Tuesday, August 29, 2006

Buy vs. Rent - home prices -ack!

The below is an IM conversation I had with my chicken wings partner (see past discussion on wings ). It is my argument for why housing prices, at least in certain geographies (like my area of Virginia) have a long, long way to go down before normalizing with renting (or renting prices have to go up a lot). Everything written, including my summary views at the end, is from August 2006. It is a real IM conversation.

I'm "TTB" and my wings buddy is "CK". CK is a smart dude in his own right, but I have to give myself the W in this debate. For the avoidance of confusion, he and I are both renters in the same town. He's getting a JD/MBA, while I am a permanent resident. Anything in brackets is additional color to clarify a statement. I made some minor edits, mostly on typos (though I left plenty) or finishing a thought. That said, this is largely cut-and-paste verbatim. I also re-ordered some of the comments so they follow what they are referring to:

TTB: I can't remember if we discussed this but I need to take a pass on wings tonight.
CK: You flip-flopped on it...no worries
CK: BTW, is your wife pressuring you into buying a house?
TTB: not specifically. she's aware of my views
CK: Given your recent article selections...I would think this to be the case.
[CK is referring to a slew of recent emails I've sent that link articles or thought pieces on the state of the housing market]
CK: Which is that residential real estate is overpriced in our town?
TTB: yes. absolutely. she is aware
TTB: i sent those because I've been more keenly aware of the housing struggles since we are, in the long run, looking to buy a house
CK: Gotcha
CK: You could always buy one of the real estate "option" products that are being introduced...buy a put on the house and get some downside protection. [CK is referring to some "creative" new derivatives that Wall Street has designed that allow one to make bets on home prices]
TTB: for example, if you assume our house [that we rent] is worth $500k ([my wife] thinks it would go for more, I think it's worth less, so I split the diff.)
TTB: if you financed 100% of the home w/ a 30 yr. fixed rate 5.75% mortgage, you'd pay $2900 per month. Of that, about $2400 is interest [at first]. It will take a decade before you're paying less than $2000 of interest. My view is that interest equates to rent. We pay $1600/month in rent
TTB: there are, of course, stupid gov't tax incentives in place for owners to finance their homes with debt that reduce the "effective" cost.
CK: You beat me to the tax punch
TTB: but, there are also costs of owning a house that we don't [directly] incur
TTB: we have not had to buy a refridgerator, our landlords did it. we do zero yardwork, they provide us with a constantly refreshed garden every season.
TTB: they stained our deck recently. they gave us some outside benches, they had a dead tree removed, etc.
TTB: so, while the tax advantage helps, it is somewhat offset and it helps in a declining way (assuming you pay down principle).
CK: So your 1600 buys shelter and convenience
TTB: absolutely
TTB: people always say, "but you're not building equity."
CK: Of course
TTB: as if it takes owning a house to build equity.
CK: Equity in the house...yes; equity in your assets...no
CK: the requirement for ownership that is
TTB: apparently the concept of building "equity" in your bank account is irrational
TTB: , or, if I need "earning" assets rather than just bank interest, I can build equity in my Charles Schwab account.
CK: Of course, we are neglecting the DV of the rental payments that you still have to make after you've paid off the mortgage...given 30 years it's pretty small
TTB: meaningless
TTB: Hell, I could even lever a bet on house price appreciation by buying homebuilder stocks (or options, if I really want leverage) [using leverage would help equate the way most people buy homes, which is 10-20% down and 80-90% borrowed]
CK: [Your wife] "buys" your argument?
TTB: she accepts that I at least have an idea that I know what I'm talking about.
TTB: "a chance of knowing what I'm talking about" would be better phrasing.
CK: There are some non-financial benefits to "ownership"
TTB: same with renting
CK: People take pleasure knowing that they own a home
CK: We've already discussed your benefits to renting
TTB: people take pleasure in having increased flexibility.
CK: People who rent take pleasure in increased flexibility
TTB: exactly what I meant
CK: Ah
TTB: people that own forego a lot of flexibility
CK: Although there are many who rent who would prefer the "ownership" option and place no value on flexibility
CK: While I would imagine that the market is fluid enough to allow people who own and want flexibility to rent/sell their home and rent for themselves
TTB: and, as I predict we will see, there are people who went to sell that find a vacuum of buyers
TTB: they also generally don't get to realize the increased "value" of their home since they often use the proceeds of a sale to buy another home, so the "gains" are really foregone and rolled into another overpriced market.
TTB: replace "market" with "property"
TTB: the only way to realize the gains is generally to switch markets [from an overpriced one to a more reasonable one], but that's often a function of luck
TTB: ...and can work backwards when going from [a fairly priced] market to overpriced market.
CK: Provided they roll over the property...you can easily gain flexibility by just cashing out, whereas the same cannot be said in reverse
TTB: I can cash out my Charles Schwab account or my bank account.
TTB: Equity is not exclusive to a house
CK: This is true, but I imagine there are many more people who rent because they cannot afford to buy (and gain the "ownership" value they desire)
CK: You are not the "average" renter
CK: I think you'll agree with me on that
TTB: agree. but that doesn't change my point, since the person that cannot "afford" to buy can't gain equity in a house either.
TTB: also, the gov't has created perverse tax incentives to roll your proceeds into another house. not buying another house often will stick you with a tax bill, so many people do feel forced to roll the proceeds into another home. Apparently home equity is the gov't's preferred form of equity.
CK: I think that is a little overstated. People have to reap more than $250K from the sale of a house...how many people are doing this if the median price of a home is little more than $250K?
TTB: my point is not that renting is inherently superior. It's that it is clearly economically superior today in many markets ([my market] included)
CK: True
TTB: about half of people
CK: If you bought the house for $0
CK: It's hard to realize capital gains in excess of the sales price
CK: Metaphorically speaking
TTB: sorry, i thought you were saying people have to sell the house for more than $250k.
[I did some more work on this and did not realize how much the gov't has changed this incentive to be even more powerful. $250k (or $500k if married) of capital gains in a house are tax exempt regardless of if you roll the gains into another property. This is insanity and, of course, will contribute to the relative overvaluation of homes as this tax benefit gets slowly and unconciously factored into the price of houses.]
CK: I think the effect of the tax incentive is overstated, that's all. People normally selling a house are moving for reasons more important than taxes (growing family, changing jobs, etc.)
TTB: so the tax incentive only impacts people with the biggest gains, which I'd speculate are the people in the most overvalued markets.
CK: That is true
CK: I can imagine there are people in DC who must think hard about the tax issues [CK is talking about the DC metro area, one of the hottest real estate markets of the past decade]
TTB: in any case, most people that sell a house, turn around and buy a house.
CK: True
TTB: so, they often don't reap the "value" increase of the sold house since generally buy another house in a similar (or the same) market
CK: Non sequitor...You should start your blog again
CK: While this isn't a conversation on wings, it still has merit
TTB: also, the economy writ large has a net zero wealth gain, since for every house sold, their is a seller and a buyer. So, if the seller benefits from selling an overpriced home, the buyer is punished equally and oppositely (or the bank, if it's dum enough to provide enough financing to get hit)
TTB: "dumb"
TTB: I figure the break even value of rent vs. buy for my house is between $300k - $350k. Either that, or my rent is way below market (which I don't think it is)
CK: 1600 for how many bedrooms?
CK: we paid 2000 for 4 bedrooms (small) near campus (which has some value)
TTB: I guess three
TTB: it's the newest house on our street and I'd argue it's a pretty solid location
CK: True
TTB: that said, three bedrooms is a stretch, since one is really an office and would have to use a bathroom on a different floor for showers
CK: Has your landlady indicated a willingness to sell?
TTB: no
CK: So perhaps you are slightly under market for rent
TTB: I think $1600 is about right.
CK: Or else you'd use your flexibility and move someplace else, right? ;)
TTB: absolutely
[end of conversation]

To your Investment Linebacker, the discussion of the financial decision to buy a house has to be taken in the context of other options (both options on where else one could reside and financial options). This clearly places the decision as a rent vs. buy decision. Sadly, because most people believe houses never decline in price, it seems the masses believe it is always the right time to buy a house. This is akin to the efficient market hypothesis in the stock market except even worse because the government has created such strong incentives for owners to leverage their home ownership as much as possible. Wall Street, always happy to oblige demand for creative financing, has developed myriad ways to deliver the desired leverage. This became, for a time, a self reinforcing cycle of rising prices beyond economically reasonable levels.