The housing bust has been well chronicled elsewhere and I won’t add much to it by summarizing it; let’s assume that readers of this blog know the outlines (and details) of the story. But while everyone has learned the (often bitter) lesson that housing doesn’t always go up, it also comes down, they haven’t fully digested other elements of the financial picture. High LEVERAGE on a flat or declining investment makes the “buy” vs. “rent” even more skewed away from “buying”.
PROS AND CONS OF PURCHASING REAL ESTATE
The case for housing as an investment (positive returns) is generally based on the following elements:
- LAND has value; most of the value in any sale is driven by LOCATION
- The premises atop the land can add some value and entice buyers, especially since buyers often want to move in and don’t want to do a lot of work. Generally enhancements to a property don’t pay off specifically, with rare exceptions
- if you have tenants or renters, you can bring in income for use of your property. If you have renters, improvements to the property are likely to bring in more rental income or increase the likelihood of your property being rented at all
- if you live there yourself, you avoid the “cost” of renting an equivalent property
- the government provides tax deductions on interest for real estate loans, and property taxes, within some guidelines
- the government allows individuals selling real estate used for their primary residence (in general) to exclude a significant portion (or all) of the gains from income tax purposes upon sale
The COST of real estate has the following elements:
- property taxes on the land and the improvements made to structures on the land
- transaction fees paid to governments and realtors when you buy and sell the property
- ongoing maintenance of the land and buildings atop the land (or assessments for condominiums)
- the cost to purchase the land and buildings atop the land
- legal, accounting, and other fees paid tied to your property, or the value of your time in running and managing the property
If you don’t pay cash outright on your property:
- the interest rate on the cash borrowed to pay for the property
- fees to take out the loan or modify the loans’ terms
THE IMPACT OF LEVERAGE
What people generally fail to think about in depth is how LEVERAGED the typical home purchase is. Many buyers are putting down 0-5% on a loan; the FHA and Federal institutions (with the death of many mortgage players the Federal government is often the only game in town) are trying to move up the down payment but housing activists (and builders) are trying to keep it in the 3% range. Note also that many of these buyers have their initial down payments “gifted” to them by the seller; for example if you are a builder, you are indifferent to whether the cost of your house is reduced from $100,000 to $97,000; but you could keep the sales price at $100,000 and “give” the buyer $3,000 for their down payment; this can help them to “qualify” for a loan. In the “old” days 20% down was considered typical; if 20% down was the norm today our housing market would go from ice-cold to a deep freeze.
The problem with any investment with 95% leverage is that you pay a tremendous amount of interest. Your “equity” portion (in this case, your down payment plus the part of your mortgage payment that goes towards principal) is very low; in any sort of down turn your equity value will almost instantly turn negative (meaning that you have to bring money to the closing, and should probably just walk away from your home if you can stomach the horrendous damage this will do to your credit rating).
Leverage MAGNIFIES your returns, upwards and downwards. If you put in $5000 on a $100,000 house and it goes up to $150,000, your $5000 investment has returned $50,000, or a 10x return (awesome!). On the other hand, if your house goes from $100,000 to $90,000, you owe $5000 IN ADDITION to those monthly mortgage payments you need to make for the next 30 years (should you be lucky enough to have a 30 year mortgage, fixed) should you sell it.
I am simplifying here, but if housing is going to stay flat for the next five years or so (a reasonable assumption, although no one knows) then if you are heavily leveraging your house, you probably would be better off walking away and renting. While you can make a case for home ownership based on the value of the tax deductions and the “implied rent” value of not having to pay rent, it probably dies with the high transaction costs, zero value of the “tax free” gain on sale, and the fact that property taxes are going UP for the foreseeable future as cities grope for more revenue (don’t worry – even if the VALUE of your house goes down – the city will increase the RATE that they imply to your value to more than compensate – in fact the highest rates are in the poorest and most down-trodden neighborhoods).
Let’s use a parallel analogy – does it make sense to use borrowed money to invest in the stock market right now? No – you are spending a lot of interest to put down money that seems just as likely to stand still as it is to go down or up. People would look at you like you were CRAZY if you told them you were going to borrow money and “go long” (invest) in the stock market now (I am not talking shorting the market because that analogy does not hold true – by buying a house you are effectively going LONG the market).
When the Federal government pushes banks and their own brethren Fannie and Freddie to do loan modifications (reducing payments) to allow people to “stay” in their homes, it seems like they are doing these families a favor, but more likely they are helping the banks. Virtually all of these buyers are heavily leveraged; their payments are almost all interest. Many of these individuals would be better off walking away, if the home values were to decline modestly or even to stay flat for the next 5 years or so. Paying interest for an asset that is flat or declining is like a double hit in the face; you still suffer the loss, but you pay interest on the “old” value prior to the loss.
Another element that falls apart in these models is the “implied rent” model. People who buy houses generally purchase nicer houses than the average renter; the delta between what people would do if they were renting vs. what they purchase when they buy a house is probably due to the fact that people think housing is a “good” investment so that buying more now just leads to bigger gains later. Don’t forget that rent rates will decline along with the overall economy; many landlords are vying for decent tenants and they are willing to discount rental rates or minimize raises to keep up with expense growth in order to keep “good” paying tenants.
A final, sadder blow to these models is that if you don’t have income coming in the door, the tax advantages are minimized. Even if you had savings and could continue your house payments (mostly interest) while out of work, your reduced income would reduce your tax benefits at a corresponding rate. Without the “value” of the sales gain (the tax exclusion) and the interest deduction, and the value of the sale itself, purchasing a house (with leverage) looks even more like a suckers’ game.
Many models that value real estate have come unglued with the changes to market behavior. Take them all with a grain of salt. Don’t be sold that the positives of real estate outweigh the negatives, and glib realtor talk is often misguided.
In particular, piling leverage atop a zero growth asset class is not a solid financial strategy, even if the government lets you deduct a portion of this on your taxes.
Letting people stay in homes when they have no equity, so they are essentially paying almost 100% interest (no principal reduction) in the forseeable future, isn’t in their best interest, although it seems like you are doing them a favor, because they aren’t “losing” their homes (homes that they have almost no equity in, so they don’t “own” at all). These programs really benefit the bank, because they avoid having to recognize (in accounting terms) a loss on the property, pay transaction costs on the sale, and the legal / maintenance costs of kicking out the “owner” (who really owns nothing). Time is the banks friend; as long as you are paying some interest on this declining asset, maybe the value will turn around and the bank can avoid the loss entirely.
Cross posted at LITGM