Buying a House – A Risky Proposition?
After renting four homes in the San Francisco Bay Area this decade, I bought a house last month. I had been a long-time advocate of renting rather than buying, so what drove me to buy a house now? Has the time come to buy a house as an inflation hedge? Buying a house should be a matter of risk, not price.
First, let’s look at prices. Home prices have come down substantially in areas where subprime lending was most prevalent, but have held up better in more affluent areas. In Palo Alto, where I bought my house, prices are down, but not by much compared to the run-up in prior years. One reason is that the typical Palo Alto homebuyer had a greater financial buffer and may have been able to hold off selling their home if they don’t like current market prices. There is also less pressure in more affluent neighborhoods because of foreclosures; note, by the way, that the recent abatement in foreclosures on a national level is mostly a reflection of bottlenecks in processing foreclosures , the pipeline of homes in various stages of default has continued to grow steadily. The reality is that many higher end homes in Silicon Valley have been bought with “options money” , that is, the cashing in of previously awarded stock options. However, the number of potential homebuyers able to purchase with “options money” is presently very small. As a result, while home prices in higher end neighborhoods in Silicon Valley have held up longer, the downward pricing pressures may last longer. A similar analysis can be applied to other regions; further, as baby boomers retire, fewer McMansions will be needed, putting long-term pressure on high-end real estate. As a result, my assessment is high-end real estate is likely to lag in any housing recovery. In the same context, consider the trend to have bonuses vest over years with claw-back provisions (in what may be the beginning of a trend, Goldman Sachs just eliminated the cash element on bonuses for its top executives). While that may be healthy (although never underestimate the creativity of con artists amongst them to hide their dealings throughout the vesting period), that is bad news for New York and Connecticut luxury goods dealers and real estate; New York governor Paterson has realized that tax revenues have also evaporated, and is now urging banks to pay bonuses. But I digress.
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A lot has been said about the affordability of homes; even with the price adjustments to date, a dual income family can barely afford a home. 50 years ago, a single breadwinner in the family with an average income was able to afford a house. Because of various government subsidies , whether through subsidized loans (think Fannie Mae, amongst others) or artificially low interest rates – home prices have been pushed to artificially high prices. Many of these policies are put in place with the best of intentions, but all efforts to make homes more “affordable” have actually done the opposite for future buyers. If you want affordable home prices, don’t subsidize buyers.
Fannie Mae was first established in 1938 to promote home ownership to low-income families; the scheme it promotes lasted for 70 years before it imploded and the government had to take Fannie Mae into conservatorship. Few have noticed that Fannie Mae, now that it is a quasi-government branch, continues to have access to the Federal Reserve’s (Fed’s) discount window. That’s akin to the Treasury borrowing from the Fed, rather than issuing bonds to finance its spending.
The policies are designed to push home prices higher. That’s because when a great number of home owners are under water in their mortgages, they may stop spending, pulling the U.S. consumer “machine” to a grinding halt. And that’s policy makers’ worst nightmare, as it jeopardizes their re-election odds. What is different about the current bust is that the Federal Reserve has teamed up with politicians to push home prices higher at just about any cost: ultra-low interest rates and aggressive intervention in the mortgage market through purchases of mortgage-backed securities (MBS) stems against natural market forces playing out.
Simplistically speaking, homeowners who are underwater in their mortgages have a couple of choices:
‚ Homeowners can work harder to earn more and pay off excess debt. Though, while that may happen on select cases, it is unlikely real wages will soar anytime soon.
‚ Homeowners can downsize. That’s the healthiest choice as someone who downsizes will once again be able to save and one day, possibly, be able to afford that larger home. However, a homeowner who is subsidized to stay in a home they cannot afford may never be able to save, as all their hard-earned money is continually poured into the home; that person won’t have the savings, either, to fix the roof or take care of other ongoing maintenance issues associated with home ownership.
However, downsizing implies foreclosures, bankruptcies, bank write-offs, not the type of headlines that get politicians re-elected.
‚ Receive a government bailout through inflation. If real home prices won’t move up, the Fed can try to engineer a higher price level by flooding the market with freshly printed dollars. Just a few days ago, Fed Chair Ben Bernanke once again emphasized how going off the gold standard during the Great Depression allowed the Fed to allow the price level to rise. He cherishes that “flexibility”. Of course it’s difficult to engineer just where that inflation will fall, but if you create enough inflation, odds are that home prices may also rise.
Potential homebuyers will find reasons why prices should be lower; once they switch to being homeowners, many find thousands of reasons to justify why their home’s value should be higher! However, when faced with such opposing forces, the decision to buy a home should not be an assessment of price, but one of risk. Can you afford not just the monthly mortgage payments, but can you afford it should the price of your home come down? Market forces warrant lower home prices to bring them in line with incomes; as such, that risk must be taken into account, even if we trust helicopter Ben to create house price inflation.
When discussing Sustainable Investing choices in my book SustainableWealth, I list renting rather than buying as a sacrifice. Beyond the reasons given here, Patrick Killelea in his blog eloquently lists many reasons why “it’s still a terrible time to buy“. Yet, when you rent, you have few rights as a tenant and you may be asked to leave your property when your lease is up; often, leases are only a year. In my personal situation – we have four children – it’s not that easy to find a rental home that satisfactorily accommodates us, and every move is a hassle. Is it worth the many thousands one can save a year when renting? Looking at the pocket book, yes, but it is more of a sacrifice than, say, saving money with a low budget vacation instead of spending vast amounts for a stay at a luxury resort. My wife did also make the point that she would like to own a home before the kids are in college (our oldest is twelve; our youngest two).
Some have said that home prices have gone up since the beginning of the decade and we should have bought a house earlier. But these arguments miss the point about risk , it would simply not have been prudent for us, just as it wasn’t prudent for millions of others. In our particular situation, we were investing a lot into our business throughout the decade; now that the business is running well, we can afford the risks associated with home ownership, including the risk that the price may fall.
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But I was motivated by more than the ability to bear the risk. If you have followed my writings over the years and read my book, you know that I’m skeptical of the economic recovery. Specifically, I cannot see a sustainable recovery even if all the fiscal and monetary stimuli get the economy to grow in the short-term: if and when the Fed starts to tighten (raise interest rates or mop up all the excess liquidity), I’m afraid the economy may crash right back down, precisely because we did not allow homeowners to downsize, i.e. the de-leveraging to play its course. With too much leverage still in the system, the Fed simply may not be able to fight inflation without destroying all the “progress” it has achieved in reflating the economy. Because of this conundrum the Fed may find itself in, the Fed is, in my assessment, going to firmly err on the side of inflation: something that may push home prices higher.
One key reason why inflation may result from all the policies employed is that the money isn’t flowing to the intended parts of the economy. Sure, those with pristine credit get financing at ridiculously low levels right now. But what about Dubai, Greece, Ireland or American consumers with scars on their credit history? For most of these groups, if credit is available at all, it is at a cost they can’t afford. Because the money doesn’t flow to the places policy makers would like it to flow, they print ever more money and institute ever more aggressive stimulus programs.
With that in mind, future access to credit is a real risk. Governments around the world will need to raise unprecedented amounts of money to finance their deficits. Will there be credit available at reasonable cost to you and me? Banks are racing to pay back government loans, not because they are suddenly so healthy, but because of the burdens that come with having the government question your business and compensation decisions. If you look at how the Treasury markets are behaving, you would think another crisis is just around the corner: one month Treasury bills recently auctioned off with a zero yield (negative after commission) , that’s a few days ago (December 8th), not a year ago (click here for auction result) , and that’s not a sign of a recovery. Sure one can argue that this means the governments will simply continue to print money in an ill-guided attempt to unfreeze the markets, but my concern is that unless you are in bed with the government, you may not have access to credit. And if you are a weaker government, you may also have an increasingly hard time financing your debt. Incidentally, the latest U.S. 30-year auction drew disappointing demand.
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I am a big believer in scenario planning; if a scenario has a sufficient enough probability, then I take it into account in my investment allocation. The big advantage of scenario planning versus merely forecasting the most likely outcome is that one takes boundary conditions / black swans / flat tails / call them what you want, into account. Is a crash in this or that market likely? Possibly no, but is it a risk you can afford to ignore? It’s important to move beyond analyzing, to implementation, otherwise the exercise can be worthless, or worse, you may incur significant downside costs.
Through a home purchase, I can extend the average maturity of my personal debt substantially through a conventional 30-year mortgage (maturity means the date on which a debt security is due and payable). Businesses and governments manage the maturity of their debt, and so can you. The U.S. government has the equivalent of an adjustable rate mortgage and in recent weeks has shown signs of shifting from shorter-term debt to longer-term debt. As the U.S. government refinances into longer-term debt, the cost of long-term financing for everyone may go up. This doesn’t mean that I encourage folks to exchange their unsecured credit card debt with a mortgage where the creditor may seize your home, but if you access the credit markets through some other means , a car loan, a business loan or other investment property – accessing the mortgage market may be a way to lock in low long-term rates.
Of course there is the valid concern home prices may fall as long-term rates rise. I can’t give specific investment advice in this analysis, but if you have debt, you may want to consider refinancing it to take advantage of current long-term rates.
In my situation, I bought a house to take the scenario into account that inflation may eventually push home prices higher. If the government actions cause inflation, but they can’t stop it in time , and remember: nothing in this crisis has really worked out as policy makers intended – real estate may once again be treated like hard assets and investors may want to hold on to anything but U.S. dollar cash. While real estate is a hard asset, it has not been acting like other hard assets because of the leverage included in most real estate ownership; in a period of credit contraction, the weight of the credit contraction may be overwhelming. But pushed hard enough, real estate will at some point also join the rise of other hard assets. If we did not have Bernanke as the head of the Fed, I would assign this a low probability; but with him at the helm, I very much doubt he will deviate from his determination to move home prices firmly higher to bail out all those with too much debt.
Conversely, there is a risk to holders of U.S. dollar cash: cash is at risk of losing its store of value and investors may want to take a diversified approach to something as mundane as cash. As a result, I took buying a home a step further and hedged my down payment against a weakening of the dollar. This is not something I would necessarily recommend to others as such hedging carries its own set of risks and may not be appropriate for many; I engaged in this risk not because of some “profit potential” when measured in U.S. dollar, but because a) I see downside risks to the U.S. dollar and b) I can afford the risks associated with the hedging.
If my concern is right and inflation will be a serious problem, at some point investors may grab any hard assets, not just precious metals and commodities, but also housing, amongst others; in that case, it may be a profitable investment. As such, I see it as a diversification; however, for those who consider the same, do remember that housing is typically a highly leveraged investment and being wrong can be rather costly. In summary, I bought a house because I can afford to be wrong on the risk that inflation may get serious enough to push home prices higher.
In my book (just released – order now), SustainableWealth: Achieve Financial Security in a Volatile World of Debt and Consumption, I dive into the dynamics that drive this world before discussing how you can invest in a boom, in a bust, in a personal or economic crisis. Make sure you sign up for the newsletter and follow the blog.
Axel
Axel Merk
Author of Sustainable Wealth – order now.
President and Chief Investment Officer, Merk Investments
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Hi Axel
Thanks for sharing your personal story. I couldn’t agree more with your assessments; in fact I had very similar assumptions when refinancing to a 30 year fixed mortgage earlier this year. The threat of higher inflation somewhere down the road prompted me to lock in a low long-term rate. I am curious to learn more details as to how you exactly you “hedged your downpayment” against a weakening dollar.
Thanks again and keep these excellent commentaries coming.
Best wishes – Clemens
Very interesting timing. Just last night my tenant called me expressing interest to buy my rental house. The market value of it has plummeted from $400K to about $140K since August, 2007. However, I’m not convinced that it won’t go lower. I’m not upside down, as I paid $130K 17 years ago. At the same time, I feel confident that we will be facing substantial inflation, soon. At the same time, since I’m probably one of the few property owners in that neighborhood (declining values in that location) who are actually paying their property tax, the county has made a series of accounting “accidents” that have resulted in an increase in my tax liability by a factor of 3 (risk). Also, I just finished reading “Sustainable Wealth” last week. My gut tells me to have faith in the Bernanke inflation machine and just hold the property. But, it’s a tough decision. FWIW Axel, I think you made the right choice in buying the house in Palo Alto for your family – in both timing and location. I attended Los Altos High School long ago and I hope that Paly High’s football program has improved. I got my picture in the paper playing against them.
Thanks for the great book and for creating funds outside the norm.
Dave
Dear Axel,
I recommend you study the writings of Dan Amerman @ [link removed by moderator] to learn why you and others that think home buying is a good proposition now could, in fact, be a great proposition.
Tom Ward
If higher inflation happens, people will spend most of their money for food, clothing, gas, bills etc. Very few will think of preserving their wealth through purchasing real-estate (because they can’t afford monthly payments). So real estate will go down. Only in last stages of inflation run (perhaps some 7-10 years down the road), those with more money in their pocket will go for it.
Printing money isn’t wealth, even if it is the US doing it. The black swan you mentioned (such as dollar dropping to 30-40 levels) may happen, or it may just be orderly decline. In any case, US population will become poorer for all the excess dollars, not wealthier.
Real estate will become expensive and good protection against inflation, but in real price (say against gold) will be much cheaper 10 years from now than it is today, simply because leverage in high inflation is hard to obtain, unless you are in the upper 1-5% of the population.
Again, this probably sits fine with your situation, but I would say that good 90% of the US population would be wise to stay clear of real-estate and go to precious metals, especially because chances of re-monetizing the yellow metal are getting better by the year, in which case there won’t be any bubble in gold, just renormalization.
If you get ahold of real good chunk of cash (say 40% of purchase price), then go ahead and buy home, otherwise you may regret it, as house prices have a way to go down respective to gold.
Axel,
That’s putting your money where your mouth is! Buying a house in overpriced Silicon Valley when all the stories in the news are that Option Arms coming due, and Commercial Real Estate is entering collapse and Jumbos are impossible to get are going to cause another housing crash. If the Fed raises rates next year, of just stops buying MBS, there could be a slowing of demand and prices fall.You were smart to rent during this housing collapse.
But buying real estate is completely in the direction of your long term opinion that fiat currencies will continue to debase (inflate) because houses are real rather then paper assets. You are also getting a tail wind of low rates induced by $1.55 Trillion of Fed mortgage related purchases. And there are tax advantages to housing investment for the owner occupied that are added benefits.
The key market question is whether the housing price collapse is now over. I have been negative on housing prices since at least 2006 when I could see the impending subprime as the first brick in the wall to crumble with disastrous follow-on for the bankers that took years to unfold. Now I am still a little negative about houses from the continued expectation of slow economic growth. I am more ambivalent now than I have been for about 4 years. Maybe that’s why I never wrote the chapter for my book even though there is lots of good data, and it was the pivot of the initial crash. My personal view is that I’d rather live here than a lot of places, and am willing to pay the higher price.
[Moderator's note: Bud Conrad is Chief Economist at Casey Research and author of the forthcoming book Profiting from the World's Economic Crisis]
Hi Axel:
Enjoyed your article about your home purchase. I lived in San Carlos for 20 years before moving to Washington State (no income tax). Never could afford Palo Alto. My daughter rents in Sausalito. Question – how did you hedge your down payment?
Regards,
Gary Harris
I can not believe that anyone rents. I do believe buying house for cash if you can for the mortgage is a rip off. I bought a studio a little after 9-11 for a student son at NYU for $117000 because the dorm rent was $16,000 a year. We have had it since and one or another son has used as a place to stay . He live in Chicago now but commutes to a job on Wall Street Monday through Thursday. I own three other houses and I am over 59 1/2 so no cap gains on the first. If stay for a while in the second then no cap gains for that one. It a million in no cap gains. Then, I have a loser bought at the peak. After it is rebuild and landscaped I will break even when I sell those. By paying for each house in cash and keeping the house modest they have all appreciated to about a total of 1.7 million with no cap gains on a million plus the improvement are deductible. It is hard to find a better investment. I bought and sold two other properties and made about $400,000 with cap gains to pay. I like rebuilding them and have made a fortune with very little tax. The next house will be a 1.7 million mini mansion on Hawaii where I will retire. I hope my children can sell it and I hope housing price do not rise to quickly after the recession.
I didn’t know Axel was a Kalifornicator! I work in computer chip manufacturing, and people I know who can live where they want leave Kali for Colorado as soon as they can. I lived in Los Gatos and had an office in Santa Clara in the mid 1990’s. In 2000, I bought a palatial mansion in Middle Tennessee for less than 10% what a similar house would cost in the Bay Area or LA. Actually, the build quality and land I got is unobtainable in Kalifornia. Tthere is no state income tax in TN.
My TN house price is unchanged in 10 years after agent commission is paid. I don’t regret not buying / living in Kali.
There are now more semiconductor chips made in Texas than Kalifornia.
You don’t live IN Kali, you live THRU it, most people are passing thru.
Axel – good, thought-provoking article.
By the same reasoning, choosing to rent is accepting the risk of further deflation in housing prices, which may not be a bad choice. Comparing cost to rent vs. the cost of capital to buy (net of tax benefits,) makes renting very attractive right now, as you well know. Adding in the personal costs that you mention, however, tips the scales a bit.
This is not dissimilar to the buy vs. lease decision on cars, or more appropriately, buying a used mid-size car vs. a new luxury vehicle.
In any case, thanks for putting your thoughts in print, and stirring my neurons.
Real estate in prime areas might be a good bet in a time of high inflation (I’ve always heard you should “buy beachfront”), but one counter-argument is that higher financing costs — due to inflation — will be a drag on the most heavily-leveraged investments such as real estate.
If the average engineer in California is anything like me, they’re probably looking at their paychecks, which have declined or stagnated in real terms over the past few years, and wondering how they can afford to borrow half a million dollars to buy a place 5 times their salary. If we get high inflation, the rising cost of food, education, energy, taxes (bracket creep), etc., will make it even harder to afford to own a home. With less job security due to the crappy economy and long-term trends such as offshoring, owning expensive real estate is a risky proposition for me.
I would love to buy a place here in LA, but I value the flexibility that renting affords. Perhaps certain areas like Palo Alto and West Los Angeles will always be special, due to the presence of high-income jobs for an elite segment of the population. However, I’m not sure I’m willing to risk everything I have for a leveraged bet on real estate.
First of all, you are a great audience, your comments are very thoughtful. A common theme in the comments is that if inflation were to become an issue, purchasing power would decrease and may not push up home prices – at least not until inflation is a very serious problem. Two comments on this:
On the one hand, it is correct and a basic problem I eluded to in my article: the Fed may be able to induce inflation, but it is rather difficult to control where it will hit. Currently, freshly printed dollars mostly support commodity prices and investments abroad rather than making it to where it is needed most. It’s one of the reasons the Fed directly purchases mortgage-backed securities (MBS) to stimulate the housing market; a rather ill-guided effort in my humble opinion as it is doubtful that buying MBS is more effective than buying government bonds (I have a problem with that too, but that’s a different story).
On the other hand, I frequently discuss how monetary (interest rate) policy that has been pursued this decade contributes to a widening of the wealth gap. A credit driven society may be more efficient using former Fed Chairman Greenspan’s words (when leasing rather than buying a car, for example, your monthly paycheck gets you much further), but it is far less shock resistant. If you have no debt and encounter a crisis, you swallow, find a job and move on. But if you have debt and encounter a crisis (say, lose your job), it is increasingly difficult to make it back onto your feet. A credit driven society is also far more interest rate sensitive, giving the Fed far less flexibility in combating inflation as any tightening nowadays is likely to have far greater consequences than it would have had 25 years ago.
What does this mean when translated to residential real estate? It may well mean that real estate in more affluent areas may be less affected by an inflation induced erosion of purchasing power. More provocatively speaking, we may be on a path to a Latin American society with a diminishing middle class.
Axel
Axel Merk
Author of Sustainable Wealth – order now.
President and Chief Investment Officer, Merk Investments
This report was prepared by SustainableWealth.org, and reflects the current opinion of the contributor. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any investment security, nor provide investment advice. SustainableWealth.org is a trademark of Merk Investments, LLC.
Axel, I think you are catching a falling knife on this one. I would love to own an Eichler home in the Silicon Valley area, but California laws/taxes are only going to get worse. It appears Inflation is the direction, but I am convinced we are going to see a deflationary collapse. This time the bubble was just too big to re-inflate. All the money pumped into the system is not getting to us commoners on main street. If only I was a Banker and not an Engineer. I am a die-hard gold/silver investor and think that will help no matter what happens. The book “The Fourth Turning” has me convinced the next 10 years will be “soup kitchen” time. Cheers
bullshit .. this is all bullshit ..
you bought a home because your wife said:
“I want a house .. NOW!
I’m sick and tired of moving every few years,
new schools, new friends, new phone numbers ..
now Axel .. buy a house now,
and no, I don’t care what it costs. “
While there are many benefits to ownership to consider, I think most people are simply fooling themselves at the present time.
First off, housing has basically had a 60 year bull market, which in my opinion makes the current juncture MORE dangerous. No uptrend or downtrend lasts forever. Similarly, the stock market has had a nice 75 year run from 1932-2007; does that guarantee the next 75 years will be the same? No.
So now after ~60 years of rising home prices, the next step is – more rising prices? Doubt it. Not in the intermediate term anyway. Yes, eventually hyperinflation will return but maybe 10-15 years away? right now there’s about 50 times more debt in existence than currency, even including the Fed’s recent actions. A debt collapse means there will be a scramble for cash to pay off outstanding debt(temporarily dollars will become rare), meaning prices for everything will go down. Really, who out there actually has a significant amount of CASH in the bank, or better yet on hand? Everyone has “wealth” tied up in stocks/bonds, which can collapse in value instantly; or housing, which will be highly illiquid in the next crisis, and subsequently also fall in dollar value.
Fundamentally speaking, housing was WAY overvalued relative to incomes back in 2003, BEFORE the final bubble in 2002-2007. Nominal prices are now only back to 2003 levels, but the average income has languished or decreased – so it is STILL WAY OVERVALUED. Just to get back to the 1970-2000 mean for housing vs. income means another 30% drop from here. To get to undervaluation, where most bear markets end, would be perhaps a further 70% drop.
Anyway, I’m glad you boomers were able to make all your money in housing over the great bull of 1970-2006. I plan on buying at the bottom, from you, at 20% of peak prices and doing the same. Maybe you should consider selling now and renting for a few years? Note that we’re in a temporary recovery, so home prices can bounce for 1-2 more years. Let’s see where things end up in 2020 if this “recovery” is just a mirage. Just follow the stock market and it’ll tell you where housing is going.