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Monday, June 23, 2008

Star Trib Article

Gas Prices Hit Home

Yesterday's Star Tribune ran a nice story by Jim Buchta called, "Latest Must-have Home Feature: A Short Commute." (see also my April 28 post titled, "Centripetal Force"). Here's the link to Buchta's story:$urlTrackSectionName

The comments that follow -- 31 and counting -- are as interesting as the story. Suffice to say that passions on this subject are running high!

Thursday, June 19, 2008

Back to the Future

One-Car Garage Comeback?

Just as some fashions -- think, wide lapels and narrow ties -- can come back into vogue if you wait long enough, home features forrmerly thought of as out-of-fashion (if not obsolete) may be ripe for a revival. Topping the list? One-car garages, at least in city neighborhoods.

Up until now, of course, the trend has been the other way. Three-car garages are considered standard in upscale suburbs, while a two-car garage in the city -- let alone one -- is still considered a sacrifice.

That may change with $4 gas. Now that monster SUV's have become white elephants virtually overnight, "SUV houses" -- too big, too far, with their inefficient use of space and energy -- may be due for a reconsideration as well.

First you drive the SUV less and less, then, you eventually sell it. After awhile, you no longer need a house that was seemingly designed around one. Just as the space formerly taken up by Living Room's got re-absorbed by "Great Room's," something new may very well succeed the 3-car garage.

Urban Retrofit

Meanwhile, homes in close-in city neighborhoods built before the advent of urban sprawl -- think Linden Hills, Longfellow, Kenwood -- suddenly look more inviting. Constructed between 1900 and 1940, they feature crown moldings, built-in's, hardwood floors, and other sought-after period details. Thanks to the billions Americans have spent on remodeling, many of these same homes also now feature more open floor plans (not to mention new Kitchens, updated mechanicals, energy-efficient windows, etc.)

The reaction to expensive gas may be less pronounced in the city than the suburbs, but there is still an adjustment taking place. Anecdotally, there are signs that city dwellers may be migrating towards a pattern of using public transportation during the work week, then using a car -- one car -- for weekend outings and errands. Suddenly, anything more than a single-car garage looks like wasted space.

Unfortunately, individual citizens can't build a truly modern, public transportation system any more than they could muster a military. That's a job for government. Hopefully, the Twin Cities will join the growing list of metropolitan areas -- Denver, Atlanta, Portland, to name a few -- that are making the requisite investment.

Tuesday, June 17, 2008

Loose Steering Wheel?

Monetary Policy
for Dummies

Because homes are overwhelmingly purchased with borrowed money (more than 90%, to be exact), to understand the housing market's prospects, you have to have a clue about how credit works. In turn, that requires at least a passing acquaintance with the credit market's overseer and regulator, the Federal Reserve (still reading? Good!).

In that spirit, here is a primer on what the Federal Reserve does.

If the economy is a car, the Federal Reserve is the driver.

When the Fed wants the car (economy) to speed up, it hits the accelerator by lowering short-term interest rates and expanding the money supply. When it wants the economy to slow down, it applies the brakes by raising rates, and contracting the supply of money.

The dilemma facing the Fed now is that many parts of the economy -- housing, the credit markets, Wall Street -- are suffering and badly need a shot of gas (actually, a sixth or seventh at this point). Meanwhile, runaway energy and commodity prices require that the Fed hit the brakes.

What to do? Exactly.

What's new in the last couple years is all the exotic financial instruments and non-bank entities that operate outside of the Fed's regulatory authority. To pick just one example, much of the money that funded mortgages at the height of the credit bubble came from creatures of Wall Street that completely sidestepped Fed and banking requirements. So instead of being limited to maximum leverage of roughly 20:1, like regulated banks, some of these entities took on leverage approaching 30:1, 40:1, or more.

Leverage primer: if you buy something for $1 with a penny of your own money and 99 cents of debt, and it goes up to $1.01-- you've doubled your "investment"! Unfortunately, if the item drops to 97 cents, you're wiped out (and then some). Add 8 zeroes and you understand what happened to Bear Stearns.

Big Fish . . Bigger Pond

The other new development is the shrinking U.S. role in the world economy, relatively speaking. Instead of a giant amongst pygmies, the U.S. is destined to become merely first among equals (see, "The Rise of the Rest," by Fareed Zakaria). That's the case not just with respect to the European Union, but also the fast-growing BRIC countries (Brazil, Russia, India, and China).

Both of these developments have significantly weakened the Fed's control over the U.S. economy.

To return to the car metaphor, it turns out that speed isn't the only thing that's important -- so is steering. As Ralph Nader might put it, if the steering wheel comes off in your hands. . . you're not safe at any speed.

Saturday, June 14, 2008

Inflation Fears

Long-Term Rates Jump

The most significant recent development affecting real estate is a fairly sudden surge in long-term interest rates. In just the last three weeks, the cost of a 30-year, fixed rate mortgage has climbed from around 5.8% to almost 6.5% -- in lenders' parlance, a rise of 70 basis points.

This change is quite clearly a reaction to accelerating inflation -- actual and expectations. As the cost of energy, food, and other items climb, long-term lenders understandably need a higher return to preserve their capital (let alone earn a profit). Also adding pressure: Federal Reserve Chairman Ben Bernanke signaling that fighting inflation is becoming a higher priority than combating economic weakness through continued monetary easing and low interest rates.

Note: although the Fed effectively sets short-term interest rates, and the Treasury decides how much money to print, the financial markets determine long-term rates.

In the long-run, higher interest rates are an (almost**) unqualified negative for the housing market. Most of the money used to buy most homes is borrowed, and more expensive money erodes buyers' purchasing power (See next post, "Monetary Policy for Dummies").

Conservatively assuming that buyers put down 20% and borrow the rest, a 12% rise in interest rates effectively translates into a 10% rise in the cost of housing. As Econ 101 teaches, when prices go up . . demand goes down.

Short-Term Catalyst?

In the short-run, however, increasing rates may actually stimulate the housing market and sales activity. As any realtor active this Spring knows, this market is full of nervous, hesitant buyers who've been reluctant to pull the trigger. Now, the prospect of further rate jumps will no doubt spur some of those buyers to lock in historically cheap money while they still can.

**In the really long run, one could make a case that higher interest rates are actually a positive for the economy, if not the housing market. As painful as Paul Volcker's early '80's rate hikes were, they succeeded in wringing then-rampant inflation out of the economy. In turn, that set the stage for the best 20 years the U.S. economy has ever had.

Of course, as (famed economist John Maynard) Keynes noted, "in the really long run . . we're all dead."

Tuesday, June 10, 2008

Poor Man's "Wash Sale" Rule?

"Buy-and-Bail" Phenomenon Observed
In Toughest Housing Markets

Stock market investors with a loss have long been able to take advantage of something called the "wash sale" rule. That allows them to stay in a stock that has dropped, but still take a tax loss. Now, something similar but much more nefarious -- called 'buy-and-bail" -- appears to be popping up in the some of the most distressed housing markets ("Some Buy a New Home to Bail on the Old"; The Wall Street Journal, 6/11/08).

Click here for the link:

In the stock market version, an investor buys a second block of stock at now-lower prices to go with the first purchase. Thirty-one days later (the minimum time period allowed), they sell the original position. Result? The investor ends up with the same stake in the company, but now has a realized tax loss on the original purchase.

In the housing version, someone who bought a home that has dropped precipitously in value purchases a second home at current, much-lower prices. To qualify for the new loan, they typically represent to Lender #2 that they intend to rent out their current home (this is the fraudulent part). Once they close on the second home, they default ("bail") on the first, leaving Lender #1 in the lurch.

While such a maneuver ultimately leaves the "bailer" with wrecked credit for several years, it arguably leaves them no worse off than they would be otherwise. After all, the alternative is often wrecked credit and no home.

Understandably, lenders don't see things that way. They are rapidly updating their underwriting guidelines to screen out would-be "buy-and-bailers," and putting them on notice that, not only may they be sued for fraud, but also, depending on applicable state law, the unpaid balance on the defaulted mortgage.

Sunday, June 8, 2008

"Bid-Ask" Spread

Paying Tomorrow's Prices Today

You can't read tomorrow's newspaper today, or see tomorrow's sports scores today, but it is possible to pay tomorrow's real estate prices today -- at least in many Buyer's markets. Huh? The explanation has to do with the "spread" between what home sellers are currently asking, and what home buyers are offering.

Normally, "bid-ask" spreads are associated with things like stocks and pork bellies. However, the housing market is also characterized by a bid-ask gap -- and now it is historically wide. This is captured by one statistic in particular: sales price as a percentage of original asking price. (Of course, when the gap between buyers and sellers widens, sales volume drops -- another characteristic of today's market.)

In a hot Seller's market, homes fetch close to 100% of their asking price -- higher if multiple offers become commonplace. However, in a Buyer's market, sizable discounts become the norm. Currently, the reported sales-to-asking percentage for recently closed sales in the Twin Cities is in the low 90's (and I'm seeing anecdotal evidence that it may be headed lower still).

Before discussing the significance of that number, three caveats.

One, I can personally point to any number of houses that ultimately sold for 75% or less of the original asking price that shed absolutely no light on market conditions: the seller simply wanted too much (and waited a long time to get it!). Second, the reverse is also true: any dummy can sell $1 for 95 cents. Price a house far enough below market value -- even in a dreadful market -- and you, too, can get 100% (or more) of your asking price.

Three, there are other variables besides market conditions that affect how much the ultimate selling price is below the original asking price. For example, in Richfield, where the housing stock is quite consistent and the average house sells for $200k, homes historically sell for much closer to asking price than areas which have more upper bracket and/or unique housing (like around Lake Minnetonka).

That said, it still means something when, out of thousands of homes sold market-wide, the average selling discount has expanded to 8%-10%.

Shrinking Discount

For Buyers, perhaps the most important -- if somewhat counterintuitive -- insight is that even though the market as a whole may not have bottomed, you may actually be able to buy for less today than in a future market with lower-but-firmer pricing.

For example, somone selling a $500k house now may consider taking $450k or even less --perhaps even paying $10k of the Buyer's closing costs. However, once the market is widely perceived to have bottomed, Sellers' resolve is likely to firm, too. So the same $500k homeowner, now asking $475k, may only be willing to slice 3%, or $15k, off their sales price.

Of course, once the market sees a $450k sale less $10k in seller-paid points, followed by a $460k sale with no points, it will likely take notice. Eventually, someone with a $500k house will decide that conditions warrant bumping their asking price to $529k -- and they'll get it! Voila! Goodbye Buyer's market, hello Seller's market (and no more $500k houses for $440k!).

Tuesday, June 3, 2008

"Home Economics"

Real Estate and Inflation (cont.)

What if there was a way to lock in what you paid, at today's prices, what you spent on necessities such as food, gas, or health care? And what if the price of any of those things ever dropped, you could - for a relatively nominal fee -- switch to the new, lower price? Best of all, what if, after paying a fixed price for any of these items long enough, they suddenly became . .. free?

You'd be crazy not to take advantage of such an opportunity, right?

While there's no way to insulate yourself from rising prices generally (at least not without resorting to complicated, expensive hedges), there's one key item in almost every household's budget that offers this potential price protection: it's called "housing." To take advantage of it, all you have to do is buy a house (or condo or townhome), using a fixed-rate mortgage.

Pot of Gold -- or Lead?

Of course, the foregoing oversimplifies things a bit. Refinancing to take advantage of lower rates only works if you have equity in your home. If you put nothing down and the price of your home drops 20% or more -- as it has for millions of home owners in Florida, Las Vegas, and parts of California -- good luck trying to get a new, cheaper loan. If circumstances force you to unexpectedly sell, you may be facing a (non-deductible) loss.

Another wrinkle is that housing comes with carrying costs and maintenance expenses. While a fixed-rate mortgage locks in the "P" and "I" (principal and interest) in "PITI," the "T" and "I" (taxes and insurance) can and do tend to increase over time.

Like any physical asset, housing depreciates. In layman's terms, things wear out. Every 8-10 years, depending on the exterior, most homes need to be painted. Every 20 years, give or take, the roof will need to be replaced. Furnaces, windows, and flooring all eventually wear out or break -- not to mention pedestrian things like window shades, door knobs, etc. Depending on the climate, tasks such as shoveling, mowing, and raking are seasonal necessities.

Tax Breaks

And yet . . . for most Americans, home ownership historically has been the single-best wealth building vehicle there is -- and eventually, will be again. There are three reasons: 1) the mortgage interest deduction; 2) principal amortization; and 3) capital gains treatment.

Each payment on a plain-vanilla, fixed rate mortgage is split between interest and principal. At first very little of each payment goes toward principal amortization (reduction), but over time that percentage accelerates. By the end of the loan's term, 100% of the home's fair market value is equity. For many homeowners, the result is a significant nest egg that, magically, can now be used to generate monthly payments for retirement and other living expenses (it's called a "reverse mortgage").

Like a Refund

To put this in perspective, imagine if, after 30 years of monthly food bills, the process suddenly reversed, and every month thereafter you got back what you'd previously paid, plus inflation???

Homeowners who instead choose to cash out by selling outright likely can do so tax-free. Thanks to generous capital gains treatment, couples can exclude up to $500k on the sale of their primary residence; singles, $250k. Assuming that one buys the "average" U.S. home (now about $200k) and enjoys historically average appreciation (3%-4%) over 30 years of ownership, the home's value at sale would be in the mid-$500's. Capital gains tax due at closing? Zero.

In between buying and selling, the tax code provides homeowners with a significant subsidy. Because mortgage interest is deductible, the effective interest rate on mortgage debt --typically, the least expensive consumer debt -- is effectively 20%-30% lower for homeowners who itemize.

In the final analysis, for the majority of home buyers the decision to buy is an emotional, not economic one. However, especially in today' volatile, increasingly inflationary environment, it's nice to know that housing prices are one of the few expenses you can control, and that long-term, the housing deck is stacked in your favor.