54 Responses to “Real Homes of Genius: Today we Salute you Downey. $270,000 off Peak!”

• surfaddict

  January 3, 2008 at 2:03 pm

  Still easy to find these crazy listings, but do you think their numbers are diminishing? Your articles are spot-on, backed by data, logic, and humorus. I enjoy every one. I have been preaching what you blog for years…my only mistake was underestimating the durration of the bubble, and NOT jumping in, making a few bucks, and getting out!! The craziness reinforces my theroy that 75% of folks in world are dummies, doesnt that have to be the case for illogical prices that ignore fundamentals?

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• Andrew

  January 3, 2008 at 2:16 pm

  Good to see Downey up here again since we are right in the middle of the implosion. Over the past couple of months I’ve noticed an increase in the number of for sale signs. Would be interesting to see inventory numbers along with number of sales and square foot price. If sales are down and inventory is up then it should be obvious where prices are going.

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• CompaJD

  January 3, 2008 at 2:53 pm

  I live in Downey, and the house prices are still unbelievable here. Its funny how even some places in the Older, Southern (Ghetto) part of Downey are still in the upper 900K. I think I know why 1/4 of all agents in California had 0 sales in 2007. They are ignorant to the things happening in their surroundings.
  I know of couple of agents that don’t understand what made prices skyrocket and also what’s making prices go down and stay down. I like to use DHB’s 2 Tsunami’s of mortgage resets to school everybody I know on the current situation and not to listen to the NRA. Thanks DHB for using my Town, which is full of Dumbass Real estate Agents, to bring us today’s RHOG.

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• drhousingbubble

  January 3, 2008 at 6:35 pm

  @surfaddict,

  You bring up a good point. As a generalization, we are a consumerist society given that we have a negative savings rate and nearly 70 percent of our economy depends on people spending typically money they don’t have. So it isn’t a far stretch to see people buying homes they cannot afford with money that doesn’t exist in a fantasy that apparently isn’t grounded in anything logical. It is even worse when our central bank is all the more willing to keep this fantasy going further before hitting a nightmare state. Nothing that we have done was sustainable for this country and it is infuriating. Let us not even talk about Social Security since the tactic being taken is don’t do anything until all hell breaks lose. Didn’t work for housing, won’t work for Social Security, and won’t work for our economy. Not unless drastic measures are taken.

  @Andrew,

  According to DataQuick:

  90240 down 17.8 percent YoY at $535,000
  90241 down 7.5 percnet YoY at $570,000
  90242 down 22.1 percent YoY at $434,000

  Total sales is 20, 18, and 18 respectively. These are numbers for Nov. 2007 so I’m sure they are going lower.

  @CompaJD:

  I’m as shocked as you are that prices are this high. In fact, there is no economic fundamentals to justify this. Downey is one of those cities that will get annihilated because of the housing bubble bursting. Middle class area heavily dependent on housing and housing related jobs with no high income base to support absurd prices. The only reason it got pumped up was because these same agents were selling to friends and family or folks in their circle of trust usually with a buddy loan officer so they could share in the incestuous ponzi scheme. Fraud cases are now coming out and they are sickening and frankly, I hope many of you are contacting or have contacted your local representatives to give them a piece of your mind.

  For those looking for the Tsnumai post, here it is:

  The Housing Wave of the Future: Two Main Mortgage Tsunamis.

  Reply
• Rory Hester

  January 3, 2008 at 6:43 pm

  I grew up in Downey during the 80’s… it used to be a pretty nice suburb, but when the defensed industry collapsed it got hit especially hard, since it was home to Rockwell.

  $75K per year median family income seems a little high. The numbers I find show the median income to be around $45.5K.

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• Eric

  January 3, 2008 at 8:53 pm

  Hey DHB. I went to school in LA and hope to one day return to Southern Cal. Your site is very insightful about the current situation. Is it possible for you to circle back to all the RHG to see the actual selling price (assuming any of them have sold)? Think the sales vs. list price would be a very telling indication of the state of the market.

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• law student

  January 3, 2008 at 11:06 pm

  First, allow me to say that I have been aware that there is a housing bubble since roughly 2005 when I was working at a hedge fund buying subprime MBS. I left the fund because the future looked so bleak, and went to law school. That being said…

  I find it very silly that you compare “PITI” to “area rents”. First, “P” should be out of the equation entirely. It is not a cost. It is just shifting of money from one point to another, it is nothing more than a silly mandatory savings component that comes along with a traditionl mortgage. A reasonable buyer with some financial stability (i.e., nearly anyone who can afford to pay 700K for a house) will disregard this element, and, furthermore, absent some assinine regulation, I/O mortgages will become available again in the near future (with more reasonable down payment and income requirements). Thus, factoring in “P” is just silly.

  You might consider “M”, for maintenance, but that is generally going to be more than offset by appreciation (even with 0% real appreciation, inflation will slowly push housing prices up). You might be tempted to argue that appreciation is negative, but this is of course just begging the question/circular reasoning.

  Furthermore, there are significant tax benefits to a mortgage, particularly in California where state income taxes are high.

  The true cost of homeownership will depend on the home, the owner’s ability to get a lower-rate loan (i.e., credi), how long the owner resides in the residence, and the tax situation of the owner.

  Two additional factors: (1) people are actually willing to pay a little more for the pride of homeownership rather than rentng, and (2) the median rental price you listed would almost certainly not allow one to rent a comparable home.

  Bottom line: based on rental values, the home is fairly close to being reasonably priced at 715K.

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• YLG

  January 3, 2008 at 11:27 pm

  did you see this article profiled on the LA Times RE Blog today?

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• jdy

  January 4, 2008 at 12:30 am

  Hmmmm………… I guess these home owners think they are the only smart ones while every one around are stupid enough to buy. or are they just plain greedy?

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• steveRB

  January 4, 2008 at 12:55 am

  @ law student –
  Your analysis is adorable. Please continue to enlighten us with your pearls of wisdom.

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• Carl

  January 4, 2008 at 8:18 am

  Actually you are wrong and should do some more research. Over the majority of time and geography, the cost to buy has been less than to rent because of the applied inherent risk. No one pays more to risk than the income it will generate. This is a generic rule about income investments. Anything else is speculation – and that cycles, waning when the returns become negative like now.

  Your response sounds like it’s written by someone who has a lot of equity or paid too much for his house, and is trying the “hold and pray” approach. You need to remove your emotional attachment to any investment as it will cloud your judgement as to what will really happen. A $700,000 house which was expensive as a $400,000 house just a few years ago – and when fundamentals where basically the same – has a tremendous amount of risk in it – unless rents or inflation skyrockets. Counting on an irrational government to continuously resolve the probelm will not work in the long run.

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• Jatta Pake

  January 4, 2008 at 8:36 am

  Just wanted to say thanks again for another wonderful RHG!

  I tell everyone I know about your website. Keep it up!

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• Mob662

  January 4, 2008 at 10:15 am

  I’m moving to Lynwood!

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• Law Student

  January 4, 2008 at 4:24 pm

  “No one pays more to risk than the income it will generate.”

  This is just one factor that may influence whether a person is willing to pay more for ownership. Other factors are the prestige and (perceived) stability of homeownership. Furthermore, you assume rationality among buyers while simultaneously arguing current prices are irrational. Pick one.

  “Your response sounds like it’s written by someone who has a lot of equity or paid too much for his house, and is trying the “hold and pray” approach. ”

  I rent and have never owned any real property anywhere, ever.

  “A $700,000 house which was expensive as a $400,000 house just a few years ago – and when fundamentals where basically the same.”

  This no more proves that 700K is unreasonable than it proves that 400K was unreasonable. i.e., the mere fact that prices are substantially higher than they were a few years ago proves nothing as far as whether current values are fair.

  Furthermore, fundamentals did change. (1) Municipalities and states across the country have been adopting increasingly restrictive land use policies. (2) The reality of a prolonged era of economic malaise (and low interest rates) is becoming clear to more and more people. (3) With a growing national deficit and debt, the likelihood of interest tax rate increases in the future has been growing. Higher tax rates mean lower net costs of mortgaging given the mortgage interest deduction.

  It goes without saying that there was a speculative element to the housing price run-up and that this lead to a national bubble. The question here is whether this particular house is fairly priced at $715K when compared to the cost of renting. DHB’s analysis of the issue is almost as half-baked as the MBS models we used to use at the hedge fund.

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• Law Student

  January 4, 2008 at 5:04 pm

  DHB’s recent post more clearly illustrates the situation, but still seems incorrect to me.

  First, you make an innocent subtraction error in your numbers. 5569-1079-666 = 3982, not 4490. Thus, the difference is $1582, not $2090. I agree no one will pay $1582 for the pride of homeownership, but, as you will see, the true cost is actually less.

  Current U.S. inflation is around 2.5% (I am generously underestimating inflation here). So the $715K home value increases by $17.8K/yr (or ~1500/month) just due to inflation. This leaves a difference of around $100/month. I do think many people will pay $100/month for the prestige and pride of homeownership.

  Of course, this oversimplifies things. First, a home brings with it the opportunity to obtain a standard thirty-year mortgage at a fixed rate. Assuming one has such a mortgage, the ability to prepay should interest rates fall and to extend payment over a longer period of time should interest rates rise has an inherent – and significant – economic value to the mortgagor. Investors in MBS understand this and the risk is known as “negative convexity” or prepayment risk. Quantification of the value of this benefit requires some complex financial mathematics that are beyond the scope of a comment here, but know that the embedded prepayment option in a mortgage has significant value. This is, of course, somewhat limited by prepayment penalties and due on sale clauses.

  A second factor relates to the fact that purchase money mortgages in California are non-recourse (see, e.g., Cal Civil Code 580b). As such, a borrower does not suffer the downside risk of a significant decline in housing prices except to the extent of the buyer’s equity and the value the buyer places on the buyer’s credit score. However, buyers do enjoy full upside benefits. Again, this has significant economic benefit to the borrower/buyer.

  Other factors are also germane, such as the homestead exemption that comes with property ownership.

  Most of these tack-on factors that I list slightly seem to balance out with the costs of selling a house and to some degree the maintenance costs. The bottom line is that although the house was clearly never worth 900K, it may be that $715K is not unreasonable.

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• AAA

  January 4, 2008 at 5:18 pm

  Please help . . . I am trying to buy a 4000 sqft house in N. Fontana for 480,000. houses in the same neighborhood w/ the same sqft have sold for 700,000 – 750,000 . . . thought it was a good deal, I am not so sure anymore, HELP !!

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• drhousingbubble

  January 4, 2008 at 6:09 pm

  @Law Student,

  The math is correct. Why are you subtracting out the principal payment? The line item I placed was the net house payment. That is, how much money is it going to cost you to live in the home per month.

  You make a couple of assumptions that are wrong:

  1. Current U.S. inflation is around 2.5% (I am generously underestimating inflation here). So the $715K home value increases by $17.8K/yr (or ~1500/month) just due to inflation.

  Yes, inflation is high in certain sectors such as commodities, healthcare, food, and daily basic necessities. However, last year for the first time since the Great Depression did we see a national yearly price DEFLATION in housing. So assuming inflation in housing is wrong and all one needs to do is look at last year’s data. In Southern California prices dropped 10 percent year over year. Where do you get your 2.5% housing inflation numbers from? The CPI does not look into home payments as a factor but owner’s equivalent of rent. You should read up on hedonics for consumer price indexes.

  2. This leaves a difference of around $100/month. I do think many people will pay $100/month for the prestige and pride of homeownership.

  Say what? If you can rent this similar place for $2,400 how is that a $100 difference from $4,490? Please show some math.

  3. Of course, this oversimplifies things. First, a home brings with it the opportunity to obtain a standard thirty-year mortgage at a fixed rate. Assuming one has such a mortgage, the ability to prepay should interest rates fall and to extend payment over a longer period of time should interest rates rise has an inherent – and significant – economic value to the mortgagor.

  Obtaining a 30 year mortgage is not reason enough to purchase an asset. This home is a perfect example. Someone paid $900,000 and now it is selling for $715,000 (with no takers); same thing happened in Japan. Take a look how their real estate did over a decade. Again, your argument places too much of an ideal perception that people are willing to pay top dollar for an asset without any economic fundamental backing. The Fed just announced they will inject another $60 billion into the credit markets and potentially will cut rates yet again. Current market sentiment if anything, goes contrary to your assumption that rates will rise. In fact, they may go down further. Thus your incentive of fixing in lower rates is no reason for buying a home. Want to buy a Pinto for $50,000 at 0 percent over 20 years? Again, asset price does matter and your argument gives light into why so many hedge funds imploded. They collateralized debt thinking there would always be a greater fool. The game had the makings of a Ponzi scheme.

  4. “A second factor relates to the fact that purchase money mortgages in California are non-recourse (see, e.g., Cal Civil Code 580b). As such, a borrower does not suffer the downside risk of a significant decline in housing prices except to the extent of the buyer’s equity and the value the buyer places on the buyer’s credit score. However, buyers do enjoy full upside benefits.”

  This is flat out wrong and is a dangerous deception. What do you say to all the short sales that are currently booming in California? What about all the foreclosures and price decreases? Where is this “upside benefits” now? Your argument is flawed since the entire region is seeing price deflation and just because a mortgage is non-recourse, meaning the lender/issuer can typically only go after the collateral, the buyer does lose something, the home. So the lender now has an asset that is depreciating and a ex-homeowner has ruined credit in a market where credit standards are tightening. Explain to me how this bodes well for the market?

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• Law Student

  January 4, 2008 at 7:37 pm

  “That is, how much money is it going to cost you to live in the home per month.”

  It is your use of the word “cost” that is problematic. It is becoming increasingly clear that a large part of the disagreement we are having is that you don’t understand the difference between cash flow and income/expense from an accounting/economic perspective. Principal payment is not a cost, it is a cash flow.

  I can tell you are not doing this out of bad faith, because you make the same error in failing to consider the opportunity cost loss of the down payment that is put into the house. This error actually ends up favoring me, because it leads you to slightly underestimate the economic cost of ownership in favor of looking solely at cash flow.

  1 – “So assuming inflation in housing is wrong and all one needs to do is look at last year’s data.”

  What is hilarious about this is that you are making the exact same error as was made by people who bought into the housing bubble! i.e., you are assuming that past performance somehow relates to [long term] future performance. It doesn’t.

  You are also confused as to what inflation means in an economic sense. Inflation is not about the price of goods – it is about the inherent value of money. CPI, which you reference, is intended to measure inflation by measuring increases in the cost of goods. It is really irrelevant whether housing values are included in CPI, which is merely a measure of inflation – the change in the value of money. What makes this significant is that you list as a “cost” the full nominal interest rate paid on a mortgage, apparently not realizing that nearly half of that interest is being offset by the effects of inflation. In real terms, mortgage rates are currently around 3.5% (4.0% for jumbo). Thus, the real cost of borrowing 700K is only around 28K/yr or $2333/month. You will note that this is quite similar to the rental value you cite – this is not a coincidence.

  2. “Say what? If you can rent this similar place for $2,400 how is that a $100 difference from $4,490? Please show some math.”

  Again, your $2,400 figure is based on nominal interest rates and a failure to distinguish between what is a cost and what is merely cashflow.

  3. [paraphrased] “Asset prices matter”.

  Of course, this is true. However, my point in that instance related to the fact that one of the benefits of homeownership and mortgaging is the fact that, when one takes out a mortgage, they can choose to get not only a 30-year fixed rate loan but also an option to cancel that loan at any time. That type of option has a financial value that is significant.

  4. “. . .the buyer does lose something, the home.”

  They also lose the obligation to repay the (non-recourse) mortgage, so in an economic sense it balances out.

  As far as the borrower’s credit – I mentioned that already, but good credit has only limited economic value.

  If I buy a 500K house in CA with 50K down, the most I stand to lose is 50K + my good credit. Even if the house value drops to 400K, or the house burns down and drops to 0, I can only lose 50K+ my good credit (for the next 5-7 years, although the impact is minimal after 4).

  If the property increases in value, I keep the winnings. There is thus an economic benefit inherent to the situation of being a homeowner with a non-recourse loan.

  Reply
• Engineer08

  January 4, 2008 at 7:45 pm

  @Law Student…. None of your comments make sense!

  I do not think that somebody paid 900k for that house and now is willing to sell it for 700k. I think somebody moved to this house from a 2 bed that they purchased for 200k before the bubble. They sold the 2 bed in 2006 for 800k and paid 900k for this house. Assuming they got an introductory rate or pay option negative amortization loan, and paid 1200 a month for the 300k loan, they were fine… Maybe now the reset is coming and they can’t even pay the 300k+ loan. So they decided to sell… They will still make about 400k in profit…

  Now, here I am, an engineer… trying to buy this house… I get a loan and pay 5500 a month PITI… Out of which 4200 is interest and another 800 taxes and insurance which I can deduct from my taxable income… So I end up with a 60000 deduction on my tax return… Ok… I make 100k a year… I go in and do my taxes… federal tax liability is only 4k.. Cool… Without the deduction it was… 14k… Ok… So I get another couple thousands in tax savings from the state… which means I will pay 1000 less a month in taxes. My take home pay will be 7800 a month… I happily pay the 5500 and I’m left with 2300 a month for food, utilities, cars, gas, insurance, going out, and ….savings…. an idiotic bank agrees to my 70% debt to income ratio… Ok, hold on, I’m not that dumb… I’m an engineer… I’ll pay 2000 a month in rent and actually go see a new movie and have some popcorn once a month…

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• drhousingbubble

  January 4, 2008 at 8:25 pm

  @Law Student:

  This is a good discussion but you are wrong on more points:
  1. “What is hilarious about this is that you are making the exact same error as was made by people who bought into the housing bubble! i.e., you are assuming that past performance somehow relates to [long term] future performance. It doesn’t.”
  And in your previous argument you said…
  “Current U.S. inflation is around 2.5% (I am generously underestimating inflation here). So the $715K home value increases by $17.8K/yr (or ~1500/month) just due to inflation.”
  Are you not using the same logic here using past performance (i.e., inflation rate and appreciation) to predict future values? You are using the overall basket of goods CPI and applying it to one asset in our economy that is trending downward. Simply put, many economic factors are showing that the trend in housing prices with higher inventory, dropping prices, lagging selling times, and general consumer sentiment is pushing prices down on houses. I’ve discussed many times the economic definition of inflation; but it is also the case that a single asset class can have an inflated price. Yes, the economist definition of inflation is too quick of growth in the money supply. Yet with so much liquidity flowing into the credit markets you would think that the CPI would be much higher. It isn’t because many things are no longer factored into it. M3 is no longer reported. There are good updated models that show the true rate of inflation somewhere at 10 percent. Again, it is possible to have nationally increasing or stabilizing housing prices while areas such as Southern California see nominal price decreases in the price of housing. My prediction is we will see both national and regional declines in housing prices.
  2. “In real terms, mortgage rates are currently around 3.5% (4.0% for jumbo). Thus, the real cost of borrowing 700K is only around 28K/yr or $2333/month. You will note that this is quite similar to the rental value you cite – this is not a coincidence.”
  Wow. Show us where a buyer can get a mortgage that will work out to be $2,333 a month for $700,000. Are you sure about that 4 percent jumbo rate? You might want to pick up the phone and call your local bank and get a quote on a 30 year fixed mortgage. Your reality won’t coincide with what is happening in the lending industry.
  See your error, like most people that look at the housing market through your lens, and the media is guilty of this, is that a housing payment either through owning a home or renting a place has to come out of your monthly net income. That is a major caveat and should not be overlooked. Again, coming back to this home, this area has an average income of $75,000 and their simply isn’t a base of buyers that can or will buy this home without unconventional financing. If all that you said applied, the removal of subprime, interest only, and option ARMS shouldn’t impact prices as much as it is since there would be an economic reason to buy the home. The problem is, now that income statements are required and many of these loans that artificially priced the inherent risk are gone, the market has dried up. When a bubble pops, and this is a bubble, things usually over correct. This decade long housing bubble is only in the first stage of a correction.
  4. “If I buy a 500K house in CA with 50K down, the most I stand to lose is 50K + my good credit. Even if the house value drops to 400K, or the house burns down and drops to 0, I can only lose 50K+ my good credit (for the next 5-7 years, although the impact is minimal after 4).”
  Again you are using past market performance to predict future economics. In your defense, to make an argument valid it is fair to argue trends and future predictions as long as you back it up with data supporting your case. See, the argument many housing bulls had was prices will go up simply because they have. This was good until prices didn’t go up. The argument of many of the housing bears is that prices became disconnected from area incomes and thus would return to historical averages. You assume that credit will be easy to get in 4 years simply because it was during the current bubble and bad credit won’t be looked at too carefully. Your example is a perfect case of why lenders and Wall Street massively under priced the risk involved and the irresponsible mentality of many people. Like you said, if the home drops to $400,000, why stay and fight to pay it off? Your only loss is $50,000. You don’t have a moral obligation to fight for the lender. You go on to say…
  “If the property increases in value, I keep the winnings. There is thus an economic benefit inherent to the situation of being a homeowner with a non-recourse loan.”
  That is the gambling mentality of Wall Street and of many lenders. Things go good you win. Things go bad, you walk away and things are still good. Maybe because of your background at the hedge fund, you simply do not see a scenario where you will lose. After all, if you really know how to hedge your bets you will never come out in the red. However, in bubbles there are clear winners and clear losers. You also stated:
  “I rent and have never owned any real property anywhere, ever.”
  Then following your logic, why aren’t you buying a home right now? After all, according to your assumptions there is a very small probability that you will lose any money.

  Reply
• Law Student

  January 4, 2008 at 9:02 pm

  This really comes down to two foundational points that neither you nor DBH grasp:

  (1) Principal payments are not a cost.

  (2) The interest you pay, to a large degree, is offset by inflation.

  Until you realize this, you are no different than the people who overvalue housing. i.e., your model is fundamentally disconnected from economic rationality; it is hamstrung by your own weak understanding of basic financial and economic concepts.

  Reply
• LeadZeppelin

  January 4, 2008 at 9:06 pm

  Yo, my credit sucks and I got NO money…
  But I do believe that things can only get better.
  Trust Me, I got skillz.
  I jumpa the Border Fence and not get shott.
  So can ya hook me up with one of doze big CALI beachfront homes.
  I wanna Surf “DUDE”. I want deferred payments for 10 year and a home “EQUIDDY” Loan, fur $100K I spose would do.
  Call me at 1-800-DEF-AULT
  Out.

  Reply
• engineer07

  January 4, 2008 at 9:20 pm

  @law student
  Thanks you for adding some very clear analysis of the situation. Please point out if I’m misrepresenting your points below.

  @dhb
  1. Inflation has, as a long-term average, been above 2.5% (a fact that you agreed to earlier). Since housing improves as an economic venture when inflation rises, a higher interest rate supports purchasing this home. The difference in the two points presented is long-term (>5 years) past performance vs. 1-year performance. 1-5 years can be easily distorted by anomalies such as boom-bust cycles.

  2. real terms are not nominal terms. Nominal interest rate of 6.5% – inflation of 2.5% = 4.0% real interest rate. Also, just a pet peeve of mine: average income for an area is NOT the average income of homeowners. If home ownership is 70%, and presumably shifted towards the upper income brackets, then median home prices should correspond roughly to 65% income levels. Where I live (Santa Clara County), the difference between the median income and the 65% level is about 30k/yr.

  3. The argument was that houses are a less risky proposition than many other economic vehicles, not that they are risk-free. They are less risky because you can bail while paying off the mortgage and not owe the balance on the mortgage. This decrease in risk has a monetary value; the idea that less risk = good is why things like FDIC insured accounts pay (in a long-term perspective) less interest than various stock market index funds.

  None of these arguments were meant to show that anyone in particular should buy the house at the listed price. They are just showing that if you wanted to own a home of this size/quality, that 715K might very well be a reasonable price to pay.

  Reply
• drhousingbubble

  January 4, 2008 at 9:28 pm

  It is rather apparent who has actually been to the area in question. People forget that when you lease or rent a home, there is some utility in that. You have a roof over your head. Now, if after tax benefits and other considerations you feel that buying makes more sense then you do it. It is as simple as that. For the majority of our history a home was never seen as a speculative vehicle. If anything, it was a forced savings account that after 30 years you would own and not be thrown out in the street to eat cat food. This is typical for most of the nation. Of course, then we have areas such as Southern California where there will always be a premium to live. Areas such as Newport Beach, Laguna Hills, Santa Monica, Beverly Hills, and La Jolla will always have this premium intact even if the market tanks. After all, if a $3 million home drop to $2 million most folks still cannot afford it.

  The issue here is that L.A. County has 88 cities with 10,000,000 residents. Each city needs to be considered in its own context. Certain areas are extremely wealthy and some are absolutely impoverished. What happened over this past decade, as you can see with the Real Homes of Genius, is cities where no premium ever existed suddenly saw massive price increases simply because of their vicinity to these perceived wealthy areas. They benefited from a halo effect and as you are seeing with this Downey home, are now losing the luster that speculation mortgages are essentially gone. It was a speculative craze like Florida in the 1920s. Anyone that has been to the city as I have and many other commentators will tell you is that in no planet in this universe does this home go for $900,000. Not even the current $715,000 price tag. Those not from the area assume that people here are making $250,000+ a year which is a wrong assumption.

  So let us run the actual monthly cost of this place after tax benefits. Here we’ll assume $35,750 down (5 percent) and a rate of 6.5 percent although jumbo rates are holding out in the state:

  Equivalent Rent Payment: $2,400
  House Payment: $5,569
  Initial Tax Savings: $1,079
  Initial Principal Payment: $666
  Net House Payment: $4,490

  So even factoring in the tax benefits and mortgage principal pay down, you are paying $2,090 more each month for the luxury of owning this home. Clearly that is out of line and does not make sense. Someone is not going to care about the “pride” of owing a home if they are going broke because of it. And in a city where the average family income is $75,000, it will break their bank completely. The median income is much lower but suffice it to say that it still way out of line.

  Reply
• Law Student

  January 4, 2008 at 9:37 pm

  Quick roundup here:

  With regards inflation – I am not using past performance as an indication of future anything, except to the extent that I assume that there will be future inflation near the historical level of 2.5%. If this assumption turns out to be wrong, and inflation goes to 0 or deflation occurs, this is no problem as nominal interest rates will fall, and the borrower can refinance into a lower rate loan at that point and we are back to square 1. Note from macroeconomics 101 – Nominal interest rate = Real interest rate + rate of inflation.

  With regards to incomes – we have been arguing up until now about the relationship between rents and home prices, which I think we both agree is one way to arrive at a “correct” value for housing. Some of your arguments here go to the relationship between incomes and home prices. That is, basically, a separate argument, and unfortunately I don’t have time for it right now so I’m going to put that to the side.

  “Jumbo Rates at 4.0%”

  Notice that I referred to the real, not the nominal, interest rate. Inflation is 2.5-3.0, nominal rates are 6.5-7.0, thus, real rates are ~4.0%.

  “Using past performance to predict future results”

  Essentially, you just plain don’t understand my argument here. Let’s say I borrow 100K from the bank, go to Vegas, sit a roullette table, and bet it on black. If I win, I have 200K. I pay the bank back the 100K (plus interest which is trivial on such a short loan), and I keep the rest. Thus, I have 100K in profit. If I lose, I have 0K, and I owe the bank 100K. However, where mortgage loans are involved, I don’t have to pay back the 100K if I lose because it is non-recourse . Thus, unless I am particularly concerned about the ethical implications, it makes perfect sense to borrow 100K from the bank and bet it on black, notwithstanding the fact that on average, roullete players lose money. In fact, if, in 5 or 6 years, I can convince another bank to loan me 100K, and do the whole thing over again, I am virtually guaranteed to make a hell of a lot of money at some point. Because mortgage loans are non-recourse, the reasoning above adds inherent value to mortgaged homeownership that goes beyond its value as shelter – i.e., mortgaged housing has inherent speculative value added, regardless of the condition of the real estate market. You heard it here first.

  “That is the gambling mentality of Wall Street and of many lenders.”

  There’s nothing wrong with the mentality from the perspective of the individual managers. WIth MBS, traders and hedge funders made millions of bucks, year after year, and then one year it blew up. It’s very similar to the casino analogy above. They were using other people’s money – i.e., money held in trust for the benefit of shareholders, the money of unsophisticated individual investors, pension money run by bozo beaurocrats, etc etc etc. The idea that the Wall Street pro’s were “fools” is, frankly, laughable. By mid 2005 everyone realized or at a minimum strongly suspected that the housing bubble would blow up soon, but for the most part they all wanted to see if they could last long enough to get their bonus for 2005. They did. And they got their 2006 bonus too. The only thing that is really surprising is that they ended up getting their 2007 bonus also, even after things blew up!

  “Then following your logic, why aren’t you buying a home right now? After all, according to your assumptions there is a very small probability that you will lose any money.”

  Three reasons: (1) Per my handle, I am a student and don’t have any money, not even enough to qualify for a NINJA loan. (2) Since I don’t have any income, I wouldn’t benefit from the tax deduction. (3) I live in San Jose and prices are still overvalued significantly here.

  Reply
• Engineer08

  January 5, 2008 at 12:15 am

  @Engineer07 – even if you add 30k to the median, you still cannot qualify for the loan if you do not have significant equity in another house or a significant amount of cash you are willing to gamble.
  @Law Student –

  “Thus, unless I am particularly concerned about the ethical implications, it makes perfect sense to borrow 100K from the bank and bet it on black, notwithstanding the fact that on average, roullete players lose money. In fact, if, in 5 or 6 years, I can convince another bank to loan me 100K, and do the whole thing over again, I am virtually guaranteed to make a hell of a lot of money at some point.”

  Well, you assume credit standards will never change and you’ll live 100 years. You also assume you’ll pay cash for everything for 5 years, because credit is going to cost you….

  Reply
• Westside Bubble Bystander

  January 5, 2008 at 12:26 am

  First, thanks doctorhousingbubble for this site – it’s a lot of fun.

  Cut through the econ-speak and Law Student does have valid points, namely homeownership can be this extremely leveraged investment with little risk – if it’s not the scenario proposed by engineer07. But it has to be. Large amounts of (albeit un”earned”) capital is invested in real estate. How else is a $900,000 house afforded? Assuming that house is sold for $700,000, an individual lost $200,000, not a bank. (When it’s auctioned 2 years from now for 425,000, that’s when the bank loses.)

  The other point, about subtracting inflation from interest is also true – except all the money you borrowed (let’s stick with engineer07’s example of $300,000) financed a house that just took a year over year hit of $200,000. You’re right, the value of the $300,000 has been eroded by inflation last year – to the tune of 2.5 percent? You got a place to live for a year (whatever that’s worth but far less than you were paying the bank) and now you’re $200,000 poorer.

  As you know, we’re in unprecedented times with this housing bubble. And right now, the reason you’re not buying that place in Downey isn’t just because you don’t have the money. It’s also because you would be betting against the forces of economics which are pulling the price of that house back into line with historical income to rent average ratios.

  Nobody’s arguing that owning a house, in the long run, isn’t “better” than renting, financially and otherwise. But if you’ve got $200,000 to burn, I can think of better ways to do it.

  Reply
• Laura Louzader

  January 5, 2008 at 2:16 am

  Some of the remarks in your post are really hilarious and really only prove DHB’s points, such as:

  “If I buy a 500K house in CA with 50K down, the most I stand to lose is 50K + my good credit” and that the impact of that will last “only 5-7 years, though the impact is minimal after 4”.

  For the 99% or so of Americans who are not wealthy, the loss of “only” $50K is catostrophic, and the loss of your good credit for “only 5-7 years” means anywhere from $10K a year to hundreds of thousands of dollars in lost opportunity in that a bad credit score cripples you in the job market and raises the costs for necessities such as car insurance, not to mention the cost of credit that may be needed for a dire emergency.

  In other words, it means ten years lost from your life. This usually means a pretty uncertain recovery, for these people will be past their prime earning years when they at last manage to make a shaky “recovery” only to face diminishing career prospects, and the need to build a retirment fund from zero.

  For a family with an income of $100K, such a loss is a crippling setback that will take ten years out of their lives (at least), and translate to lower income, higher costs, and a reduced retirment income- all in all, a steep reduction in the quality of life.

  For people with family incomes that are lower, such a loss is catostrophic and they will never recover from it in their lifetimes, especially in a deteriorating economy with much tighter credit requirements and shrinking opportunity. They will be mired in substandard rental housing for the remainder of their working lives while they scramble for second and even third jobs, in order to rebuild retirement nest eggs and a cash reserve for emergencies.

  Only to someone with an income in the high 6 digits, or higher, would such a loss be a minor thing. However, many millions of actual losses in the hundreds of thousands spell disaster for the financial institutions and investment pools such as hedge funds holding these mortgages, and that means the loss of tens of thousands of jobs and a pretty steep contraction in the amount of money and credit available for business expansion, resulting in further economic deterioration.

  Reply
• MannyinMiami JD, CPA

  January 5, 2008 at 2:48 am

  @lawstdudent

  Your analsys of real versus interest rates ignores the fact that in any “household impact” calculation regarding the purchase of this home, the buyers’ monthly gross income is also subject to your 2.5% yearly interest inflation factor, but this time as a subtraction from gross income rather than as a subtraction from nominal interest expense. So, assuming both wage inflation and core inflation are equal, their effect is “effectively” canceled for this transaction, and any gains you’ve made by lowering your nominal interest payments are equally offset by having lost 2.5% of your income to inflation.

  Secondly, both costs and principal payments are in-fact costs in analyzing a realization transaction, ie, a sale of residential property over a lifespan, and comparing the same property to the same lifespan rental value. In real estate, the realiztion of the asset is all that should matter, regardless of the point in time of that realization. A typical 30 year mortgage on a $500K house at 6.5% nominal interest will generate $637,722 in mortgage interest paymnents over its life, in addition to $500,000 in principal payments, untold real estate tax payments, untold property insurance tax payments, and untold maintenance and capital expenses to the property. Additionally, the value of the mortgage interest deduction is truly limited to any amounts above the floor amount that the IRS already gives every single taxpayer as a standard deduction. Only the excess above the floor is a tax benefit attributable to mortgage interest.

  Thus, only if it was cheaper to own and sell this property over the thirty year period (taking into account property appreciation) than to rent this same property and invest any difference will this transction have positive economic value for this family. Otherwise, rental would have made more sense, and any economic description of principal payments as not being a “cost” would have ignored realization profitability analysis, which is the ultimate determinant in measuring costs/cash flows. A cash flow is nothing more or less than an allocation of funds, and in this case the family chose to allocate those funds to a principal payment, in the hopes that their after-tax 30 year cost to own is less than their 30 year cost to rent. Obviously, we ignore the effects of opportunity costs here and present/future value of money concerns.

  Reply
• MannyinMiami JD, CPA

  January 5, 2008 at 3:06 am

  @lawstudent:

  Principal payments are certainly not mandatory savings components once a realization event (ie a sale) has occurred. And, as noted above, if total costs after sale exceed the rental costs, then one made a very poor decision. And most calculations I’ve seen lately indicate that with purchase prices and operating costs so high, one would need to live in the property nearly 25-30 years to break even. And don’t forget sales costs.

  Finlly, many states do in fact have recourse provisions built into their statutes, making this part of your analysis void in those states.

  Reply
• Scott

  January 5, 2008 at 3:26 am

  I might agree with Law Student’s general outline if we were talking about pre bubble housing prices. Clearly this is going to have to be ‘unwound’ before his arguments about the advantage of owning over renting make economic sense. There is also risk in home ownership. Demographic and cultural changes can cause a loss of home value regardless of the overall value of residential real estate.Not all communities experience ‘gentrification’. Some experience the opposite. Poor schools, high crime rates and, unfortunate though it maybe, the ethnic composition of a community will affect housing values.

  Reply
• John Ewing

  January 5, 2008 at 9:13 am

  Law Student, in the grand tradition of phony academics, is just making stuff up.

  $2300 would actually get you a similar, and perhaps even substantially nicer, home in Downey. He really doesn’t have a clue.

  And this ratio is not unusual to Downey, I rented a place in Santa Barbara in a nice neighborhood last year for $2000 per month…..the owner had an $800,000 loan out on the place…..and was partying in Hawaii with the refi funds.

  Law Student is clueless about reality, even the reality that he claims he left his job at the hedge fund due to his great foresight about the future…..nah, just a guy who doesn’t live in the real world and is more comfortable with baseless conjecture – perfect fit for academia.

  John.

  Reply
• law student

  January 5, 2008 at 12:54 pm

  @eng08

  “Well, you assume credit standards will never change and you’ll live 100 years. You also assume you’ll pay cash for everything for 5 years, because credit is going to cost you….”

  This is true, but the point remains the same that it presents an opportunity to shift /some/ but not all of the risk of an investment to a lender. This has some economic value and that value is incorporated into the cost of housing since it is one of the few investment vehicles that makes that opportunity available to the average joe.

  @Westside Bystander

  Your argument seems to focus on the fact this property has declined 200K in the past year, and thus it is a bad investment. As with DHB and others before you, this is the EXACT error that was made by buyers who bought into the housing bubble. The fact that prices decreased last year is /irrelevant/ to whether prices TODAY are fair. You will note, based on my method of analysis, that buying the property today is 100/month more expensive than renting. Thus, had I conducted the analysis at 900K 1 year ago, buying would have been around 1000/month more than renting, and I would have concluded the property was overvalued – which would have been right, as the property subsequently declined 200K. See why this analysis works?

  You also aver that the buyer of the propety lost 200K. There is no way to know if this is true, because as stated before, due to Cal Civil Code 580b, California purchase money loans on owner-occupied 1-4 unit residences are non-recourse. Thus, if the buyer put 10% down, which was common at the time of purchse, then the buyer lost 90K, not 200K. At 5% down, buyer lost $45K. Of course, using my analysis, buyer would not have bought the house at that price.

  @Laura “A 45K loss is devastating for the typical buyer”

  My analysis is intended to value an asset. It is not intended to determine whether a particular level of loss will be devastating for a buyer. The fact that the purchase of houing presents the opportunity for upside return with an effective limit on the downside loss adds inherent economic value to housing. This is true regardless of the level of emotional or financial impact that a particular level of loss may have on a buyer should it occur.

  @MannyJDCPA

  Honestly, I’m not sure how to respond to what you just said about wage inflation offsetting the inflation in housing. Given your background, I suspect you realize by now that your statement is mistaken. When an individual pays interest on a loan, the true economic cost of that interest is the “real interest rate” being paid, which is equal to the nominal rate minus inflation. It is not relevant how the individual chooses to make the loan payment, be it with wage income, investment income, savings, or otherwise. Second, even if it were relevant, wage inflation leads an indivdiaul’s wage to increase in dollar terms over time. This meas that, even if an individual’s wage stagnates in real terms, their mortgage payment using a fixed-rate mortgage wil decrease every year as a percentage of nominal income because their nominal income increases with inflation. Thus, each year, their mortgage payment is a smaller and smaller bite of their paycheck. The renter, however, pays the same amount each year because the renter’s rent increases with inflation, whereas a fixed-mortgage payment does not. This is just another way of looking at the same analysis I put forward above – i.e., the borrower of a mortgage, in economic terms, benefits in an amount equal to Rate of Inflation * Principal Value of Loan.

  Your statement about the standard deduction is certainly true. Interest on 700K at 6% is 48K/yr. Standard deduction for a married couple in 2007 is 10,700. Thus, the net gain in deduction by itemizing with the mortgage interest included is a little over $37K. The buyer is probably in the 25% federal tax bracket (63.7K-128.5 (married filing joint). Buyer is probably in either the 8% or 9.3% california bracket (income greater than 70.9K or 89.6K MFJ).

  Thus, the total applicable tax rate is around 34%. Buyer benefits from an additional 37K in deduction at 34%. Total tax benefit = $12,580. As a percentage of the total interest paid, this is 26% (i.e., the net effect is a 1.5% decrease in the interest rate on a 6% mortgage). Thus, nominal interest rate is 6% – inflation (2.5%) – tax benefit (1.5%) = real, tax adjusted interest rate of 2%. Not bad, eh? In real, tax adjusted, terms, the buyer only pays 2% or 14K in annual interest to own this property. That is the real cost of owning a 700K house for a buyer in this tax bracket with this level of inflation and this level of interest. Needless to say, at 1166/month, it is a lot cheaper than renting. But, of course, I neglect costs of sale, costs of maintenance, taxes, and insurance, which combined should total around 2% (taking into account their own respective tax deductions where applicable). This adds another 14K/year to the cost, or 1166/month (note that this exceeds the actual interest paid on the mortgage in real terms). Total cost? Around $2333 – very similar to the cost of renting, which, again, is not a coincidence.

  Want to see something really cool? Should inflation rise to 5.0%, rates will rise accordingly to 8.5% because nominal interest rate = real interest rate + rate of inflation. But buyer is entitled to deduct nominal interest rate, yielding a tax benefit equivalent to a 2.125% drop in rates. So now, the effective, after-tax, after-inflation interest rate is 8.5% (nomnal rate) – 5.0 (rate of inflation) – 2.125 (tax benefit) = 1.375%. Total cost, in real, after-tax, terms, to borrow for a 700K house? Less than $10K per year. That’s right, you heard it here first – rising inflation rates magnify the tax benefit of ownership. In fact, at rates of inflation above ~12%, the actual cost of borrowing on a mortgage becomes *negative* for many tax situations. Yes, this did happen during the 1980’s, which explains why, pardoxically, prices remained high despite historically interest rates.

  @MannyJDCPA Comment 2

  I agree it is correct to look at total costs after sale. You mention that “I’ve seen lately indicate that with purchase prices and operating costs so high, one would need to live in the property nearly 25-30 years to break even.” Without a referral to a particuar analysis, I am not in a position to critique it. I will say that none of those calculators consider as factors (1) the inherent speculative value of mortgaged homeownership due to lopsided distribution of returns arising from the non-recourse nature of mortgage loans in most states in most circumstances, (2) the possibility that there is some inherent value to ownership for which people are willing to pay a premium, (3) the state tax benefits of ownership (note all states allow mortgage interest to be deducted, but most do), (4) the fact that there is a systematic difference in quality between “rental” and owner-occupied housing that is not adequately accounted for by any rent comparison I have seen (rentals are known to be more poorly maintained – a factor which does not come to light when looking at a simple comparison of units with a particular number of bedrooms), (5) the economic benefit of the homestead exemption as a protection from creditors in event of bankruptcy, no similar protection being available to renters in most states, (6) The economic benefit of the built-in call option on an ordinary mortgage loan, which allows the buyer to benefit from negative convexity and capitalize on changes in the interest rate market, and (7) The financial, social, and other costs associated with involuntarily changing homes periodically [long-term leases are quite uncommon, and rental homes [as opposed to apartments] are frequently unavailable in subsequent years due to sale or a change in plans by the landlord/owner. On the other hand, most models I have seen are also seem to assume real home price appreciation (as opposed to nominal appreciation), which is equally silly and favors the owner side of the model.

  The bottom line is that, taking all factors into account and clearly analyzing the situation economically, it would not be an unreasonable decision to buy this house at 715K as opposed to renting a similar house at 2400.

  Reply
• law student

  January 5, 2008 at 1:03 pm

  Dear John: Personal insults seem unnecessary and add little to the underlying debate. DHB is the individual who supplied the 2400 figure. I am not from the Downey so don’t know and am not going to argue it. However, I can say that in San Jose, and most other places I have lived, it would be very difficult to make a real comparison between rentals and owner-occupied homes. Even if we compare same number of sq. ft., same number of bed/bath, same lot size, same zip code, same immediate area, more often than not the rental is (1) on a worse street/in a worse area, (2) more poorly upkept. i.e., a comparison based on listings on craigslist, or even public records, is not going to work because neither of those allow an effective appraisal of what the rental house is really worth. Hint: it will tend to be worth significantly less than an apparently comparable non-rental house, because it will tend to be in worse condition and in a worse area.

  Reply
• Fazsha

  January 5, 2008 at 2:20 pm

  None of us know whether buying a home will be profitable or not, just like we don’t “know” whether buying Google when it IPO’d made sense. Well, I thought it didn’t, then it went from $100 to $700. What I didn’t know was whether other people would be willing to pay that high a multiple of earnings. Google would still be a fine company if it sold for $120. US Steel’s EPS is higher than Google’s, yet it sells for 1/7th the price. So, Law Student is not wrong, but neither is he right. Law Student argues that the homeowner is at risk for only his equity, but has all the upside. That’s only partially true. Arguably, you could say that the homeowner is also risking the appreciation that the homeowner foregoes by renting and putting the money into an alternative investment. If homeowner goes 20 years and builds $1M appreciation, then there is a crash and he loses it all, he’s also lost the money he could have had with such alternative investments. It’s a variation of Frederic Bastiat’s “what is seen and what is not seen” argument.

  Reply
• ben

  January 5, 2008 at 2:53 pm

  This is to the educated law student:

  You say:

  First, you make an innocent subtraction error in your numbers. 5569-1079-666 = 3982, not 4490. Thus, the difference is $1582, not $2090. I agree no one will pay $1582 for the pride of homeownership, but, as you will see, the true cost is actually less.

  Current U.S. inflation is around 2.5% (I am generously underestimating inflation here). So the $715K home value increases by $17.8K/yr (or ~1500/month) just due to inflation. This leaves a difference of around $100/month. I do think many people will pay $100/month for the prestige and pride of homeownership……………..

  Well I did not see here you discuss property taxes? If am not mistaken they range from 1% to as High as 3.45% of the home value( legally the purchase price in most cases) in different areas. A 2.3% property tax rate is a fact. So at $715K home that turns out to be around $16,500.00 a year That is all money going to toilet. Multiply this with 30 years assuming that prices do not go up any further due to inflation and see what you get. You will go definitely broke.

  Reply
• Andrew

  January 5, 2008 at 6:25 pm

  And too see how even further out of whack things are, you can get a one bedroom apartment in Downey for around $900, 2 bedroom run about $1200. I’m renting a 2 bedroom condo for $1400. At my current income I couldn’t even afford to rent a house let alone buy one.

  Reply
• onthewestside

  January 5, 2008 at 10:50 pm

  Valiant attempt law student…But, as mentioned previously, you are mixing nominal and real amounts. You should also heed what Scott mentioned about assuming the base asset value adjusts upward by inflation each year…doing so creates a circular logic error as the hypothesis we are evaluating here is whether there is a bubble in the first place. As for the principal amount – it is a cost. True you will get your cash flow back – but only in 30 years so that the PV of that payment coming back is close to nil. I can see why it was out of the hedge fund and back to the books for you…

  Reply
• asdfasdf

  January 6, 2008 at 12:17 am

  this market is just getting crazier and crazier.

  Check this out: http://www.flixya.com/photo/173755/housing_market_RIP

  Reply
• SoCalWatcher

  January 6, 2008 at 1:13 am

  @Law Student…

  Even with real estate, there is no “walking away scot-free” if the market sours and you cannot afford your home or find a buyer.

  The IRS sends you a 1099 for the difference on what is owed to the bank and what the bank wipes the REO off their books for. You get to pay taxes on that difference as “debt forgiveness”.

  I see alot of backpedaling and skewed concepts in your replies.

  Reply
• FZ6

  January 6, 2008 at 2:06 am

  Dr. HB, yet another great post. Laura, I agree completely with your argument.

  Law Student seems to want to show off his ability to say something that is pretty simple in a really complicated fashion. Maybe its because of his current law schooling. (He reminds me of that jackass who tries to make fun of Ben Affleck’s character during the bar scene in Good Will Hunting. Only to get his ass handed to him by Matt Damon’s character, in this case Dr. HB.)

  I will say this, I find something ironic and/or “hilarious” about Law Student.

  He says, “when I was working at a hedge fund buying sub-prime MBS. I left the fund because the future looked so bleak.” Wait a minute, you come to this blog to mention/brag about how you sold MBS only to say…”Per my handle, I am a student and don’t have any money, not even enough to qualify for a NINJA loan.” You must of not been any good at selling them or else you’d of made some money, enough to buy a home at your choosing. Not to mention that a NINJA loan requires no qualification since by design it is a NO INCOME, NO JOB, NO ASSETS. Hence the acronym, jackass’onova!

  I personally think that law student is just pissed off that he lost the opportunity to make some money like those “Wall Street pro’s” he so much admires.

  Law student what you fail to understand is that it doesn’t matter how much you know or pretend to know, you will continue being as broke as you apparently are if you don’t learn some people skills. Walking around with something up your rear and thinking you’re the big man because you can sound/act like a smart person is simply not enough. In fact from my experience most people like you are so difficult to deal with you probably have very few friends in the work place because you’re simply such an asshole.

  One more thing. “I live in San Jose and prices are still overvalued significantly here.” Are you kidding me? I have been there plenty of times and I never saw any houses like this RHOG.

  Reply
• SoCalWatcher

  January 6, 2008 at 12:24 pm

  FZ6… you hit the nail on the head with Law Student’s comments.

  Where you hang your hat is just that. A Home. You borrow money, make the payment every month and enjoy it. If you buy another, you either live in that one as a second home, rent it out for profit or flip it.

  If you can’t afford any of them, you sell them.

  If you rent, you move in and send the landlord a check every month until you move out.

  When demand is high, prices go up. When demand is low, prices drop.

  If you owe more than the home is worth, you are upside down. If you owe less or nothing, then you will make a profit when you sell.

  Why making things super over complicated for the sake of spouting an overactive ego on a housing blog is beyond me and Law Student should either stick to studying law or change careers and get his RE licencse in CA and join the 300,000 other geniuses that think they can outsmart the market.

  Reply
• Nabil

  January 6, 2008 at 1:28 pm

  I think Law Student is very fun to read and I’ve learned much from him.
  This is a great discussion about how low home prices might go. Law Student makes a good point that there might be a world which has a city named Downey where a reasonable person might buy a house there for $715K.
  Sorry Law Student. While this person may be ‘reasonable’, he will still be better off waiting. What’s his hurry? –More houses will be for sale. People will start losing their jobs. California’s economy is going to bring the rest of the country down with it. House prices will become undervalued. That’s when it becomes unreasonable NOT to buy a home. Problem is, this is around the same time most people are short on cash and have more important things to worry about like their health and/or credit card bills.

  Reply
• law student

  January 6, 2008 at 2:39 pm

  @Ben

  Property taxes are included in the analysis, with the figure supplied by DHB. His “PITI” is “Principal, interest, [property] taxes, and insurance”.

  @Andrew

  You seek to compare rental of a 2 bedroom condo/1 bedroom condo to ownership of a detached single family residence. Clearly this is silly on multiple levels.

  @Onthewestside

  “You should also heed what Scott mentioned about assuming the base asset value adjusts upward by inflation each year”

  As I explained before, this isn’t an assumption. You will recall from introductory macroeconomics that Nominal interest rate = real interest rate + rate of inflation. Thus, in real terms, the amount owed on a mortgage declines each year due to the rate of inflation and the inherent value of money, this is above and beyond any decrease in debt attributable to the principal payments . It really requires no assumption as to the change in the value of the housing, as it relates only to the decrease in debt owed on the *mortgage* in real terms.

  “As for the principal amount – it is a cost. True you will get your cash flow back – but only in 30 years so that the PV of that payment coming back is close to nil.”

  This is just getting to be silly. (1) People either refinance or sell less after less than 5-years, on average. Even as cash-out refi’s decrease, people will continue to sell much more frequently than every 30 years on average. (2) The P paid decreases the interest due in the next period, and this yields an embedded Return on Investment (ROI) on the P payments within the closed analysis. This ROI cancels out the PV issue you address. (3) Since most of the principal is paid in later periods, the average principal dollar would be paid approximately 9 years before full amortization in a fully amortizing 30-year loan. Thus, even if you were correct to do a PV analysis, and even if the average mortgage lasted 30 years, and even if the payoff of the mortgage were the realization event (it isn’t, sale of the house or refi is), the correct discount factor would be based on 9 years, not 30.

  There is no serious argument that principal payment is a “cost”. There might be a serious argument that tying up principal in an underperforming asset reflects an opportunity cost, but this would be a different calculation, would amount to far less than the full principal portion of the payment, and requires the assumption that the discount rate that is higher than mortgage rates.

  @SoCalWatcher

  The tax issue that you describe is no longer true. The Mortgage Forgiveness Debt Relief Act of 2007 has passed house and senate and was signed by President Bush on December 20, 2007. I assume without knowing that certain state tax implications may remain. http://www.govtrack.us/congress/bill.xpd?bill=h110-3648 . I am quite happy to be the one to inform you about this new tax handout for homeowners.

  @FZ6

  “Jackass, idiot, etc.”

  “Why’d you leave the hedge fund and why do you have no money”.

  I was a first-year analyst at the hedge fund, not a major player. I made significant money, but most of that went to taxes, loans from college, and a down payment on 100K+ in law school tuition. The stories of people making 1 Mil+ are generally individuals with several years of experience who have moved up and gone on to get MBAs, become managers or highly-prized traders, etc. (some exceptions apply). I left because it was imminently clear that the MBS market would blow up by the time I got to that point, and I had doubts about how transferable the experience I was gaining would be if the market were to disappear (which it now has). The NINJA loan comment was a quasi-joke, but the bottom line is that with no income and no assets, I am not in a position to go get a prime-rate mortgage right now, and the analysis of whether renting is cheaper than owning really changes when you assume an interest rate of 8%+ like most subprime borrowers are paying.

  “Law student what you fail to understand is that it doesn’t matter how much you know or pretend to know, you will continue being as broke as you apparently are if you don’t learn some people skills.”

  Thankfully in the legal profession your social skills are graded on a curve, so despite being a dufus by normal standards I am considered fairly refined for the profession 😉

  Reply
• jake55

  January 6, 2008 at 5:29 pm

  It fundamentally all comes done to valuation; and with real estate, it is surprisingly difficult because the absolute/intrinsic value of the property does not determine the asking or selling price. There are many subjective variables like location, style/design, quality of schools, perceived demand, etc. that greatly impact the perceived “value” of the property. An unlike a commodity, the asset does not transact with enough frequency to get a liquid rational price. These subjective value elements are chaotic and from a price perspective can be irrational. Would I buy this featured property? No way, i think it is indeed quite overvalued. Paying a quarter of a million dollars for a bland rancher is not worth it to me. But law student has outlined an economic argument which argues otherwise and is credible. The doctor uses a different set of assumptions and comes to a strikingly different rational conclusion. And that is the crux of it–ultimately, something is worth what someone is willing to pay.

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• olegurl

  January 6, 2008 at 10:44 pm

  lawstudent – i recommend you get a GED before heading to law school. your numbers dont add up and neither does your story. if it was “imminently clear” that the MBS market was going to blow up, and you worked at a “hedge fund”, then why didnt you short it? wouldn’t that have been a good trade, lawstudent? here is the bottom line, GED-boy, if principal isnt a cost, then send me a check every month.

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• MannyinMiami JD, CPA

  January 7, 2008 at 1:53 am

  @lawstudent:

  “It is not relevant how the individual chooses to make the loan payment, be it with wage income, investment income, savings, or otherwise. Second, even if it were relevant, wage inflation leads an indivdiaul’s wage to increase in dollar terms over time. This meas that, even if an individual’s wage stagnates in real terms, their mortgage payment using a fixed-rate mortgage wil decrease every year as a percentage of nominal income because their nominal income increases with inflation. Thus, each year, their mortgage payment is a smaller and smaller bite of their paycheck. The renter, however, pays the same amount each year because the renter’s rent increases with inflation, whereas a fixed-mortgage payment does not. This is just another way of looking at the same analysis I put forward above – i.e., the borrower of a mortgage, in economic terms, benefits in an amount equal to Rate of Inflation *

  1. In any investment transaction, it is certainly correct to determine THE SOURCE of repayment, and for 99% of individuals, that source is their income from wages.

  2. Every transaction has an income component and an expense component, and while you correctly note that as a percentage of fixed income, if income remained stagnant, the percentage repayment would technically decrease, you ignore what continue to happen to wages in our economy:

  Nominal Wages vs. Real Wages

  These work in the same way as the nominal interest rate. So if your nominal wage is $50,000 in 2002 and $55,000 in 2003, but the price level has risen by 12%, then your $55,000 in 2003 buys what $49,107 would have in 2002, so your real wage has gone done. You can calculate a real wage in terms of some base year by the following:
  Real Wage = Nominal Wage / 1 + % Increase in Prices Since Base Year
  Where a 34% increase in prices since the base year is expressed as 0.34.

  For the vast majority of folks, real wages have actually declined, offsetting any gains from your “expense side” of the analysis. The core inflation numbers put out by the government Ministry of Truth are so manipulated and massaged as to be largely incoherent. Thus, any gain on the expense side of real vs. nominal must be filtered through the prism of changes in the source of repayment for that asset, ie, wages, investment income, etc. To ignore this is to ignore 50% of the transaction event.

  Th reality is that most folks wages are likely losing ground every single year,e even if they remain stagnant or unchanged in their paychecks, and don’t actually decrease through job loss. So any “gain” they would see through a nominal vs real calculation of their interest charges is largely offset by the wage calculation. If they ignore this variable then they are simply looking at an economics class textbook example when evaluating their real-world transaction.

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• rick

  January 7, 2008 at 12:19 pm

  Hm, so if Law Student is correct, people really can afford the houses, then why this guy left the Hedge Fund? It must be a good time to buy! 🙂

  As I hear from this guy,

  1. Price does not matter

  you are getting 2.5% a year for $700k, but forget about that 10 years ago it was less than 300k – when prices rise WAY more than inflation it is OK, but now we are starting from $700k and we should get 2.5%. Great. No depreciation here because house prices won’t fall and it is affordable. I guess people 10 years ago just didn’t discover this magic and thanks to Law Student and his clan we are now realizing the true value of homes.

  2. You don’t need to make money to qualify

  So 10 years ago people need 20% down and income verification and banks will not loan more than 4 times or so of income to them. That, acccording to him, was silly. As he demonstrates, even though he’s never owned a home, that $70k a year is perfectly able to afford a $700k home.

  3. You cannot rent a $700k home for 2.3k.

  I wonder where he lives. I am renting a $1m home and my rent is less than that. In a great neighborhood. He is telling us that a medium income family home valued at less than $300k 10 years ago cannot be rented for 2.3k. And who precisely make the income to pay for these MEDIUM income home? I can tell you you cannot afford 2.3k rent if you are making 70k, unless you eat ramen and don’t have a family.

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• ben

  January 7, 2008 at 8:38 pm

  In response to the Law student

  If PITI means all principal, insurance ,taxes and interest….,, well I did not know what PITI meant.

  If that is the case than I would say that only Taxes and the Insurance will probably run you for the first year only at around $19,000.00 ($1,700.00/ month) for this $725K home.

  So it leaves the mortgage payments at around $$3,870.00 a month. I am not sure that you can get that kind a rate that requires only a mortgage payment of $3,870.00 on 725K loan. I would say that a realistic mortgage only monthly payment on $725K is at around $ 5,100.00 for the current rates, to pay for interest and principal.

  As the inflation brings up the real value of this home, it will proportionally increase the tax rate . In our area here in New Jersey the tax rate increase has been approx 4.3% a year. You actually have a lot of people complaining for that tax increase but that is what is going on. It has gone from $4.3K in 1999 for one homeowner that I know to around $7.6 K now.

  So if your home would be let say $1.5M after 10 years, the tax alone would run you at around $35k a year at that time. The insurances on 1.5M home would probably be double at $ 4,000.00 a year after 10 years.

  All these calculation assume an ideal house that does not need maintenance, repairs and does not count for other expenses such as water, garbage, heat/air conditioner etc.

  So , as you can see almost all your paper gains on the home are all paid for by you on taxes and insurance alone in this 10 years period.

  If you make $100k / year, I do not think that your salary will double in that period because of inflation. Do not be surprised if there is no salary increase and or even decrease on your salary during that period. I say this because it is going to be that Chinese will be making $30/ year during this period or the US workers will be making the same as they do now. I think the latter is much more realistic.

  My friend if you buy this house at $ 750k even assuming that you have a salary of $100k you will be upside down with your finances for a long time. At the end of it ( after 10 years you will understand that your house investment was a bottomless pit that ruined your finances completely).

  At the end of this period , assuming that you get there you will find out that you can not afford this home anymore, and you are going to foreclose on it.

  Addition to the argument:

  There is also a problem with the concept of this high inflation as a sure thing which will increase the value of the homes indefinitely while the rates will remain artificially low.
  That is not going to be the case for a long time. There is definitely a problem now with the bond market .It is absolutely manipulated somehow. It can not be possible for someone to be willing to lend money at a loss. How can someone lend money at 4% when the inflation runs at 5%, 6% or whatever???

  This can be accomplished only by to factors. Either the the bond market expects
  a correction and therefore higher rates if the case of high inflation can develop or the government is printing money nonstop( which is probably the case), and if that is the case the currency will collapse and the fiat money will end , and the law student will win because he will own this home free and clear without paying for it anything really.

  If that is the case than it is a pretty unique case which happens once in a thousand years. It could happen , but I think if you wait for that event to happen, I would rather say that gambling in Vegas $725k would probably make more sense.

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• AAA

  January 7, 2008 at 10:05 pm

  Please help I just want some advice on buying a home right now. I want to know if now is the right time to buy. The property I am interested in is 4000 sqft in N. Fontana. Was listed in 07 for 779,000. Accepted my offer of 480,000. I can still back out but I need advice. HELP !!!!

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• FZ6

  January 8, 2008 at 12:33 am

  @AAA

  Just out of curiosity what is the number of bed/bath, living square feet, size of the lot, the zipcode of the prop, tax rate, HOA? One other important thing, what type of loan have you secured?

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• Steener

  January 8, 2008 at 10:29 am

  SoCal – Thanks For keeping it real simple.

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• jbp

  January 9, 2008 at 2:30 am

  @LawStudent:
  While it may be true, judging from the numbers you give, that the cost (or loss) of a mortgage would be equivalent to the cost of renting a similar unit, you fail to acknowledge two things:
  1. Considering that the average income of the area stands at about 70K and that someone at the 65% income level makes 30K more or roughly around 100K, a PITI of $5400 represents around 70% of your take home pay! which is clearly unsustainable.
  2. Assuming that only $2400 of that is actual cost, then you are putting $36K a year into depreciating asset. Who would ever buy something today that you can get cheaper tomorrow!? Especially if as you said the average home is sold within five years?!

  This is also without considering that you have the option of renting, and putting that extra money into a high-yield interest account with no risk until prices return to sanity.

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• momo

  January 9, 2008 at 7:42 am

  I am coming late to this discussion and I don’t know if anyone is still looking, but one thing that it might be important for Law Student (and all of us) to consider is that, if I remember my education correctly, it is only the original home loan that is non-recourse by law in California. So, for anyone who has refinanced, there is a good chance their new loan is not non-recourse and they would stand to lose more than just money down plus credit rating.

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