Home Prices Show Strongest Increase on Record
A recent quarterly survey by N.A.R. found (National Association of Realtors) that U.S. home prices rose at an annual rate of 13.6 percent. When you adjust the rise with inflation, according CNN Money, this is the strongest increase ever recorded! The biggest gainer being Phoenix, AZ.
When you compare this with the last article I published, it looks like the market is ripe for a bad downturn. Based on this last article which showed that the majority of Californian’s were over $70k short of income to support the median home, it’s hard to find where these gains are coming from. Earlier in the boom, interest rates really helped to explain the growth. Of course there are other factors like population growth, increased economic health, etc., however interest rates were probably the biggest driver to increased housing prices. Almost every 1% drop in interest rate increased the housing affordability by approximately 10% (based on the same monthly mortgage payments).
Today however the real estate market is completely different. Interest rates are now climbing thereby decreasing the mortgage amounts people can afford. The problem is that the lowering of interest rates created a bubble, where the prices were no longer determined by logic. If you ask the vast majority of people on the street just how much interest rates can affect real estate prices, they can’t tell you. Actually, if you ask these same people why housing prices have increased, they can’t give you a logical answer other than houses are a great investment and they’ll always increase (which isn’t true by the way). What’s happened is that emotions are now ruling the market, setting us up for a large real estate crash! The good news is that there are many things you can do to protect yourself.
10 things to do to protect yourself from the upcoming housing crash:
1. Generally avoid the real estate markets with the strongest gains. Although not perfectly accurate, it’s a good metric to start with. It’s the same principle as the dot com boom. The tech companies that has the largest and unexplainable gains where the most likely the ones that fell the hardest. Not always, but generally. The same is probably true for real estate markets.
2. If you’re going to buy a property, get a fixed rate mortgage of at least 10 years, preferably more. Based on the last 40 years of data, no real estate bust has lasted more than 7 years, so with a 10 year fixed rate, you should be protected from any interest rate increases that cause the market to crash. As well, this gives you a much more accurate idea of what your fixed costs will be. Therefore if you can’t get positive cash flow today, you should be able to keep that positive cash flow for at least 10 years.
3. Avoid interest only mortgages. Plain and simple, avoid them! These are very risky for most people because very few people are adept at handling the associated risk. If you can only afford your home this way then you’re buying too much home. You’re putting yourself at a high financial risk. Fortunately for real estate investors, and unfortunately for uneducated home owners, 31% of all new single family mortgages in 2004 were interest-only mortgages which will create great deals in the next few years.
4. Start hoarding your cash now for when the market does drop. This will be a great time to get properties much lower than today. Based on the housing affordability index of California, we could see drops as high as 56.7%. Who wouldn’t appreciate the possibility of purchasing properties as much as 50% lower than today!
5. If you’re going to pull out equity from your house, verify that you’re not over-financing yourself, that you have the same protections mentioned above as someone buying today.
6. Assumable and transferable mortgages provide you with more protection than not because if interest rates increase as expected, you can sell your mortgage with your property at today’s low rates. So for example, if interest rates climb to a historical average of 8-10% lowering the prices of homes, you can still sell your properties higher than the neighbors because you can also sell the mortgage with the property. That is you don’t have to decrease the price of your property by 30-50% to keep the same monthly mortgage payments, your transferable mortgage does it for you!
7. Whatever equity you pull out today, don’t use it to acquire consumer goods or pay off consumer debt. Use it wisely because you will need it tomorrow.
8. Assuming you went with a low down and a short term mortgage (either variable or 5 year fixed), start preparing yourself by saving as much cash as you can because if you have to refinance (say in 5 years), and you owe $200k on your property, but the price has dropped to bring it below that, say to $180k, then you will have to come up with some additional cash to cover your refinancing. In a bust real estate market, banks will probably not lend out 100+% mortgages. You’ll have to come up with at least that additional $20k, probably more.
9. Verify that all your properties are cash flow positive. Not that they shouldn’t be, but if they aren’t, it’s going to get a whole lot more difficult for you if you have a short term mortgage (5 years) or a variable mortgage as interest rates increase.
10. CASH IS KING! Start saving your cash now. This is where fortunes are made and lost, and fortunately for those with cash, this is where they are made! If you look at history, the common person buys at the peak of market booms and sells at a loss in market busts. Whereas strong investors, those that have lasted through many busts and booms, generally do the opposite. The near future will be one of those times, be prepared for it!
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Until This Week Californian's Were $70,480 Short of Income to Purchase a Home, It's Now Increased!
The California Association of Realtors, recently released a survey indicating that Californian’s where $70,480 short of income to afford a median home priced at $530,430, even worse for San Francisco Bay Area where the shortage in income is $102,230. These numbers assume a 20% down payment, with monthly payments for principal, interest, taxes, and insurances that are no more than 30% of the household’s total income. Based on the Fed’s interest rate hike this week, how much can this hike increase the income necessary to afford a home?
This week the Federal Reserve raised the interest rates by another 1/4 percent, with another raise expected on September 20 of this year. Assuming housing prices don’t change and an initial interest rate of 5%, that means that on September 20 (assuming another expected 1/4 percent interest rate hike), Californians will have to come up with an additional $133.29 a month, or gross income before taxes of another $205.27/mth. That’s $2,463.20 a year. In other words, the median affordable income will then be raised to $72,943.20 a year, an increase of salary of at least 3.4%.
If interest rates keep climbing, the real estate market is in for a lot of problems. Although $2,463.20 in additional income a year might not seem like that great an increase considering the scale of things, note that that’s just two minor rate hikes with more expected in the near future! And not only that, but according to BusinessWeek.com, 31% of all new single-family mortgages in 2004 were interest only! This means that many people are already financially stretched to their very maximum. And do remember, the numbers above are with a 20% down payment which is not nearly as common with interest only mortgages. Assuming the worse case, a 0% down payment and an interest only loan with the same 5% rate, the monthly amount is $2,210.12. Now add the two rate hikes to that rate and you get a monthly payment of $2,431.13, an increase of $221.01/mth, or $4,048.26 a year, almost double! And don’t forget that interest only loans generally have higher interest rates.
As you can see from these numbers, if interest rates continue to climb, we’re definitely going to see real estate housing prices drop. The good news is that you can plan ahead and protect yourself today. You can, for example, refinance your property and lock in today’s low interest rates for longer terms, the longer the better. And if you do purchase a new property, you should avoid purchasing at the upper limits or your budget and especially avoid interest only mortgages.
Now that we know the income required to own a home in California, let’s look at the numbers from another perspective. How far do real estate prices need to decrease to make housing affordable to Californians today?
Given the same 20% down payment, the mortgage amount comes to about $430,430 (20% is actually $424,344, but we’ve rounded it up a little to add some acquisition costs). Assuming the same 5.5% interest rate, we have a monthly mortgage payment of $2,443.93, making our yearly payment $29,327.16. At this point we have two options, we can determine how the survey calculated their numbers or we can make a rough approximation. For the scope of this article, we’ll use the rough approximation approach. Since we know that as we lower the housing prices some of our other numbers will also be relatively affected we can safely assume that the decrease will likely be less. As an example of such an affect, lowering the price of a property should also lower the insurance costs as it requires less coverage. Using our rough approximation, we can take the percentage difference of the required income of $124,320 and the shortage of $70,480 to give us an income shortage percentage of 56.7%.
What this means is that we need to drop the price of our mortgage by as much as 56.7% to make housing affordable today for Californians. Or in other words, the real estate housing price needs to drop from $$530,430 by approximately 56.7% to $300,753.81! That’s a large difference.
Odds are that real estate prices won’t decline this drastically because, as mentioned just above, if you add other factors such as inflation, insurance, taxes, etc., the drop will be a slightly less. How much less exactly, I’m not sure. But if you assume a drop 56.7% then you should be safe. And based on the past history of the real estate market, such drops have existed before. The good news is that no bust has yet lasted for more than 10 years. So again, if you’re going to buy in today’s market, buy with a long term fixed interest rate with the expectations that there will likely be a significant price drop before for some time.
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Recent Survey Shows Some Markets Heading for a Price Decline
As is evident by the articles on this blog, it’s no mystery that I’ve been a large proponent that real estate prices are exaggerate, that they have to fall. Well a new survey from PMI Mortgage Insurance Corporation shows that some of the US’s housing markets are increasing their chances for a price decline based on factors such as home prices, employment conditions, affordability, etc.
The study shows that more than one city has a higher than 50% chance of a price decline, cities such as Boston MA, Nassau NY, San Diego CA, San Jose CA, Santa Ana CA, Oakland CA. Actually, the national average is 21.3%!
The good news is that based on the article, the cities less likely to be affected by the bubble burst include cities such as Pittsburgh PA, Philadelphia PA, Indianapolis IN, Cincinnati OH, Columbus OH, Memphis TN, Nashville TN, San Antonio TX, and Seattle WA.
I was not able to find the details of how exactly they came up with these numbers, but they are interesting nonetheless.
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The Great Real Estate Dilemma
As you probably know from my previous real estate posts, I believe that we’re past due for a real estate bust. This week I came accross another very interesting article related to the topic by Dr. Steve Sjuggerud. I’m not sure I’m in full agreement with the article, but it does provide some very interesting arguments that are definetely worth reading.
For example, the graph above shows the prices of new houses adjusted for inflation. There are a few interesting points to notice about this graph. First, the general trend over time has been upwards. That is, as populations increase and space within cities become more condensed, prices have to go up, that’s the law of supply and demand. What’s also very interesting is that the prices have not always gone up steadily, there have been some drastic dips!
The delimma faced by today’s real estate investors is whether or not to buy, or to hold out until the bust when you can buy properties for much cheaper. Based on the fact that interest rates have nowhere to go but up, and the effect interest rates have on property prices, I know a lot of you out there are thinking of waiting it out. The reality is that a great investor can invest successfully in any market! The key is what you select and how you finance it. That’s the topic of this article.
If you look closely again at the graph above you’ll quickly notice that over the last 40 years that no dip has lasted 10 years. Although this graph is for new houses, let’s take the assumption that it applies for all housing (since conceptually it’s very similar). Therefore, assuming that you buy a property at the very height of a boom, if you can hold it for at least 10 years, than by all accounts you should be able to sell it at least the price you paid! At quick glance, that might not look so good, but take a second to think about it…
This means that no matter what the market, if you have at least a 10 year fixed mortgage at today’s interest and you can hold it for at least 10 years, you’ll make money (assuming you picked a good income property). At the very least you’ll have paid down the equity with your rental income. However, chances are that you will be able to sell it at a price higher than what you paid for at at least one point over those 10 years.
All said and done, it’s important for today’s investor to lock in their interest rates for at least 10 years and select positive cash flow properties. Actually, You should never purchase a negative cash flow property!!! Why would you? How can you call it an income property when you continually dump money into it? What’s the benefit of it? I’ve heard people say that they will make their profit when they sell. Why would you want to do this? You might need to make payments for who knows how many years before you can sell at a profit, maybe as much as ten years. How much profit will you really make? If I have a negative cash flow of say $200/mth for 10 years (which some people accept today), that’s $24,000 that you will need to put into your property over those 10 years.
|
Scenario 1 – $200/mth Negative Cash Flow |
|
|
Total cash flow payments over 10 years |
$24,000.00 |
|
Total Annuity earned on $24,000.00 |
$7,056.46 |
|
Total equity paid down |
$37,711.66 |
|
Total |
$6,655.11 |
|
Scenario 2 – Break Even Cash Flow |
|
|
Total cash flow payments over 10 years |
$0.00 |
|
Total Annuity earned on $24,000.00 |
$0.00 |
|
Total equity paid down |
$37,711.66 |
|
Total |
$37,711.66 |
|
Scenario 3 – $200/mth Positive Cash Flow |
|
|
Total cash flow payments over 10 years |
$24,000.00 |
|
Total Annuity earned on $24,000.00 |
$7,056.46 |
|
Total equity paid down |
$37,711.66 |
|
Total |
$68,768.12 |
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An Amazing Solution to Enhance Your Real Estate Listing
Have you ever thought of putting up your own real estate listing on the internet? Or even just to complement your regular listing? Imagine if you could put a webpage link on your normal listings. Then, on that webpage, you could show any number of pictures, comments, videos, and so on, of your properties. You could even have audio commentaries associated with the pictures, or with descriptions showcasing particulars of the property. For example, you could have comments such as “The beautiful morning sun shining through the large bay windows in the kitchen just make waking up in the morning a delight” just below a picture of the kitchen in the early morning. The possibilities are endless…
The nice thing about this is that the costs are very cheap to set it all up, especially when you compare it to the cost of listing a property.
You can buy a domain from www.GoDaddy.com for $8.95 for one year (for example it could be your listing’s address to make it memorable – 123MainStreet.com). Then you can go to a service like Blue Host
and buy hosting for as little as $6.95 a month.
If you add up your total costs, then you’re looking at a fraction of the listing cost, but now you’ve got more than a glossy handout to give, you’ve got a fully interactive webpage with as many pictures, videos, audio commentaries, etc. as you want. Considering how much it costs and what you get in return, I think it’s a worthwhile investment. Remember, this website is not about introducing people to your property, it’s about closing the sale with people who have already taken the first step. This is the difference between closing the deal and not, or of getting your price!
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Is There Really a Real Estate Bubble?
Yes! Many of the articles on this website clearly indicate a real estate bubble. Today I came accross an interesting article by the Angry Bear which helps to confirm that there is a real estate bubble. This article is more about the impact of a housing bust on the economy in large, however it does provide some great information, including two very important graphs.
The first graph, seen above, shows a large increase in annual household mortgage debt. This is not a small increase, it’s a very significant increase! The amount was fairly constant for at least a decade until around the mid-90’s, at which time it just exploded, almost at a 45 degree angle. This means that a lot of individuals are getting much more leveraged than before, well beyond the historical averages.
The second graph shows that for the first time in at least 40 years, the annual increase in mortgage debt has been larger than GDP growth in the US. All these, plus the interest rate indicators, definetely lead me to believe a bust is going to happen very soon!
The article also mentions that mortgage equity withdrawal has significantly increased, that is the amount of money borrowed against your home. This is what has in part, along other factors, fueled the refinancing boom. More and more people are taking out the equity from their houses to use elsewhere, often to pay or acquire consumer debt rather than re-investments.
To quote the article on the significance of this graph:
“Hatzius has calculated that homeowners have pulled $640 Billion from their homes in 2004, as compared to just $74 Billion ten years ago.”
That’s about nine times the mortgage equity withdrawal from a decade ago! Combined with the above two graphs, as well as the interest rate article I recently wrote, and the quote from business week, this really tells me that we’re in for a serious real estate bust.!
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A Very Significant Increase in New Single Family Interest Only Mortgages!
Here is a quote from a Business Week magazine article (May 30, 2005 edition) that I just came accross today:
“31 – Percentage of new single-family mortgages that were interest-only during 2004. That is up from 1.5% in 2001”.
Take a second glance at this statistic, it is not just saying up 1.5%, rather up from 1.5%. This means 29.5%, not 1.5%, more single-familly mortgages were interest-only in 2004. This is a very significant increase in highly leveraged mortgages and a serious indicator that a housing bubble is in full swing. Its just a matter of time before it bursts. This is great news for the serious investor. This means that in the near future there will be a lot of properties available on the market from people who over-leveraged themselves during the boom, just like with stocks in the dot com boom.
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How interest rates can drastically affect real estate prices
Do you know the power interest rates have over real estate prices? Well, they can drastically affect real estate prices and the profits you make on your properties, probably more than you realize. If you look at the graph just above, you will see that the total amount of mortgage that you can afford changes significantly (assuming you want to keep the same monthly payment) as interest rates fluctuate.
As an example, let’s take a mortgage payment of $1000 at an interest rate of 5% amortized over 30 years. With these numbers, you can pay a mortgage principal of $186,281.62. Now let’s increase the interest rate by 1% to 6%. If you want to maintain the same monthly payment of $1000, then you cannot sustain a mortgage of more than $166,791.61, making the mortgage principal amount 10.97% less than before. Let’s take a higher, more realistic interest rate, of around 8%, what difference does this make? Well you can now only afford $136,283.49 of mortgage principal, a significant drop of 26.8%.
Many people believe that what has driven the real estate market to today’s high prices is the investment value of properties, plain and simple, just like stocks in the dot com boom. However, if you ask someone walking down the street what started the boom, as in what exactly is the “investment value”, most won’t be able to answer you. Put fairly simple, housing got affordable really quick because interest rates dropped like a rock, to their lowest in decades! The reality is that for each 1% interest rates dropped, a person could afford a lot more mortgage with the same monthly payments, especially when the interest rates are on the lower side. That is what initially fueled the real estate market, however as the flames burned high, the market has taken a fire all of its own because people forget why the market started to get hot.
From the first graph we can extrapolate the data to create the graph just above.The good news is that we can see the mortgage principal drop to be more significant at first, so if you can ride it out for the first little while, you’ll probably be able to make some real money, pennies on the dollars. All those unfortunate souls that have been buying up real estate without really doing the research or working the numbers, or that are on the edge, will most likely get squeezed out and cause some over zealous fire sales, much like the dot com bubble and bust of 2000. For the smart investor, the next few years may become really fertile lands for making profits.
For your interest, I’ve added below the table used to compute these graphs (for a monthly payment of $1000):
| Interest Rate (%) | Mortgage Principal Amount | Percentage Difference |
|---|---|---|
| 4 | $209,461.24 | 12.44 |
| 5 | $186,281.62 | 11.69 |
| 6 | $166,791.61 | 10.97 |
| 7 | $150,307.57 | 10.29 |
| 8 | $136,283.49 | 9.66 |
| 9 | $124,281.87 | 9.07 |
| 10 | $113,950.82 | 8.52 |
| 11 | $105,006.35 | 8.01 |
| 12 | $97,218.33 | 7.54 |
| 13 | $90,399.61 | 7.11 |
| 14 | $84,397.32 | 6.72 |
| 15 | $79,086.14 | 6.35 |
| 16 | $74,362.88 | 6.02 |
| 17 | $70,142.20 | 5.71 |
| 18 | $66,353.24 | 5.43 |
| 19 | $62,936.92 | 5.17 |
| 20 | $59,843.74 | 4.93 |
For the smart investor, the coming real estate bubble bust can be a great time to increase their wealth! And now that you know and understand how much interest rates can truly effect housing affordability, you are in a much better position to make some real money from this real estate bubble bust.
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How Taxes can Dramatically Affect Your Real Estate Gains
Many people believe that flipping real estate is a good investment strategy, that it can give you a give boost to your pocket book, that holding a property for too long is not a good thing since you should cash your gains out often enough and re-invest it again and again in other properties to flip. This strategy does work for some individuals who are good at find hidden gems and can renovate them at a profit. However, for many this is a very sub-optimal strategy, unless you are doing a 1031 exchange.
What most people don’t realize is that flipping can be very costly. Every time you buy or sell a property, you need to pay the income tax on the capital gains (assuming the highest tax bracket and no 1031 exchange since you need to use the cash to live off of) of 50% on your capital gains, not to mention all the associated professional fees. This means that the next time you buy another property to flip, you lose 50% of your compounding gains. Over time this can drastically reduce your returns to only a very small fraction of what you truly could have gotten with nothing other than just holding your properties over a longer time.
Investing is about making money, not losing money, and one of the best and easiest ways to make money is compounding your gains over and over and over and over… Making $1 into $2, then making that $2 into $4, and so on. I find that a decent amount of investors flip real estate properties as soon as they have a reasonable gain and use that as their earned income. This is all fine and great, but imagine what you could do with those gains if you re-invested them? Since these investors don’t re-invest they lose 50% (assuming the highest tax bracket) of the gains to taxes. Assuming we use our example of $1 to $2, you would then have only made $0.50 to re-invest, not $1. You have just handicapped yourself a 50% compounded gain.
This might not seem like much, but let’s follow this simple example to the next stage, let’s now take that gain and double it again, so our $2 goes to $4. In our example, we take our $1.50 and double it to $3. Now we need to take 50% off of our $1.50 gain to taxes, which gives us a total balance of $2.25. We’re already 10% behind (our $4 is actually $2.50 after taxes as we need to pay 50% taxes on the $3 gain from our initial $1) as shown in the table below.
| Year | Income After taxes paid each year | Income After taxes paid only on the closing date | Difference (%) |
|---|---|---|---|
| 1 | $1.50 | $1.50 | 0 |
| 2 | $2.25 | $2.50 | 10.0 |
| 3 | $3.38 | $4.50 | 24.9 |
| 4 | $5.07 | $8.50 | 40.4 |
| 5 | $7.61 | $16.50 | 53.9 |
| 6 | $11.41 | $32.50 | 64.9 |
| 7 | $17.11 | $64.50 | 73.5 |
| 8 | $25.67 | $128.50 | 80.0 |
| 9 | $38.50 | $256.50 | 85.0 |
| 10 | $57.75 | $512.50 | 88.7 |
| 11 | $86.63 | $1,024.50 | 91.5 |
| 12 | $129.94 | $2,048.50 | 93.7 |
| 13 | $194.91 | $4,096.50 | 95.2 |
| 14 | $292.36 | $8,192.50 | 96.4 |
| 15 | $438.54 | $16,384.50 | 97.3 |
| 16 | $657.81 | $32,768.50 | 98.0 |
| 17 | $986.72 | $65,536.50 | 98.5 |
| 18 | $1480.08 | $131,072.50 | 98.9 |
| 19 | $2220.12 | $262,144.50 | 99.2 |
| 20 | $3330.18 | $524,288.50 | 99.4 |
Let’s take a closer look. Our $4 becomes $8 (remember we only pay taxes at the end in this scenario). In our example, our $2.25 becomes $4.50. After we take out the taxes, we get a total of $3.38. We’re now about 25% behind the person who hasn’t sold their properties until the very end of our sample 20 year time period. By now you can already see how quickly the spread is increasing (as show in the graph below).
If you continue this over 20 years (yes I understand that it becomes increasingly difficult for an individual to double each year for 20 years, however let’s assume for simplicities sake that it does really happen) you will get two very different final numbers! The first person who doubled each year and pays a large tax at the end of the 20 years will have after tax a whopping $524,288.50.
Compared that to our scenario where the only difference is that we flipped our properties each year and paid the capital appreciation tax after each year, we get a total of $3330.18 after taxes.
That’s an amazing difference of $524,288.50 or 99.4%! WOW! This really helps to explain why most investors take advantage of the 1031exchange in the US, or that they refinance their properties to buy new properties (no capital appreciation in this case since you haven’t sold the property, all you’ve actually done is shuffle your debt on the property).
In this perspective, commissions on real estate sales for example don’t seem as significant. Are we indeed spending too much time saving pennies? Compare that potential saving and benefit of holding a property for a long period of time. There is no better way to increase your real rate of return than to purchase properties with consistent growth over long periods of time!
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