Painkiller for Few but Headaches for Many?

It hurts me to post this entry. Some of my well-admired qualities about U.S. economy, its hard work and die-hard optimism, the reason why I aspired to come to the U.S. more than 15 years ago as a student to earn a Ph.D. in engineering, suffered a serious setback during the course of recent events.

The last 4-5 months were painful as the process of "deleveraging" began in our capital markets. Sub-prime was how it started but it has spread to 'prime' and other areas of credit markets, affecting most recently, even a bellweather corporation like GE. Much of this is normal part of business cycle and it is healthy (possibly even cathartic) for the economy to self-reflect once in a while and shake off the excesses, in this case, in the housing market. The country emerges from this process (as it did from several such declines in the past) with a stronger and more efficient economy poised to embark on another long period of growth. But the deep credit crunch was caused by the excesses of too much and too easy credit in the last few years, so the severity of pain could have been mitigated but the pain itself could not possibly be avoided.

Enter the politicians or as a recent book called them the homopoliticus. From Japan to Jamaica, from Uruguay to United States, they are often one of a kind species. A wide range of policy makers and influential officials, ranging from the Federal Reserve to Presidential-hopefuls are stampeding one another to bail out the very individuals, banks and other Wall Street institutions that contributed to the recent boom-and-bust cycle. Responsible homeowners, investors and institutions are left wondering why they are suffering the pain for the excesses caused by a few. What do I tell my son, that America is a land of no consequences? That you can engage in fiscally irresponsible behavior all you want and when the going gets tough, Uncle Sam will bail you out?

When I last blogged about the craziness of the Washington DC real estate market after I first moved into this area, I thought I was making a responsible decision by not buying at the peak while feeling sorry for those who were stretching way beyond their means to buy obscenly priced homes. While I probably did the right thing, I did not imagine that even as a bystander, I would pay a price one day. As a renter, I did not suffer any home value deterioration as prices in our area suffered double digit declines and are going down further. However, the impact was still felt by my portfolio, which suffered along with the rest of the U.S. equity market over the past few months. Of course, homeowers suffered a 'double whammy' with the declining home values and equity markets. Many who bought a house in 2005 or later are facing an 'upside down' mortgage and some of them, though eminently credit-worthy, have locked in bloated monthly payments on their 30-year mortgages as the massive premium they paid haunts them for years to come.

Financial responsibility seems to be increasingly rare in America and unreasonable profligacy is ever-present, egged on by the populist political cries and mindless bailout policies. What happened to the America that rewarded hard work and responsibility while refusing to become a 'welfare state' like much of Europe is? The pain of the credit cruch is now unfairly borne by responsible individuals and well-managed institutions, in the form of serious erosions in their wealth and currency values, and whose only fault is to live in the same neighborhood or city as the profligate few.

The Worst Investment Ever?

I often like The Motley Fool for their folksy, no-nonsense style of writing. Their writing style is probably inspired by that of the legendary investor Warren Buffet (who can forget his Time article couple of years ago on Thriftville vs. Squanderville? It should have been a wakeup call to the American politicians to do something about the balloning U.S. trade deficit but alas!). Okay, I digress.

http://biz.yahoo.com/fool/070518/117951154741.html?.v=1&.pf=real-estate

Anyway, the above article is an attempt at comparing a primary home as an investment versus other financial asset classes. While the home has historically never been a great investment (over 80 years of data show that home prices generally keep pace with inflation and do marginally better in some cases) versus stocks, calling it the "worst investment ever" is extreme even for me, who has written articles against real estate in my blog. I can certainly think of several investments that may qualify for the ignominious title than a primary home.

While the article certainly makes valid points, it ignores a fundamental premise of investing. The comparison between primary home to stocks is apples-to-oranges, because most people don't think of stocks or other asset classes as an alternative to buying a primary home. It is fair to compare the financial assets with investment real estate (such as REITs, income-generating properties, time-shares or even vacation homes) but a primary home is bought with the sole purpose of living in it. No other asset class provides an acceptable substitute!

While I am not in favor of real estate in these (still) overpriced market conditions, purchasing an affordable primary home for those who plan to stay in a location for at least 10 years is generally a good decision, even financially. A balanced article would have advised its readers to purchase the least expensive primary home that one needs for one's family and put the rest of the monthly savings to work in the asset classes that return a higher yield, like stocks. To call the primary home the "worst investment ever" is like saying, having a child is the "worst financial decision" a family can make.

Owner Pride but No Renter Envy

Friends, this has been tugging at my heart for a long time. Ever since I moved to the Washingon DC area during the peak of the real estate bubble in 2005, I have been recommended, advised, urged and sometimes even warned about my foolish decision to rent.

My wife and I rented an older, but renovated and spacious (1200 sq.ft.) 2 bedroom condo for $1200 per month in 2005. I was elated by what a deal I got when similar condos were going for $1600+ in most places along the DC Metro line. With just a 45 min. commute, you can't do a whole lot better in the DC metro area. The condo was also available for sale at that time and the owner was willing to 'sacrifice' it to me for a mere $330,000. I said, no thank you!
Since the owner was in a sacrificial mood, I figured that at a rental yield of just 4.4% (1200x12/330,000), my renting the condo will be the true 'sacrifice' of the owner!

While I was feeling pretty good about my rental decision, my wife and I were subjected to the "Joneses" effect by many of our well-meaning friends and colleagues. We were told that buying a home in the DC metro area (DC, Southern MD, Northern VA) is a "no lose" proposition. What, with very low unemployment, plenty of high paying professional jobs, and above all, the security of a stable and expanding federal government will ensure real estate will always be in demand in DC. It appeared to be a compelling argument but boy, are we glad we did not succumb to it. When the market started to turn south in 2006, our friends again warned that by continuing to rent, I was passing up on a "rare" to a "once in a lifetime" opportunity to buy DC area real estate at 'bargain' prices.

My wife and I moved to a bigger condo in mid-2006, also on rent, because the owner of the previous condo pressured us to buy it for a special price of $300,000. The owner was clearly worried that she will be stuck with a condo she cannot sell in a down market but was adamant that $300K was a 'bargain'.

Fast forward to March 2007. Many of our friends who bought over-priced townhomes and single family homes in 2004-2005 period, are now sitting on essentially flat to declining home values compared to their purchase price. Once you figure in all the costs of selling, many of them are in the red. Of course, they are not selling, but there is one change the sobering market reality has brought to them. None of them now advise us about buying a home; I figure they are busy worrying about their own home values. Some are silently wondering if their jobs will remain stable enough to ride out the downturn. Others are hoping that this month will be the bottom of the market and the turn is just on the horizon. This is what I have been hearing for the last 6 months but the bottom is nowhere to be seen. The sub-prime mortgage craziness combined with higher interest rates and the 'Houdini act' pulled by many buyers (what else will you call it when sellers frequently complain "where are the buyers?") has started to unravel the 'invincible' DC real estate market. I was tempted to quote a Titanic analogy to my friends. Titanic had another name, frequently used by its builders and upper-deck patrons - "the unsinkable ship".

Unfortunately, for those who bought homes in 2004 and later, the story is getting worse. Not only did they buy near the market peak, the so-called 'bottom' is far away. Nearly a million mortgages will re-set their interest rates in 2008, meaning the true impact of higher monthly mortgage payments is yet to be seen. Imagine an already-stretched family having bought a home they can barely afford having to suddenly fork over an additional $300-$800 per month. I feel sad for them but the real estate sharks are getting ready as they are starting to smell blood here....a long time real estate investor I know is starting to salivate over the upcoming defaults, bankruptcies, repossessions, tax lien sales, auctions and all the ugliness that accompanies a painful real estate crash.

Those who bought DC area homes in 2003 and earlier may do fine because they are sitting on a mountain of gains, which is a nice cushion to ride out the continuing value erosion. But real estate madness is the same as stock market madness. A large number of real estate buying occurred in 2004 or later, when there was fear of missing the real estate party. When everybody is buying, that is precisely the wrong time to buy. So, renters who want to put down roots in the national capital region, hold on but get ready. You will have your pick in 2008!

My advice to owners: Understand what a home really is, a place to live. Enjoy the benefits of owning a nice place to live. But don't buy into the press that your home is an investment that will always payoff. Most of all, don't advise renters to buy just because you did. You don't see renters advising you to sell your home during market peaks.

To those who are interested: My previous condo owner is still struggling to sell her condo. I saw yesterday that the condo is now priced at $265,000 (20% decline from the peak) and is still going down! She had bought it for $240,000 in 2004. With sales commissions, taxes and other maintenance costs (including nice interior renovation - must have cost in the neighborhood of $10K), can you guess if she will make any profit even if she sold it at $265,000?

(Un)real Estate

I received this forwarded email from a good friend of mine. It had everything I wanted to say about real estate "investments" that I found no reason to make any corrections! With the continuing crash (which the pundits call 'soft landing', yeah, you better have a cushion attached to your butt!), this article is timely and de-bunks the myth of owning real estate in the U.S., especially in the East/West coasts and other regions that saw a dramatic rise in home prices in the first half of this decade. Some of the points may even apply to the bubbly real estate markets in the many of the cities outside the U.S.

Wonder if house prices will continue to fall? Real estate related businesses disagree, because they don't make money if buyers do not buy. These businesses have a large financial interest in misleading the public about the foolishness of buying a house now.

Buyers' agents get nothing if there is no sale, so they want their clients to buy no matter how bad the deal is, the exact opposite of the buyer's best interest. Agents take $100 billion each year in commissions from buyers. Agents claim the seller pays the commission, but always fail to mention that the seller gets that money from the buyer.There are good buyer's agents who really believe they are helping the buyer, but they often in denial about their conflict of interests.

• Mortgage brokers take a percentage of the loan, so they want buyers to take out the biggest loan possible.
• Banks get origination fees but sell most mortgages, so they do not care about the potential bankruptcy of borrowers, and will lend far beyond what buyers can afford. Banks sell most loans to Fannie Mae or Freddie Mac. The conversion of low-quality housing debt into "high" quality Fannie Mae debt with the implicit backing of the federal government is the main support for the housing bubble. That is ending as Fannie Mae shrinks.Even for the "jumbo" loans that banks cannot sell to Fannie Mae and Freddie Mac, they have a motive to lend beyond what buyers can afford. Banks designate interest as "income" whether they receive it or not. As long as borrowers do not actually default, additional interest owed is counted as bank income, and banks can claim higher "earnings". That is going to end when those borrowers cannot even make the principal payments.
• Appraisers are hired by mortgage brokers and banks, so they are going to give the appraisals that brokers and banks want to see, not the truth.
• Newspapers earn money from advertising placed by realtors, so papers are pressured to publish the realtors' unrealistic forecasts.Worse, realtors have a near-monopoly on sale price information, and newspaper reporters never ask realtors hard questions like "how do we know you're not lying about those prices?" The result is an endless stream of stories which quote David Lereah of the NAR saying it's a good time to buy, as if there were some news in hearing salesmen say that you should give them your money. To be optimistic about this market takes a real estate "professional". Everyone else speaks the truth too clearly.As one reader writes: "The advertiser-paid media continues to interview commission-based salesmen who try to cover up the crash and hope to bring a few more young suckers into massive debt for houses that are falling in value."
• Owners themselves do not want to believe they are going to lose huge amounts of money.What are their arguments?

1. "Renting is just throwing money away."FALSE, renting is now much cheaper per month than owning. If you don't rent, you either

* Have a mortgage, in which case you are throwing away money on interest, tax, insurance, maintenance.

* Own outright, in which case you are throwing away the extra income you could get by converting your house to cash, investing in bonds, and renting a place to live. This extra income could be 50% to 200% beyond rent costs, and for many is enough to retire right now.

Either way, owners LOSE much more money every month than renters. Currently, yearly rents in the Bay Area are about 2% of the cost of buying an equivalent house. This means a house is returning about 2%, and it is a bad investment. Pretty much any other investment is better. If you don't like risk, put your money in US Treasuries at 5%.In effect, landlords are loaning the purchase price of a house to their tenants at a 2% interest rate. This is a fantastic deal for renters. When it is possible to borrow a million dollar house for 2% yearly rent at the same time a loan of a million dollars in cash costs 6% interest, plus 1% property tax, plus 2% maintenance, something is clearly broken. I would think every rational businessman would take the extreme discount renters are enjoying.

2. "There are great tax advantages to owning." FALSE. The tax advantage is not significant compared to the large monthly loss from owning. For example, it is far cheaper to rent in the San Francisco Bay Area than it is to own that same house, even with the deductibility of mortgage interest figured in. It is possible to rent a good house for $1800/month. That same house would cost about $700,000. Assume 6% interest, and we can see that a buyer loses at least $4,936 per month by buying. Renting is a loss of course, but buying is a much bigger loss.Renting:Rent: $1,800----------------------Monthly Loss: $1,800

Buying:Property Tax: $486 ($729 per month at 1.25% before deduction, $486 lost after deduction.)Interest: $2,333 ($3500 per month at 6% before deduction, $2333 lost after deduction.)Other Costs: $450 (Insurance, maintenance, long commute, etc.)Principal loss: $1,667 (Modest 3% yearly loss on $700,000. Reality will be much worse.)----------------------Monthly Loss: $4,936

This is a very conservative estimate of the loss from owning per month. If you include a realistic decline in house prices, as in this rent-vs-own calculator, you'll see that owning right now is a very poor choice. Here's a more optimistic calculator which ignores price changes entirely. House value losses will stop eventually, but it could take 5 or 10 years to bottom out.Remember that buyers do not deduct interest from income tax; they deduct interest from taxable income. Interest is paid in real pre-tax dollars that buyers suffered to earn. That money is really entirely gone, even if the buyer didn't pay income tax on those dollars before spending them on mortgage interest. Of course the creeping AMT will eliminate the mortgage interest deduction soon anyway. Ah, you didn't know that there are limits to the mortgage interest deduction and that more and more people are hitting that limit every year?Buyers do not get interest back at tax time. If a buyer gets an income tax refund, that's just because he overpaid his taxes, giving the government an interest-free loan. The rest of us are grateful.If you don't own a house but want to live in one, your choice is to rent a house or rent money to buy a house. To rent money is to take out a loan. A mortgage is a money-rental agreement. House renters take no risk at all, but money-renting owners take on the huge risk of falling house prices, as well as all the costs of repairs, insurance, property taxes, etc. Since you can rent a house for 2% of its price, but have to pay 6% to borrow the equivalent amount of money, it is much cheaper to rent the house than to rent the money.Then there's earthquake insurance. It's really expensive, so most people just skip it and risk everything on the chance that no earthquake will happen.

3. "A rental house provides good income."FALSE. Rental houses provide very poor income in the Bay Area and certainly cannot cover mortgage payments. In the best case, a $1,000,000 house can be rented out for at most $25,000 per year after expenses like property tax and repairs. The return is therefore 2.5% with no liquidity and a huge risk of loss.If the owner were to sell that rental house for a million dollars, he could get about 5% with no risk, no work, and no state income tax by buying a US Treasury Bond. And the money would be liquid and secure.That said, there are many parts of the US where it does make sense to buy because mortgage payments are less than rents in those areas. They are generally rural areas away from the coasts, and have not seen the same bubble that the coasts have.

4. "Impending regulation changes to allow 40 and 50 year mortgages will fix everything."FALSE. 40 and 50 year mortgages will probably not be paid back, since a large number of borrowers will die before 40 or 50 years are up. This makes these loans a bad idea from the lender's point of view. It also doesn't make sense from the borrower's point of view, since almost of their payment will go to interest for most of the life of the loan. This makes it almost the same as renting - except that it's 2 or 3 times more expensive!

5. "OK, owning is a loss in monthly cash flow, but appreciation will make up for it."FALSE. Appreciation is negative. Prices are going down in most places, which just adds insult to the monthly injury of crushing mortgage payments.

6. "House prices never fall."FALSE. San Francisco house prices dropped 11 percent between 1990 and 1994. Buyers in SF in 1990 did not break even in dollar amounts until about 1998. So those buyers effectively loaned their money to the sellers for 8 years at no interest, losing all the while to inflation. With inflation, 1990 buyers truly broke even only about the year 2000, ten years after buying.Los Angeles' average house plummeted 21 percent from 1991 to 1995, and of course there have been many similar crashes all around the US. The worst may have been after the oil bust in the 1980's, when Colorado condos lost 90% of the value they had at their peak.

7. "House prices don't fall to zero like stock prices, so it's safer to invest in real estate."FALSE. It's true that house prices do not fall to zero, but your equity in a house can easily fall to zero, and then way past zero into the red. Even a fall of only 5% completely wipes out everyone who has only 10% equity in their house because realtors will take 5%. This means that house price crashes are actually worse than stock crashes. Most people have most of their money in their house, and that money is highly leveraged.

8. "We know it will be a soft landing, since it says so in the papers."FALSE. Prices could fall off a cliff. No one knows exactly what will happen, but the risk of a sudden crash in prices is severe. As Yale professor Robert Shiller has pointed out, this housing bubble is the biggest bubble in history, ever. Predictions of a "soft landing" are just more manipulation of buyer emotions, to get them to buy even while prices are falling.Most newspaper articles on housing are not news at all. They are advertisements that are disguised to look like news. They quote heavily from people like realtors, whose income depends on separating you from your money. Their purpose is not to inform, but rather to get you to buy.

9. "The bubble prices were driven by supply and demand."FALSE. Prices were driven by low interest rates and risky loans. Supply is up, and the average family income fell 2.3% from 2001 to 2004, so prices are violating the most basic assumptions about supply and demand.

10. "They aren't making any more land."TRUE, but sales volume has fallen 40% in the last year alone. It seems they aren't making any more buyers, either.

11. "As a renter, you have no opportunity to build equity."FALSE. Equity is just money. Renters are actually in a better position to build equity through investing in anything but housing.

* Owners are losing every month by paying much more for interest than they would pay for rent. The tax deduction does not come close to making owing competitive with renting.

* Owners are losing principal in a leveraged way as prices decline. A 14% decline completely wipes out all the equity of "owners" who actually own only 20% of their house. Remember that the agents will take 5%.

* Owners must pay taxes simply to own a house. That is not true of stocks, bonds, or any other asset that can build equity. Only houses are such a guaranteed drain on cash.

* Owners must insure a house, but not most other investments.

* Owners must pay to repair a house, but not a stock or a bond.

12. "If you rent you are a buyer. You are just buying it for someone else."FALSE. It may be true that rent covers mortgage payments in some places like South Dakota, but not in any of the markets that have shot up in the last few years. Rents are much less than mortgages in most places now. No landlord buys with the intention to rent out in California because that's not profitable. The owner is generously subsidizing the renter, a wonderful thing for renters during this crash.

13. "If you don't own, you'll live in a dump in a bad neighborhood."FALSE. For the any given monthly payment, you can rent a much better house than you can buy. Renters live better, not worse. There are downsides to renting, such as being told to move at the end of your lease, or having your rent raised, but since there are thousands of vacant rentals, you can take your pick and be quite happy renting during the crash. There are similar downsides to owning anyway, such as being fired and losing your house, or having your interest rate and property taxes adjust upward.You may worry about being forced to move, but the law says the landlord has to offer you a one year lease at a minimum, and they'll probably be delighted to offer you a two year lease and give you a discount for that. Other people want the mobility that renting affords. Renters can usually get out of a lease and move anywhere they want within one month, with no real estate commission.It is much easier and cheaper to rent a house in a good school district than to buy a house in the same place.A fun trick to rent a good house cheap: go to an open house, take the real estate agent aside, and ask if the owner is interested in renting the place out. Often, desperate sellers will be happy to get a little rental cash coming in and give you a great deal for a year or two.The biggest upside is hardly ever mentioned: renters can choose a short commute by living very close to work or to the train line. An extra two hours every day of free time not wasted commuting is the best bonus you can ever get.

14. "Owners can change their houses to suit their tastes."FALSE. Even single family detached housing is often restricted by CC&Rs and House Owner's Associations (HOAs). Imagine having to get the approval of some picky neighbor on the "Architectural Review Board" every time you want to change the color of your trim. Yet that's how most houses are sold these days.In California, the HOA can and will foreclose on your house without a judicial hearing. They can fine you $100/day for leaving your garage door open, and then take your house away if you refuse to pay.

15. "If and when the market goes south, you can walk away."FALSE. If you have a single loan with just the house as collateral, it may be a "non-recourse" loan, meaning you could indeed walk and not lose anything other than your house and any equity in it (along with your credit record). But if you refinance or take a "home equity loan", the new loan is probably a recourse loan, and the bank can get very aggressive, not to mention what the IRS can do. A reader who lived through the 1989 housing crash in LA pointed out the following nasty situation that can happen:

* Let's say you buy a house for $600,000, with a $500,000 mortgage.

* Then the house drops in value to $400,000, you lose your job, or otherwise must move.

* If you can't make your payments, the bank forecloses on you and nets $350,000 on the sale of your house.

* The bank's $150,000 loss on the mortgage is "forgiveness of debt" in the eyes of the IRS, and effectively becomes $150,000 of reportable income you must pay tax on. It is true that buyers who put zero down and have nothing invested in the house are much more likely to walk away. The large number of new uninvested buyers increases the risk of a horrifying crash in prices rather than a "soft landing".