‘It’s Clear A Lot Of People Are Nuts’
The New York Times has a look at how to spot a housing bubble. “Gary and Margaret Hwang Smith, economics professors at Pomona College, 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.”
“In a paper the two presented at this week, ‘Bubble, Bubble, Where’s the Housing Bubble?’ 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.”
“At at the risk of sounding like a real estate agent, Mr. Smith said 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.”
“Robert J. Shiller, the Yale professor who has few doubts that a real estate bubble exists in many American cities. He said he did not buy the Smiths’ point that certain markets were not overpriced. The way the Pomona professors reached their conclusion, however, has generated a lot of interest among fellow economists. ‘I think the paper is a sign of the times,’ Mr. Shiller said, because it emphasizes the link between home prices and rent as the proper way to understand the value of real estate.”
“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.’”
“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.’ Of course, few people do that math when they buy a house. They look at what other houses in the neighborhood are selling for and base their bid on some expectation of what the house may be worth in the future.”
“Those expectations are far too optimistic, numerous studies have shown, most notably a 2003 study by Mr. Case and Mr. Shiller that found, for instance, that homeowners in San Francisco expected annual price increases of 15.7 percent. ‘It’s clear a lot of people are nuts,’ Mr. Case said.”
“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. One-third of taxpayers do not itemize their deductions and many more are getting hit with the alternative minimum tax that removes some of the advantages of home ownership.”
“The questions many people want to know about housing prices are not answered by the Smith research: when will they fall and by how much? ‘Some people think we are trying to predict prices and we are not,’ Mr. Smith said. Sure, he said, if prices drop you would have been better off if you had waited. ‘If you are a house flipper, we aren’t talking to you,’ he said.”
From the Washington Post. “Homeownership makes Mary Casey feel as if she has more control over her destiny, even though she pays 75 percent of her net income for a 600-square-foot co-op in the District, including the monthly co-op fee. ‘I’m willing to live that way if I buy,’ she said. ‘I’m not willing to live that way if I’m not buying.’”
“An even better indicator of how divorced home prices are from their underlying economic value is the price-to-rent ratio. Consider the example of a townhouse in Fairlington, a venerable apartment and townhouse community in the Virginia suburbs just a few miles from the nation’s capital. It’s an instructive example because there are hundreds of similar units.”
“A typical three bedroom townhouse in Fairlington recently sold for $575,000. Assuming the owner put 10 percent down and took out a traditional 30-year fixed-rate mortgage, the monthly payment would be just under $3,200. Add in property taxes, a condo fee, and the tax breaks for home ownership, and the cost of owning this unit comes to about $3,000 a month. (Note that this analysis takes into account the lower cost of owning due to low interest rates and ignores the $57,500 down payment.) Yet the very same place rents for no more than $1,700 a month, or just over half the cost of ownership.”
“Why own it? One powerful reason must be an expected profit down the road. As with the stock market during the tech bubble, many are basing purchasing decisions not on underlying economic value, but on what they think they can sell a property for in the future, the very definition of a speculative bubble.”
‘At at the risk of sounding like a real estate agent, Mr. Smith said 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’
Oh really? In the first, I risk being underwater on a home for years, unable to sell and move, etc. In the second, my rent hasn’t moved a bit while homes are even further over-valued. I’m sorry Smith, you sound like a snake-oil saleman to me.
“At at the risk of sounding like a real estate agent, Mr. Smith said 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”
Smith should have said: “The second is more socially unacceptable”
Exactly
It also doesn’t take into account the relative probability of the two events occurring. Even if the second is more scary - which I don’t think is the case - would you still buy if you believed the probability of the first occurring was far higher than the second?
Yep this guy is a hack for the real-estate industry. You really have to keep a few “what if…?”’s in mind: What if prices do go down, and your job goes away? What if, unlikely as it might be (*cough*), house prices don’t double in the next five years like they did in the last five? What if you sell your place at a handy profit and invest it prudently while you rent, instead of buying another place? (Many of the economic arguments for owning rather than renting don’t work if you have a nice wad of money in the bank.)
I know you’re not supposed to think of a house as an investment, but speaking as an active stock trader, an actual, realized loss is much worse than missing a gain. You can’t rule out that you’ll catch a winner later.
Economic Profs. at Pomona? The Dean better verify Mr & Mrs. Smith teaching credentials. Those comments sound more like the NAR church choir!Brad Pitt and Jollie even know better!
Risk 1) Prices go UP..In finance we call this “opportunity loss” In GAAP unrecordable- unrealized gains (But in Pomona Economics this is SCARY?)
Rsik 2) Prices go DOWN…In finance this a true economic loss and usually results in loss of 100% of ones equity ownership, forcing de- leveraging. This of course, makes the owner a slave to his banker landlord who holds a lien to 100% of any Marketable Value and leaves the tenant in debt for the difference, so other assets may be abruptly wisked away! Hwever Risk 1 Smith says “is more scary”! Check with me in 3 yrs.
Thank God, my daughter had the good sense not to go to POMONA, as I thought she should..At the top of my head there are at least (6) other economic risks Mr. economics left off his granite chalk board!
Risk 3) Loss of prior income Such as, losses their job, illness etc.
(Finally my Favorite) - Loss in Real money value due to Fiat currency manipulation versus true money {GOLD}…Home owners believe their home prices are going UP but in reality it losses real purchase power over time. This I beleive are the facts - US Median home prices versus true money Gold since 1979 (i think) but for sure it is not in the last 15yrs.
Risk 4) Interest rates rise, - (Mortgage ARMS make up 40% or more of the lending market and therefore a considerable risk)”such as a 25bp. for 15 times and counting…and your monthly mortgage payment grows faster than your original income…
Risk 5) Under-insured & uninsurable risks -Natural disasters - (earthquake, flood, hurricane,sink holes;Others - War, invasion,terrorism, mold etc.
Risk 6) Government Fiat - Taxes & Legislation changes
Risk 7) Undetected Product defects.- after contractor left town or went BK!
Risk
in real terms…{Oh Mr Smith
Not to mention Pomona is one of the crappiest places to live in SoCal. Maybe these people are trying to feel better about themselves.
Sounds like the Profs. Smith used rental numbers that were too high. If you assume a high enough rent, any property will look like a good buy.
I can’t imagine what kind of rental numbers they used. We are in a $1.2M house that we lease for $2800/mo. You would have to “assume” an awful lot of appreciation to have that pencil out.
Is it ever correct to value assets by assuming a certain fixed percentage of appreciation every year? By factoring in a fixed guaranteed rate of appreciation the study will find homes to be affordable at much higher prices. Why don’t we all just assume 15% annual appreciation and then homes will be really reasonably priced?
The whole idea of ASSUMING a fixed rate of appreciation reminded me of the hilarious blog http://www.thereisnohousingbubble.blogspot.com. Here is one particularly hilarious bit…..
“Hi Mr. Bubble,
Prices have gone up so much in the last 5 years. I’m worried about buying at the peak and overpaying for a house. The house I’m considering is a fixer upper in North Oakland. It is 1100 sq. ft. and needs a new roof. The asking price is $675,000. What should I do?
Good question. First of all, remember, you can not over pay for a house. In fact, as I proved previously, the more you pay for the house the more money you’ll earn in the long run. I know some deluded renters are screaming at their monitors right now “that’s the stupidest thing I ever heard!” Here’s the proof. Let’s say you buy that house for 675K and we’ll be very very conservative and assume only 10% yearly appreciation instead of the industry standard 20%. After 10 years you’ll have a little over 1 million in equity (even if you negatively amortize a few hundred thousand you’re still sitting on a mountain of cash). Now, let’s say you aggressively bid 750K on this Oakland charmer. After 10 years at ONLY 10% appreciation on the higher price you’ll have over 1.2 million in profit. That’s right, you made an extra $200,000 by “overpaying” for that house. As the math above proves you can not make a mistake of overpaying for a home. In fact the only mistake would be passing on that cute Oakland home.”
Great stuff!
good lord, people. you’re relying on a newspaper reporter’s description of the research. how about taking a look at the research instead????? http://www.economics.pomona.edu/GarySmith/papers.html
6% isn’t an assumed growth rate in house prices, it’s the opportunity cost of capital that goes into the discount factor. They note that the house prices are wildly sensitive to growth rate assumptions. I suspect that’s what Chris Mayer was saying when he was talking about demand - in a place like Indianapolis where land isn’t limited and building technology improves, rents are more likely to go down than go up by there assumed 1% (real) rate of rent increase. I suspect that there rent increase assumption is a little high, and their property tax and maintainence percentages are a little low, and that’s what drives the results.
But the methodolgy isn’t suspect - hell it’s standard. It’s exactly what you do for income based appraisals on multifamily property.
I read it and there are many flaws with the most obvious regarding the “housing as an investment”. Most reasonable people regard housing as a liability and to use asset based financial models to calculate a projected return above the inflation rate has as much merit as throwing darts at the stock pages.
I have live in the area for decades. Oakland has awful awful schools. Buy anything there and you will be like all my educated friends who didn’t want to miss the boat. They are all paying over $10,000 per kid per year for private school on top of high prop.taxes to live in a dump (with granite counters of course)
Oakland schools are horrible (SF, too.) That is the exact reason we moved to SD. We now pay $2K/mo rent for a place that appraised at ~800K, and our son attends a school with >900 API scores. I almost feel like I’m robbing the owner at this rent.
Industry standard of 20%??? What???
Wouldn’t industry standard be more like the rate of inflation?
Was this guy trying his best to rattle cages… trolling?
I have never heard something as absurd as this in my entire life. I wonder if this is why real estate never goes down. No one with any brains is buying it - Only complete morons. A complete moron can never overpay for anything because by definition he won’t know what the value is in the first place. A chcken and egg, provided the world doesn’t run out of greater fools…
Guys, the above post is SATIRE!
Deb, you need to watch “property as income” infomercials. Really flashy cars, lots of good looking women with expensive jewelery, boats, champagne and a lot of smiling going on. They sneak in a lot of the very same comments in between glamor shots. This practice was really going strong in the 88-90 period. An Asain guy, something Chan. The shows were all gone in ‘91.
Funny thing is they reappeared the past 3 or 4 years…
I think that the assumption was that rents would continue to increase over the time span being considered. I.e., buying now is cheaper than renting in the future. And we are all interested in the future, because that is where we will spend the rest of our lives.
But if their analysis is correct and the places we think are bubbles are not bubbles, then up to a few years ago, they were grossly undervalued, and have been for many years. Thoughout all of modern history, in fact.
“they were grossly undervalued, and have been for many years. Thoughout all of modern history, in fact.”
Great point!
Which by economics would be an impossibility, as goes the old joke:
Two economists were walking down the street when one said, “Hey look, there’s a $100 bill on the ground.” The other replied, “That’s impossible. If that were a $100 bill then someone would have already picked it up.”
I think the problem is that their assumptions hard-wired in an exogenous 6% gain forever. In other words, no matter how big the mountain of for-sale inventory, how terrible the affordability numbers, how rock-bottom the interest rates by historical standards, how lax the underwriting standards that helped push prices to insane levels, or how unprecedentedly high the recent percentage of homes bought by speculators, SoCal housing will always produce a long-run return at a 6% YOY gain off the current price level.
I’ll take the second choice. This way I still have options. Once you’re upside down, you have no options. Been there, done that in the ’90s.
into account the lower cost of owning due to low interest rates and ignores the $57,500 down payment.
In today’s market, that $57K is generating 2.9K/ year, which lowers the effective rent by another $240. And if you invest it so that you’re producing qualified dividends, you’re only paying 15-20% income tax (thanks mr bush).
And interest rates are going up.
The Smiths are just bubble apologists probably loved by the real estate industry. I wonder why they have to justify the lack of a bubble with their financial software calculations by plugging in their unrealistic assumptions. You can come to any conclusion you want about the value of real estate by making incorrect assumptions. We could plot real estate appreciation on a graph and show how rich we would all be in 5 years, 10 years, etc., by plotting the trend line on a graph. Hey, maybe rents will go up 10% per year so obviously it would be better to buy. Why don’t we just agree that housing is in a new paradigm (like internet stocks were in 1999) and forget about rationalizing real estate appreciation with financial software calculations. I think the Smiths were just trying to rationalize their own purchase to themselves. It will be fun to see them underwater in a few years.
I totally agree with the poster about what is more scary. It is real estate going down that is more scary. Wasn’t it March 2000, when everyone was so scared of not making gobs of money in the internet boom? There were not too many people worried about the NASDAQ crashing. Remember, it was going to 20,000 and people were scared that they were going to miss out.
“Consider the price-to-income ratio, an obvious measure of affordability. This ratio has reached an unprecedented level in the bubble markets. While this ratio hovered around its average of 4-to-1 for the past 30 years, it has zoomed to nearly 8-to-1.”
In San Francisco it’s more like 30-to-1.
8-1 is the mean in San Diego for the past 30 years, but with the bubble it’s currently 11-1. In the two previous cycles it peaked at 9-1 and troughed at 7-1. I’ll by my house in 5 years when it’s at 6-1.
Grush–
Those numbers sound very reasonable according to what I have read for SD. The trick is to not expect that ratio to go down much below 6-1, because everyone wants to live here. (Historically it has averaged around 2.3-1 for Wisconsin, by comparison.)
GS
I remember 20 years ago ,(where I worked) ,appraisers were instructed not to give a present value based on future possible gain .
A classic example of this was the rumors or chatter that Palmdale ,Ca. was going to build a airport . The price of land went up for a while based on that future value . They never built the airport . Why should the current buyer pay for something that will take 10 years to materialize like in Merced Ca. regarding the University planned .My point is current value is current value and if you add a speculative premuim you paying in the now for future value .The appraisers were instructed not to add for that at the place I worked .IMO you cant add future rents to determine current price . Its what the rents are at today that determine the fundamentals of price .The real estate industry will do anything to justify these outragous prices ,even making the buyer now pay for rental increases 10 years from now .
“…a good annual rate of return of 6 percent or more…”
That is the Tell Tale - any economic model that shows housing appreciating faster than inflation is double dipping and therefore bogus .
There are a lot of questions about that research-
1- What was the exact apprecation rate they used
2- how often did they compound it
3- They mention that counties outside of there own are not in a bubble. Therefor thier study means nothing outside of thier area
4- They mention only specific cities that are not bubbles. We all know parts of Texas are not in a bubble. So what? Almost everywhere else is.
5- DID YOU SEE THE PART ABOUT THEM PLANNING TO MAKE THIS INTO A TOO THAT THEY CAN SELL FOR PROFIT????
BubbleTrack.blogspot.com
What parts of Texas aren’t in a bubble?
I’d say perhaps Midland, Lubbock, Beaumont, Port Arthur, Orange
Everywhere else is
I don’t think Houston is in a bubble.
Austin is not in a bubble. If I were still there I wouldn’t hesitate to buy a house. I should get a gold star for coming to glorious Hampton Roads where incomes are half as much and homes cost twice as much.
Consider that even an area where prices are falling may be getting support from the bubble — prices might be falling even more rapidly without it.
Here is a link to the paper.
I found the following assumptions interesting:
It looks like they assumed their result. They dramatically understated the costs of buying, and it also looks like they ginned up the cost of buying.
Notice that they are assuming a 5% 30 year fixed mortgage and with a high tax rate (increases the deduction savings). Also, their property taxes, maintanence, and insurance seem absurdly low.
I could go on…but why would I waste my time with their non-sense?
Make that “ginned up the cost of renting.”
OK, someone do the math, if houses appreciate 6% and rents appreciate 3%, sometime in the future, renting will be 1% the cost of owning.
Those assumptions are on crack.
This is interesting. I looked quickly, but it appears to me they used summer of 2004 data with regard to home prices and rents.
Where have LA area home prices gone in the last 20 months?
Also, I’d like to know the number of buyers today in their region putting 20% down and using a 5% 30 year fixed.
I guess a bubble is not a bubble when one “uses” unrealistic buyers and old data.
Dead on
What if the average price or Smiths house goes to 2 million . It would be worthless because you couldn’t sell it . So, where does affordabilty come into the picture as part of the Smiths calculations .They are just going to price themselves out of the reach of any buyers even if their house goes up . What good is a asset if nobody can afford to buy it .It has to be a easy to market asset .
What a joke!!! 20% downpayment? How many years has it been since SoCal buyers were required to make a downpayment? I just had a conversation two days ago with a colleague about this change in the rules-of-the-game. We concurred that a reversion to traditional downpayment requirements alone would be sufficient to pop the bubble.
Well I’m glad they are putting their money where their mouth is. 1 million bucks for two teachers…awesome!
Gary Smith seems to be about 61 and probably earns around $100k as an economics full professor at this college. His wife seems to be about 36 and probably makes $70k from her job. She is also certified as a financial planner…. They might be wealthier than you would assume.
I hope they included the cost of insurance, including earthquake. I think that drops another percent or two off their return.
Get ready for a pay cut. It’s not just Delphi and Detroit that are facing some pain. Technology and globalization will push teachers pay down. Good luck paying off that million dollar house.
It’s happening my little sub-industry, though most people don’t recognize it. (It’s a voliatale business to begin with).
We’re planning for the long term, to be able to live comfortably on well less than what I made the last several years.
Part of the ‘corporatization’ of American education. There has been a steady barrage of articles in the LA Times, detailing how UC administrators get around the rules for reimbursements to pad their salaries. Strangely enough, faculty don’t have access to similar perks. A good part of those sky-rocketing tuition expenses are lining the pockets of University administrators.
The ‘life-death’ struggles between workers and managers that we’ve seen in manufacturing are now occurring in American education.
That reminds me… Have Mr. & Mrs. Smith been able to sell their house yet?
Ah. should have RTFA before taking a cheap shot. But I was corrent in that they have a personal stake in the stuation being as they expressed.
5% 30 year fixed. Wow. My credit union gives me 6.375% now if I don’t buy any points. Maybe I need to find another bank.
You’d also have to have perfect credit to even get that.
gary and his wife margaret all wrote this paper
Scared to Death?, British Medical Journal, 325, 2002, 1442-1443. Are Chinese- and Japanese-Americans so frightened by the number 4 that they have abnormally high cardiac mortality on the 4th day of the month?
Smith’s are being paid by each word they publish.
Are Jewish Deathdates Affected by the Timing of Religious Holidays?, with Peter Lee, Social Biology, Spring-Summer 2000, 127–134. In contrast to other research, we find no persuasive evidence that Jews can postpone their deaths until after the celebration of religious holidays or birthdays. Our data do suggest that there may be an increase in deaths in the weeks shortly before and after birthdays.
Can the Famous Really Postpone Death?, with Heather Royer, Social Biology, Fall-Winter 1998, 302–305.. It has been reported that famous people are often able to postpone their deaths until after a birthday. A reanalysis of these data shows that there were actually a relatively large number of deaths in the month preceding and the months following the birthday.
‘Indeed, the Smiths used an early version of the formula before they moved from a tract home in Claremont to a home closer to the college. The two met and married while teaching at Pomona, about 35 miles east of Los Angeles. They have three children (a fourth is on the way), so they needed more room.
They found a four-bedroom house a short walk from the college that also had a separate guest house they could use as an office. But the owner was selling it without an agent and did not have an idea of what to sell it for. “He told us to figure out a price,” Ms. Smith said. They determined what rents were for comparable homes and ran their cash-flow software to find a price. “We knew where we could go up to,” Ms. Smith said. Their first offer was rejected, but he eventually accepted $950,000.
That was about 30 percent more than the price of the house they had been living in, but the net present value calculation told them that they would be generating an 8 percent after-tax return. “It seemed like a no-brainer,” she said.
“Then it occurred to me that it was an appropriate method for looking at the question of the bubble,” she said.’
Hmm…
Children, do you know how to say ‘rationalization’?
I knew that you could.
For all the really, really stupid decisions us humans make in life…
…we can always, always, always…
…create ill gotten data to support them.
Good luck keeping that house on two economics professor’s salaries.
I look forward to seeing it on the market again in the next two years.
I’ll call my ’study’ this…
“A Thesis On How Two Impatient Economics Professors From Pomona College Went Broke In Two Years- And Ended Up On Skid Row”
Data to be forthcoming, as soon as I create it…
…just like they did.
so what you are saying is Smith’s wrote paper for only one reason. To protect value of there home. appears to be very academic.
They’re going to be protecting a cardboard box, pretty soon.
How long of a drive is it from Skid Row in downtown LA to Pomona?
Maybe they can do a new study after that experience…
“The Positive Aspects Of Raising Four Children With Whinos”
“Whinos” LOL, that’s very funny. They will be winos and whinos soon enough.
Could buying a $7,000/mo house on two ekkonomiks professors salaries…
…when you have four kids…
…could that be considered ‘child abuse’?
Can you imagine the family dinners?
Won’t they be kinda like the ones in Cinderella Man?
Should someone call Child Protective Services?
“Naw…you go ahead and eat, kids. I’m full. I ate yesterday. Now it’s off to lecture with me…you kids be good, and don’t eat that last leather jacket…we’re in for a cold spell.”
Are there really that many homes?
Most sellers start too high, that’s for sure.
Smith calls it his: “Throw caution to the wind and buy now because everything stays the same for a really long time and nothing bad ever happens study”. They are teaching this in school now? OMG, they need a serious attitude adjustment if they are counseling people using this formula.
A year ago, if you will recall, this kind of thinking was the norm, and bubbleheads were the exception. Now the reverse is true. The author is a last-gasper.
Actually, it’s pretty interesting how far we’ve come in a year.
OT
http://www.latimes.com/classified/realestate/news/la-re-fliptax2apr02,0,4735064.story?coll=la-home-realestate
LA Times article on the cautions of home flipping.
I actually built a spread sheet a few weeks ago based on the Smiths’ buy vs rent article at ; I’m a finance novice so it took me awhile to figure out that I didn’t need to do Newton-Raphson approximations to calculate IRR because Excel already has it built in, but otherwise it would have been a few hours’ work on a Saturday morning. Good learning experience for me. Plenty of folks here would be able to run the same test with very little effort, I imagine.
Anyway, I have to say that the results made a lot of sense; I would be surprised if there’s anything deeply flawed with the *model*, besides the fact that it doesn’t take AMT into account. On the other hand, the *assumptions* you put in make a huge difference … if you use their assumptions for rent increases and maintenance and house appreciation, then it looks like renting’s better than buying in the Boston market, just not overwhelmingly so; if you could get a bit of a discount from the market you would at least consider to go ahead and buy. But I just don’t think the assumptions are that good. Rents have been pretty much flat for 6+ years now. Winter heating costs (again I’m thinking Boston-centric) are way higher than their assumptions would handle, as are property taxes in many (though not all) towns around here (of course they’re working with CA prop 13 assumptions, the point is you can’t do that in MA). And if you assume 0% annual house price appreciation instead of 4%, things get ugly fast.
In short, though I’m no expert their tool seems to be pretty useful. Plug in some more conservative values and the thing basically shouts “Don’t buy.”
so sorry, I screwed up the link. closing …
I can’t really fault their model. However, their choice of data and parameter assumptions basically give them their result. They certainly weren’t being conservative.
Right, exactly. Guess they must have really wanted that house.
People say this area is not in a bubble. Prices in my hood have gone up 6%/yr last few yrs. Howver, the city is nearly bankrupt, schools are closing, city doesn’t always clean streets in winter, city couldn’t afford to pay for rat catchers’ training, taxes are going up, govt not willing to cut entitlements, giving taxbreaks to condo developers… it’s all relative. My old landlord built “luxury townhomes” in my hood. 12 @ $1M each. Since 2004, they’ve sold 7 of them.
It’s funny that this just made it into the NY Times. I read this paper over a year ago - when I first was curious about a possible bubble. Maybe when the study was done, the conclusions made sense. Now, however, it is definately a bubble. Check out when it was first published and when the comps were derived.
Not funny at all to me — smells like the Times is desperate for some positive real estate spin. I almost spit my soup out hearing their 20 percent down, low interest rate “assumptions” — thank you everyone on the blog for pointing all of this out — also makes me wonder whether shiller’s quotes were old too… i mean it is important to factor in cost of renting v owing, but it’s just good business sense, not something economist should be backslapping themselves for “figuring out”
in their assumption they put in a 20% down payment. I didn’t see their calcs but do they also assume the renter puts this into a different type of investment? Like say tax exempt muni bonds? On the 585K thats 120K to invest. Which will generate roughly 9,000 in income. They can either use that money to offset their rental costs for the year, cutting them by about a third, or they can plow it into another investment (s&p 500) and “assume” that return over a thirty year cash flow discounted back to PV. I am fairly certain that based on those “assumptions” the renter comes out way ahead.
It’s a rent vs buy model, not a investment vehicle A vs investment vehicle B model … surely that’s legit? You have to live somewhere, however much return your investments are generating, and that housing has a cost that subtracts from your income/investment returns.
Anyway, running what I consider to be reasonable numbers in their model, I get results that encourage me to do exactly what you suggest: rent, put the cash to work elsewhere, and be happy.
How could there possibly be opportunity cost? Next thing you’ll say is that there is downside risk. No professor ever loses their job and has to move.
I think thye apply a cost of capital to the downpayment as part of the cost of buying. I am sure their model is valid. Their assumptions do seem low regarding mortgage rates and even the tax rate from what was posted here. Isn’t it 1.25% in CA?
Actually, the scarry thing, has nothing to do with price appreciation or depreciation. It is called Foreclosure. Boo!
Oh here’s one of those luxury townhomes in my hood. They’re selling for $1M now. Sold 5/26/05 for $545K. It’s value for tax scheme? $9,300 The taxbreaks on this development (in a great neighborhood - grad students, Orthodox Jews, doctors, lawyers, Elsie Hillman) expire in 2007. My previous landlord has a rep for overpaying. They are the big fish in this little pond. Made many millions in another field, started buying up properties left and right. Often paying much more than properties were worth. This though, is their crowning achievement.
Mr. Smith, the writer of this pap must have property to unload, or is an example for the biggest Darwin’s Greatest Fool Award for 2006.
Maybe the article was really just an April Fools joke?
It would be kinda funny, now that I think about it…
I mean…Mr. and Mrs. Smith?
Economics professors?
Could we all be April Fools?
I’d laugh my a$$ off if this turns out to be true…
The people who funded this paper were real estate investors. The first page of the paper thanks some foundation. So I decided to google them, and this is what I found.
1) “Dora Fellows Haynes (1859-1934) was born and grew up in the coal mining region of Pennsylvania. Her father, like her future husband’s, was a mine manager, and the two families were friends. John and Dora married in 1882 after Dora returned to Pennsylvania from a year’s attendance at Wellesley College. Their only child, Sidney, died at the age of three of scarlet fever, an event that motivated the couple’s move across country to the budding metropolis of Los Angeles. There, John set up a medical practice and entered into business as a real estate investor.”
SOURCE: http://www.haynesfoundation.org/about/index.cfm
2) ” John Randolph Haynes (1853-1937) and his wife Dora (1859-1934) came from Philadelphia to Los Angeles in 1887, just in time to make a fortune in real estate, banking, and other endeavors.”
SOURCE: http://www.socalhistory.org/Articles/Hoffman2a.htm
Need I go on, so keep your shirts on, this is just campaign to get more money from that foundation.
Dear Economics Professors;
The median home in Claremont costs $600k. The highest rents in Claremont are $2500. Do the math. $2500/mo is a $400,000 mortgage. THe higherst rent comes nowhere close to covering the median home. Using your own formula there is a massive bubble in your own neighborhood.
“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.”
Ahem, like the Feds don’t have a vested interest here at this moment in time!!!!!!!
“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.”
Mr. Smith, I’m sure intrinsic value that you consider is the changing environment of the neighborhood with time, the changing job market, worker incomes that cap the upside potential rent, escalating energy costs, etc. And Mr. Smith, what about the intrinsic possibility for divorce, I mean isn’t that capped at about a 50% probability?
Oh dear. The Federal Reserve thinks it’s an important paper. Why wouldn’t they? They are being blamed for causing this supposedly non-existant bubble. They also think inflation should exclude things that increase in cost. The Fed computes housing costs in the CPI using rental costs. Why does the press give the Fed a pass that they don’t give to elected officals?
I am more shocked by the WP article…… 75% of net (low) income on housing. I wouldn’t be surprised if she took home $2000 max, so $1500 goes to the IO mortgage. Holy smoke…..
I bet shed couldn’t rent anything where they inquired about her income, but…. sure…… why don’t you buy something.
““Homeownership makes Mary Casey feel as if she has more control over her destiny, even though she pays 75 percent of her net income for a 600-square-foot co-op in the District, including the monthly co-op fee. ‘I’m willing to live that way if I buy,’ she said. ‘I’m not willing to live that way if I’m not buying.’”
And this is my nominated winner for the 2006 Darwin RE Patsy of the year. She should by center stage with Cindy Sheehan.
Ummm… I agree with the Darwin thing, but why the reference to Cindy Sheehan? What does an outspoken woman who lost her son in war have anything to do with real estate?
To Baldy,
“The Fed computes housing costs in the CPI using rental costs.”
Nice try but you are not, and I repeat not, going to get me more riled up today then I already am !!! I’ve put that one behind me after screaming and no one listening.
“”We knew where we could go up to,” Ms. Smith said. Their first offer was rejected, but he eventually accepted $950,000.
That was about 30 percent more than the price of the house they had been living in, but the net present value calculation told them that they would be generating an 8 percent after-tax return. “It seemed like a no-brainer,” she said. ”
There’s the secret of their real estate deal: once again, it was a no-brainer!!!! I wonder if all economics professors are no-brainers.
I’ve never heard of Ponoma College, is it any good?
If Mr and Mrs Smith can get a job there, I don’t think I’d send my kids there.
Right …..I think the reason we are getting all this bias data and garbage opinions is because so many people are homeowners . So many people have a stake in this housing bubble .
Pomona College is one of the undergraduate “Claremont Colleges”, based (strangely enough) in Claremont, California (just east of Los Angeles and west of San Bernadino).
They’re pretty good for the hard sciences - don’t know much about the liberal arts or soft sciences. Very pricey for tuition, amongst the most expensive in California.
It is very good. They are good economists too.
“Bubble, Bubble, Where’s the Housing Bubble?” – You are the proof of it.
Here is their paper for those of you who want to read it. (http://www.economics.pomona.edu/GarySmith/BrookingsHousingBubble.pdf)
The Smith’s line of think are the same as those you would hear at a RE investment seminar, but only more dangerous because it has an academic authority to it. They base their entire research on the premise that home prices will always go up to justify current prices as being fair to undervalue. The Smiths did put money where their mouths are by buying a 4-BR home in Claremont for $950,000. (Although, it’s a lot easier for them to buy an inflated bigger home with their inflated smaller home as compared to a first-time home buyer.). The bottom line is that the Smiths are very long in rhetoric but very deprived of common sense.
This is the equation they use:
NPV = X0 + X1/ (1+R)1 + X2/(1+R)2 + X3/(1+R)3 + Xn/(1+R)n
(note: the equation did not look as intended due to limited text format in blogging, but check out the equation in the research paper.)
NPV = Net Present Value
X0 is a negative number equal to the down payment and out-of-pocket closing costs, Xn is the net amount received when the house is sold and the mortgage balance (if any) is paid off. The required return R depends on the rates of return available on other investments.
“A homebuyer can use the projected cash flow and a required rate of return to determine if a house’s net present value (NPV) is positive or negative. If the NPV is positive, the house is indeed worth what it costs; if the NPV is negative, renting is more financially attractive.”
The problem with the Smith’s and all RE speculators is that they assumed Xn is always positive (meaning home prices will always go up). God forbids if home prices go down in the future which would make Xn a colossal negative number and so is the NPV.
What makes the Smiths more idiotic than the average RE speculators is that it took them 60 pages of research paper just to say that “home prices will always go up”. And if you believe in that premise, you don’t need all that convoluted and tortured rationing like they did in their research to buy RE. Just leverage up to the maximum that the banks allow, buy the most RE that you can get by monthly, sit back and watch the power of leverage to swell your riches.
“Gary and Margaret Smith, who is also a certified financial planner, say they want to commercialize their program so that the average person can determine a house’s value. She has helped several clients decide whether to buy or rent. “We may have some intellectual property that is valuable,” Mr. Smith said.”
So now they are claiming intellectual right to that new law of economics - “home prices will always go up.”
The economic students should demand a refund for their tuition if this is the kind of academic teaching they get from their universities.
I can see why it is hopelessly difficult for the average persons without a college degree not get consumed in this RE mania when the university’s professors are telling them it is cheap to buy now, and that home prices will always go up. Many of them have acted and put all their hope and dreams into it. Many of them will spend years trying to recover from this financial catastrophe.
This is what mania looks like folks. Even Isaac Newton could not escape the hallucination of a mania, he too loss a fortune in the South Sea bubble.
I always love your comments Tommy_Trojan . You have one hell of a brain .
There’s a higher education bubble too, just as awash with shoddy construction and lender-appraiser collusion as the housing market.
Okay, this is insanely funny. 60 pages to explain that housing prices only go up? By academics? Shoot! Some of those late night infomercial guys could have told them the same thing in 3 CDs and a couple of books with pretty pictures!
Tommy_trojan, thank you for your analysis. After hearing of the report and reading some of it last night, I too found the basic premise of their study to be flawed. My senior project for BS Finance degree was on the use of IRR and NPV to evaluate real estate investments. After graduation, I spent the next 16 years (1979-1995) buying/managing and selling properties for limited partnerships. The investors in those partnerships should have been so fortunate to realize performance using such assumptions as annual fixed rent increases. In addition, no formula can take into account such events as the Tax Reform Act of 1986.
A quick scan of the 60 page report sent my head into a whirl of “does not compute, does not compute” and consequently, a sleepless night. This morning, I wake up and the mind is swimming in NPV calculations, and I’m trying to decide if I want to spend a day writing a paper to give the economists a dose of the real world. I don’t think I’ll bother, since there are plenty of academics that are, I’m guessing, doing the same thing. I don’t think you’ll read their response in the NY Times.
Finally, for you academics, my research arrived at the conclusion that NPV was might be more appropriate (versus IRR) for evaluating the return on real estate investments, since the bulk of the “return” occurs when the property is sold. It also assumed that real estate values always go up and that there was a lump sum return at the end of the investment term.
I can assure you that after 16 years as a crisis property manager helping investors “bail out” of real estate post 1986, the assumption that real estate always goes up is totally without merit.
Upon further analysis, I guess they could have held on for another 15 years and top-ticked the market. I don’t know too many investors that have that kind of stomach.
Isn’t that “old” economics? The idea that the bulk of the return occurs when property is sold?
Under the new “flopper” economics, the bulk of the return comes when you liberate your trapped equity via a loan of some sort, right?
For every pyramid scheme, and any asset bubble is somewhat akin to one. Those looking to perpetuate the pyramid always employ some `so called expert` to attemp to reel in more suckers.
Even if the so called experts are economics professors.
Their assumption is that all people buy houses to live in, that clearly isn`t the case.
If rents cannot sustain the mortgage payments, then flippers cannot indefinitly hang on to these properties. Hence more come on to the market and the old supply and demand comes into play.
This is a repost – noticed some syntax errors with the original post.
“Bubble, Bubble, Where’s the Housing Bubble?” – You are the proof of it.
Here is their paper for those of you who want to read it. (http://www.economics.pomona.edu/GarySmith/BrookingsHousingBubble.pdf)
The Smiths’ line of think are the same as those you would hear at a RE investment seminar, but only more dangerous because it has an academic authority to it. They based their entire research on the premise that home prices will always go up to justify current prices as being fair to undervalue. The Smiths did put money where their mouths are by buying a 4-BR home in Claremont for $950,000. (Although, it’s a lot easier for them to buy an inflated bigger home with their inflated smaller home as compared to a first-time home buyer.). The bottom line is that the Smiths are very long in rhetoric but very deprived of common sense.
This is the equation they used:
NPV = X0 + X1/ (1+R)1 + X2/(1+R)2 + X3/(1+R)3 + Xn/(1+R)n
NPV = Net Present Value
X0 is a negative number equal to the down payment and out-of-pocket closing costs, Xn is the net amount received when the house is sold and the mortgage balance (if any) is paid off. The required return R depends on the rates of return available on other investments.
“A homebuyer can use the projected cash flow and a required rate of return to determine if a house’s net present value (NPV) is positive or negative. If the NPV is positive, the house is indeed worth what it costs; if the NPV is negative, renting is more financially attractive.”
The problem with the Smiths and all RE speculators is that they assumed Xn is always positive (meaning home prices will always go up). God forbids if home prices go down in the future which would make Xn a colossal negative number and so is the NPV.
What makes the Smiths more idiotic than the average RE speculators is that it took them 60 pages of research paper just to say that “home prices will always go up”. And if you believed in that premise, you don’t need all that convoluted and tortured rationalization like they did in their research to buy RE. Just leverage up to the maximum that the banks allow, buy the most RE that you can get by monthly, sit back and watch the power of leverage to swell your riches.
“Gary and Margaret Smith, who is also a certified financial planner, say they want to commercialize their program so that the average person can determine a house’s value. She has helped several clients decide whether to buy or rent. “We may have some intellectual property that is valuable,” Mr. Smith said.”
So now they are claiming intellectual right to that new law of economics - “home prices will always go up.”
The economic students should demand a refund for their tuition if this is the kind of academic teaching they get from their universities.
I can see why it is hopelessly difficult for the average persons without a college degree not get consumed in this RE mania when the university’s professors are telling them it is cheap to buy now, and that home prices will always go up. Many of them have acted and put all their hope and dreams into it. Many of them will spend years trying to recover from this financial catastrophe.
This is what mania looks like folks. Even Isaac Newton could not escape the hallucination of a mania, he too lost a fortune in the South Sea bubble.
If your eyes, heart ,and soul tell you the house price isn’t worth it ,than it isn’t. To many people are operating on fear. Even the Smiths brought up the fear factor saying…. “The other is that you don;t buy and the price goes up .The second is more scary”.
The Smiths sound like realtors .
If you buy property with no money down, isn’t a $1 gain on sale an infinitesimal percentage?
Please tell me how this piece of SH&& is worth 200K??? And then tell me there is no housing bubble.
I forgot to mention it’s in cracktown.
Not bad - but this “remolded [sic] doll’s house” is 55 miles west of D.C. http://www.homesdatabase.com/FQ5587484
ok you win!!!
that is the world’s perfect graffiti wall. a tagger’s dream.
“Hugh Covered Front Porch”.
Yes, it’s true. Even a high school dropout can become a highly-paid real estate professional.
That house would be 600 to 700 thou. in alot of places in L.A.County .
I guess it’s cheap then. Maybe we ought to buy it.
No No .
Sad but true. A little doll house like that in a bad neighborhood would run about $500K to $600K. It would have to have boarded up windows to be priced under $500K.
I have only known two economics professors personally, and neither of them strikes me as particularly bright - or in control of their personal finances. One lost a ton of money on JDSU in the dot-com crash (I did repeatedly warn him to “sell too soon”). The other bought a brand-new townhome for an outrageous price in a remote suburb of Boston. This was in September 2005, I only met him after the fact. Hmmm… maybe he was on the peer review committee for the Smiths’ paper!
The story of the Long Term Capital Management debacle, “The Trillion Dollar Bet” depicted on Nova, is what can happen when you depend on economists too heavily for financial decisions. LTCM was founded by two nobelists in economics, and led to a debacle that not only took out LTCM but nearly destabilized the U.S. financial system:
http://www.pbs.org/wgbh/nova/transcripts/2704stockmarket.html
If the Smiths are making ’sound’ business decisions based on ’solid’ financial models that are standard in the U.S., then no wonder we’re in a world of hurt.
In defense of econ profs, a friend of mine is one, and he thinks the housing bubble is undeniably real and enormous. In fact, he’s salting away as much cash as possible for the coming economic downturn.
I’m an economics professor
Don’t own a house and believe in the bubble in coastal markets…
Gary_Smith@pomona.edu
Hey Tommy - you should read a bit farther than page 9 of the paper. The basics may in fact be a simple discount model, but the way the Smiths get to their variables is fairly astute. And they run a number of sensitivity models which answer a lot of the questions posed in this thread. I am not saying I agree with their agressive assumptions, but the Smiths run the same analysis that every corporation does before investing capital.
Just because you don’t understand what the Smiths are doing doesn’t necessarily mean they are wrong.
I have heard this same specious argument before. I heard it prior to the Japanese real estate collapse. The surprise is that this appeared in an arguably credible news service.
I agree with Apple Butter. The model seems pretty sound and clever. It’s the assumptions that are flawed. Put in real numbers and get some pretty good answers. Not the ones the Smith’s get, though.
By using the Smith & Smith formula I have determined that I should purchase the Sears tower from the Arabs and make 8% on the deal over the long haul. Can I afford it? Where does that go into the formula?
This sounds like sour grapes, even. The formula is based in a concept of finding like comperables, and there are not any like comperables to the Sears Tower which is even relative to Chicago skyscrapers quite a stand out. Bubble advocates need to admit that the comparison of an apartment which is really more like a condo to a house based on them both being a unit is kind of weak.
Let’s assume the Smith’s model is correct. Isn’t an assumption that it will only be valid for people that use it? Following that train of thought, unless a good number (majority?) of people use that model to make their decision to buy or rent then it doesn’t matter if the model is “correct” or not? Kind of like if a tree falls in the forest and no one is there to hear it does it make a sound? Also, isn’t there a point where people make the choice not to buy or to rent but just to get out of town to a place where they can live better on less money?
Thanks for any insights.
Right . The Smiths are assuming that the demand factor for their home will be there when they sell .
If you read between the lines, and note that the couple thinks their software has some commercial value, you will note that their research paper is nothing more than an advertisement.
I think they are simply trying to cash in on their evaluation software, because they can’t afford their million dollar abode on two prof’s salaries. They are latecomers trying to sustain the wave and ride it just a tad longer, so they can make $. Good luck to them. Caveat emptor.
I agree with you on their motives but I don’t wish them good luck .They are going to sell their tapes to a bunch of real estate agents that will confuse buyers with the formula . As Tommy Trojan said in essence ,the formula is based on the premise that real estate always goes up .
ric: economics professors are paid very well; as a senior tenured professor he is making at least 100K if not more for over 20 years ; his wife will probably make even more teaching in this elite college and working as a certified financial planner ; most professors in the school of business and in economics work for the private sector when they are not teaching in May, June, July , August (and sometimes classes don’t start until September). They make much more money in the private sector in those 4 months than what they get paid to teach in one entire year. I would be surprised if they make less than $400 k per year - like it or not, economics professors like them can easily afford such a house. But most Americans can not - that’s the point of the bubble. If you make more than $250 k household income you belong to the TOP 1% American households. Check the US Census data. If median household income is pretty much stagnant since 2002 in most states you cannot expect Americans will be able to afford getting ever deeper in debt to get ever more expensive mortgages. The 1% elite is incredibly wealthy, but how many mansions does Tom Cruise want to buy and own? If the overwhelming majority of Americans can not afford to buy anymore, that’s when the bubble will go down…
o.k., i just read the entire paper. They ignored many current problems with the real estate market right now.
1.What I have a problem with is the limited discussion of the fungibility of real estate. While it may have been easy to sell in an up market, it may not be easy in a flat market. For someone who has to relocate for work (highly plausible in this economy), this could mean a substantial carrying cost of dual mortgages, or paying a mortgage and rent at the same time. In some cases houses were sitting on the market for over a year in the 90’s.
2. There was very limited discussion of outright fraud in buying vs. renting. I have never heard of a no-doc rental agreement, have you? Because mortgages are packaged and diversified out there is less motivation to verify vs. a one to one risk relationship in a landlord tenant situation. Most landlords require a more true representation of actual ability to pay the rent than a no documentation mortgage requires. There is also more incentive to commit fraud when buying vs. renting because of the ability to profit from it.
3. No discussion of the opportunity cost of the down payment. Does the renter not have the 20% down to invest in something else that generates return? What if that return were taken out to infinity and it was “assumed to be the historical s&p average return?
And also, i found the fact that they used 20% down a majorly misleading assumption.
From the Economist:
” New, riskier forms of mortgage finance also allow buyers to borrow more. According to the NAR, 42% of all first-time buyers and 25% of all buyers made no down-payment on their home purchase last year. Indeed, homebuyers can get 105% loans to cover buying costs. And, increasingly, little or no documentation of a borrower’s assets, employment and income is required for a loan. ”
http://www.economist.com/finance/displayStory.cfm?story_id=4079027
4. No real discussion of the supply of housing. While trying to extrapolate a dividend discount model to price out housing is plausible, if you ignore the possibility of an oversupply of housing, and thus a downward pressure on rents, your model is basically shit.
again from the Economist:
“A study by the National Association of Realtors (NAR) found that 23% of all American houses bought in 2004 were for investment, not owner-occupation. Another 13% were bought as second homes. Investors are prepared to buy houses they will rent out at a loss, just because they think prices will keep rising—the very definition of a financial bubble.”
How many of those that purchased in the recent upswing really want to be landlords? Are they prepared for that headache or will they bail? During the upswing, how many investors were able to carry and flip without renting, thus causing a “shadow” market of housing supply?
All of these things lead me to believe that while mathematically sound in their calculations, their assumptions are wildly optimistic and ingnore signficant factors that point to irrational pricing in the current real estate market.
You’re correct! The Smith’s formula might be a good fit for a pyramid scheme, but they assume too many constants where variables exist.
“1.What I have a problem with is the limited discussion of the fungibility of real estate. While it may have been easy to sell in an up market, it may not be easy in a flat market. For someone who has to relocate for work (highly plausible in this economy), this could mean a substantial carrying cost of dual mortgages, or paying a mortgage and rent at the same time. In some cases houses were sitting on the market for over a year in the 90’s.”
I believe real estate is easy to sell in any market, other than maybe New Orleans just after Katrina. Imagine listing a home for a price of $1 — your real estate agent would shoot you because of the flood of offers which would come forth.
P.S. Last time I checked, there was a specuvestor frenzy going on in NOLA.
anyone ever heard of a no-doc rental agreement without a deposit?
Shirley, you jest.
Just my $.02…I’m in Los Angeles county, as is Claremont. Checking the public records here, the Smith’s bought this property in 2004 for $950,000 with 20% down. BUT the property is a triplex with different addresses, and their address is only one of the 3. Couldn’t they be collecting rent on the other two? I’m not an economist and didn’t peruse all their research, so maybe that was left out of their model. That could make an enormous difference.
If that happens to be true, I think you need to send that little bombshell into the publishers of the article.
It would be the ONLY thing that would make sense in the paper…
…especially since it isn’t in the paper.
Honestly Shelia…
If that’s true, you really need to contact the New York Times.
Could you imagine the fallout from your discovery if it got out?
Assuming your discovery is correct…
Shelia Anthony get a Gold Star!
Let us know what happens when you talk to the Times!
The writer is…
Damon Darlin.
If you go to the actual article, you can send him an email by clicking on his name. You could probably also reach him at his desk on Monday, I bet.
Go Shelia Go!
…gets…
(sure wish I could edit my posts so i wouldnt spell like a meethead)
I’d contact the writer too. The NYT will love this story!
The flaws in Mr. Smith’s formula:
1) Where is the term based on local income available for rent or own? You see as housing values increase there are fewer and fewer potential buyers and that caps appreciation. This term is an increasing negative term.
2) There has to be a term that reflects the job market. Positive for an up market and down for a declining market like Detroit.You sure as hell can’t reflect this 5-10 yrs hence. A renter can pick up and go in a down market, the home owner has to sniggle a buyer.
3) Term for Neighborhood changes. Five to ten years can inflict great demographic changes. Younger families can’t afford higher priced neighborhoods so they move elsewhere and schools close due to a lack of kids. Hospitals cannot meet costs and close. Local stores close because people drive 3miles away to that super WalMart, Costco, or Sam’s Club. This term can only get more negative over time.
5) Hazard Term: Increased insurance rates for flooding(CA, HI), hurricanes, tornadoes, fires,Child Sex Offenders living nearby (CA),Water shortage, Utility rates, new bond issues, etc. This is another negative term.
6)Home maintenance costs, negative term.How long before reroofing? What about that old sewer line? Carpeting, flooring, etc. Renters don’t have to worry. Got a gardner now? Can you afford him in the future?
This is a nasty evil thought but if you were a determined ‘flopper’ that’s a new term for someone who wants to drive down the RE prices and then buy at a discount then you’d rent to or move in several child molesters into the neighborhood where you want to drive down prices. Remember, in CA that info now has to be disclosed to prospective buyers.This is a prime example of why legislation will never solve society’s ills. Common sense should always prevail and common sense on buying a house should always be BUYER BEWARE.
Oh, don’t think I haven’t thought of that as a funny to play on the folks in one of these Toll Brothers snooty “I got mine, you go to hell” neighborhoods where they really don’t “have it,” but they’re financing the appearance with a mountain of debt.
How about going in there and buying a couple of houses and then moving in a few families of Katrina refugees? YOu know, the ones they want to kick out of Houston now. LOL. Now THAT would be funny to watch the havoc wreaked in the neighborhood and the comps take the long ride down!
Maybe I’m oversimplifying but…
If (ownership_cost > 1.10*rent_cost)
{
bubble = TRUE;
}
else
{
bubble = FALSE;
}
You’re pretty close there, programmer! Tracking the movement of prices v. rents are the best indicator of risk, the P/E ratio. No need for sixty pages of fluff. The Smiths are the best suckers to hook because his stable income means that their contract will be easy to discount (sell) at a premium.
If you patent that algorithm, you’ll be rich!
if (China_goes_away && India_goes_away && Eastern_europe_goes_away) {
wages = ok;
}
else {
us = not_ok;
}
In control of their destiny???
Silly Smiths….they forgot to list L. Ron Hubbard in the references.
Give the Smiths credit. This is a serious academic paper. Just because its conclusions differ from what many on this blog (including myself) believe does not make them flakes or shills of the real estate industry.
We should email all the authors msmith@pomona.edu; gsmith@pomona.edu; christopher.thompson@pomona.edu
It appears this research was done 2 years ago. Many biased assumptions were used that favored home purchase. However, using current data would your projections change if you addressed these concerns:
1) According to today’s rate (Apr 1, 2006) from Eloan and Countrywide, 30yr mortgage rates are 6.5% with no points and all the 1/3/5 adjustables are 6.25 to 6.5%, almost no savings. Paper assumed 5%!!
2) Mello Roos and homeowners associations dues ignored. Many new homes have 1.5%-2% tax rate, like MINE. Would you like to pay my tax bill due next week??
3) No discussion of the opportunity cost of the down payment with FDIC money market rates paying 4.5% at emigrantdirect.com,etc.
4) Assumed the highest tax rates in CA, which only applies to top 8% of population in CA.
5) High property taxes are not allowed as deduction under AMT, which is snagging more people every year.
6) Countrywide CEO stated in March 6, 2006 interview with Businessweek his thoughts on the bubble:
MOZILO: I would expect a general decline of 5% to 10% throughout the country, some areas 20%. And in areas where you have had heavy speculation, you could have 30%. We will see…sellers back off from the prices they have been demanding. A year or a year and half from now, you will have seen a slow deterioration of home values and a substantial deterioration in those areas where there has been speculative excess.
Where are the most vulnerable areas?
MOZILO: Miami and Fort Lauderdale. Las Vegas is another area where there is heavy speculation. That means people were buying three, four, five condos at a time and thinking they can flip them. Those are the spots we have identified where… we will only make loans when we know the person will live [in the housing].
I suggest you offer your consulting services to Countrywide so they can provide no-doc loans to all illegals. There’s no bubble in LA, right?
I cannot believe that these moronic professors are being touted in the NY Times for a model that everybody on this blog uses. Go back to your ivory towers! Like any model, it is only as useful as the information that is put into it: garbage in, garbage out and these professors have a whole lot of garbage if they are trying to argue that ANYWHERE in California is even close to fair value. We all have craigslist, MLS, this blog’s anecdotes and our own living situations to prove how much we are all saving.
I have been the biggest proponent of using a 0% down interest only calculation + maintenance + insurance (with assumption that property taxes and total interest deduction on mortgage + prop tax cancel each other out) versus rent.
So for example: my house is valued at $1m. My max potential rent is $3,300. Maintenance and insurance run around $300 per month (very conservative). At 6% interest rate, I therefore pay $5,300 net per month as a buyer versus the $3,300 to rent, making my house 62% overvalued.
I could easily assume that the equivalent rent is $25,000 per month, therefore making my place massively undervalued.
Furthermore, a little lesson for the professors. The required yield on an investment property should be much higher than the 6% or so required for a personal property. One can use the baseline interest rate for one’s own living situation, but there are tremendous opportunity costs associated with investment above and beyond primary residence.
Can I now get published? DUH!
By the way, open up the newspaper and you will see plenty of Claremont homes for sale at around $2,000 per month, with the highest maybe at around $2,500 per month. Let’s see 12*$2,300/6% (net rent)=$460,000 TOPS…
To get published, you’d have to stretch you post over 60 pages, and come up with a complex foumula that proves what is already known.
“I cannot believe that these moronic professors are being touted in the NY Times for a model that everybody on this blog uses.”
Hardly. Even the moderator of this blog took me to task several weeks ago for suggesting that NPV is the appropriate basis for valuing a home. One problem with the Smiths’ approach is that they focus on the least sensitive input in the NPV model (rents) and gloss over the required rate of return and the growth rate.
“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.’”
If that were the case, then keep on racking up those short terms. As far as I am concerned, it shouldn’t matter much since we are still under-priced in SoCal and much of the coasts. Can’t wait until they look like fools. BTW, Pomona College is only famous as a liberal arts school and not economics, no offense to those who are affiliated with that college.
From Jon Lansner OC Register
Sometimes we miss stuff people say that’s important.
Take a look at what Shelia Anthony may have discovered a few posts up.
The Smiths may have actually bought a triplex, and been renting out some of the units to pay for the mortgage.
I haven’t read the paper, just the overall description, but the paper sounds like BULLS**T to me. They are doing what I believe is the right metric (cost of renting vs complete cost/benefit of buying).
I have run the numbers, for buying vs renting, a hundred times over. In a normal market, (Interest, Property tax, Hoa, -Tax savings) rent.
Even assuming 3% inflation in rent, it would be 7 years of amortization and inflation before the per month cost of buying in lost-money is less than rent, for typical numbers in the bay area.
As rental property, a bay area condo, if you bought it outright, would have a
(repost because of \ rent.
Even assuming 3% inflation in rent, it would be 7 years of amortization and inflation before the per month cost of buying in lost-money is less than rent, for typical numbers in the bay area.
As rental property, a bay area condo, if you bought it outright, would have a \
(repost because of (lessthan) interpretation) I haven’t read the paper, just the overall description, but the paper sounds like BULLS**T to me. They are doing what I believe is the right metric (cost of renting vs complete cost/benefit of buying).
I have run the numbers, for buying vs renting, a hundred times over. In a normal market, (Interest, Property tax, Hoa, -Tax savings) (LE) Rent. In abnormal markets, like now, its (GE) rent.
Even assuming 3% inflation in rent, it would be 7 years of amortization and inflation before the per month cost of buying in lost-money is less than rent, for typical numbers in the bay area.
As rental property, a bay area condo, if you bought it outright, would have a (LE)2% return on investment for rental income.
It is PRECISELY this huge deviation between buying and renting which is why I believe this is a bubble (and what the Economist has been harping on for 2 years as well).
Amazing! They have created a buy rent calculator that takes into account rent, taxes, rates of appreciation,etc.
Nothing wrong with that, but they have been available on the internet for years. http://www.dinkytown.net/java/MortgageRentvsBuy.html
It all depends on the assumptions you put in. If you assume rents and housing prices will go up, owning will work out well.
But the reality is (locally at least) that home prices are going down while rents are stagnant. So you’re effectively throwing away money by buying instead of renting.
You have to love this part of their paper. They note that there are many models comparing current prices to historical prices which point to overvaluation. But they don’t find this meaningful because “it may be because past prices were consistently below fundamental valuations.”
There are those who don’t listen to the bubble talk because they assume markets are efficient and current market prices must be rational. While many of us are willing to assume that markets may be chaotic and temporarily be mispriced, they are willing to believe that the bulk of market history in housing prices has been irrational.
“There are those who don’t listen to the bubble talk because they assume markets are efficient and current market prices must be rational.”
I think you’re giving folks too much credit. Those who think prices never fall view the ascension of real estate prices as being driven by an immutable force of nature, just like a falling object is driven by gravity.
“American Theocracy: The Perils and Politics of Radical Religion, Oil and Borrowed Money” is a book just published by a well respected and connected author who was a key player in the Nixon campaign.
The book gives some context to the Debt Bubble.
Our local paper, the Baltimore Sun, recently turned over the RE section to advertising–there is no editorial RE section at all. As a result, those who like to try and track the local market get there occasional gems from the Sun
Reg. reqired, sorry, but here are the first few lines. There are no sumbers or statistics given, and they apparently fully discount that is people flock INTO Baltimore to escape high DC prices, what will happen when their bubble bursts? And Mr. Strohminger says home prices may never land here…wow.
“The cool-off in the Baltimore-area real estate market has edged it closer to being a buyer’s market than it has been in several years, though there’s little chance of a big fall in home prices, according to local experts interviewed for an analysis to be released Monday.
“We’re coming out of a two- to three-year period when it was a seller’s market,” said Eric Smart, principal of Bolan Smart Associates, a real estate consulting firm and project director for the study entitled Trend Watch 2006: the Baltimore/Washington Residential Real Estate Outlook. “It’s a shift toward a more normal market. It’s a buyer’s market compared to the past two or three years.”
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The study, prepared by the Appraisal Institute and the Johns Hopkins University’s real estate department, reports, “The prerequisite of a bubble is oversupply, which we do not have in our region.” But there are some areas of vulnerability, including higher-end homes, condominiums and homes in outlying areas, the study said.”
Looks like God has spoken on the housing bubble. This one was too funny to pass up.
BubbleTrack.blogspot.com
‘It’s Clear A Lot Of People Are Nuts’
No fooling. At least the editors of the SD Union Tribune appear to be coming back to their senses. Here is a center-front-page article from today’s SD Union Tribune. Downtown SD condos for everyone!
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“Downtown downturn?
With more condos on the market in central San Diego and appreciation flattening, boom appears to be slowing
By Mike Freeman
STAFF WRITER
April 2, 2006
http://tinyurl.com/jaba2
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Today, rising interest rates and sky-high prices have sobered the housing market countywide, with sales declining and appreciation flattening.
Downtown is mostly following the trend. An unprecedented number of previously owned condos – about 600 – are for sale downtown, roughly double the number at this time last year. Moreover, 2,010 unsold new units are being actively marketed in projects that recently finished, are under construction or are expected to start construction soon.
Property values have stalled overall. The median price per square foot for resale condos downtown rose just $2 last year to $503, a 0.4 percent gain. Countywide, the median price per square foot rose $32 to $343 – a 10 percent gain, according to La Jolla-based market researcher DataQuick.
A few buyers, meanwhile, have begun to negotiate good deals. At La Vita, that same condo that sold for a hefty profit changed hands again late last year, but for only $640,000. A 15th-floor unit in Discovery on Cortez Hill purchased for $725,000 in 2004 sold a year later for $681,000.
Downtown “is probably one of the only places in Southern California where you can buy a house for less than you could a year ago,” said Jim Abbott, managing partner of Jim Abbott & Associates Prudential California Realty.
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“People keep waiting for that nasty story that the market is falling. But I don’t see it,” said Rich Gustafson, a principal with CityMark, the developer of M2i and Fahrenheit condo projects downtown.
Of the couple thousand available units in new projects, only one-third will be ready for move-in sometime this year, said Russ Valone, a principal with research firm MarketPointe Realty Advisors.
The remainder won’t be finished until next year or the year after. High-rise developers commonly market their projects and enter into contracts with buyers before the building is complete, since it takes up to two years to construct a residential tower.
Valone thinks there are plenty of buyers for the 650 unsold new units – many of them condo conversions – that are hitting the market this year. “The glut in inventory downtown is a misconception,” he said.
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In the fall of 2004, George Hadjis of Carlsbad purchased a 1,027-square-foot condo in Little Italy’s Palermo for $504,000 as an investment. Hadjis, who is an electronics salesman, flipped – bought and quickly sold – a couple of houses in San Marcos for a nice profit. “I thought I’d try downtown,” he said.
Today, he’s asking $489,900. The unit lacks a spectacular view. It has been listed for about six months with no offers. If it doesn’t sell in the next three months, Hadjis may take it off the market and rent it – likely at a rate that would not cover his mortgage payment.
Hadjis calls the experience frustrating. “I ask myself should I have dropped the price another $10,000 six months ago?” he said. “Do I really drop it right now or do I take the slow bleed (by renting.) That’s what I’m struggling with.”
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Downtown is on the radar screen nationally. In the past few weeks, Abbott, the Prudential agent, has been interviewed by The Wall Street Journal, ABC News and other media.
“The guys at ABC said this is the canary in the coal mine that they look at to see if there’s a bubble,” he said in a recent interview.
But Abbott and other real estate experts say downtown is a poor barometer of the overall market – not only nationwide, but for places like Carlsbad or Chula Vista.
For starters, it has a narrower buyer pool than most communities. “Family buyers are not typically in that market,” said Peter Dennehy of The Sullivan Group, a San Diego real estate research firm. “First-time buyers also are not typically in that market – somebody who is more affordability constrained.”
The biggest difference between downtown and most other markets, however, is the number of speculators. Last year, 30 percent of the buyers downtown had their property tax bill sent to an address other than their condo unit, according to DataQuick. Countywide, 18 percent of buyers had their tax bill sent elsewhere. Without rapid price appreciation, investors are getting out of the downtown market fast.
“Some developers have sold openly to investors, so what you have is a significant amount of resale units downtown on the market today,” said Doug Wilson, developer of Park Loft and The Mark downtown. “Those units will take a while to be absorbed, perhaps a year or two.”
The inventory bulge is likely to sideline at least some new condo construction, experts say. With the unsold inventory and flat prices, developers are going to have a hard time making the economics work for anything but expensive luxury units. That’s especially true since construction costs for steel and concrete have risen as much as 30 percent over the past 18 months. “I happen to be of the view that unless you’re under way now with a (high-rise) building, you’re not going to start for some time – perhaps two years,” Wilson said.
Already, a handful of proposed projects have been put up for sale. Developers of The Elle, an 179-unit condo tower planned in Little Italy, are selling the site and development plans. The asking price is $17.5 million. It is now a parking lot. Intracorp’s Triangle, a 57-unit project in East Village that has yet to start construction, is on the block for an undisclosed price. And Market Street Village, a proposed 273-unit mixed-use project in East Village at 13th Street, is for sale at an asking price of $30 million.
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One buyer of a penthouse in Horizons downtown offered between $400,000 and $500,000 less than the $2.2 million asking price, said Abbott, the Prudential broker. The property is now in escrow, with the seller still making a hefty profit.
“I think the smart people out there are doing this type of thing,” he said, “recognizing that Southern California coastal real estate, long term, always does well.”
It’s also clear a lot of nuts are people.
“The questions many people want to know about housing prices are not answered by the Smith research: when will they fall and by how much? ‘Some people think we are trying to predict prices and we are not,’ Mr. Smith said. Sure, he said, if prices drop you would have been better off if you had waited. ‘If you are a house flipper, we aren’t talking to you,’ he said.”
I would say 6% YOY long-term gains represents a very confident and optimistic prediction, disclaimers notwithstanding.
renting in Ma,
You have summed up what most folks here believe; that markets are sometimes “irrational” and therefore price points are not stable…. i.e. historical bubbles have existed and corrections have followed suit.
The professors assume away the present value as being out of line by extending the higher price into the future.
The problem with all present value models is that markets cycle, often to extremes. Buying into a high-end time frame of any market usually results in short term losses.
While it is true that over the “long run” in an inflationary fiat dollar economy, in the long run, we are all dead.
I recently read an article on the Stock Market, that studied buying over the long run. Many pundits of the market use an average annual return of about 8% of the market performance. But, if you take the high and low cycles at the time you entered the market, over a ten year horizon, you get very different results:
Buy at the high: annual return over 10 years was 0.6%
Buy at the low” annual return over 10 years was 10%, annual return………..a very, very different result.
I think most everyone here (with a few exceptions) will agree that we are at a market “high” in Real Estate prices.
Most likely, prices will correct downward, making a positive return in the short run impossible. So, the professors must use the 30 year metric to determine value. However, this Present Value model doesn’t really work for long-term calculations.
In 1980, I could get 15% on a money market.
Last year it was about 0.5%, a huge change in return.
This model assumes steady state.
Most importantly, as you pointed out, it assumes a high appreciation rate, while ignoring historical returns. Reversion to the mean will prove the analysis useless.
I know many believers in the Stock Bubble. They have been holding devalued stock for 6 years, waiting for the Nasdaq to get back to the 5000 “price”. What else could they do? They bought too high and didn’t get out in time.
Real Estate is limited to INCOMES. They have not changed. The Fed CHEAP money made CHEAP mortgages that allowed Low salaries to buy higher priced homes. It is not the NORM. It is starting to revert.
Let us sit back and wait. Please keep track of these “Professors”. When the value of the house DECLINES, how long will they need to hold the property until the market price gets back to the purchase price???
At that point, use there own stupid analysis and recompute the “Present Value” of their “investment”.
And you can’t dollar cost average into a house. You’re putting all of your chips (plus a lot more borrowed chips) on the table at once. If you happen to catch the wave (as those who purchased around 2000 did) it’s great. Otherwise you’re screwed.
“I know many believers in the Stock Bubble. They have been holding devalued stock for 6 years, waiting for the Nasdaq to get back to the 5000 “price”. What else could they do?”
They could have sold their holdings and purchased a small cap value index fund.
as mentioned several times before, we already know from the ‘Herengracht index’ and some similar studies done in other countries, that over the long run real house price appreciation (corrected for inflation) is less than 1% yoy.
The only way to arrive at 6% yearly appreciation is by cheating with the inflation numbers or by being in a bubble (when appreciation is by definition too much, and a correction will by definition occur sooner or later).
It is very clear that the Smiths are not up to date in their field.
as for the stock market: the reality is that you only get decent returns if you start investing at the right time, and that is just a fraction of total history. The big gains are made in very small time spans; if you miss them or step in just after such a jump upwards, there is no chance of getting this 8% or more yoy gain.
It is shameful when academically trained economists pat themselves on the back for “discovering” a new pricing theory that any layman who reads and posts here could explain. In fact, Ed Leamer at UCLA was talking about the price-rent ratio (he called it the “price-earnings ratio for a house”) indicating a bubble back around 2002 or so, long before the Hwang Smiths weighed in on the subject.
Diogenes,
Great analysis. I totally agree.
I just went to “Keep Track” of the Smiths. The metrics on Zillow are probably as good as theirs. Their current Zestimate, 2 years after buying their Claremont triplex for $950,000 with 20% down is $964,000. Not even a 1% gain YOY! Not a money maker at all, but must be the home of their dreams. Who knows, after 30 years, when it’s paid off, they’ll think they made a killing with those big YOY gains.
With all due respect to the good professors and their economic theories, I have learned to trust what I see in this world.
According to charts from First Republic Bank (www.FirstRepublicBank.com), homes valued over $1 million in Los Angeles fell by 41% from 1990 to 1996.
What most people overlook is the fact that Economics is a social science, not a physical science. Fear and greed is the over-riding force that drives market cycles - and that’s what takes prices too high and too low above the long-term trend.
And, in a perfect world, there would be no inflation (or debased paper money) and the driving force of market cycles would simply be occur as a result of supply and demand. Since we live in an imperfect world, real estate values have been driven upward by fear, greed, debased currency and temporary imbalances in supply. The current market cycle correlary: real estate values will be driven downward by fear, uncertainty, rapid increases in supply, higher interest rates, decreasing affordability and willingness of the consumer to pile on more debt.
Gary Smith received his Phd in economics from Yale; his wife received her Phd in economics from Harvard.
I think their model is sound–basically it compares the cost of renting to the cost of buying over an assumed holding period, which is what rational buyers would do, isn’t it?–but as others have noted, with all models the devil is in the input variables. Using 6% as expected annual appreciation seems tame by recent years, but we may well be looking at a lot less than that here in Cali over, say, the next 10 years.
A lot also depends on one’s marginal income tax rate. Here in Cali, the combined federal and state marginal rate hits 38% fairly quickly; since mortage interest and property taxes are deductible, this means that the government is picking up about 1/3 of one’s mortgage and property tax payments (through the tax savings).
I will say this: Over my lifetime, just about anyone who has bought a decent property here in Cali and held it for at least 10 years will tell you that it was the best investment he or she ever made, and much better than the rental alternative. However, given the truly unprecedented runup in prices here over the past 5-6 years, whether this will prove to be the case going forward remains to be seen. I have my doubts, but then again I thought the market had topped out 3 years ago.
By the way, if you go to Gary Smith’s private website about personal finance, his model is available for use; you just key in your input variables.
… hilarious blog http://www.thereisnohousingbubble.blogspot.com. ..\
This is too much… I could not stop laughing…
What do you all think about the problem of using rental income from comparable houses in their assumption? On the one hand, using apartment rentals is difficult when you are evaluating a single family home, on the other hand I would propose that it is virtually impossible to use comparable single family home rents because sfh’s tend to be bought be people to live in. I know a few families who are renting sfh’s but they are renting from owners who originally lived in these homes. That means sfh’s are not typically purchased and let by professional landlords and end up as rentals only relatively rarely. That means they are in low supply which drives up rents. If lots of sfh’s were for rent, let’s say as much supply as apartments the discrepancy between sfh’s and apartments would probably be less.
Additionally, the Smith’s calculation does not deal with affordablilty levels. It doesn’t really matter if your one million dollar house returns anything over time if you cannot make the mortgage payments. And most people couldn’t, just like most people cannot afford to pay $2,500/month in rent.