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Tuesday, March 25, 2008

Floor Under Prices?

Homes that Pay Dividends

Everyone knows that stocks pay dividends, but few know that houses can, too. Not just the psychic rewards of ownership or the aesthetic enjoyment one gets from a beautiful home in a great location -- but actual, concrete dividends (albeit in-kind).

The best example is the value of a good school district.

Unlike a generation ago, parents can no longer take for granted that the local public school will do a good job educating their kids. Truly great public schools are now few and far between, seemingly crowded out (literally) by increasing student-teacher ratio's, tight budgets, and myriad social ills that inevitably show up in the classroom.

As a result, more families are electing to send their kids to private school. The ones that don't want to, or can't financially, are being ever more discerning about the quality of the public schools serving their community.

Unlike proximity to a nice park or an exciting commercial district, it's possible to put a price tag on the value of a "free" education. A good starting point is cost: taxpayers nationally appear to spend about $10,000 per pupil on public education. When kids defect from declining public schools to charter schools, that $10,000 per head "bounty" follows them.

Ten thousand dollars per student is also about what the thriftiest parochial schools spend annually. At the upper range, elite prep schools can spend double or triple that.

Using the conservative figure, $10,000, the value of a good, "free" public school education to a family with the "average" 2.3 kids is . . . almost $25,000 a year! That’s equal to what PITI (principal, interest, taxes, and insurance) payments are for the prototypical, $250,000 American home! Even stipulating that the education “dividend” is in-kind, for a family contemplating a dozen years of pre-college education per child, the associated benefit can easily amount to a quarter million dollars.

Not surprisingly, sophisticated families take cognizance of that, and incorporate that into their criteria when shopping for a home. As a result, demand for homes in good school districts is higher, which translates into a housing premium. There are plenty of examples just in the Twin Cities where one home, just inside a desirable school district, fetches 5%-10% more relative to an almost identical home literally across the street that’s just outside the district. Free public schools, indeed.

Savvy stock market investors know that, in down markets, stocks that pay dividends often hold up better than stocks that don't. There are two likely reasons: 1) dividends provide a significant percentage of investors' total return -- a fact that gets overlooked in prolonged bull markets (capital appreciation is the other component); 2) companies often pay dividends because . . . they can. In an era of opaque financial statements and turbulent markets, one of the most reassuring signs that a company you own stock in is prospering is a cold, hard dividend check in the mail at regular intervals.

Similarly, a strong school district -- and its "stream" of in-kind education dividends -- can set a floor under housing prices.

Like dividend-paying stocks, at least some communities undoubtedly spend more on education because . . . they can. Higher per capita school spending correlates with all sorts of desirable things: more disposable income, more expensive and better maintained housing stock, a higher concentration of nearby amenities to serve the foregoing wealth, etc.

In turn, those attributes bode well for long-term housing price appreciation.

Conversely, not being able or willing to spend on public education can be a proxy for community decline. Chronically under-funded schools can also be a sign of an aging population, whose budgets and priorities lie elsewhere.

For taxpayers, scrimping on education is like under-investing in house maintenance. There may be short-term savings, but at the expense of greater, long-term costs (“a pound of cure later vs. an ounce of prevention now”).

Home buyers looking to protect their housing investment in a tough market should take note . ..

Sunday, March 23, 2008

Irrational Owners?

Opting to Rent Instead of Sell:
Does it Make Sense?

Today's slow housing market is making many would-be sellers act stubbornly, if not irrationally.

Perhaps the best example is the long-time owner who is disappointed with prevailing prices, and instead opts to rent until the market improves. While this can be a rational, economic response to a soft market, in practice it seldom is. That's especially the case when the seller's original cost is a fraction of current fair market value, and some (or all) of their realized gain would be tax-exempt, due to the $250,000 and $500,000 exclusions available to singles and couples, respectively.

The following numbers explain why. (Note: while the numbers are assumed, they are based on my familiarity with Twin Cities home prices and rental market data covering thirty-plus years).

Assume that someone bought their home in the 1970's for $150,000. In 2005, at the height of the market, the home would have fetched $700,000 (yes, long term returns have been that good). Today, however, due to the downdraft in prices, the home is worth 15% less, or "only" around $600,000.

Instead of accepting a $100,000 "loss," the homeowner elects to rent for $2,500 a month. That generates $30,000 of income a year. Meanwhile, the homeowner is still obliged to pay property taxes, which we'll conservatively assume are $6,000 annually; property management fees, which would be approximately $2,000, unless the owner handled that themselves; $1,500 for property and liability insurance; and $1,000 annually for lawn care and snow removal, again assuming they paid a third party. Add to that a conservative estimate for repairs and maintenance, $1,000, and total expenses come to $11,500. Pre-tax income, assuming no vacancies and no marketing expense to find tenants: $18,500.

Of course, that amount is reduced by the owner's tax rate. Conservatively assuming a 25% income tax, and after-tax income from renting comes to about $14,000 . . . on a $600,000 asset! And that's without factoring in the wear-and-tear associated with renting, and the associated costs to make the house market-ready once selling conditions improve.

By contrast, assume the owner instead sells for $600,000. Subtracting a full-service commission of 6%, and another 2% for various selling costs (transfer taxes, title work, closing fees, etc.), and the seller still realizes more than $550,000.

And what about capital gains taxes? If the owner is married, there aren't any! The $550,000 net proceeds, minus the $150,000 purchase price, is $400,000 -- less than the $500,000 exclusion available to couples. Voila! They're done.

What would that money earn? Anyone selling a home they've owned for close to 40 years is probably near retirement, and therefore more interested in security and income than capital appreciation. So assume that the whole $550,000 nest egg goes into municipal bonds, which now yield 5% tax-free. Annual after-tax income: $27,500.

So why would any rational person pass up a risk-free $27,500 to make half that, with significant risk? Because they think they're leaving $100,000 on the table, which can be theirs if only they're patient.

Of course, the question is, how patient? Every real estate cycle is different, and no two markets (or neighborhoods) are identical. However, anecdotal data from past downturns suggest that it can take 6-8 years to revisit the high water mark from the previous "up" cycle. Too few owners consider that in the interim, prices may go down, not up.

Ultimately, timing the real estate market --just like stocks -- is notoriously difficult. The right time to sell is when one's life circumstances dictate, and when selling is the best financial option available of all the (current) alternatives.

"Freakonomics" Rebuttal

Do Realtors Really Add Value?

[Note: this post is a companion to "Realtors, Chauffeurs, and Investment Bankers"; Economists in Glass Houses; and "Freakonomics Re-revisited"]

I don't go to that many cocktail parties, so I'm not really privy to "cocktail party" chatter. However, I think that it's safe to say that far fewer realtors these days are being button-holed by their friends and neighbors about the latest real estate killing, hot new development, etc.

Instead, what regularly seems to come up is a criticism famously made about realtors in the book "Freakonomics," by economists Steven Levitt and Stephen Dubner. Suffice to say, neither one is a fan of realtors, or what they do.

In particular, Levitt recounts his dealings with an especially sleazy realtor in Palo Alto, California.

Headed cross-country to a new academic post at Stanford, Levitt hired the realtor to help him house-hunt near the university. In the course of showing him properties, the realtor cautioned that, unfortunately, it was a hot market with an imbalance of prospective buyers like Levitt relative to sellers. As a result, if Levitt wanted to buy anything, he needed to be prepared to pay full price soon after a desirable property hit the market, with little or no negotiation.

Which is apparently what Levitt did.

Just a few months later, Levitt was offered a plum academic post back east, and unexpectedly needed to put his just-purchased home on the market. He called his realtor, who now told him that, due to all the inventory and slow sales, he needed to price his home "realistically" (code for "low") if he wanted to attract a buyer.

Who wouldn't be incensed by such treatment? And which client doesn't wonder, just a teeny bit, whether their realtor is capable of the same?


I can't speak for all realtors, but I doubt that such behavior is representative, for the following three reasons:

One. Lying about market conditions is easily found out. In an era when everyone is online and real estate data is ubiquitous, a realtor who calls "up," "down," or "cold," "hot" is simply not credible. The New York Times, The Wall Street Journal, cable tv, local newspapers and Web sites, real estate Web sites, etc. now threaten to drown today's housing consumer with data. To mischaracterize that data would destroy a realtor's credibility, and without credibility there are no clients.

Admittedly, relocation buyers often know little about their new community, and therefore may be more vulnerable initially to an unscrupulous realtor. However, in my experience such clients tend to do more due diligence, not less -- frequently with their realtor's help and encouragement.

Two. Market statistics eventually fade away and what matters is one house -- the one the client is interested in buying. At that point, the discussion between realtor and client becomes very concrete and factual: What are the "comp's" (comparable sold properties)? How do they compare and contrast with the subject property? How long were they on the market, and what did they ultimately sell for?

Twenty minutes into this discussion -- if not far earlier -- it's usually apparent whether area homes are selling in multiple offers above their asking price, or languishing on the market and suffering serial price cuts. It seems unlikely that a trained economist such as Levitt wouldn't be able to tell the difference.

Three. Lying is hard, telling the truth is easy. By definition, every good realtor juggles: multiple clients, dozens of showings, lots of parallel deals at varying stages. It's hard enough keeping all the details straight and presenting them coherently to your client(s); not tripping yourself up in a web of lies would seem to increase the "difficulty factor" exponentially.

Levitt and Dubner do make some legitimate claims. For example, they cite statistics indicating that realtors selling their own homes tend to wait longer, and get a higher price. While the statistical differences are small, they do appear to be real. The explanation applies to any sales professional paid a commission (vs. an hourly fee): each additional dollar that an item fetches accrues overwhelmingly to the owner. Meanwhile, 100% of the costs (time and actual outlays, for advertising, gas, etc.) associated with longer market time fall on the salesman. Ergo, Levitt and Dubner conclude, realtors have an incentive to sell homes too fast and too cheap.

Once again, Levitt and Dubner ignore that prices are ultimately set by the market, not realtors. Specifically, realtors (and appraisers) establish a price range not in a vacuum but based on the comp's -- typically three similar, nearby properties that have sold in the previous six months (or less). Realtors distort or spin the comp's at their own peril (see, "lack of credibility" above).

Path of Least Resistance

In my experience, particularly in today's soft market, it is far more common (and easier) for realtors to accede to clients' unrealistically high initial asking price, than to insist on a lower but achievable target. Too, realtors can often empathize with clients' financial needs, and let their emotions (and hope) influence the asking price rather than cold, market logic.

No matter the motivation, in buyers' markets overpriced homes sit, and the longer they sit the steeper the ultimate discount.

True to their economics background, the Freakonomics authors implicitly treat all homes as indistinguishable "widgets," whose market value is a given. In fact, skilled, conscientious realtors often work with sellers for weeks and even months before a home comes on the market, suggesting strategic repairs and improvements, addressing code compliance and municipal point-of-sale inspection requirements, putting the owner in touch with various contractors, etc. Meanwhile, the realtor is busy networking behind the scenes, building market awareness for the property and identifying prospective buyers.

Perhaps that's why homes listed with realtors sell for 12%-14% more than "FSBO's" (for sale by owners). That's far more than the average realtor's commission -- and a statistic that's nowhere to be found in Freakonomics. The public may not like realtors, for some of the reasons identified by Levitt and Dubner, but they avoid dealing with them at their own (financial) peril.

Thursday, March 20, 2008

Shifting Capital Flows

Volatile Stocks:
Good for Real Estate?

When asked to predict stock prices almost a century ago, J.P. Morgan famously opined that "they will fluctuate."

How right he was! According to experts, the current market is the most tumultuous in over 70 years. Anyone with exposure to stocks -- or even The Wall Street Journal -- has witnessed huge, see-sawing moves on an almost daily basis since the first of the year.

Ignoring what's underlying these gyrations, continued volatility in and of itself has implications for future stock market prices. Namely, higher volatility increases risk, and increased risk requires greater returns. Translation: the premium investors put on company earnings, called the price/earnings or PE ratio, is likely to contract if the current period of turbulence comes to be seen as the new norm.

Arguably, this is merely the flip side of what happened beginning in the early 1980's, when the world's greatest and longest bull market began. Then, stocks benefited from a potent one-two punch: companies started to make more money, more consistently (or at least it appeared that way); and 2) investors bid up the multiple they were willing to pay for corporate earnings, due to the aforementioned consistency.

From a historic ratio in the low teens, average stock PE's expanded to the low 20's at the height of the stock market frenzy in 2000. Of course, many companies, especially high-flying Internet companies, had no PE ratio at all -- because they had no earnings!

Fast forwarding to 2008 and current market conditions, it could very well be that the price-earnings multiple is beginning a long contraction back to the low double-digits. In truth, such a shift would simply represent a regression to the mean established over a century.

So what difference does all this make, and how is it likely to effect real estate?

For stock market investors, it means that even if corporate earnings remain unchanged -- hardly a given in a recession -- valuations may shrink because the PE multiple contracts. Investors contemplating lower returns in stocks are likely to shift to other assets with better prospects.

Clearly, commodities as a class have already benefited from this shift in capital flows. However, they're hardly immune from the "Volatility Flu" -- gold and oil both just saw wicked, 10% price drops in less than three days. Meanwhile, another asset class seeing capital inflows, bonds, are now yielding practically nothing (at least the safe ones), and are hugely exposed to inflation and a weakening dollar.

That leaves . . . not much. There are always collectibles (rare cars, paintings, etc.), but it's hard to imagine billions of dollars suddenly ploughing into 1937 Bugatti's, Mattisse's etc. (there simply aren't that many of them, and they're not very liquid).

Like Dorothy, many investors may very well (re)discover that "there's no place like home." In a world where stocks can blow up in hours (Bear Stearns), and commodities like wheat and gold are best left to sophisticated traders, housing represents a relatively stable, tangible, and, dare anyone point it out today, long term investment.

Sunday, March 2, 2008

Relative Safety

Housing Market: Investing Safe Haven?

Winston Churchill is famous for saying that "Democracy is the worst form of government . . except for all the others." The same might now be said of investing in real estate.

According to the latest S&P/Case-Shiller Home price index -- quickly becoming the Dow Jones of the housing market -- prices nationally are now down 10% over the last year. As bad as that sounds, consider the following:

--the U.S. stock market is down more than 10% in just the last six weeks. As analysts' pare their 2008 earnings estimates and high volatility continues, "the preponderate risk appears to be to the downside," as Federal Reserve Chairman Ben Bernanke might put it.

--Commodities, led by wheat, gold, and oil, are exploding to the upside. Wheat contracts traded on our very own Minnneapolis Grain Exchange have doubled since the beginning of 2008. Investors' appetite for these items appears to be driven not by fundamentals, but rather by inflation fears and momentum. What do you call markets driven by speculation, untethered from economic reality? A B-U-B-B-L-E (remember those?)

--Another supposed safe haven, U.S. Bonds, have attracted so much capital that they now yield less than inflation. The 10 year bond now yields about 3.5%; the 30 year bond, about 4.5%. Meanwhile, depending on which numbers you believe, inflation is now running between 5% and 7%. Investors focused on protecting principal forget that inflation and diminished purchasing power are to bonds what acid is to paper.

Surveying the foregoing, one might conclude that the housing market doesn't look so bad, after all. Much damage has already been done, sellers in many markets are both motivated and realistic, and the range of choices has never been better, due to record inventory. Such conditions and psychology are usually much more characteristic of market bottoms than tops.

Disagree? There's still time to buy gold before it hits $1,000 an ounce . . .