August 19, 2005

THE GRAY LADY COMES OUT FOR PRIVATE ACCOUNTS:

In the Long Run, Sleep at Home and Invest in the Stock Market (MOTOKO RICH and DAVID LEONHARDT, 8/19/05, NY Times)

When Marti and Ray Jacobs sold the five-bedroom colonial house in Harrington Park, N.J., where they had lived since 1970, they made what looked like a typically impressive profit. They had paid $110,000 to have the house built and sold it in July for $900,000.

But the truth is that much of the gain came from simple price inflation, the same force that has made a gallon of milk more expensive today than it was three decades ago. The Jacobses also invested tens of thousands of dollars in a new master bathroom, with marble floors, a Jacuzzi bathtub and vanity cabinets.

Add it all up, and they ended up making an inflation-adjusted profit of less than 10 percent over the 35 years.

That return does not come close to the gains of the stock market over the same period. The Standard & Poor's 500-stock index has increased almost 200 percent since 1970, even after accounting for inflation.


So much for buying stock indexes with our SS money being a risky scheme, eh?

Posted by Orrin Judd at August 19, 2005 12:00 AM
Comments

Clever, Orrin, very clever.

If we use inflation data from the Consumer Price Index, they sold their home for the 1970 equivalent of $ 175,000.

We don't know exactly how much they spent to improve their property, nor when they did so, but assume a basis of $ 135,000 (1970).
After paying a realtor, they would have a profit of $ 30,000 (1970).

That's a nearly 25% profit, not 10%, and mostly tax-free to boot.

If we assume that the CPI overstates inflation, which many argue is the case, then the Jacobses sold their home for $ 225,000 (1970), which after expenses is a profit of 57%, an annual gain of 1.2% + inflation, which is similar to a good bond yield.

None of that changes the basic proposition that a diversified portfolio of stocks is better than real estate for the average investor, in the long run, but it does illustrate that in addition to their other problems, the employees of the NYTimes can't do basic math.

Posted by: Michael Herdegen at August 19, 2005 1:00 AM

you should have michael do postings related to real estate (and most things economic, far as i can tell), oj.

Posted by: lonbud at August 19, 2005 4:01 AM

Michael:

Whoa! Surely you, lonbud and the NYT are forgetting something rather important here. If you are going to compare investing in a principle residence with stocks, you have to read in the minor little fact that their investment provided them with thirty-five years of shelter.

Presumably their initial mortgage in 1970 was less than 100k--chump change by the 90's. If they had invested in stocks they would have had to pay elsewhere for shelter, and pay it out of after-tax income. Unless the alternative stock investment paid consistently and predictably very high dividends (unlikely)they are making a tidy monthly notional profit throughout, which you have to add in, index for inflation and gross-up for taxes. With the house, you just subtract taxes and necessary maintenance. Then, as you note, when the investment is finally sold, the stocks attract capital gains and the house (presumably) doesn't. In most cases, they are way ahead with the house.

Your proposition may hold with real estate generally, but not with principle residences or even recreational properties.

Posted by: Peter B at August 19, 2005 5:00 AM

Michael:

Yes, that's the point.

Posted by: oj at August 19, 2005 8:19 AM

This discussion is why I hate to read about finance. No matter the ups and downs of the past 30 years and which investment strategy is, in retrospect, best and how they would have been better off yada yada.

The only fact that matters is that M&M Jacobs are walking away with almost a million tax free dollars in their pockets after living in what appears to be luxurious comfort for three decades.

May they enjoy their retirement years as much as we are.

Posted by: erp at August 19, 2005 9:06 AM

Michael & Peter: Good points on both sides. The other thing missing is how much was paid in property taxes over those 30+ years. My guess is it's a number that would be fairly staggering as well. And how do we treat that? But ya gotta live somewhere, right? And whether you rent or own, you're paying the property taxes so maybe that's a wash.

Mathmatically, Peter's point about paying it out of after tax income would have to be compared to the characteristics of a Roth IRA (or soon available Roth 401k) to be consistent.

Either way, I think we're conflating the argument a bit here. Nobody's proposing to let me invest some percentage of the SS confiscation from my pay check in to my own home or some other real estate.

Certainly real estate is an inteligent asset category to hold in a diversified portfolio. It's risk/return characteristics tend to have a very low correlation with stocks. But it's obvioiusly not the only place returns come from nor is the "S&P 500".

Letting the argument focus too much on returns is a losing proposition in the bigger debate though. It should turn on the freedom for you to chose what to do with your own money. Period.

Posted by: John Resnick at August 19, 2005 10:40 AM

John:

No, it's about the return on the money., We've decided as a society not to give people the freedom to retire into poverty.

Posted by: oj at August 19, 2005 10:49 AM

Peter B:

The article addresses that - it's a thorough basic primer.

From the article:

Despite the fact that home values usually appreciate over time, most of the value of a house actually comes from the ability to use it.[...] Whenever people sell one house, they must immediately pay to live elsewhere, meaning that they can never wholly cash out of a home's value. Including the value of living in a house - that is, the rent that a family would have to pay to live in an equivalent house elsewhere - homes in New York have returned more than 15 percent a year since 1980, according to an analysis by [Thomas Z. Lys, an accounting professor at the Kellogg School of Management at Northwestern University]. But only five percentage points of this return comes from sheer price appreciation, as opposed to the value of shelter. Mr. Lys accounted for property taxes, spending on renovations, interest payments and the tax deductions on those payments, and the fact that most house purchases are made with mortgages.

Also:

When home prices are rising, the leverage from a mortgage lifts real estate returns in the short term. Someone putting down $100,000 to buy a $500,000 home can feel as if the investment doubled when told that the house is now worth $600,000. But the power of leverage vanishes as homeowners pay off the mortgage.[...] Leverage also creates more short-term risk, especially for those who have stretched to afford their house. "If the home went down by 30 percent, you'd probably be sitting with a bankruptcy attorney," said Jonathan Golub, United States equity strategist at J. P. Morgan Asset Management in New York.

We also learn that the Jacobses spent around $ 100,000 in the mid-eighties on home improvements, in addition to the (possibly) $ 25,000 master bath, so any money that they saved over renting would be the only real profit that they made on the sale of their home.

As John Resnick points out, there are many costs associated with buying, that renters have a lower exposure to.

If one expects to stay in the same home for decades, and one lives in an area that has appreciated at an average annual rate of 5% or better since 1980, such as LA, NYC, or Chicago, then buying is probably more profitable than renting.

If one lives in areas where the appreciation has been lower, then renting and buying are probably equally rewarding choices, from a purely financial perspective, and buying is a lifestyle choice.

If the expected stay is between three and ten years, then buying almost always makes more sense; less than three years, and the transaction costs will almost always be far higher than any appreciation, and renting is the best financial move.

erp:

Mostly tax-free; they'll have to pay taxes on maybe $ 100,000.

John Resnick:

Of course, landlords would like to pass on the cost of property taxes, but sometimes market conditions make that unlikely - such as right now.

The NYTimes had an article (reg. req.) which touched on that:

Apartment building owners faced with dwindling returns are selling their properties to developers willing to pay ever larger premiums so that they can convert rental units into condominiums. The trend is driven by low mortgage interest rates that have encouraged renters to become homeowners, leaving landlords in many areas with falling occupancy rates and forcing them to lower rents and make other concessions to keep their buildings full.

Posted by: Michael Herdegen at August 19, 2005 11:50 AM

Fun to listen to Michael shoot down all his own bubble arguments.

Posted by: oj at August 19, 2005 12:07 PM

MH - I can live with that.

Posted by: erp at August 19, 2005 12:07 PM

oj:

Really ?

Please explain to me how I did so - I'm not as quick on the uptake as you are.

In any case, I thought that we were essentially arguing over semantics.

In past discussions, you agreed that in many places around the nation, there is likely to be a multi-year but not permanent decline in real estate prices of about 25%, and I agreed not to call it a "bubble".

Posted by: Michael Herdegen at August 19, 2005 12:59 PM

most of the value of a house actually comes from the ability to use it.

Posted by: oj at August 19, 2005 1:11 PM

oj, so I noted.

Posted by: erp at August 19, 2005 2:11 PM

OJ, I'll rephrase: The Private Account portion of the argument shouldn't be overly focused on a discussion of returns as the means for justifying why they should exist. They should exist because it's my money.

Another thing I haven't seen anybody discuss (and I admit to growing weary of looking too hard) is the fact that there are in existance today several annuity contracts issued by enormous insurance companies which will guarantee a minimum rate of return during accumulation (some at 6%) while letting the holder invest in various market-based portfolios and give the holder the option to lock in the greater of the guaranteed minimum return OR what the market delivers. Imagine this hypothetical: here's how your PA will work > You'll get an income you can't outlive at the end based on an annual compounding rate of return of at least 6% or what the market does over the next 10 to (however many years until you retire) WHICHEVER IS GREATER. Even Krugman would have to take that offer.

Posted by: John Resnick at August 19, 2005 2:44 PM

john;

If there were a way to guarantee the historic stock index return on the money even though it was held by the government and if it didn't involve the government actually owning stock there'd be no real reason to privatize.

Posted by: oj at August 19, 2005 2:51 PM

oj:

Now you're on the cusp of wisdom: The difference between a thing's value, and its price.

A person with a keenly discerning eye for the difference can make a staggering fortune with arbitrage; witness Warren Buffet and George Soros.

Of course homes have value as shelter, regardless of their market price, but most homes eventually get sold, and then the market price matters. A lot.

You have constantly advocated the notion that most homeowners are the type that stay in the same home for decades. All available data indicate negative support for that position.

Most homeowners will not have the time, the money, or the patience to wait a decade to be made whole. If the market price of their homes has been declining for the past three years, they're going to assume that the prices will CONTINUE to decline, just as most people are now convinced that double-digit annual appreciation is the norm in real estate.

There are ONE TRILLION DOLLARS in adjustable rate mortgages coming off of their fixed-payment periods in 2007, on top of $ 300 billion next year.
How many of the approximately four million households who hold those loans are prepared to pay an extra $ 300, $ 400, $ 500 a month in mortgage payments ?
A significant number are going to find their increased payments, (whenever they do increase), a burden that cannot be met, and a further significant number will meet the increased payments, but will have to cut back on other consumer spending.

We don't even want to talk about interest-only loans, which so far this year make up about 40% of the mortgages written in localized hypervalue discontinuity zones like San Diego, Washington, Seattle, Reno, and Atlanta.
Suppose that, after four years of making interest-only payments, these people are looking at beginning to have to pay on the principal as well, raising their monthly payments by 30%, but their home is only worth 90% of their loan amount ?
How many of them are just going to take a walk, as you have suggested that they should do ?

You don't care if speculators go bust, and as a moral position, I agree.
However, speculators have purchased at least 30% of all of the single-family dwellings sold over the past three years in places like San Diego, Las Vegas, Phoenix, and Southern Florida.
While the speculators are crying in their Mountain Dew, the banks are going to be putting an awful lot of real estate on the market, and the glut of available homes is going to drag down prices, just as the speculators increased demand and drove up prices when Joan Q. Public was buying family shelter.

People are twice as disappointed by a loss of X dollars as they are gladdened by a gain of X dollars.
Just as the "wealth effect" has been a positive influence on the American economy the past few years, the "poverty effect" of dropping home prices will curtail retail spending and be a slight drag on the American economy, EVEN IF THE HOMES AREN'T SOLD, since "average homeowner" will feel less well-off if her home is worth 10% less than it was two years ago, regardless of whether she plans to sell.

Yes, the sun will continue to come up, and children will still play.

However, the pain will be real, and it will be widespread, although of course it will be most deeply felt in today's localized hypervalue discontinuity zones.

OK, blah blah blah.

The very bottom line is that you are essentially saying that nominal prices don't matter, because people will arrange their lives around the value of their homes, and I don't agree.

I've tryed to present the reasons that market values will decline, for a time, in some areas, and once people become convinced that DOWN is the natural direction for home prices, they'll just go about their business, and take the hit when they sell.

That loss of paper wealth will have real-world consequences for the entire nation, albeit small ones.

***

On a personal note, I had a longer, more eloquent, and better documented comment prepared, but somewhere between "preview" and "post", it vanished into the ether.

Grrrr !

Posted by: Michael Herdegen at August 19, 2005 3:05 PM

So they'll move to other homes. The only fact that matters in the whole equation is that we have less housing stock than our population needs. The rest takes care of itself over time.

No one ever needed a tulip or a Pet.com stock.

Posted by: oj at August 19, 2005 3:13 PM

John Resnick:

Exactly.

The amounts of money that SS privatization would affect are too great for a guarantee of 6% returns to be valid, but the equity and money markets could certainly back a guarantee 2% returns.

There's no reason for anyone to be concerned about anything less than a Greater Depression causing them to lose money from their privatized SS accounts.

Posted by: Michael Herdegen at August 19, 2005 3:20 PM

So they'll move to other homes. The only fact that matters in the whole equation...

Yes, they'll move, losing money all the while.
THAT is a fact that matters, to the American economy.

is that we have less housing stock than our population needs.

No, we have MORE housing stock than our population needs, tens of millions of homes and apartments more.

There are places with housing shortages, and places with every third dwelling standing empty, but on the whole, there is a surplus to requirement.
Further, there are plenty of people who currently occupy their own dwellings, who would live with others, if it became necessary for some reason.

The rest takes care of itself over time.

It always does.

The question is whether we'll like how it works out.
And then we die.

You seem stuck on the concept that people "need" homes.
People need shelter, but that fact doesn't mean that any particular home couldn't decrease in price, or even value.

If someone loses their life savings due to fluctuations in the real estate market, the concept that their former home is worth more than a tulip will provide scant comfort.

If you want to ensure a red-hot housing market through 2010, then bring on your 70 million Mexicans.
However, if they trickle into America at the rate of a few million a year, they're not going to do more than prop up the rental rates of cheap apartments.

Posted by: Michael Herdegen at August 19, 2005 3:36 PM

We're too wealthy a society for people to willingly share homes anymore. Immigrants do it when they first get here but quickly have enough to move on.

The supply of homes available is at record lows and only about half of the number required to achieve equilibrium.

Posted by: oj at August 19, 2005 3:50 PM

Michael, after numerous mishaps, I started writing all my comments in a MS Word file first, and there's the added benefit of spell checking.

Posted by: erp at August 19, 2005 4:34 PM

Great posts, Michael. This is about as cautionary as I've ever seen you get, but you are right on the mark.

Posted by: Robert Duquette at August 19, 2005 5:44 PM

erp:

That's a good idea, I should probably do that with the long ones.

You had to bring up spellcheck after a comment in which I made a spelling error, eh ?
Or is that what brought it to mind ?

oj:

We're too wealthy a society for people to willingly share homes anymore.

Families do it all the time.
If times get tough, or the rents get too high, Junior can give up his apartment and move in with the 'rents. Or his college buddy.
Which will increase the supply of available housing. Now multiply by 10 million.

The supply of homes available is at record lows and only about half of the number required to achieve equilibrium.

Incorrect on both counts, assuming that you're speaking about the national situation, and not, for instance, just about Hanover, NH, where that's probably true.

If I achieve nothing else, I hope that I can successfully communicate this concept, which I also wrote about here.

There is a currently a high level of demand to purchase homes in America.

That demand can be broken into three groups:
* Those primarily seeking to occupy their home.
* Those primarily seeking a vacation home.
* Those primarily seeking to make a profit from the property, either by renting or reselling.

The first group has relatively inelastic demand, since, as you note, everyone needs shelter, and this group typically owns only one home.
However, many of this group would rent if they had to, so this group's demand to purchase could lessen a bit.

The second group is comprised of people from both the first and last groups, but more heavily from the first.
They are typically older, more affluent, and often do not plan to sell their vacation homes within their lifetimes.
However, they do not NEED their second (third, etc.) homes, and so can sell with impunity, should they decide to do so.
Their demand is slightly more elastic than the first group's, but they are also, by far, the smallest group.

The third group's demand is nearly COMPLETELY ELASTIC. Individual members of this group often own multiple properties, and organizations may own thousands.
This group is also FULLY EXTENDED, they CANNOT brush off interest rate increases or falling property prices, although the larger organizations have the resources to hold through a downswing, if they desire to do so.

A simplified model, to be sure, but good enough.

Here is the most important point:

In today's localized hypervalue discontinuity zones, THE LAST GROUP IS BUYING 30% OR MORE OF THE AVAILABLE PROPERTIES.
Further, since low interest rates and aggressive lending practices are moving millions of people into the first group and away from being customers of the third group's rental properties, the third group is disproportionately made up of people intending to resell their properties for a profit.

The demand to purchase homes in these sizzling markets, therefore, is based largely on DESIRE, (and greed), and not on NEED.
Desire is ethereal.

The current frenzy of demand masks the fragility of that demand.

Whatever event or condition it is that finally dampens demand, when it occurs, there will be an avalanche of homes hitting the market, as the weakest speculators unload.

To use a restaurant analogy, demand for chicken patties is relatively inelastic; demand for chocolate cake is elastic.
If you simply add up the total demand, and assume that it will behave as if everyone wanted chicken, you WILL BE STUCK WITH A LOT OF INVENTORY, should the Atkins diet come along.

Simply saying that demand is high isn't enough.
We must also know who is buying what, and what their purpose is.

Otherwise you're calculating annual demand for fireworks by multiplying June's sales by twelve.

Take a market with a 1% vacancy rate for homeowner housing.
Now squeeze out the speculators, and put their properties on the market.

The vacancy rate goes up to 3%.
The supply of homes is suddenly huge.
THAT is the natural equilibrium point.

Speculators have, in effect, "cornered the market" in some regions.

Posted by: Michael Herdegen at August 19, 2005 6:00 PM

No. Michael. I noticed no typos of yours, but I make many of my own, so I appreciate spell checking.

Posted by: erp at August 19, 2005 7:03 PM

Michael's comment and that of many media comments on the issue of interest only loans make one huge assumption. First, here's his comment:

'...There are ONE TRILLION DOLLARS in adjustable rate mortgages coming off of their fixed-payment periods in 2007, on top of $ 300 billion next year. How many...are prepared to pay an extra $ 300, $ 400, $ 500 a month in mortgage payments?...'

The assumption is that these people are just making the basic interest only payment because they cannot afford more. This is not true across the board. I believe a significant percentage of the interest only borrowers prefer to make principal payments once or twice a year when they have they cash. The interest only loan is a tool to help those who have variable income (salespeople, realtors etc.)manage their cash flow.

Posted by: Kurt Brouwer at August 19, 2005 7:26 PM
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