-9% fee (not on the amount you have “saved” mind you, but on the total sale price of the home)? Of course not. That doesn’t sound anything like a savings plan.

If our potential homebuyer has that $85,000 saved up for a down payment and deposits it along with just half of the monthly savings over buying ($578 per month) into an account at 8% interest, the balance will be nearly $300,000 in just 10 years. That’s a liquid investment, that can be used for whatever you want, no relocation required. Buying a home is not a savings plan. Actually saving money every month is a savings plan.

“Home ownership is an excellent path to build wealth.”

If your goal is to build wealth, you will be much better off investing your money in the stock market than buying a home. While both stocks and housing are cyclical markets, long-term historic trends show that housing appreciates at a rate barely above inflation, while stocks tend to return an inflation-adjusted 7-10%. In our hypothetical scenario, a renter who invested in the stock market with the $85,000 down payment plus the monthly difference between the $1,515 rent and the $2,690 home-buying costs would be over $500,000 better off after 30 years than the homebuyer, assuming 4% average appreciation.

An important thing to consider is that home prices in the United States are just now beginning to correct from an enormous unprecedented run-up in recent years. Despite what those in the business of selling real estate may insist, the correction in housing is still in the early stages. Four percent is most likely overly optimistic for most areas in the next 5-10 years. The only thing we know for sure is that double-digit gains are gone and won’t be coming back any time soon.

Also keep in mind—I mentioned it above but it bears repeating—in order to cash in on any “wealth” you build through your home you will need to sell that home and move. No, “extracting equity” does not count, since that simply results in a larger debt. Debt != Wealth.

Conclusion

For most people buying a home will result in their largest monthly bill (by far), and because they believe that it will bring them wealth or that they are “throwing away their money” if they rent, they often take on a much larger home debt than a prudent budget would allow. It is a real shame when people are driven to get into the housing market because of misplaced notions of imagined financial benefits. Of course, everyone’s circumstances are different, and for some (particularly those that live away from the coasts) the numbers may actually work out in favor of buying.

Don’t misunderstand me here. I am not saying that no one should buy a home, or that my example scenario is a golden standard of truth for all. Don’t take my word for it. Run the numbers for yourself, check out other articles (a small collection is listed below), and do what works for you. I highly recommend the great graphical calculator from The New York Times for comparing the financial aspects of renting and buying. Many people will consider all of the consequences—financial, emotional, etc.—and conclude that buying a home is the best decision. Just don’t trick yourself into thinking it’s a good financial decision if it’s not.

I myself intend to buy a house some day. However when that day comes, I will be buying a house because I want a nice, “permanent” place to live where I’m the boss, not because I think it will help me get me rich.

Additional Resources:

Wall Street Journal: Your Home Isn’t the Nest Egg That You May Think It Is
New York Times: A Word of Advice During a Housing Slump: Rent
New York Times: Is it better to buy or rent? (graphical calculator)
The Motley Fool: The Worst Investment Ever
SmartMoney.com: Renting Makes More Financial Sense Than Homeownership
CNN Money: Stocks vs. Real Estate
Priced Out Forever: Renting vs. Purchasing

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Robert Shiller: Fundamentals No, Psychology Yes

By The Tim on September 4th, 2007 at 5:00 PM · 18 Comments

For those of you that are interested in more lengthy reading, a new paper by Robert Shiller (as in Case-Shiller) was released this weekend: Understanding Recent Trends in House Prices and Home Ownership (pdf).

Here are a couple of money quotes:

It does not appear possible to explain the boom in terms of fundamentals such as rents or construction costs. A psychological theory, that represents the boom as taking place because of a feedback mechanism or social epidemic that encourages a view of housing as an important investment opportunity, fits the evidence better.

…

Within the United States, the current boom differs from prior booms in that it is much more of a national, rather than regional, event.

Here’s a great chart that summarizes the foolishness of any argument that home prices are supported by “fundamentals”:

Home Prices vs Rent vs Construction Costs

Enjoy.

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The Mythical Equity Locust

By deejayoh on July 8th, 2007 at 10:56 PM · 58 Comments

There are many arguments to be had between the Seattle Bubble housing bulls and bears, but one belief that seems to be commonly shared is that one of the primary drivers of demand and pricing in our market is a steady stream of rich Californians moving up and driving prices up. The bulls argue that our booming market is fueled by a never-ending flow of California equity, and that this situation is unlikely to end because Seattle is just-so-special. The bears point out that, as the California market slows down, so will the flow of emigrants, which will bring this gravy train to an end.

I counted myself more in the latter camp than in the former. But as someone who is always on the lookout for data to support my viewpoint, I was excited to find out that the State of Washington Office of Financial Management publishes an annual population estimate for the state. In this report, they show immigration trends based on license surrenders by major source of population. The chart below, showing the long-term migration trend from California and Oregon, is the one that caught my eye.

The dips and peaks of California immigration shown on this chart looked suspiciously like the oscillations of our local real estate market. So, I put in a couple of calls to Theresa Lowe, the State Demographer – and soon found myself in possession of the data from which this chart was derived.

From there it was a quick effort in Excel to compare this data to the Case-Shiller Index, the longest running and most accurate gauge of price available for this market. I matched the 12 month rolling total of immigration to the year-over-year appreciation in the index, because looking at annualized data should smooth out seasonal variations. The results of this comparison surprised me.

The left hand side of the graphic below shows California immigration versus home prices. To the naked eye, there does appear to be a relationship. Major peaks and valleys roughly align. However, the right hand side of the same graphic, which uses the same data, tells a very different story. This chart shows a scatterplot of the two time series. As you can see, there is almost zero correlation between the two. The coefficient of correlation is negative 3%, and the R-square is practically zero. Based on this data – there isn’t a slight relationship between the two data series, there is effectively no relationship at all!

Actually, if you look closely back at the chart on the left- you can see why this is the case. At the beginning of the time series, immigration is still climbing right through the biggest drop in home appreciation. Then for the next 7 years (through 1998), immigration tails off, while the rate of appreciation climbed steadily. Both trended the same way from 2001 to 2006, but more recently immigration has held steady while price appreciation has drastically eroded. The two series don’t move together at major points of change, and for a good part of the series they are moving in opposite directions altogether.

Not ready to give up yet, I thought that perhaps most people are like me – and don’t go to get their licenses immediately after moving. They do important things first, like buy houses. So I experimented with shifting the moving-date data data out further – between one and 12 months. That modification only served to make the explanatory value worse – and if anything, ended up showed a greater negative correlation. (in other words, more Californians equals lower home prices!)

So the relationship between the number of Californians moving here and home price appreciation appears to be a bust. What about immigration at large? I ran the same analysis for all immigration to the state versus home prices to see if that showed any relationship. Here, I found a greater correlation. This time, I got a coefficient of correlation of postive 34% and an R-square of 0.116 – which can be interpreted as “moderate” correlation. There is definitely a relationship, but with such a low R-square -the explanatory value of immigration as a driver of home prices is very low.

So it appears, at least based on drivers license data (which should include most, if not all, potential home buyers), there doesn’t appear to be that great of a relationship between immigration and home price appreciation – and that old standby that California Equity is driving our market doesn’t appear to have much substance behind it at all.

The “California Equity Locust” appears to be a mythical beast, whose powers are greatly exaggerated.

Edit: The graph below shows how CA immigration compares to a blended CS index for California, built from weighting SF, LA, and SD in the same way they are in the CS 10 city index. As you can see, there is a very strong negative correlation between these two time series, as many readers have commented.

CA Emigration

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