Housing: To Buy Or Not To Buy?

By Jennifer Barry

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.

Exploding ARMs

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.

No Do-Over

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.

( Photo by WoodleyWonderWorks )

15 Responses to Housing: To Buy Or Not To Buy?

  1. Hi Kevin, thanks for the opportunity to guest post! I like the picture – it really sums up the situation for a lot of people.

  2. Thanks Jennifer – I like different opinions, somehow we get closer to bankable information by bouncing ideas back and forth. I agree with what you’ve written too. Jobs are the biggest issue, I think, and right now that’s looking questionable. Any play in real estate right now would be based on the projection that employment will strengthen considerably in the years ahead. If not, it’ll be best to stay out of the game entirely.

  3. Jennifer – I’m a numbers guy and appreciate the ratios you cite – the 2.8 house to income is intriguing.
    I’d ask one thing. How does it account for rates? For argument’s sake assume one would use 25% of their $100K income to pay the mortgage, that’s $2083/mo. At 8% they can borrow $284K, but at 4%, $436K. Looking at these numbers, we see two things (well, I do, you may have more insights) first, the 8% rate produces that 2.8 ratio you reference, which seems a high rate. Second, if we stick with the 30yr fixed, the swing in what you can afford vs the interest rate swing quite dramatically. I dare say, the median numbers in housing never really reflected the housing bubble. It took a combination of fraud and bad loans to drive the bubble at the higher end. But it appears that conservative lending practices (28% to mortgage plus property tax, I took off 3% to leave 25% for the mortgage) produce those swings in ratios strictly on interest rates.
    Glad to discover you on Kevin’s site, enjoyed your article.

  4. Hi Joe, the 2.8 ratio doesn’t account for rates directly. However, I checked historical interest rates for 30 year fixed mortgages, and 8% isn’t outrageous. The chart I found here (http://mortgage-x.com/trends.htm) starts in 1984 and the rate doesn’t dip below 8% until 1992. It doesn’t drop below 6% until 2002! Today we have near record low rates, and that can’t last. When we revert back to the mean, houses will get a lot less affordable as you point out. I agree that reckless lending practices and fraud were necessary to get the market out of control, as requiring a 20% down payment would have eliminated many buyers. Thanks for your comments!

  5. Enjoyed your article Jennifer. Normally there is an inverse relationship between interest rates and home prices. However I don’t believe these are “normal” times. I live in an area that has weathered the economic storm very well and we never had the run-up in prices like the rest of the country, yet I see houses in my neighborhood sitting for an awful long time on the market even with low interest rates. The interest rates don’t have as much effect right now, because it has more to do with the overall economy and workers’ perceptions of long-term job stability.

  6. Hi Norman, I’m glad you liked it! Are you in the Midwest? There seems to be less froth there. I agree these are not normal times. People are understandably reluctant to take on a long-term commitment right now, especially when the market is so illiquid.

  7. I’m looking to buy a house in early 2011 and definitely have a long term plan in mind, I want to make sure I have enough money so that in the worst case if I do decide to move before 7 years (which knowing me, I probably will) I can always rent the original property out.

  8. Hi CreditShout, I definitely think a long term plan is a good idea, as well as a backup. I have so many friends who planned to keep their house for a long time but then things happened like divorce, a serious health crisis, sudden unemployment, etc.

  9. Joe and Norman brought up interest rates, and that’s the issue that’s the most troubling. At any other time in history, rates below 5% would have been more then enough to ignite an explosion in both housing activity and housing prices. What’s different now?

    It makes you wonder what will happen to housing when rates go to 6%–and they will eventually–or 8% or 10%. That’s the “X” factor looming in the distance. It’s hard to imagine that rates will decline much from where they are, but the upside potential is…overwhelming.

  10. Hi Kevin, I think it’s 2 things. The first is the terrible jobs picture as you mention above. The second is the massive oversupply of houses in many areas. Not only have people had to move in with relatives after foreclosure, but there are many properties which were bought or built on speculation and have never had anyone living in them.

  11. I am a mid 50’s widow whose engineer husband did all the investing/savings, bills etc., and after 4 years of living alone find myself competely at a loss. I was renting and realized that I was spending more than I was making, having to dip into the what savings I have left. Several people have mentioned the ‘great bargins’ in AZ, with houses selling in the 90’s which a few years ago went in the 200 & 300’s just a few years ago. After reading these posts, the numbers dealing with an overstock of housing and the competition in the rental area, I am feeling very insecure about purchasing anything. For those of us who are not as savvy in the markets, who do we believe? Those who say things are looking up? Those who say employment will continue to be down? Uncertainity is not a comforting answer.

  12. Hi Laura, I’m sorry to hear of your dilemma. Is there a way you could rent someplace cheaper or live with relatives or a roommate? It can help to live in a cheaper area of the country too. My husband and I moved to a different, cheaper state when we had money problems about 10 years ago. Uncertainty is definitely difficult to deal with.

  13. People keep saying it’s a buyer’s market. I’d say if you have some spare cash and a clear mind of what you are doing, then this IS your market, go for it. If you are not sure, and in fact you are quite happy renting at the moment, then think about buying more carefully. I have bought my house at the beginning of the recession when house market was at it’s “historic low” according to the media. Now it’s even lower!!! Good news is, I don’t really care, cuz I have no plan of selling it, at least for the next 5-7 years.

  14. Hi omgloan, I agree that there’s no rush to buy if you are happy renting. Maybe your area never appreciated much or you are getting a sweetheart deal from a relative, but in most cases, I would hold off. Prices are likely to be cheaper in 2011 and 2012. It’s good that you have no plans to sell, that way you shouldn’t lose any money!

  15. omgloan – I wold agree with Jennifer here, even though I’ve written that now might be a time to seek out deals. For most people in most situations, patience will probably work in their favor. Buying–if it’s the thing to do–would mostly be advised under certain circumstances where an obvious deal can be had. “Buying off the shelf” as most people do, still has enormous risk.

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