The 1990s gave birth to hundreds of Internet-based companies, popularly known as dot-coms. Some dot-coms had good ideas and matured into strong, successful companies. But many did not. In too many cases, the business plan was simply to start a company and sell it to someone else—which could be immensely profitable if delusional investors could be found, but a disaster otherwise. The tech-heavy NASDAQ index increased by more than 40 percent a year between 1995 and 2000. Dot-com entrepreneurs and shareholders were getting rich and they wanted to believe that it would never end. But end it did, with the NASDAQ falling by 75% between 2000 and 2003 and the Internet Index falling by almost 95%. That was a bubble.
The housing market is quite different. When real investors, like Warren Buffett, buy something, it is not because they expect the price to be higher tomorrow than it is today, but because they expect the income from their investment to provide a good return. If you can buy a stock for $100 that pays a $10 dividend every year, forever, you don’t have to sell the stock for $200 for this to be a good investment.
Flimsy dot-com stocks were bad investments because there was no income at all. What is the income from your home? If you are a landlord who rents a home to someone else, the income is obvious—the rent check you get each month from your tenants. If you own a home and live in it, your income is the rent check you don’t have to give to someone else. When you write a rent check for $1,500, this money goes out of your bank account and into your landlord’s bank account. If you own your home, the $1,500 doesn’t leave your bank account. This $1,500 is not an abstract theoretical $1,500. It is a real $1,500 that you can invest or use for food, clothing, and entertainment. This $1,500 is income from your home.
The purchase of a home is the most significant investment decision confronting nearly all adults. Yet sound advice, untainted by the self-interest of real estate and mortgage brokers, is extremely scarce. In Houseconomics, the Smiths provide simple and understandable answers to the vexing questions surrounding home ownership, making it a valuable resource for anyone serious about their financial future.
Of course, there are other financial benefits from home ownership (including the tax deductibility of your interest payments and property taxes), and there are also expenses associated with owning a home (including the monthly mortgage payments, property taxes, and maintenance). The point is that the investment value of a home depends on its income—the rent savings and other benefits net of the mortgage payment and other expenses. Because this income is as real as the dividends from a stock portfolio, we call it your home dividend.
Home prices won’t ever collapse the way the prices of dot-com stock plummeted because homes are fundamentally different from dot-com stocks. When the prices of dot-com stocks started falling, there was no longer any reason to buy them. If home prices fell dramatically, you would have a very good reason to buy a home—to get the home dividends! Like many a great investor has said, if you like a stock at $50, you will love it at $40. If you like a home at $300,000, you will love it at $200,000.
We are convinced that real estate continues to be one of the most appealing ways for you to achieve financial security and, along the way, to enjoy—indeed love—your investment in ways that you could never love stocks, bonds, and bank accounts. Build up equity in your home and invest your home dividends wisely. If you do, your home will be the best investment you will ever make.
What happened to home prices in 2007? It depends who you ask.
The Case-Shiller index says prices dropped 9%. The National Association of Realtors says prices only dropped 3%. The Federal Government says prices actually rose 1%.
What’s going on? The problem is that there is no straightforward way to calculate average home prices.
In the stock market, stocks are traded every day and it is easy to tell what a stock’s price is at the end of the day. In the real estate market, a home may be bought one year and not sold again until 10, 20, or 30 years later. And a home that is bought, for example, in 1988 and sold ten years later may have changed quite a bit over the years. Maybe a bedroom was added, or the kitchen was upgraded. Or maybe what was once a brand new home has turned into a fixer upper.
The National Association of Realtors calculates the average price of all existing-home sales—single-family homes, condos, and co-ops. The problem with their approach to calculating home price changes is the sensitivity of the average to changes in the composition of homes sold over time. For example, if prices hadn’t changed at all from 2006 to 2007, but most of the homes sold in 2006 were million dollar homes while most of the homes sold in 2007 were $100,000 homes, then the average price will look like it fell from 2006 to 2007, even though what changed was not home prices but rather the composition of homes sold!
In order to tell whether prices have truly been rising or falling, we need to compare the prices of individual homes over time, and not compare the prices of different baskets of homes. The other two indexes try to do this, but their conclusions are quite different. The Case-Shiller index says home prices fell by 9% in 2007, but the federal government says home prices rose by 1%. Both indexes try to compare the prices of individual homes, but they do it in somewhat different ways and such comparisons are inherently tricky for both.
Another problem is that the Case-Shiller index does not cover the entire country. It does not have any data for 13 states and has incomplete data for another 29 states. Some of the strongest housing markets in the country (Idaho, Montana, and Wyoming) are omitted from the Case-Shiller and others are only partially covered, which would help explain why their index is so gloomy.
In addition, the Case-Shiller index gives more importance to expensive homes than to less expensive ones, while the federal government’s index does the reverse. If modestly priced homes are doing well and expensive homes are suffering, the Case-Shiller index will say that home prices are going down and the federal government will say that home prices are going up.
Are you confused yet? You should be.
But IT DOESN’T REALLY MATTER, because when you are thinking about buying a home, national home price indexes don’t really matter.
What’s the bottom line?
1. Don’t pay a lot of attention to home price indexes. They are complicated, confusing, and contradictory.
2. All real estate is local. If you live in Indianapolis, what do you care about home prices in Detroit, Houston, or Las Vegas ?
3. The real question for homebuyers is not how home prices today compare to home prices last year or 20 years ago, but instead how the costs and benefits of homeownership stack up. Do the benefits outweigh the costs, or vice versa? In Houseonomics, we explain how to calculate the benefits and how to calculate the costs. This comparison is what really matters.
News people say, “If it bleeds, it leads.” This means that the front-page stories in newspapers and the lead stories on television are often scary.
If an airplane crashes into a park and kills a family, this is bloody; this is scary; this is news! If a family goes to the park and has a great time, so what? Where’s the blood? Where’s the misery?
For real estate, this means that news people think it is interesting when someone loses their home to a foreclosure. That’s scary; that’s news! But it isn’t interesting when someone buys a home and lives happily ever after. Where’s the blood? Where’s the misery?
This news bias can give a very distorted picture of life. We start worrying about airplanes crashing into parks, instead of having fun at the park. We start worrying about home foreclosures, instead of thinking about how much money we would save and how much pleasure we would get from owning our own homes.
If you are thinking about buying a home, what you need to think about is how much money you will save and how much pleasure you will get from owning your own home.
Think of buying a home like buying stocks and bonds—with one important difference. It is a lot more fun to own a home than to own a bunch of stocks.
When buying stocks, successful investors follow four simple rules.
Rule 1. Don’t try to time the market. It is hard to predict. In 2003, many people thought there was a housing bubble and they put off buying a home, waiting for prices to fall 50%; instead, home prices in their town went UP 50%. Now they can’t afford to buy the home they put off buying. Don’t try to time the market.
Rule 2. Instead of trying to predict short-term price changes, think long-term. Warren Buffett says “My favorite holding period is forever.” Instead of trying to predict short-term changes in home prices, look at whether a home’s financial benefits are high or low relative to the expenses. In Houseonomics, we call the difference between the financial benefits and expenses your “home dividend.” This is what you should focus on. Is the home dividend high or low relative the price of the home?
Rule 3. Don’t be obsessed with market averages. All real estate is local. The question is not what home prices are in other parts of the country, but whether the home dividend for the home you want to buy is high or low relative to its price. We’ve looked at real estate all over the United States, and in most places the financial benefits from home ownership are compelling. In most places, buying a home may be the best investment you will ever make.
Rule 4. The best time to buy is when most people are pessimistic. The best time to buy is when buyers are scarce. In a buyer’s market, you can get a good price on a great home that will providefinancial benefits and personal joy year after year.
Find your dream home and calculate your home dividend. If the numbers make sense, now may be a great time to buy a home!
We are in the middle of a severe credit crunch, one of the worst in memory. This crunch was caused by two factors: subprime loans and incomprehensive derivatives.
1. The first factor is subprime loans. A few years ago, a lot of unscrupulous brokers and lenders made loans to people who wouldn’t normally qualify for a mortgage. They didn’t have enough savings to make a normal down payment. They didn’t have enough income to make normal monthly mortgage payments. Nonetheless, they got loans because some salespeople got paid for every loan they made, regardless of whether it was a good loan or a bad loan. Often, these so-called subprime borrowers got a low teaser rate for a few years, and then their mortage rate jumped to double-digit levels.
These subprime borrowers cannot afford to make higher mortgage payments unless their income increases dramatically or the value of their home increases dramatically. They were a foreclosure waiting to happen. They couldn’t make their monthly payments. These forced sales are a huge drag on the real estate market.
Plus the lenders who got burned by these bad loans are hurting and they can’t afford to make a lot of new loans.
2. The second factor is incomprehensible derivatives. Bundles of loans were put into packages and then sliced and diced into pieces like baloney. These are called derivatives because the value of this baloney is derived from the values of the mortgages that were used to make the baloney.
The problem is that that no one really understands what is in the baloney. A very good rule is “Don’t invest in anything you don’t understand.” But even sophisticated investors are human and humans are susceptible to wishful thinking and greed. They held their noses and bought this rotten baloney because they hoped they were buying prime rib.
These two factors created a credit crunch.
A credit crunch means that many banks can’t make loans and some banks don’t want to make loans.
So, people with lots of income and assets and impeccable credit scores who’ve paid every bill on time are getting turned down for mortgages simply because lenders are very nervous and are being very cautious.
This credit crunch is awful for home sellers and it is awful for home buyers who have their mortgage applications rejected. But it is a great opportunity for anyone who can get a mortgage. This is a genuine buyer’s market. Mortgage rates are low, and sellers can’t find buyers. This is a great time to be a buyer because mortgage rates are low and you can have the upper hand in negotiations with the seller.
When will the market turn? When banks rebuild their capital and are willing to lend again. The Federal Reserve, Congress, and state and local governments are doing what they can to end the credit crunch. And it will end.
If you can get a mortgage now, now may be a great time to buy, before the credit crunch ends and the real estate market turns into a seller’s market again.
