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Some New Math on Homes

 
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PostPosted: Sat Apr 01, 2006 11:40 pm GMT    Post subject: Some New Math on Homes Reply with quote

There is a very interesting New York Times article today on a "new" method for determining the fundamental value of a home developed by a pair of economics professors at Pomona College. The original paper referred to by the article can be read at http://www.economics.pomona.edu/GarySmith/housingBubble.pdf While the paper specifically studied real estate near LA and as such doesn't have numbers that would be directly applicable to Boston, the methodology should be applicable and seems like a plausible way to determine a home's true worth.

In a nutshell, the methodology is to treat the true value of the home to be the rent that it could generate from the time of purchase on, minus expenses. It is not relevant what home prices would be in the future, because the home is never sold. This is very similar to how the fundamental value can be calculated for stocks and bonds.

The authors conclude that the housing bubble may not be an actual bubble in various areas despite prices breaking with practically every historical ratio because prices are still below what would be justified if consumers based their purchasing decisions on net present value. This is probably the first argument I have ever read that makes a reasonable argument for why prices are so high and which could possibly be applied to Boston (cliched arguments like "the population is growing" are just flat out wrong in Boston). The authors readily acknowledge that people may at present have very unrealistic expectations regarding price appreciation but state that prices may still be justified if the future stream of implied rent adds up.

Obviously, nobody owns a home forever, so the authors then proceed to refine the analysis by varying the net present value by holding period (and at this point, applying this methodology to housing isn't all that new anymore). This changes things a bit and prices are no longer quite so justifiable as the holding time decreases. Indeed, "the homebuyer’s anticipated net cash flow is negative for the first 10 years" in the analysis. Given that the average holding time is seven years, this would seem to shore up the argument for a bubble rather than refute it.

There are also some other assumptions that are probably not realistic for most buyers (e.g., 20% down) or in Boston (e.g., Massachusetts residents don't get the Proposition 13 cap on property taxes that was factored into the analysis of the California property). I can enumerate some more of them here if anybody is interested, though I think the holding time is enough to discount this as definitive evidence that there is no bubble.

I think that this would be a great model to have in software so that people can make their own assumptions and see what the net present value is. Would anybody reading this be interested in paying for such software? Which parts of the report are of the most interest to you? The New York Times did say that the professors had some related intellectual property, which may mean that they are readying their own software/service or it could mean that they have some patents. If there are no patents involved, the owner of bostonbubble.com might be interested in developing related software, depending on the interest.

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PostPosted: Sat Apr 01, 2006 11:54 pm GMT    Post subject: Oops, wrong paper Reply with quote

I think I may have read a different report (by the same authors) than the one referenced by the New York Times article. The actual report appears to be at:

http://www.economics.pomona.edu/GarySmith/BrookingsHousingBubble.pdf

I haven't yet compared it to the one which I did read at:

http://www.economics.pomona.edu/GarySmith/housingBubble.pdf

The subject matter is very relevant, in any case.

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PostPosted: Sun Apr 02, 2006 1:17 pm GMT    Post subject: Reply with quote

The math is beyond me, but isn't there an underlying assumption here that one's home is in fact rentable? If even a modest percentage of homeowners decided to rent their homes all at the same time, the rental market would crash, would it not?
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PostPosted: Sun Apr 02, 2006 4:03 pm GMT    Post subject: Reply with quote

I think that they are using the equivalent rental price as a way of putting a number on the value that you derive by residing somewhere - it doesn't actually need to be rented out. This seems to me to be an imperfect assumption because if you were actually renting a place you would have certain advantages that you wouldn't have by owning, such as the ability to leave when you wanted/needed. Of course, there are disadvantages too, so there are many factors at play which might make the derived value either higher or lower than the equivalent rent.

A similar but different approach would be to use the amount that you could get by renting out the place to someone else (the opportunity cost), instead of pretending that you are paying yourself rent. This is subtly but crucially different in that you would need to reduce the rent by contingencies for vacancies and delinquencies as well as by the necessary property management fees. The derived value would end up being significantly lower, I suspect. I spoke with a mortgage broker a few years ago about buying a multi-family building, living on one floor, and renting out the others, and he said that the rule of thumb that they use when determining how much of a mortgage you can afford is that they consider 75% of the rent to be what will get applied to the mortgage. I assumed that this was to cover vacancies, delinquencies, liability insurance, etc., though it may also include some things that were actually in the Smiths' calculations, such as maintenance. In any case, the fundamental value of the home would be lower if you use this opportunity cost instead of the hypothetical rent that you would pay to yourself.

You do raise a good point in that if everybody made their purchasing decisions based on net present value, this would potentially flood the market with rental properties, driving rents down, which would in turn drive net present value down. Of course, this is not how most people make purchasing decisions, so the individual is free to make the optimal decision in this manner without worrying that the whole house of cards will collapse because most people do not behave like fully rational players.

On the other hand, I have a feeling that if everybody were acting rationally, there would be an awful lot more renters because most people simply cannot afford current housing prices. This isn't an issue addressed at all in the paper that I read - they only address the issue of whether the prices are justifiable, not whether individuals can practically buy. Most people can't afford to buy, but this has been masked by historically low interest rates and the surging popularity of "creative" financing.

Take a look at the assumptions that the Smiths used in order to generate a scenario where buying made sense. In the first paper, they assumed a 20% downpayment - that strikes me as completely unrepresentative of almost everybody I know who has either bought or is looking to buy around Boston. Seriously, how many people could put down 20% here? I would guess that the percentage of people who do so is very small. They also assume a 5% fixed rate 30 year mortgage. I just checked bankrate.com and the overnight average is currently 6%. They probably wrote the paper when rates were lower, but rates are likely to go up from here, so their numbers would need to be re-run. More importantly, a large proportion of prospective buyers opt for riskier loans because they would have trouble covering the higher monthly payments on a fixed rate loan, and so this message of prices being justified is not relevant to them and they would be mistaken to think so. Also, a minimum holding period of 10 years is required before buying is worth it even with these optimistic assumptions, despite the fact that the average holding time is 7 years. So the moral of the story is that buying a house may be worth it if you can put down 20%, take out a 5% fixed rate 30 year mortgage, and not need to relocate for at least 10 years, but who does that really apply to?

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PostPosted: Sun Apr 02, 2006 5:29 pm GMT    Post subject: Reply with quote

I'm not at all a numbers guy, but for me the bottom line is that, as you say, very few people can afford to buy homes with anything like the traditional 20 percent down...A market that is too expensive for its participants seems to me, by definition, over valued...

I go into this thing with a freely admitted bias based on an almost lifelong distrust of the herd mentality....It seems to me that numbers aside, there's simply no way one can look at the (literally) unprecedented appreciation that took place on 04 and 05 (have reference here to the chart recently published in the NYT's), without realizing that something's afoot.

I think the only real remaining question is the eventual shape of the collapse..Personally, I'd like to see 30-40 percent in the next couple of years.....Some sort of extended, death by a thousand cuts scenario where prices decline slowly, or even stay flat (though no doubt losing grouind to inflation) is the least healthy option, certainly for those hoping to buy a home in the near future...

You're doing good work with this site..I expect it to become ever-more popular as things begin to unwind even more dramatically than they already are..
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PostPosted: Sun Apr 02, 2006 9:26 pm GMT    Post subject: New Math=Old Reasoning Reply with quote

Saturday, April 01, 2006

New Math on Homes
The New York Times is writing about New Math on Homes. Let's tune in to the latest "It's different this time" thinking.
Gary and Margaret Hwang Smith spend a lot of time musing about real estate.

It is not just that the couple, economics professors at Pomona College, have put so much of their money in the game, having bought a home in Claremont, a college town in Southern California, a real estate market that has been described as overpriced by most and a bubble by some.

Rather, they said, applying economic tools to buy a five-bedroom 1922 Craftsman home sharpened their thinking and guided two years of research into whether there is a bubble. They concluded that not only was the Los Angeles region not in a bubble, but many markets that others were calling overpriced, like Chicago or Boston, were probably underpriced.

Their findings are at odds with other surveys that use the relationship of home prices to income to determine whether home buyers are overreaching. Homes in Orange County, Calif., were fairly priced, the Smiths found. Some cities like Dallas, Indianapolis and Atlanta were screaming bargains. Homes they surveyed in San Mateo County, south of San Francisco, were, however, overpriced by about 54 percent.

In a paper the two presented at the Brookings Institution this week, "Bubble, Bubble, Where's the Housing Bubble?" they said that even though prices had risen rapidly and some buyers unrealistically expected the trend to continue, "the bubble is not, in fact, a bubble in most of these areas."

They argued that the value of a home is determined by the rent it could fetch. Calculate the future rents, subtract mortgage payments, taxes and other costs, factor in a good annual rate of return of 6 percent or more, and one should be looking at the proper price of a house or condo.

Their bottom line was: "Buying a house at current market prices still appears to be an attractive long-term investment."

Richard Peach, a vice president at the Federal Reserve Bank in New York who studies home prices and their relation to income, echoed that view, saying, "This is an important paper."

The value of the Smiths' research may be its practicality. It concentrates on the how, more than the why, in laying out a method to determine the underlying value of a home. They offer a way for real estate agents, financial planners and prospective homeowners to understand how much is too much to pay for a house.

Karl E. Case, a Wellesley College economics professor who has been studying real estate prices for more than 25 years, calls the paper's method "absolutely the correct way to think about it."

The Smiths say a prospective homeowner needs to ask, Should I buy or should I rent? That the value of a house is tied to the rent it can command is not a new idea. Other economists have advanced the idea and some have advanced the notion that a bubble can be measured with price-to-rent ratios that correspond to price-to-earnings ratios for stock.

But a price-to-rent ratio does not go far enough, according to the Smiths. Investors like Warren E. Buffett value a stock by looking at its intrinsic value — that is, how much return one would get on the stock over time. For stocks, that is the cash the company generates and, in some cases, gives back to shareholders in the form of dividends.

The intrinsic value of a house is the rent that it can generate. "It's not that houses are like stock," Mr. Smith said, "but if you think about them as you do stocks, you start thinking about it correctly."

The problem is that there has not been a good way to compare rents with homes. Indexes that try often end up comparing apartment rent with prices of a single-family home. A result, the Smiths said, is inflated price-to-rent ratios that are displayed as evidence of a bubble when one may not exist.

The Smiths solution was to look for "matched pairs" of similar houses, one rented, one owned, but both in the same neighborhood. They did this in 10 cities in which they could find enough real estate data and matched pairs. Once they had established what rent was for a certain house, they used software they created to compute the flow of rents over time, factoring in the outflow of mortgage payments, maintenance costs and taxes. Then they had to determine what those future payments would be worth today, which economists call the net present value. If the net present value is a positive number, the house is worth the price. If the result is a negative number, the buyer would be better off renting it.

Several economists, like Mr. Case and Mr. Shiller, quibble about the assumptions the Smiths make in doing their calculations — for example, homeowners spending only about 2 percent of the house price a year on maintenance or that everyone can obtain a mortgage interest deduction.
I find it interesting the number of complete fools hopping on the "no bubble bandwagon". The 2% maintenance figure is of course questionable, but I am very surprised that no one questioned the key assumption that house prices will rising 6% a year from now until eternity.

It simply does not wash. Here is something that does. Long term prices of houses simply can not rise above people's means to pay for them. That is a simple economic fact. Here is another simple economic fact: Family incomes are falling. The negative savings rate and rising foreclosures are more proof of stress in the system. Real wages have fallen for 4 consecutive years and that includes some pretty fat bonuses of the Wall Street fat cats at the top end.

The fact is that home prices are several standard deviations above norm in terms of affordability in many locations. Gary and Margaret Smith are simply making the classic mistake of projecting into the future what has happened over the last 10-20 years as if it that period is the norm. That is the same type of mentality used to justify the Nasdaq bubble in Spring of 2000.

At 6% appreciation a year home prices would double again in 12 years. That nifty 3 bedroom shack in California now priced at $800,000 would supposedly go for $1.6 million in 12 short years. That $750,000 condo in Florida supposedly would be going for $1.5 million 12 years from now. Sorry, I do not think so. Who could afford to buy them? Buyers are already stretched.

Did the Smith's factor in property taxes? Did they factor in the possibility of rising federal taxes? Did they factor in the possibility of a ball breaking recession? Did they factor in global wage arbitrage that is working to suppress wages in the US? Did they factor in possible effects of a baby boomer retirement?

What did they factor in other than an absurd and unfounded belief that home price will continue to appreciate at a 6% clip from now until eternity?

The Smith's are in fantasy land. There is no economic justification for their key assumption. Proof will be coming up shortly when bubble area prices drop 40% or more, and the non bubble areas stagnate at best.

People are always looking for reasons to justify their purchase. It happened with the Nasdaq bubble and it is happening again in the echo bubble in housing. Their study, a 60 page PDF, is impressive in length but unfortunately their key assumption is as flawed as dot com "click count" analysis was in 1999.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com
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PostPosted: Sun Apr 02, 2006 10:06 pm GMT    Post subject: Reply with quote

One point to consider, housing does not need to be affordable by everybody or even by the vast majority for the prices to make sense. It need only be affordable by enough wealthy people to purchase the totality of property. As a gross simplification, property for an entire town could be unaffordable for all of its residents but still be purchased in its entirety by Bill Gates because the stream of rents meets his requirements for a 6% return. Everybody would then be renting from Bill Gates. So while unaffordability does not imply unsustainability, it would eventually lead to land ownership being concentrated in the hands of a wealthy few.

My point, however, was that this talk of "there is no bubble" is being served up as general advice for the masses, when in fact it is totally not applicable to them. A more thorough characterization of the paper would be "there is no bubble, if you're rich and not going anywhere for 10 years". For the 76% of Boston area homes that are not affordable by families earning the median income for the area, an analysis showing how wealthy people can justify current prices should not be used as evidence to compel them to take on risky financing to reach for something that they can't afford.

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PostPosted: Sun Apr 02, 2006 10:27 pm GMT    Post subject: Reply with quote

Thanks for identifying that absurd key assumption of 6 percent growth per year.

I too was struck by the writers' clear bias. They're up to their necks it seems in real estate...

"At the risk of sounding like a real estate agent, Mr Smith said (in a NYT's article) there are two risks to consider when buying a house. 'One is that you buy and the price goes down. The other is that you don't buy and the price goes up..' "The second is more scary," he said.

Huh? I don't know about anybody else, but I'm going to lose more sleep over money I've actually lost, than money I might have made. This also ignores that even if one makes money on paper on a home, unless you're an investor, that's very difficult money to actually realize...
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PostPosted: Fri May 19, 2006 3:02 am GMT    Post subject: Reply with quote

Check out this guy.
It is 59 minutes and it worth every minute of it.

http://video.google.com/videoplay?docid=-2640239019877885520&q=housing+bubble
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