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On Housing and Bears


I’ve long been bearish on residential real estate in the United States. There is too much leverage and too much cheap capital for housing prices to stay at their present levels. I believe this is true even of decimated areas such as Phoenix and Imperial County, CA.

The Economist reports:

IN ITS early days, the Obama administration argued over whether the financial system or the real economy should be the economic priority. Critics disputed the premise. They argued that no lasting recovery would be possible until housing markets were healthier.

Yet the housing-market recovery has almost run out of steam. Sales of new and existing homes have fallen for three consecutive months. As a result inventories have grown, putting downward pressure on home values. According to some measures, prices are dropping again: the Federal Housing Finance Agency reported national declines in December and January.

Things looked rosier last autumn. An $8,000 homebuyer tax credit helped stabilise both prices and sales, while Federal Reserve purchases of mortgage-backed securities held down mortgage rates. House values climbed across the country, and existing-house sales hit levels not seen since the end of the boom in early 2007. By September building-industry confidence had more than doubled from January’s all-time record low, generating optimism about new employment. Anxious to keep the recovery going, Congress extended the tax-credit programme to the end of April this year. But the magic has not survived the winter.

America’s weak labour market deserves much of the blame. Job losses continue to drive loan defaults. Foreclosures declined from January to February, but remained above 300,000 for a 12th consecutive month. Bank sales of foreclosed properties are depressing prices further and dampening the industry’s hopes (see chart). The latest data show declines in both builder confidence and new housing starts.

I don’t think this tells the entire story, however. The problem with residential real estate is that many, if not most, people who buy houses and apartments don’t really seem to know much about finance and economics, and assume that housing prices will continue to go up. The veneration for real estate is a bad sign: when it becomes a commonplace that “financially responsible people own homes” you need to question the unstated assumption, which is that it is financially responsible to own a home.

As I see it, there are two main arguments against home ownership. One is moral, and the other financial. The moral argument merely rests on the idea that mortgage debt ought not be tax-deductible. I ought not have to subsidize your purchase of a house merely because the government has declared that the interest on your debt is tax-deductible.

The more practical argument against home ownership is this: it encourages the use of cheap capital and leverage to buoy prices. Home owners buy houses by putting down anywhere from 0 to 20%, and then increase their equity stake over time by paying down the mortgage principal and accumulated interest.

But, in order for the home owner to make a positive return on this investment, he has to assume that, at some point down the road, someone else will pay substantially more for the place. The homeowner may be lulled into thinking “I am buying this house for $150,000; if I can get someone to buy it for $200,000 five years from now, I will have made money!”

But here’s the rub. You can’t calculate the return on investment in housing like you can for a stock. Housing has significant carrying costs: annual taxes, maintenance, and insurance are all significant expenses not normally budgeted into the home ownership decision, but which surprise and confound many a new home owner. Add to this the interest that compounds on the mortgage principal over the life of the mortgage, and you have a very large expense that you need to deduct from your returns calculations.

A final note on interest rates. The US government has undergone a massive borrowing binge; the only way to pay it off is to inflate it away or increase tax rates significantly. If interest rates increase, that will put downward pressure on residential real estate. As interest rates rise, capital, in the form of mortgage debt, becomes more expensive and so each dollar of debt buys less than before. The greater fool down the road cannot be counted on any more.

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