I’ve put together this chart showing the magnificent run-up in housing prices from January 2001 to present in
Historically real estate prices had treaded at a slightly higher rate than inflation. Again I refer you to the above graph. One is the actual price and the other is linked to 5% appreciation compounded on a monthly basis. Although looking at the adjusted price range you may think to yourself that those prices will never come you must also look at the current price range. The truth is somewhere in the middle. But the stubbornness of many sellers and banks is unbelievable. While insiders in the housing industry leave through the red fire exits, late players are still coming into the game. They think that pie in the sky prices will be back again as soon as they place their 800 square foot home on the market with a new Maytag dishwasher. Many forget that there was a secondary mortgage market implosion in 1981 in
Let us assume that you are in the market to purchase a home in a middle-class neighborhood with good schools and a low crime environment. We will also assume that you have 20% down and the place you are looking at is $500,000. I want to walk through three various scenarios you would expect should you follow this route. I will not factor in tax benefits since this monthly nut has to come out of incoming cash flow. No abracadabra exotic financing nonsense:
Scenario 1: Fixed-30 year Traditional Mortgage
$100,000 Down-payment
$400,000 Mortgage at 6.75%
| Principle and Interest Payment: | $2,594 |
| Taxes (1%): | $416 |
| Insurance (.75%): | $312 |
| Total Monthly Payment: | $3,322 |
Scenario 2: ARM Interest Only
$100,000 Down Payment
$400,000 Mortgage at 5%
| Interest Payment: | $1,667 |
| Taxes (1%): | $416 |
| Insurance (.75%): | $312 |
| Total Monthly Payment: | $2,395 |
Scenario 3: Option ARM
$100,000 Down Payment
$400,000 Mortgage initially at 1.25% Teaser*
| Option Payment: | $1,429 |
| Taxes (1%): | $416 |
| Insurance (.75%): | $312 |
| Total Monthly Payment: | $2,157 |
*note this teaser rate has been common in the sub-prime market
So going over the three monthly payment nuts, we have $3,322, $2,395, and $2,157. From lowest option to highest, we have a difference of $1,165. This is enormous considering we have a difference of about 35% from the traditional loan to this more exotic form of financing. Interest only loans are dangerous because they are resetting and as the equity in the home is currently evaporating, there is very little room to navigate considering minuscule down payments. In addition, no principle is being paid since this is interest only. These loans, as many renegade brokers have advised, will free up additional cash-flow for other investing. Or as we know from the epic rise in foreclosures, squeezing in minimum wage crusaders into McMansions. The worst culprit of these has to be the Option ARMs; these loans give you the worst of every world. For one, you’re not even covering the interest payment if you don’t want to. As you may guess, the majority of folks opt for the lowest option; this is taken out of page 3922 in the credit card companies play book. If you give people a minimum payment they will opt for this. This is the psychology of the American consumer. Why else would we have a negative savings rate?
After looking at these scenarios is it any wonder we are in this mess? $2,157 sounds appealing especially if you can jump into a $500,000 home. However this number is vastly deceiving and many homeowners are quickly realizing this as rates reset and the pied piper is coming for his payment. The yellow brick road is paved with good intentions and many homeowners jump into the largest purchase of their lives without reading the contract. After witnessing this orgy of finance and most of us standing in the afterglow, we are starting to see the intricacies of this mess. It has been that people want to be deceived so let them be deceived. I’m not sure I agree with this. Basic finance isn’t taught in college or even in high school. Most folks assume that basic commonsense reigns in the world of finance but this rarely is the case. Given that only 25% of the population has a bachelor’s degree, and not everyone that goes to college studies finance or accounting, it shouldn’t be expected that people would understand complicated no-doc-negative-amortization loans that are concocted by MBS institutions. Brokers simply push the product, lenders simply underwrite the product, and Wall Street eats this crap up. Now that Wall Street has a full stomach, the option in terms of what you can use to purchase a home will tighten. Lenders are forced to use stricter underwriting criteria therefore forcing brokers to push more conservative lending options. Essentially the pool of buyers will shrink drastically at the worst possible time. Foreclosures are up, rates are resetting, and appreciation will soon go negative.
Looking at your three options if institutions become more stringent even enforcing only a 10% down payment the market will tank quickly. Maybe the above chart isn’t so unrealistic after all.
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21 Comments:
Small nitpick with your analysis:
1) Property tax should be 1.2%
2) Insurance should be something like 0.3%. You pay insurance only on the value of the HOUSE, which is likely $200K, not the land underneath it.
limbsakimbo:
Actually it varies by a small amount depending on which county. For example OC is at 1.1 to 1.5%.
From the California Tax Assessors Office:
"Your property tax bill consists of three separate categories of levies: General Tax Levy, Voter Approved Indebtedness, and Direct/Special Assessments. That portion of the bill labeled General Tax Levy is the only amount controlled by Proposition 13. This tax is limited to a maximum of 1% of the assessed value of your property (the "land" and "improvements"), and can be no more than 2% greater than the previous year's tax bill. The portion labeled Voter Approved Indebtedness includes taxes levied to repay bonds approved by the voters. This amount varies greatly from county to county depending upon the number of local bond issues approved. Under current law, local general obligation bonds require a two-thirds majority vote to pass.
The portion of the bill labeled Direct/Special Assessments is now controlled by Proposition 218. Assessments now require a majority "YES" vote of the property owners, with each owner voting the dollar amount of their assessment. Fees charged for the property related services of sewer, water, and refuse collection can be imposed without a vote, but may not be greater than the cost of providing the service"
Either way, the numbers still work out at the end because the total I used was 1.75% and this falls within the range of 1.5% to 1.75% for taxes/insurance combined. Thanks for pointing this out though. Goes to show the discrepancies out there.
A reminder of the past:
Antelope Valley Struggles with 1990 Memories - LA Times
"Commuters are saying, 'Why am I driving four hours a day, getting up at 4 o'clock in the morning and getting home at 7 or 8 at night, when my home is $50,000 upside down? Why am I banging my head against this wall when I can go back to L.A.? I might not be able to own a house, but my quality of life will be better, and I'll be able to spend more time with my family."
"Houses were getting dumped right and left," she said. "There were all these empty houses, and people were crawling in through the screens and living in them. It was really scary."
Yup, no worries everyone. Southern California is immune this time. They mention in the article that we have a stronger economy and more businesses; too bad they don't highlight the fact that a large number of these businesses are co-dependent on real estate. Hence the housing downturn will cause job losses; not like in the 1990s when job losses led to real estate declines. I know its hard for pundits to wrap their heads around that one.
Dr. BH:
Dare I nitpick a little too? My quibble is with letting people off the hook for their greed. It's all common sense, something that isn't taught in school, but clearly is no longer being passed down from generation to generation in America.
My first journey into home buying was 25 years ago. It was common knowledge that one should not spend more than 25% of Gross on housing, especially on a long term debt load. Heck, I was an irresponsible hippie back then and still knew that.
I will give you that lenders had more common sense and standards back then, insisting on things like income statements and down payments. Even if they hadn't, I knew damn well I couldn't afford to live with the rich people!
On another aspect, I think the situation this time, versus earlier LA downturns, is just the gigantic debt load all these people are carrying outside of the home mortgage nut and the dollar is and will be sinking. Then add some event like 9/11 with the associated spike of economic fear and wow....hold on tight. Or even a hefty 6.5 quaker. Of course, those don't happen any more.
Dr.HB,
What becomes glaringly obvious from your graphs and your three scenarios is that the historical 5% appreciation is still holding true as the norm even during the 2004-2005. The option 2 & 3 mask the real price of the home, the people who have these only want and can only pay the lower initial teaser rate. If you made the rate into a scenario 1 loan using the teaser rate you would see home values are much closer to the historical level, not the current level. This will of course affect the WHOLE market because the entry level homes push up the price of all the homes above them, and when they go down they will bring the houses above them down with them.
The Norm is holding true, it’s all that sub-prime, Alt-A creative mortgage crap that is obscuring reality. Like any illusion, it’s not real and eventually reality will set in. It is like trying to resolve ones debt problems using credit cards and financing, sure you can move the debt around but you don’t abolish it, the debt will catch up to you. All credit and financing will do is post pone the inevitable, that being a balance that must be paid (Bankruptcy is the other alternative to this).
Dr HB,
That L.A. Times article discussing the Antelope Valley (Lancaster / Palmdale) included a quote that I found interesting:
But he noted that commercial development remained strong in his city because of the demand for more restaurants, retail outlets and other businesses to serve a population that has boomed since the late 1980s.
"The commercial guys say, 'Hey, there are people living in those houses and they've got money to spend, and, golly gee, I need to capture some of that market,' " he said.
Commercial development HAS taken off in areas like Palmdale, and retail business has become more self-sustainable (10 years ago, you'd have to go into L.A. for most major purchases). Palmdale enjoyed significant business/development growth about 5 years ago, after certain areas were designated as an economic development zone with tax incentives were offered to anyone who opened businesses. I suspect a downturn will be more sustainable than it was in the 1990's.
HOWEVER, the major factor the above person is overlooking is that just like everywhere else, much of the $$$ people were spending was easy money made possible by re-financing their rising home equity! The so-called 'wealth effect" kicked in, and people who had moved to exurbs like place like Palmdale/Lancaster felt like they deserved the good life, with all the amenities.
Now that the tide is pulling out, we'll see what happens, but it'll be getting ugly before it gets better....
FWIW, the final scenes of Lethal Weapon II show the destruction of houses in a neighborhood: this scene was filmed in Lancaster, CA, after the film studio bought a tract of houses that were left unfinished by a developer after the last bubble burst.
sed,
I agree with you. I wasn't trying to imply that these folks should get off easy just because of their ignorance. If anything, the lack of common financial sense has led to this mess. In addition, I think losing your home, being foreclosed on, and having ruined credit may be punishment enough. Maybe we can resurrect the ancient debtors prison; we've built enough prisons in California anyway so why not add one more?
anon,
You know I tend to believe we will go down but this mania is so crazy it is like having a conversation with a schizophrenic patient. We really don't know what will come next. Will it be a soft-landing or hard-landing? Not sure, but one thing in life that is certain is that things usually don't occur as we predict.
Chris,
You're right about the economy being sustained by funny housing money. These diversified businesses are being supported by a very homogeneous market of home equity and home price gains. The emperor will be revealed to be wearing Versace underwear financed by his Visa 0% credit card.
Good timing, with Realty Group spamming us with the same tired old promises, as if they apply to EVERY market during EVERY time. I love this one:
Building equity in your home is a ready-made savings plan.
That is, unless Joe Mortgage Holder decides to break the piggy bank of that "ready-made savings plan" and take out a home equity loan, squandering it on expensive consumer items (jet skis, plasma TVs, etc)! With the benefit of hindsight, we can now see that is exactly what HAS happened!
When discussing this with a friend, they reminded me of how a few years ago you could not only buy a house with zero down, but turn around an take out a loan for up to 100% of appraised value of the home immediately afterwards! Talk about "doubling down", leveraging to the hilt! Is it any wonder people are in trouble now?
@@@@
As far as the 'rent vs own' question, even the venerable N.Y. Times ran an article today called, "A Word of Advice During the Housing Slump: Rent."
http://tinyurl.com/yrmvfk
A promotional spot for the National Association of Realtors came on the radio the other day. The spot, introduced as something called “Newsmakers,” was supposed to sound like a news report, with the association’s president offering real estate advice.
“This is the best time to buy,” Pat Vredevoogd Combs, the president, said cheerfully. “There’s a lot of inventory in the marketplace. Interest rates are low. It’s a wonderful tax deduction.”
By the Realtors’ way of thinking, it’s always a good time to buy. Homeownership, they argue, is a way to achieve the American dream, save on taxes and earn a solid investment return all at the same time.
That’s how it has worked out for much of the last 15 years. But in a stark reversal, it’s now clear that people who chose renting over buying in the last two years made the right move. In much of the country, including large parts of the Northeast, California, Florida and the Southwest, recent home buyers have faced higher monthly costs than renters and have lost money on their investment in the meantime. It’s almost as if they have thrown money away, an insult once reserved for renters.
Most striking, perhaps, is the fact that prices may not yet have fallen far enough for buying to look better than renting today, except for people who plan to stay in a home for many years.
With the spring moving season under way, The New York Times has done an analysis of buying vs. renting in every major metropolitan area. The analysis includes data on housing costs and looks at different possibilities for the path of home prices in coming years.
It found that even though rents have recently jumped, the costs that come with buying a home — mortgage payments, property taxes, fees to real estate agents — remain a lot higher than the costs of renting. So buyers in many places are basically betting that home prices will rise smartly in the near future.
Over the next five years, which is about the average amount of time recent buyers have remained in their homes, prices in the Los Angeles area would have to rise more than 5 percent a year for a typical buyer there to do better than a renter. The same is true in Phoenix, Las Vegas, the New York region, Northern California and South Florida. In the Boston and Washington areas, the break-even point is about 4 percent.
“House prices have to fall more before housing becomes a clear buy again,” says Mark Zandi, chief economist of Moody’s Economy.com, a research company that helped conduct the analysis. “These markets aren’t as overvalued as they were a year ago or two years ago, but they’re still unfriendly. And that’s one of the reasons the market is still soft — people realize it’s not a bargain.”
There is obviously no way to know what home prices will do in the next few years. But there are two big reasons to doubt the real estate boosters who insist that it’s once again a great time to buy.
The first is history. After the last big run-up in house prices, in the 1980s, a long slump followed. In the New York area, prices peaked in early 1989 and then fell 9 percent over the next three years, according to government data. (Adjusted for inflation, the drop was much bigger.) Not until 1998 did prices pass their earlier peak.
Keep in mind that the 2000-5 boom was even bigger than the ’80s boom and that house prices on the coasts, according to the official numbers at least, have fallen only slightly so far. So it is hard to imagine that prices will rise 5 percent a year, or another 28 percent in all, over the next five years.
The second reason for skepticism is that buying has never been quite as beneficial as Realtors — and mortgage brokers, home builders and everybody else who makes money off home purchases — have made it out to be. Buyers have to pay property taxes on top of their mortgage, while renters have the taxes included in their monthly rent bill. Buyers also face thousands of dollars in closing costs (and, in Manhattan, co-op charges). Renters, meanwhile, can invest what they would have spent on closing costs and a down payment in the stock market, which hasn’t exactly delivered a bad return over the last 20 years.
And that famous mortgage-interest tax deduction? Yes, it reduces the borrowing costs that come with a mortgage, but it doesn’t eliminate them. Renters don’t face any such borrowing costs.
Almost two years ago, I interviewed a thoughtful 37-year-old man named Tchaka Owen, who happens to be a real estate agent. (Whatever the sins of the Realtors’ association, there are a lot of smart, helpful agents out there. Just remember that they have a financial interest in getting you to buy a house.)
Mr. Owen and his girlfriend, Polly Thompson, had recently moved from the Washington suburbs to the Miami area and decided to rent a two-bedroom apartment with spectacular bay views. “You can get so much more for your money, renting instead of buying,” he said at the time.
Sure enough, house prices soon began to fall in South Florida, and Mr. Owen and Ms. Thompson started to think about buying a place. A three-bedroom Mediterranean-style house that they liked was originally listed for $620,000 last year, but the price was later cut to $543,000. They bought it in June for $516,000. Since then, the market has fallen further, but Mr. Owen said he didn’t mind, because they plan to stay in the house at least a decade. “We love it,” he told me.
Clearly, there are benefits to owning a house beyond the financial, like the comfort of knowing you can stay as long as you want or can fix the roof without permission. But real estate has been sold as more than a good way to spend money. It has been sold as a can’t-miss investment. Back in 2005, near the peak of the market, the chief economist of the Realtors’ association, David Lereah, published a book called “Are You Missing the Real Estate Boom?” The can’t-miss argument was wrong then, and it may still be wrong today.
After hearing that radio spot, I called Ms. Combs and asked her whether she thought there was any chance that she and her fellow Realtors had gone a bit too far in promoting the boom. “I absolutely disagree,” she said, still cheerful. “We help people look at the marketplace.”
So I asked what advice she gave her own clients in Grand Rapids, Mich., where she is an agent. “We often tell people that they need to stay in a house five to six years for it to make sense,” she said.
That’s a nuance that didn’t make it into her “Newsmakers” interview. In Grand Rapids, where the median home costs $130,000, it is probably good advice. In a lot of other places, it may still be too optimistic.
IMF: Housing Killing US Economy. http://infohype.blogspot.com
Great information! For information on the real estate market in Steamboat Springs, CO visit http://www.mybrokers.com
That was really funny.
I laughed so hard from the posting from the realty group. For a moment I thought they were serious, and then I realized it must be a joke. They can't think the readers are that stupid or can't do some calculation of their own. That's a good one. : )
You almost got me until I noticed that the reasons don't make any sense anymore in LA.
Thanks for making me laugh today.
Dr. Housing Bubble,
Your excellent post reminds of something I may post about over at Irvine Housing Blog: We have all talked about the cost of owning being much higher than the cost of rent, but this isn't actually true strictly on a monthly payment basis. Where I live in Irvine, if you purchase on a neg am loan, you can get your cost of ownership below the cost of a rental. 30 year fixed is double, and I/O is about 30% more expensive, but neg am actually brings the monthly ownership cost down below rental costs.
I have expended a lot of energy chiding people for paying too much to own, but many have actually been saving on their monthly nut by buying with neg am loans. Of course, we all know this is going to blow up in their faces, but the lure of that kind of loan is too much for many to resist. The Siren Song of neg am loans is going to lead a great many homedebtors to crash on the rocks.
I have expended a lot of energy chiding people for paying too much to own, but many have actually been saving on their monthly nut by buying with neg am loans. Of course, we all know this is going to blow up in their faces, but the lure of that kind of loan is too much for many to resist. The Siren Song of neg am loans is going to lead a great many homedebtors to crash on the rocks.
True. Don't forget the costs of bankruptcy and foreclosure, as well as credit restoration services. ;)
One of my pet peeves is how we often allow the use of language to hide the reality of a situation, as described on the Irvine blog in the posts dealing with Orwell's 1984.
A perfect example is how everyone refers to buying a home as "home OWNERSHIP" (and notice how even you did it, above).
Of course, you don't OWN the home UNTIL you pay for it. Until then, you're actually a MORTGAGE holder, AKA home debtor. Even referring to the person as a home BUYER makes more sense than calling them a home OWNER.
The reality is that using the term 'home owner' and 'neg-am' loan in the same sentence is a horrible insult, as some unscrupulous lender allowing someone to live in the house for a few months to years until it's foreclosed upon is nowhere close to approaching "home ownership".
Hi Dr HB,
Just an update. The house that was a fixer for 700,000 has sale pending on it. It was on the market for about a week.
I'm still glad I didn't buy it, because we would of had to borrow 100,000 to fix it up. It's crazy, but I feel Glendale is in another market. I have this feeling that sellers are going to keep the price high.
Thanks again for your great work.
homedebtor,
You are absolutely right, these "buyers" are not owners in any real sense. I usually refer to them derogatorily as homedebtors or FBs. In my previous post, I was being too kind.
New Web Giant Launches Portal Site – Plans on Dominating Web-based Real Estate Sector
04/12/2007
Chicago, IL based Profertee Realty Group, inc launches its much anticipated real estate portal site (www.profertee.com) Monday morning. Partnering with Melville, NY based American Home Mortgage(NYSE: AHM) and Home Buyers Marketing inc, Profertee’s site is boasting access to over 3.6 million real estate listings nation wide, as well as various premium new construction developments located in Orlando, Las Vegas, and Chicago, just to name a few. Profertee’s mission is to offer a free, user-friendly real estate shopping experience, while also providing additional value-added features such as investment groups, home-valuation tools through Zillo integration, useful real estate investing strategies, and free mortgage quotes through American Home’s retail channels. “We are truly a one-stop-shop”, says Profertee CEO Rhoniel Daguro. “The site has everything a user could want, but we really wanted to feature the premier new construction developments. That is something that no one is really organizing online, and we’ve taken things one step further by forming buyers into investment groups, giving them access to considerable savings at the various developments.”
Profertee also provides local one-on-one services through the thousands of realtors approved with Home Buyers Marketing, inc. Users can create an account on www.profertee.com to search over 3.6 million listings for a home anywhere in the US and still deal with a local partner agent once they are closer to buying. It is in this way that Profertee is providing the best of both worlds: the power of the internet + traditional local realtor partners. Navigate to www.profertee.com today and test drive their site. Also stay tuned for our follow up segment on Profertee in June.
Profertee – Prosperity in Property: Exclusive New Developer Condos http://www.profertee.com
irvinerenter,
I wish you were right. However I haven't seen any stats showing that folks in exotic mortgages are saving the difference in stocks, bonds, commodities, or anything else of value. What I am seeing is folks over extended and hanging by a thread. Chide away, these folks will get a strong dose of reset medicine. Sad but something they should have thought about before hand.
HomeDebtor,
Language is powerful. Patriot Act doesn't sound too bad does it? What about Operation Freedom? Sure sounds better than 150,000 troops in the middle east right? Or what about inflation? Ask 100 Americans to explain inflation to you and you'll get 10 people that understand it. Most will say prices ALWAYS go up. Hence this housing psychotic spree we are on is nothing atypical to what the mass public is used to.
Crazed,
Count your lucky stars. That is way overpriced. A good rule of thumb is a home fixed on a conventional mortgage will run about 1% a month of the total cost. Somehow I think you can rent for ALOT cheaper than that - I'm talking about the difference in the thousands per month.
@Spam ads:
I'll leave some of these on because I think they are a good case study of what is happening in the industry. Folks are actually trying to sell real estate on a housing bear site? Why not try to sell ice to Eskimos.
--FWIW, the final scenes of Lethal Weapon II show the destruction of houses in a neighborhood: this scene was filmed in Lancaster, CA, after the film studio bought a tract of houses that were left unfinished by a developer after the last bubble burst.--
It was Lethal Weapon III :)
6.75% for a 30 year fixed? what are you smoking? Go to bankrate.com and see that the current national avg. is currently more like 5.75%.
And $312 for a monthly home owners insurance policy? Nope. Not unless you live inside the Los Angeles River. Think more like 60-100 a month.
Granted, property tax can fluctuate with mello roos and bond assessments and what not.
I think your numbers are a little skewed to your point of view.
I currently have a 4.5% interest loan (7/1 arm, not interest only)that won't reset until 2011. What me worry?
What happens when people walk away from their homes? Are they still responsible for payment? Simply letting people off the hook for $500K+ loans seems ridiculous, especially when the banks will be lucky to get half of that back.
I don't think ruined credit and bankruptcy would be enough punishment - in a few short years (8?) that bankruptcy would be wiped off the borrowers record. If borrowers maintain every other aspect of their creditworthiness during those 8 years, what's to stop them from taking out another oversized loan for another home and driving prices up again? Hmm... maybe that's part of the reason why these bubbles are so cyclical - people who foreclosed during the early 90s bust now have a second chance to make the same mistakes!
Hey other Anonymous: "I currently have a 4.5% interest loan (7/1 arm, not interest only)that won't reset until 2011. What me worry?"
So when interest rates jack up to 10 percent by 2011 to tame inflation, we'll still be seeing prices come down more and more as there are more people looking to get out.
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