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The Great Real Estate Debate
Everyone from grizzled real estate execs to first-time homebuyers
wants to know what’s next for home prices. So we’ll
tell you. Twice. In the bear corner is veteran senior writer
Shawn Tully, who’s been sounding the alarm about irrational
exuberance in real estate since 2002. In the bull corner is
new senior writer Jon Birger, who just joined us from Money
and thinks comparisons between stocks in 1999 and homes in
2005 are hogwash.
TULLY:
The huge rise in prices is happening precisely because people
believe prices will be higher tomorrow. It's true that a drop
in real interest rates does raise home prices. But that drop
only explains a 20% or so increase. Prices have jumped around
100% in New York City, Miami, Los Angeles, and most other
coastal markets in five years. The real problem is that it
can’t happen twice. Inflation-adjusted rates will not
drop from 1.2% to zero. They’re far more likely to go
back to their historical average of 2.7%. In that case, prices
will suffer a one-time shock in the opposite direction. As
for the fundamentals driving the boom, the biggest fundamental
in housing is rents—it’s what earnings are to
share prices. Eventually people won’t spend $1 million
on a house they can rent for $2,000 a month. Historically
the ratio of housing prices to rents in the U.S. has been
around 12.5; since 2000 that number has jumped to over 17!
Expect the number, once again, to go back to the mean. And
it’s obvious that housing on both coasts is becoming
increasingly unaffordable, even with the help of exotic interest-only
or reverse-amortization mortgages. The California Association
of Realtors says that less than one-quarter of California
households can afford a median-priced house. America is a
fluid society—eventually jobs and residents will flee
from the high prices.
BIRGER:
QI’ll grant you that there are a couple of markets where
the ample supply of undeveloped land makes it hard to justify
the huge price increases—Las Vegas comes to mind. And
like you, I’m no fan of interest only and other mortgage
exotica. But frankly, I’ve never understood why people
are so surprised by the idea that the prices of homes—an
asset that is usually financed via a mortgage—are rising
faster than incomes. Isn’t that the definition of leverage?
From 1999 to 2003 income grew at an annual clip of about 5%
in California, according to the Federal Reserve. So let's
take a California family whose income in a given year rises
from $200,000 to $210,000, leaving about $6,000 in extra cash
after taxes. Say the family chooses to put 30% of the money—$1,800—toward
improved housing. Well, at today’s 30-year fixed rates,
that would mean that they could carry $25,000 more in mortgage
costs. In other words, each $1 in extra income translates
to $2.50 more for housing. I know, I know, you’re going
to say that even if incomes in California were rising at a
5% annual clip, according to my math that would account for
only half the annual gains we’re supposedly seeing in
places like Southern California. But I’d argue that
the statistics trotted out by bubble mongers grossly inflate
the actual price appreciation taking place. For instance,
I’d have to pay 45% more today for my Larchmont, N.Y.,
home than I paid five years ago—not the 75% reflected
by the OFHEO home-price index for my region. The problem with
OFHEO numbers is that they include only homes purchased with
mortgages below $360,000 that can be bought or backed by Fannie
Mae or Freddie Mac. That’s a big distortion, considering
that the low end of the market is where most of the speculation
takes place. The median price of properties bought for investment
is $148,000—versus $236,000 for all existing homes,
according to the National Association of Realtors. So it seems
to me that the OFHEO numbers over-represent the very segment
of the market that is most affected by real estate speculators.
It’s like judging the equity market based solely on
$5-or under stocks. There’s another, even more comical,
flaw in the OFHEO data: These geniuses make absolutely no
adjustments for property improvements! If I buy a home for
$250,000, spend $100,000 on renovations, then sell it for
$380,000, the entire $130,000 difference would be treated
as appreciation.
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