Asymmetrical Information

Does your summary suggest an impending drop in real estate prices? If that happens, anyone with cash (or good financing) could find bargains as long as rising interest rates don't offset the drop in price.

If I recall, interest rate has a greater effect than principal for long terms like mortgages.

Housing owners are insulated from real estate volatility. If the value of a house goes up, the owners is compensated for their higher implicit rent by owning a more valuable house, while I renter just has to pay a higher rent.

Also, house owners get to enjoy neighbourhood improvements. If the city installs a park in a neighbourhood, houses in that neighbourhood become more valuable and rents go up to match. For a house owner the two cancel, but now they get to consume the park for free, while Renters have to pay to enjoy them

Your point about liquidity risk is correct. But these countervailing forces might make owning more valuable than renting, net.

I'd argue that the risk of disimprovements, or falling values, countervails those, but possibly not in a growing economy. But they're points well taken, anyway.

I have thought for some time that we were a bit over the top in housing prices (eastern MA region) and sooner or later some people might get a post-purchase surprise. Makes me worry about my friends who just bought a $340,000 house, and about all the lawyers I know who are flush with real estate work.

Zimran makes the excellent point that buying a house is a hedge against rising rents.

A point to consider when comparing housing prices to income is that consumption preferences change as we age. It may be that, as people get older and spend less on raucous living, they shift consumption to housing.

It may also be that housing is what I think is sometimes called an "ultra-superior" good. This is a good on which we spend a disproporionate share of any increase in income, so if we get a 10% raise we might increase our housing expense by 15%. So as a society becomes wealthier the ration of housing costs to income would naturally rise.

This is all pretty conjectural, of course, but it's worth noting that from 1970 to 1999 the median size of new one-family houses increased by about 50%, while median household income went up only 25%. Other features of houses improved as well. The percentage with central air conditioning went from 34% to 84%, and garages went from 58% to 87%. So we are, in real terms, buying more house today, and that needs to be considered in judging whether the ratio of prices to income is unreasonably high.

For those with shorter memories, eastern Massachusetts went through a real estate bubble bust back in the early 1990s. I knew a number of people who owned houses where the market value was noticably less than the principal on their home loans.

At least in Atlanta, it has been apparent for some time that housing prices are out of line with rents. The rule we usually use is to charge 1% of the property value per month as rent. When the value of the rental houses rose to the point that the rental market would only permit rent of 0.6% of value per month, we began to sell rental properties.

The only bargains in real estate here right now are in foreclosures. We are setting records for the number of properties in foreclosure each month.

Monthly rent should be 1% of the property value?

Last May, the house in which I lived in West Somerville, MA (double decker, 750 sq ft each), was sold for $450,000. I moved literally next door (double decker, 1,000 sq ft each) at a rent of $1,350 a month. Even if the 2 X 1,000 sq ft house sold for the same as the 2 X 750, that's 0.3%. In fact it would be less.

It sure looks like a bubble to me. Of course, I live in Southern California, one of Greenspan's local "hot spots."

The increase in prices has been sustained by concurrent decreases in interest rates, but that's at an end. Interest rates can't go any lower. And as the flat economy starts to sink in, people are going to stop buying.

It never ceases to amaze that every single bubble is accompanied by legions of commentators claiming that there has been some fundamental change in the way the world works, so the bubble will keep going forever. But, you know, fundamentals are fundamentals. I predict that 1.45 ratio will fall to 1.25 or less within 2-3 years.

As we all know, bubbles always look great until the instant they burst. And when they do, watch out.

In other words, this is not a good time to buy a house. Wait a couple of years.

Then there are these whacky guys that suggest that the rise in real estate costs has more to do with the rise in the cost of complying with regulation than in a shortage of supply.

http://www.newyorkfed.org/rmaghome/econ_pol/2002/702glae.pdf

Another consideration is that it's easier than every before to get into a house. I had to save up 2000$ to buy my present home in 1996, and only by having 1000$ rolled out from the mortgage financing.
I couldn't get into a "zero-down"
mortgage which are avaliable all over the place today. People don't have to save up to get a house. They can also get 2 mortgages(one for the down payment, one for the 80%+ financing on the house) if they can't get a "Z-D" mortgage.

Owning a house has a number of intangible benefits that have nothing to do with it's investment value. I like being able to make changes to my house without having to worry about a landlord. I can redecorate, repaint, remodel, etc... to my heart's content. I can also make repairs and fix things how I want to, not how some landlord wants to to save money. I get a lot of pleasure out of owning my own house.

Life is not about making a series of investment decisions. At some point, you have to get some benefit and use out of what you have.

Having said all that, I'm not ignoring the financial position I'm in and I am trying to make owning a house as inexpensive as possible in light of my goals.

I don't think I'm alone in making home-buying decisions based on considerations other than the investment potential...

Bolie IV

There have also been a number of changes to tax law in the last 5-10 years that encourage people to keep "flipping" their real estate investments. I don't have the specifics on hand but I believe that you can now sell a home and have up to two years to invest the gains tax free into a new property. There used to be limits on the size of the gain and (I think) a six month turnaround to reinvest.

Essentially these changes make real estate investment more profitable.

Also, sitting in an inflated market (northern california) it seems that a lot of people a.) pulled money out of the market in 99/00 and needed to put it somewhere and b.) pulled equity out of their current property via refinancing or taking a 2nd to purchase vacation or investment property.

Then again a good friend of mine in the higher eschalon of real estate finance tells me that they are making a killing on the foreclosures right now.

My understanding regarding the changes in the tax laws is that the two-year rollover requirement for capital gains on the sale of a primary home was the prior law, and that requirement has now been essentially eliminated. Now, gains of up to $250K (or $500K for a married couple) are simply non-taxable, regardless of whether one purchases a new home.

"Then there are these whacky guys that suggest that the rise in real estate costs has more to do with the rise in the cost of complying with regulation than in a shortage of supply."

There is something to this. It may not be the primary reason, but it does have a localized impact. My county is in an "anti-growth" mode and has dumped heaps of additional requirements on property develpers. The result is that people buying into my neighborhood this summer on some newly developed lots will pay 30% for the land that I did just last fall, due in part to the additional costs of developing it for residential construction. Not that I'm complaining or anything as it only helps me since I'm already here!

I'll echo what Zimran said about neighbourhood improvements.

Also, urban housing costs may have risen in the 1990 'cos of the downward trend in urban crime, making urban real estate more attractive. If we see a spike in crime 'cos of demographics, reduced labor force participation, or local goverments reducing policing to save money, or more extensive early release programs, there might be a decline in urban real estate.

Wouldn't you expect housing prices to track income levels (at least in markets where additional supply e.g. urban areas), or even to accelerate faster than income levels, as the falling real cost of other goods increases one's ability to pay more for housing? Wouldn't that suggest that your NPV of rent + tax shield would underestimate the value of the home (r-g on the bottom rather than just r).

(Fortunately for me, my wife is a real estate economist, so we bought in the Bay Area in 1996, and saw our house almost double in value.)

Chris,

Same thing happens here -- for instance, in Boulder, CO...they have rules that constrain growth in housing stock to 1% per year. As a result, buyers typically don't evaluate a property based on the current house, but on the size of the lot. It's not unheard of to see 1/4 acre lots go for $60-$75 even $100 a square. Want an acre lot? Better come prepared to write a seven figure check.

The result is if you're sitting on a 20-30 year old house, no way are you making improvements -- they won't matter. No one's going to buy your house...only the land it sits on. The house gets demolished no matter what condition its in.

For commerical real estate the regulations are even worse...anyone ever try to develop raw land for commercial use? I'd bet those of you who have, probably have never ending stories of the insane costs of regulatory compliance.

And here's this little note from the Washington Post over the weekend that the District area's land use policy directly contributes to sprawl and higher home prices: http://www.washingtonpost.com/wp-dyn/articles/A63192-2003Mar8.html

Excerpts:

More than half of the land surrounding the nation's capital is now "protected" from typical suburban housing development.

Land use plans in 14 counties of Virginia and Maryland limit home builders to no more than one house on every three acres -- with some counties curtailing development even more.

The restrictions are supposedly aimed at preserving farmland, forests and meadows, but in practice have resulted in the loss of "open space."

"Rural" lots of six acres which have been set aside for just one residence, for example, would have accommodated 30 homes under typical suburban zoning.

Also note according to that Fed article I sent earlier that in at least 10 markets, housing prices have declined in the past ten years...do to what? lower regulation.

Still believe in that bubble?

And here's this little note from the Washington Post over the weekend that the District area's land use policy directly contributes to sprawl and higher home prices: http://www.washingtonpost.com/wp-dyn/articles/A63192-2003Mar8.html

Excerpts:

More than half of the land surrounding the nation's capital is now "protected" from typical suburban housing development.

Land use plans in 14 counties of Virginia and Maryland limit home builders to no more than one house on every three acres -- with some counties curtailing development even more.

The restrictions are supposedly aimed at preserving farmland, forests and meadows, but in practice have resulted in the loss of "open space."

"Rural" lots of six acres which have been set aside for just one residence, for example, would have accommodated 30 homes under typical suburban zoning.

Also note according to that Fed article I sent earlier that in at least 10 markets, housing prices have declined in the past ten years...due to what? lower regulation.

Still believe in that bubble?

Can anyone hazard a guess as to when the bubble in D.C. (the city, not the 'burbs) will pop? I want to buy, but I have the neat luck of always getting into something just before the bubble bursts. I'll alert everyone when I buy so they know to get out. The last time I invested substantially, I triggered a global recession.

I'd be fascinated to know what the ratio is for the UK. My guess is that it's stupidly high.

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