Jun072010

Safe Haven Buying: Kool Aid Intoxication of the Housing Bust

You want to buy with your fancy friends? I’m tellin’ you the rally’s got to end. Don’t bring them down. I’ll tell you once more as prices bounce off the floor, they will go down.real_estate_only_goes_up

Prices have crashed nationwide because buying only made sense as long as prices were going up. Once the rally stopped, prices were doomed to crash because the only alternate reason to buy is to save money versus renting. In many areas of the country, prices are low enough that buying makes sense because it is cheaper to own than to rent. Locally, that is not the case.

During the rally kool aid intoxication caused people to buy to capture appreciation, but this is not the only manifestation of kool aid intoxication. Now, some people are buying merely because prices have not gone down. This reason is just as crazy because it isn’t grounded in anything tangible. The herd is seeking protection from the crash, and people are buying in areas simply because other people are buying and holding up prices. This isn’t careful analysis, it is herd-following foolishness.

Back in 2007, many real estate boards had heated arguments between bulls and bears. The bulls would pull up charts showing the huge preceding rally as evidence that prices would go up forever. It is hard to argue with a chart, but past performance is no guarantee of future outcomes, and just as the bears predicted, prices fell off a cliff.

Those who argue for safe-haven speculation make the same argument: prices haven’t fallen therefore they will not fall. The bulls ignore the huge inventory of distressed properties as if it isn’t there. “I’ll believe it when I see it,” they say. How much more obvious does it need to be? We can see years worth of inventory in the foreclosure pipeline, and although we don’t have addresses of the shadow inventory, First American CoreLogic does, and they say 8.4% of Orange County mortgage holders are delinquent on their payments. That doesn’t seem particularly safe to me.

New Trulia Real Estate Index: Rent vs. Buy

Today Trulia announced America’s Top 10 Cities to Buy vs. Rent and the Top 10 Cities to Rent vs Buy.  Trulia calculated the price-to-rent ratio using the average list price compared with average rent on 2 bedroom apartments, condos and townhomes listed on Trulia.com. To create the list, Trulia analyzed the largest 50 cities in America, by population.

Top 10 Cities to Buy vs. Rent

City Price-to-Rent Ratio
1. Minneapolis, Minnesota 8
2. Arlington, Texas 8
3. Miami, Florida 8
4. Fresno, California 8
5. San Antonio, Texas 8
6. Mesa, Arizona 9
7. Jacksonville, Florida 9
8. Phoenix, Arizona 10
9. El Paso, Texas 10
10. Las Vegas, Nevada 11

“At the peak of the real estate bubble, cities like Miami, Phoenix and Las Vegas were not affordable for many. Now the opposite is true,” said Pete Flint, co-founder and CEO of Trulia. “Home sellers in these hard hit areas are forced to lower their prices to compete with all the foreclosures on the market. As a result , these unattainable markets are so affordable it makes better financial sense to buy than rent.”

Yes, it is better to own than to rent in all of the places listed above. I would also include most of Riverside County. Prices in these areas are well below rental parity. Renters in these areas pay a premium for the freedom of movement and lack of liability — as they should. Renting is supposed to cost a premium. Ownership is a burden; taxes, maintenance, debt service, transaction costs, and illiquidity.

Top 10 Cities to Rent vs. Buy

City Price-to-Rent Ratio
1. New York, New York 33
2. Omaha, Nebraska 26
3. Seattle, Washington 25
4. Portland, Oregon 22
5. San Francisco, California 22
6. Oklahoma City, Oklahoma 21
7. Kansas City, Missouri 20
8. San Diego, California 20
9. Cleveland, Ohio 20
10. Dallas, Texas 19

“It is not a surprise to see cities like New York and San Francisco on the ‘Rent’ cities but I was surprised to see areas like Omaha, Oklahoma City and Kansas City on our rental list, “said Flint “We’re not suggesting that it’s unwise to buy in these areas, though – just that it’s significantly more expensive than renting. In many of these cities, even though home buying is much more costly than renting, prices are still much lower than they have been in a long, long time.”

To see the Top 50 City Rent v Buy Index, please click here to download.

Trulia.com’s Rent vs. Buy Index – Interpretation Key

Price-to-Rent Ratio of 1-15: It is much less expensive to own than to rent a home in this city Price-to-Rent Ratio of 16-20: It is more expensive to own a home in this city are The total costs of ownership of a home in this city are greater than the costs of renting, but it might still make financial sense depending on the situation. Price-to-Rent Ratio of 21+: The total costs of owning a home in this city are much greater than the costs of renting.

Definitions: Total costs of home ownership include mortgage principal and interest, property taxes, hazard insurance, closing costs at time of purchase and ongoing HOA dues and private mortgage insurance, where applicable. Total costs of homeownership include an offset for the tax advantages of homeownership, including mortgage interest, property tax and closing cost deductions.

Total costs of renting include rent and renter’s insurance.

I was surprised to see San Diego is still unaffordable. Prices have crashed pretty hard there as they led Orange County on the way up and on the way down. If ownership is still more expensive than rent, that market may experience more pain.

One of the weaknesses of the Trulia method is that it does not take into account changes in affordability based on interest rates. With our current 5% interest rates, price to rent ratios near 20 are close to rental parity.

A Fresh Look at Rent vs. Buy

“Why on Earth would you buy down here when you can rent?” asked a friend of mine in Miami Beach not long ago. “Buying is so over.”

He promptly moved to Manhattan for work reasons–and bought a $1 million loft on the Upper West Side.

Note the typical behavior. People want to buy when prices are up, and turn more wary when they’ve collapsed. Logically it makes no sense.

Mathematically, it makes no sense either. The various strata of the market are spread out based on incomes and amounts borrowed. During the housing bubble, the low end increased in price because first-time homebuyers whose income could only afford a $200,000 were instead given a $500,000 mortgage. The added $300,000 pushed up all prices in the marketplace. The natural spread between the low end and the high end was maintained.

However, during the bust, the low end of the market has collapsed, and the high end has held up because lenders decided to let high-end borrowers squat. The result is a wide dispersion of market prices, far wider than what is normal. Market dynamics indicate that the substitution effect will restore the natural balance of prices by lowing prices at the high end. Since many high-end borrowers are delinquent on their loan payments, the only reason the high end has not collapsed so far is that the supply has been withheld by banks not approving short sales and not foreclosing on squatters.

Research out Thursday adds some hard numbers.

Real estate website Trulia.com has looked at major real estate markets across the country and asked: Is it cheaper to buy, or to rent?

By Trulia’s math my friend was moving in exactly the wrong direction.

Rent in Manhattan: Home prices there are way too high, says Trulia. (Ditto San Francisco.)

Buy in Miami. And Phoenix. And Las Vegas. And most of the other places that have been flattened by the crash. Homes there are cheap compared to rents.

The cross-over point is about 15 times annual rent, the company believes. In other words, as a rough rule of thumb, homes are probably fairly valued in a city when they cost about 15 times a year’s rent. So, for example, if you’re paying $10,000 a year to rent a place, think twice about buying a home that costs more than $150,000. Dean Baker, economist at the Washington, D.C. think-tank The Center for Economic and Policy Research, came to a similar conclusion in research on the subject in recent years. Fifteen times is the historic average, he said.

With 5% interest rates, the crossover is closer to 20 than 15. I used to write often about a gross rent multiplier of 160 (I used monthly rent rather than yearly). As interest rates dropped to 5%, the 160 GRM increased to about 220, a number well above historic norms.

So what’s the multiple in New York right now?

About 32 times, says Trulia. The average two-bedroom condo or townhouse in New York city costs about 32 times as much to buy as it does to rent. Other major markets over 20 times include Seattle (24 times), San Francisco (22 times) and Portland, Ore. (22 times).

On the other hand Miami list prices are now about eight times annual rents, says Trulia. Phoenix is about 10 times and Las Vegas about 11.

The most beaten down markets are where the best deals are to be had.

Trulia’s data need to be taken with some caveats.

Trulia looked at list prices rather than actual transaction prices, so its figures for prices may be too high.

Furthermore drawing the cut-off point at 15 times rents may be on the low side.

Mr. Baker, in conversation yesterday, said that figure assumes that you’re only going to stay in your home for the typical seven years. If you stay a lot longer, he says, the transaction costs of buying and selling become less and less important. That makes owning more attractive.

Nonetheless the Trulia analysis seems directionally correct. Work done by the C.E.P.R. last year came to similar conclusions: Namely that markets like New York and the California coast remained expensive compared to rents, while the hardest hit markets now look cheap.

And Trulia’s research emphasizes two points that are absolutely spot on.

First, homeowners need to look first and hardest at present cashflow. The cult of homeownership made no sense. If renting is much cheaper than buying, think seriously about it.

Second: The markets that have fallen the furthest now look like good places to buy, while those that seem to be “safest” aren’t. As the saying goes: There is no such thing as a “safe” investment, merely one whose risks are not yet apparent. It’s a principle that a lot of people forget time and again.

Write to Brett Arends at [email protected]

When the spread between low-end and high-end prices becomes as extreme as it is now, market forces and the substitution effect will force this spread to tighten — either low-end prices must go up significantly or high-end prices must come down. Both scenarios suggest speculating at the high end is not a good idea.

Safe-haven speculation is kool aid intoxication

In The Great Housing Bubble, I described the three typical beliefs of a bubble:

  1. The expectation of future price increases.
  2. The belief that prices cannot fall.
  3. The worry that failure to buy now will result in permanent inability to obtain the asset.

The belief that prices cannot fall is the fallacy behind safe-haven speculation. This erroneous belief is supported by a host of other fallacies including:

  1. They Aren’t Making Any More Land
  2. Everyone Wants To Live Here
  3. Prices Are Supported By Fundamentals
  4. It Is Different This Time

Doesn’t this all sound familiar? Long-time readers of the IHB used to see this nonsense frequently in 2007 when denial ruled the market. It disappeared for a couple of years, but it is resurfacing again. This is kool aid intoxication, a disease proven to be harmful to speculator’s net worth.

Safe-haven buying is not true investment, it is speculation. It is purchasing property based on faith rather than math. It is following the herd rather than studying and analyzing financial performance. There is no logic to it, but there is the allure of emotional comfort from making the same mistake everyone else does. Everyone who bought in 2006 thought they were going to be rich following the herd. Most of them were slaughtered.

I wish the safe-haven argument were true

In case you didn’t notice, the IHB also operates in the real estate sales market. Since most readers of this blog are interested in Irvine real estate, it would benefit my business greatly to embrace buying in Irvine as a safe haven. I don’t for one simple reason: safe-haven speculating is foolish. Don’t do it. It will cost you dearly.

If you want to buy in Irvine today, know the risks. Prices may go down further (they probably will), and the best case is tepid appreciation or an extended period of flat prices. With the low payments from 5% interest rates, many properties are affordable, but buyers may find themselves underwater while the distressed properties are pushed through the market and interest rates rise. Any buyers planning to buy should expect to stay put for at least five to seven years. If there is any chance of moving three years from now, would-be buyers should rent instead.