Merlin

Read this in this week's Economist and thought I post it here in the investments forum. Enjoy the read...
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It is time to expose some popular fallacies about buying a home

IN 1929 John D. Rockefeller decided it was time to sell shares when even a shoe-shine boy offered him a share tip. During the past week The Economist's economics editor has been advised by a taxi driver, a plumber and a hairdresser that “you can't go wrong” investing in housing—the more you own the better. Is this a sign that it is time to get out? At the very least, as house prices around the world climb to ever loftier heights (see article), and more and more people jump on to the buy-to-let ladder, it is time to expose some of the fallacies regularly trotted out by so many self-appointed housing experts.

One common error is that house prices must continue to rise because of a limited supply of land. For instance, it is argued that “house prices will always rise in London because lots of people want to live here”. But this confuses the level of prices with their rate of change. Home prices are bound to be higher in big cities because of land scarcity, but this does not guarantee that urban house prices will keep rising indefinitely—just look at Tokyo's huge price-drops since 1990. And, though it is true that a fixed supply of homes may push up house prices if the population is rising, this would imply a steady rise in prices, not the 20% annual jumps of recent years.

A second flawed argument is that low interest rates make buying a home cheaper, and so push up demand and prices. Lower interest rates may have allowed some people, who otherwise could not have afforded a mortgage, to buy a home. But many borrowers who think mortgages are cheaper are suffering from money illusion.

Interest rates are not very low in real, inflation-adjusted terms. Initial interest payments may seem low in relation to income, but because inflation is also low it will not erode the real burden of debt as swiftly as it once did. So in later years mortgage payments will be much larger in real terms. To argue that low nominal interest rates make buying a home cheaper is like arguing that a car loan paid off over four years is cheaper than one repaid over two years.

Fallacy number three is a favourite claim of Alan Greenspan, chairman of America's Federal Reserve. This is that price bubbles are less likely in housing than in the stockmarket because higher transaction costs discourage speculation. In fact, several studies have shown that both in theory and in practice bubbles are more likely in housing than in shares. A study by the IMF finds that a sharp rise in house prices is far more likely to be followed by a bust than is a share-price boom.

Safe as houses?
Another curiosity is the popular claim that investing in property is safer than buying shares, for bricks and mortar are here forever. But that says nothing about relative value. Buy at the peak of a property bubble and your investment is not “safe”. To an investor, the value of a house also lies in the rents that a property can generate. If your tenant unexpectedly moves out, you will suddenly find that your income drops to zero.

This leads to a fifth falsehood: it is always better to buy a house, because “paying rent is money down the drain”. Thanks to a growing glut of rental properties in many cities, from Sydney to London, the cost of renting is currently cheaper than the cost of paying a mortgage. Only if (a big if) prices continue to rise does buying always make sense.

Myth number six is that, even if houses are overvalued, their price is unlikely to fall because interest rates will not rise to the double-digit rates that burst previous housing bubbles. Again, the experience of Japan suggests that prices can fall without a big increase in interest rates. All that is needed is a change in sentiment. First-time buyers may balk at sky-high prices, for example, or if rents fall and prices stop rising investors may sell as their expectation of capital gains disappears.

The seventh fallacy is to believe that, even if prices have overshot, they will not fall, but just level off. When inflation was high, real house prices did indeed adjust in this way. But, if inflation remains at 1-2%, it will take years for real house prices to return to normal levels. So today prices are more likely than ever to fall in nominal, as well as real, terms.

Each of these seven arguments may contain a small grain of truth in certain circumstances, but they should never be the articles of faith they have become. The more often they are invoked, the greater the risk that prices are headed for a crash.

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DaFunkyUnit

here in SoCal, we have had fires, and then a quick flood.

Now, all we need is an 8 on the Richter scale. After that, I'm soo buying a house!

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ray

I think the better question is, what city/area/location will you be looking? I'm in Los Angeles and even with fires, floods and earthquakes I'm pretty sure the housing market is going to remain high priced and high in demand.

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DaFunkyUnit

i was sorta kidding (but sorta not). Right now, I live in the Mar Vista/Culver City area, but I work in Anaheim. It's a 40 mile commute, so I figure I'd prolly move down closer to work but staying near the coast (Irvine, Costa Mesa, or Huntington Beach, perhaps?)

yea, OC is even worse when it comes to housing costs as there is no rent control like there is (sorta) in LA.

LegendKiller

There are some assumptions he is making about those myths.


First one is renting. I consider paying rent "throwing money down the drain" not because a mortgage is cheaper, but because you aren't actually buying anything more than the right to stay there. It isn't like buying a house where a mortgage payment is bringing future earnings into the present to build equity into the future.

Second is inflation, he is assuming that inflation will keep going up. The fed has kept inflation at a very low amount for a good number of years. This does not mean we will be see rapid inflation as a return to the mean.

Furthermore, he says that those loan payments will make up a larger chunk of money. This is complete BS. If you have a 30-year fixed and your paying 400 today, 400 tomorrow, and 400 in 10 years, in 10 years that 400 will be a MUCH smaller section of your overall pay. Fixed mortgage payments are higher than variable for that fact, it will not adjust to inflation.

Along with that he is assuming that there is no risk adjustment FOR inflation. My parents were paying 12.85% on their mortgage in 1979. Not all of this was inflation, and certainly not 10%, it also had a built in componant of riskiness due to the economic times.

Rates were higher even still during low-inflation times, so his "rates are low because of inflation not because they are low in real terms" is BS.

While I agree that there is a bubble it is NOWHERE near what it was in Japan, where people were paying a half million dollars for a square foot in Tokyo, or more. Using japan as an example is like quoting the fact that the market will crash as bad as 1939 in the next 10 years. That example is the VERY extreme.



While some of his stuff has truth to it, he is ignoring a lot of historical facts and future predictions that are grounded in more fact than fiction. He is also applying some limited reasoning to renting and using half of the interest rate equation when figuring overall interest rates.


LK

johnnymk

I bought my house in 1980 for $38,000. Every year, the prices for a similar house creeped up to around $100,000 in 1987. Then prices actually dropped to $90,000 and stayed there until 1996. Because of low interest rates and other factors, it is now worth $140,000. So prices do drop.

During that 10 year period, people actually walked away from their mortgages and I recall some heavy tax burdens that they encountered as a result of their dilemma.

There is an affordability chart for buying houses. I forget what the recommended percentage of disposable income which people should spend for housing and to qualify for a loan, but I seem to recall 30% to 33%?

Anyway, when interest rates are low (in relative terms), the price of housing generally goes up. When they creep up, like they will in the near future, the affordability index will still be in effect. Result? Either stagnant prices or the possibilty of dropping prices.

It is to be noted that wages are currently low in America and will remain there for a long time. Plus local and State taxes are increasing a lot faster than inflation. This will definitely keep a lid on home prices.

We are in a speculative phase in the housing market and I am convinced there will be a shakeout in the coming five years.

It is already occurring in some areas.

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cheapchinese

how much does it cost to build a house???
sometimes i really wonder, because the housing in LA are getting so high.. it might be cheaper to buy a land and build on it.

zippyjuan

With all the fees and things required for new construction (like having sewer and electrical and phone services connected to your property), it would probably be cheaper to buy a lot with an existing building and have it mostly rebuilt (you need to keep like one wall from the original building to consider it a remodel vs a new building which requires more permits and expense) than buying a vacant lot and starting from scratch.

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johnnymk

That is a very good idea!!

However, you will have to incur the costs of tearing down the structure along with disposal of the debris.

Kevster

That's not that much with a good demolition company. It would take them about a week to completely tear down and remove a 3-bedroom 1200 sq. foot house. You have to dispose of the debris, but a lot of that is also recycled (wiring, some fixtures, piping, some of the good wood, etc.)

In California you can technically do a "remodel" instead of a new construction by leaving 1 wall instact. That will not incur the same property taxes as a new home. I have seen this done several times on my street in the last couple of years (we're in a trasitional phase from 50's bungalow type houses to much nicer and bigger sq. footage homes).

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I think over again
My small adventures, my fears.
The small ones that seemed so big,
For all the vital things I had to get and to reach.

And yet there is only one great thing, the only thing:

To live to see the great day that dawns,
And the light that fills the world.

-old Inuit song

cheapchinese

i just see a bunch of POV , condo's being built... and apartments