Friday, December 22, 2006

Who Disagrees That 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.

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.

It remains true, however, that banks are not required to get any appraisal at all for loans they sell to Fannie Mae or any government-guaranteed loans. This encourages banks to overstate values and sell bigger loans to Fannie, pushing the risk onto taxpayers.

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 MLS, so papers are pressured to publish the Realtors'® unrealistic forecasts.

Worse, MLS have a near-monopoly on sale price information, and newspaper reporters never ask MLS 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.

Owners themselves do not want to believe they are going to lose huge amounts of money.

What are their arguments?

"There are great tax advantages to owning."
FALSE. It is much cheaper to rent a house in most places than to own it. 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.

Rent: $1,800
Monthly Loss: $1,800

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.

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.

"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. 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 better than 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.

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

"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 % 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.

"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 4% completely wipes out everyone who has only 10% equity in their house because Realtors® will take 6%. 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.

"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.

"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.

The site has data for Santa Clara County for the years 2000-2003 which shows that the number of housing units went up at the same time that the population decreased:

year units people
2000 580868 / 1686474 = 0.344 housing units per person
2001 587013 / 1692299 = 0.346
2002 592494 / 1677426 = 0.353
2003 596526 / 1678421 = 0.355

So housing supply in Santa Clara County increased 3% per person during those years. There is an oversupply compared to a few years ago, when prices were lower.

At a national level, there is a similar story in the years 2000 to 2005:

2000 115.9M / 281M = 0.412 housing units per person
2005 124.6M / 295M = 0.422

At a national level, there is 2.4% more housing per person now than in 2000. So national prices should have fallen as well.

The truth is that prices can rise or fall without any change in supply or demand. The bubble was a mania of cheap and easy credit. Now the mania is over.

"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.

"It's pointless to pay rent in the long run."
FALSE, there is a great point in paying rent in the long run -- you can make much more money investing in anything other than housing and then go back and buy a house for cash. 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.

"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.
* Owers 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.
* Owers 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 6%.
* Owers 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.
* Owers must insure a house, but not most other investments.
* Owers must pay to repair a house, but not a stock or a bond.

"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.

"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, but since there are thousands of vacant rentals, you can take your pick and be quite happy renting during the crash.

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.

"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. There's a good HOA blog here.

"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".

"The house down the street sold for 25% over asking, and that proves the market is still hot."
FALSE. Realtors® try to create the false impression of a hot market by deliberately "underpricing" a house. Say a seller's agent knows that house will probably go for $500,000. He places ads asking $400,000 instead. (Bait-and-switch is illegal when selling toasters, but apparently not when selling houses.) The goal is to first of all prevent buyers from knowing what a realistic price is, and secondly to get buyers to blindly bid against each other. There are four players in this game and three of them are against the buyer: the seller, the seller's agent, and the buyer's agent. Yes, the buyer's own agent works against the buyer, because there is no commission if there is no sale. There's a saying in Las Vegas: "There's a patsy in every game, and if you don't know who the patsy is, you're it."

If you want to prove your agent is not on your side, ask to see houses "for sale by owner" or houses listed by discount brokers. If the agent cannot make a commission, you will not be told about the house.

There is a way around the conflict of interest inherent in being a buyer's agent: let the seller's agent be your agent too, just for that one house he's trying to sell. Then the seller's agent has a big motive to lower the price, because he will get double the comission if you buy it rather than some buyer with his own agent.

Update: the underpricing game is now over. You are free to bid far lower than the asking price. You might be surprised to find out how desperate the sellers are.

"I was lucky that my Realtor® told me to increase my bid by $100,000. Otherwise I would have lost, because my Realtor® knew about a secret bid $90,000 above mine."
FALSE. Your agent gets paid nothing if you don't buy the house, and he gets more if you waste more money by bidding too high. Those are two big motives to invent false bids.

"The MLS proves things are great."
FALSE. All sorts of funny things happen in the MLS (Multiple Listing Service, a private database controlled by real estate agents). For example, if a house just doesn't sell, Realtors® can remove its record in the MLS so that you cannot see that it failed to sell. Then the house comes back on the market at a lower price, and unsuspecting buyers think it's on the market for the first time. Their Realtor® can "prove" it's a new listing by showing the MLS record to the buyer: "See, here's the listing date, just came on the market. Better hurry and buy it, this one is hot."

There is nobody checking that the MLS shows true transaction prices. The MLS prices are often just wrong.

Furthermore, the MLS will not list any house for sale by owner or for sale through a discount broker, except perhaps those listed by Help U Sell. Those cheaper prices are just not in the system, because if you save money, they lose money.

"The Bay Area is a special place that will always be expensive."
TRUE, but it was just as special when it was half as expensive ten years ago, so being special does not account for the run up in prices.

Many people are confused about the difference between high prices and increasing prices. Prices are high, but they are not increasing. They are falling. Falling prices make housing a bad investment.

"Rich Chinese (or Europeans, or Arabs) are driving up housing prices."
FALSE. The percentage of US houses bought by rich foreigners is tiny. Furthermore, American housing is clearly a bad investment at this point. Foreigners can just wait and watch both the dollar and American housing continue to fall, and then buy for much less in a few years. Rich foreign investors are not dumb enough to buy into a badly overpriced market, but your broker is hoping that you are.

"There's always someone predicting a real estate crash."
TRUE, yet irrelevant. There are very real crashes every decade or so. Even a broken clock is right twice a day.

"But housing was high when interest rates were 21%, so higher interest rates don't matter."
FALSE. Inflation was much higher then, so fixed debt was easier to pay off with increasing salaries. Now we have adjustible mortgages and stagnant salaries.

House price increases exactly mirror the increase in mortgage debt. According to the Washington Times: "Consumers have doubled their mortgage debt from $3.5 trillion to $7 trillion since 1996, borrowing and spending profusely on the assumption that house prices will keep rising." So the increase in house prices is not backed by assets. It's backed by debt. The debt in turn is backed by the houses. It's just smoke and mirrors.

"Local incomes justify the high prices."
FALSE. Most bankers use a multiple of 3 as a "safe" price to income ratio. We are well beyond the danger zone, into the twilight zone. The price to income ratio is currently around 10. Another rule of thumb is that a fair house price is less than 200 times the monthly rent. If a house rents for $2000 per month, then a fair price must be less than $400,000.

"Look, housing continued to rise after the 2001 stock market crash, so it will always rise."
FALSE, consider the turkey in the farmer's barnyard. He thinks the farmer will always come feed him and not ask for anything. Then Thanksgiving comes. Whack. Past performance is no indication of future results.

"Rent can go up, but a 30-year fixed mortgage payment cannot."
TRUE, but irrelevant. House owners lose even with a fixed mortgage, because the price of a house falls as interest rates go up. Most people want to sell within 7 years of moving in, and many have to sell because of job loss, illness, or divorce. No one can afford what the owner paid for it, so the owner has to take a large loss. Renting it out will not come close to covering the mortgage. Bay Area rents have fallen 23% in the last 4 years.

"You have to live somewhere."
TRUE, but that doesn't mean you should waste your life savings on a bad investment. You can live in the same kind of house by renting during the crash. A renter could save hundreds of thousands of dollars, not only by paying less every month, but by avoiding the devastating loss of his downpayment. In fact, it's currently cheaper to live in a nice hotel in most parts of the US than it is to make mortgage payments in the Bay Area.

"Newspaper articles prove prices are not falling."
FALSE. The numbers in the papers are not complete and have murky origins. Those prices are "estimated" from the county transfer tax and making that tax public record is optional. A buyer who does not want you to see how little he paid has only to ask to put the transfer tax on the back of the deed and it will not show up on computer searches of the deed, which show only the front. Others voluntarily pay more tax than they have to, in order to inflate the apparent price to fool the next buyer. At a tax rate of about $1 per thousand of sale price, as in San Mateo county, you have to pay only $100 extra tax to make your purchase price look $100,000 higher.

Even though you can in theory go to your county building and get sale price information, in reality the county will give it to you in a painfully slow and inconvenient way. For example, in Redwood City's county building there are PC's where you can look at data for any particular house, but you cannot print, you cannot save to a floppy disk, you cannot email data out. All you can do is write things down manually, one at a time. And that's how real estate interests like it. Your elected representatives are serving them, not you.

Supposedly impartial sources like Dataquick are paid for entirely by people with a large financial interest in "proving" that prices are not falling, like Realtors. This makes it unwise to take their numbers at face value.

For the obviously biased sources like the National Association of Realtors, you can be sure that their sales price numbers do not include the effective price reductions from "incentives" like upgrades, vacations, cars, assumed mortgages and backroom cash rebates to buyers.

"My appraisal proves what my house is worth."
FALSE. "An appraisal in its typical residential real estate form is little more than a comparative analysis conducted by someone with no skin in the game offering confirmation that other lemmings are paying too much for their houses as well." -from an article on

Amazingly, government house price measures do not include houses with mortgages greater than $417,000. This excludes well over half of all houses in California. So the government can report a slight price rise, but fail to mention that prices actually fell for the other 60% of houses in California.

"It's not a house, it's a home."
FALSE. It's a house. Wherever one lives is home, be it apartment, condo, or house. Calling a house a "home" is a manipulation of your emotions for profit.

As a MLS said to me, "a house is a wooden box that sits out in the rain and slowly rots. No one would buy in this market if they really thought about how much pain it's going to cause them in the long run. That's why we have to sell them a home, not a house."

Also, MLS is a not a real word. It's a registered commercial term. Note the "®" symbol.

"If you don't buy now, you'll never get another chance."
FALSE. This argument was also popular in 1989 in Los Angeles, just before a huge crash. It's silly. If no one like you ever gets another chance to buy a house, then you will not be able to sell your house in a few years either, because there will be no more buyers like you ever again.

Here is a great quote from June Fletcher, a Wall Street Journal reporter, that says it all: "The real issue isn't whether you will be stuck being a renter all your life, she says. Its whether you'll get so scared about being shut out that you'll buy at the market's peak and be stuck in a property you can't afford or sell."

"Property in the Bay Area is a luxury good, and so will be less affected by economic downturns."
FALSE. 82% of last year's Bay Area mortgages were ARMs, and ARM loans are not taken out by the rich. People on the border of bankruptcy take out ARMs because they can't afford fixed rate loans. The rich don't have loans at all.

Many of these ARM loans have exceptionally deadly repayment terms, and so are known as "neutron mortgages". Like the neutron bomb, they destroy people, but leave buildings standing. They are also known as "suicide loans".

"Housing will be permanently higher since downpayments are now obsolete."
FALSE. The current wave of defaults is making downpayments suddenly seem like a good idea again. Lending standards are already improving.

"House ownership is at a record high, proving things are affordable."
FALSE. The percentage of their house that most Americans actually own is at a record low, not a high. We do have a record number of people who have title to a house because they have dangerous levels of mortgage debt, but that is no cause to celebrate.

"California houses are worth whatever fools will pay for them."
FALSE. At interest rates of 6%, houses are worth at most 17 times what you can rent them out for per year. (1 / 0.06 = 16.7) You can get 6% with no work and very little risk in the bond market, so why accept less than 6% return (called rent) on your capital in the very risky housing market? Since typical house rent is about $24,000 per year in the Bay Area, the typical house is worth about $408,000, not $700,000.

Another rule of thumb is that houses are worth about three times the median household salary of an area. Let's say four times the median salary because this is a desirable area. Since the median household income is under $70,000, the value of a typical house is under $280,000. Again, not even close to $700,000.

"Limited land means prices will always go up."
FALSE. Japan has a much more severe land shortage than America, but that hasn't stopped prices from falling for 14 years straight. Prices in Japan are now at the same level they were 23 years ago. If we really had a housing shortage, there would not be so many vacant rentals.

"It would take another 911 terrorist attack or a major earthquake that wipes out this area in order for the price to fall by 50%."
FALSE. Even with a 50% decline in prices to $350,000 or so, the median price in the Bay Area will still be roughly double the median price in most of America, and the median Bay Area household income of about $70,000 will still not be sufficient to buy a house. So a 50% decline is well justified by the fundamentals.

"Housing is a hedge against inflation, so you should buy now anyway."
FALSE. Interest rates go up with inflation, and higher interest will be the last straw for ARM mortgages in the Bay Area. Their defaults and foreclosures will drive down the cost of housing for everyone else around here. Remember that 82% of recent Bay Area mortgages were adjustable. There is little chance that salaries of ARM owners can keep up with inflation because of two billion people in India and China who would be happy to do their jobs for much less money.

"Houses always increase in value in the long run."
FALSE. House values are actually constant. Adjusted for inflation, prices in Holland, for example, rose less than one quarter of one percent annually in the 350 years since their tulip bubble. Warren Buffett and Charles Schwab have both pointed out that houses don't increase in intrinsic value. Unless there's a bubble, house prices simply reflect current salaries and interest rates. Consider a 100 year old house. Its value in sheltering you is exactly the same as it was 100 years ago. It did not increase in value at all. It did not spontaneously get bigger, or renovate itself. Quite the opposite - the house drained cash from its owners for 100 years of maintenance and taxes. Its price went up about as much as salaries went up.

My grandmother always used to complain about the cost of milk. "Why, when I was a girl, a gallon of milk cost a dime! Just look at how much people are overcharging for milk now." I asked her how much people got paid back then. "Oh, about $15 a week", came the reply. Hmmm, sounds very much like the reasoning people use now when they talk about how much their father's house appreciated "in the long run" without considering that salaries rose a proportional amount.

"Maybe we should just accept that we missed out on a great opportunity to get into the real estate in the past N years."
FALSE. Did we all miss out on a great opportunity to get into the stock of or other Internet companies with no business model? The real question is what is likely to happen in the next few years according to fundamental economics. The answer is a huge crash. The last guy to buy into the bubble will get hurt the most.

"You failed to factor in emotion. More houses are sold on emotion than will ever be sold based on perceived value. They buy all they can afford plus."
FALSE. Buyer emotion doesn't matter at all to the lenders, not on the way up or on the way down. Most people will borrow more than they can afford, but only if the lender goes along. The whole thing was a party of cheap and easy credit. When the credit machine gets sober again, millions of people are going to be ruined. Foreclosure rates are already going up exponentially.

"I just want to own my own house."
TRUE, most people do and that's fine. Buyers will get their chance when housing costs half as much and they have saved a fortune by renting. House ownership is great - unless you ruin your life paying for it.

As reader Sean Olender put it: "Many people have forgotten that their number one restriction on future freedom -- to do what they want, when they want, and to go where they want -- it isn't the Iraqis, or Iranians, or North Koreans, it isn't the axis of evil, it's their mortgage lender."


Post a Comment

<< Home