A couple of weeks ago, Kevin wrote Has the Time Come Again to Invest in Real Estate? and made the case for and against investing in this area, making some excellent points. However, I think the majority of people who jump into real estate right now will be kicking themselves in a few years when their investment continues to lose value.
Kevin is right that prices have dropped a lot since the peak – down more than 50% in some cases. Unfortunately, this doesn’t make housing cheap or even affordable.
Americans are spending too much on housing still. For over two decades, the ratio between the median home price and median household income was 2.8. Based on the latest government figures, the ratio is 4.3. The situation is getting worse as income is falling faster than prices, as unemployment remains stubbornly high.
As a percentage of their budget, the average American household is spending 47.58% on just housing and utilities, not counting food, transportation or health care, which add another 34.97%. This is way too much of your budget to spend on necessities, leaving very little for savings or debt reduction.
I agree with Elizabeth Warren’s view to only spend 50% or less of your after-tax income on “Must Haves.” When most
households are spending 35% or less of their budget on housing, then I
will believe that housing is reasonably priced.
On the other hand, each real estate deal is individual. I believe it’s
possible to get a good deal somewhere right now. Midwesterners are the most likely to find a good investment, as median home prices are only $139,700, while the Northeast is still the most expensive region at a hefty $239,200.
Landlord = Cash Flow?
I’ve heard some gurus advise buying property to rent it out, with the
argument that you can cover your expenses and generate steady cash flow.
This assumes two things I don’t think are true. First of all, it’s not
that easy to find a reliable tenant right now. Not only are there too
many rental units empty in most areas, making competition fierce, but
many people who’ve suffered foreclosure aren’t renting, but are moving
in with relatives. You also risk having your formerly great tenants lose
their jobs and be unable to pay you, necessitating eviction.
Second, these pundits assume that buying is cheaper than renting. I did a little experiment in my neighborhood. Although I couldn’t find a
directly comparable property, I found one 25% smaller down the street.
Moving there should save me a lot of money, right?
I found that even with a 20% down payment and a 30 year fixed mortgage, downsizing would cost me $200 more in taxes and mortgage payment per month. That doesn’t count realtor fees, moving expenses, or paying a landscaper instead of having that included in my rent. In addition, as a smart homeowner I would need a savings account with several thousand dollars in it to cover the expensive things that need replacement periodically, like fences, roofs, and upgrades of bathrooms and kitchens.
Inventory, and Shadow Inventory
In any bubble, there is too much investment in one area, as people pour in expecting easy money. The housing bubble was no different. Builders constructed dozens of homes or condos before they had buyers, and homeowners pyramided loans to purchase another house or two to flip.
Today we see home inventory near a 10 year high of 3.86 million units. That’s bad news for anyone trying to sell.
What’s even worse is the estimated 2.1 million “shadow inventory” of
homes that are available but not on the market yet, like new
foreclosures and other bank owned properties. These houses are vacant but not “for sale” for fear of pushing prices down even further. There are possibly another 3 million excess vacancies awaiting a renter or new owner. All this overhang must be slashed before the housing market can meaningfully recover. I wasn’t surprised to see the recent Case Shiller forecast which predicts a 7.1% drop in prices by the end of the second quarter of 2011.
Things could get even worse if the job picture doesn’t turn around soon. With the real unemployment rate above 20%, I believe millions
of people are just barely holding on to their homes. Congress is not
planning to extend unemployment benefits again, so if they don’t find
employment soon, they will suffer foreclosure.
The housing market is further suffering from the effect of adjustable
rate mortgages. Many people chose this option over a fixed rate because of lower payments, the belief that they could refinance later, or just ease of getting the loan. Frankly, just about everyone with a pulse was getting approved for a mortgage a few years back, including people without a job or even residency papers.
I agree with Kevin’s point that mortgages will be much harder to get in
the future. Many people with ARMs will find themselves unable to get an affordable rate or get refinanced at all. When mortgage rates go up as they must eventually, even more people will be unable to afford their new house payments. Those homes will be added to the inventory pile as borrowers go into default.
Appreciation won’t help you if you made a mistake in
your real estate investment. In fact, I believe your property is likely
to lose value, and excess inventory is putting downward pressure on rents.
If you buy property in the US, you should be prepared to stay a long
time. It’s now common for houses to stay on the market over a year.
Unless you are willing to slash your price aggressively, few will be
interested. I’m not expecting the market to bottom until 2014 at the
earliest, so I wouldn’t buy anything unless you plan to be there for a
minimum of 7 years.