Andrew's investment space

• Price Appreciation. Since we're in Seattle area, I will use a little higher number then US national average price growth rate of 6.12% because Seattle area used to grow faster then US. It actually could be a bad sign, it could be a sign that in the next 30 years Seattle will consistently underperform US growth. For these reasons I decided to use average between US growth rate and Seattle growth rate. Average(US, Seattle) = (6.12% + 7.91%)/2 = 7.02%
• Rent Saved. We will use 4.95%. Please see topic on that below.
• Housing Expenses. We will use 2.9%. Please see topic on housing expenses below.

Given that TOTAL_RETURN = 7.02% + 4.95% - 2.90% = 9.07% annually. Not bad.

One of the best benefits of owning a house is that you don’t have to pay rent. Savings on rent is significant component of total return on real estate investment. Let’s calculate how much it is. We’ll use the same approach as with housing expenses and will calculate rent saving in % of house price instead of absolute $ numbers (I guess you don’t have a doubt that rent rates will to grow:) ). In my case my 2006 annual rent payment is 3.3% of the equivalent condo value (400k). But there is one catch here.

Please take a look at the last chart. It shows ratio of median rent / housing price index for the last 18 years. The ratio number actually doesn’t mean anything except that it shows dynamics of how rent rates grow comparing to housing prices. What we see on this chart is that today’s ratio is at the historical bottom. US 2005 ratio is 32% lower then 18 year average 2.99; West 2005 ratio is 63% lower then 18 year average 3.16. Based on that, we should expect that the rents will significantly increase in the near future. Today’s rents are bargains and given 18-year historical data we can expect rates to increase 32%-63%.

So I expect that if I buy a condo then my average rent savings will be 32% - 63% higher then my 2005 annual rate, because the rates will be higher. On average let’s assume that rent savings will be ½ higher. So in my calculations of total return on real estate I will use 3.3% + half = +4.95% rent savings.

Hey, now we have all the components to calculate total long term real estate investment return. Coming soon…   

Historical data on rent rates is coming shortly... It will be the last thing needed to calculate total long term return on real estate investment.  

The return on houseA is very predictable: based on the charts we can predict it around 6% in the next 35 years:)

The return on houseB is very tricky. You're gambling that houseB's price appreciation will be more then the interest you pay to your bank. So given the charts:

• if in the next 5 years real estate will continue to grow 10-15% then you're making a nice profit over 6% interest you pay to your bank. You’re a hero.
• but if in the next 5 years real estate will fall into stagnation: your houseB made nothing, but you still have to pay 6% interest. You just lost big.
• if you’re unfortunate enough to see modest housing prices declines - you loose on your houseB and you still have to pay 6% interest. That’s what I call the great suffering 

Since for most people houseB is a way larger then the houseA: this makes the whole “investing in my house” enterprise a very risky business. If you use mortgage your investment is becoming wild and volatile, comparable probably to stock market. Until you pay off your mortgage, or decrease your mortgaged component significantly, the total return on your real estate investment is unpredictable. It 's more speculation then safe investment, and no wander why - by using mortgage you're buying house on margin.

PS The post-2005 scenario of great suffering for real estate investors (when real estate prices decline) is not that much unrealistic. Real estate prices sometimes do decline. You can read in the books about the spectacular Florida real estate crash of 1925, the magnitude of which is similar only to Great Depression's stock market crash. It's a pity that FreddieMac has only short 35-year history, but it still shows periods of price declines in local markets. Please note how close these local markets are to Seattle area :)

Tax bonus for taking large mortgage. There is additional bonus on houseB. IRS allows you to deduct all the interest you paid on your mortgage. Let's get some clue how much it is. Keep in mind: if you deduct mortgage interest you have to loose standard deductions ($10,000 for married couple), but now you can also deduct WA sales tax and other (let's say all together you deduct additional $2,000)

Let's see how it looks in numbers. Let's say you buy $350,000 house, you finance 80% = $280,000 mortgage at 6% rate. I took my financial calculator PV=280,000 i=6% n=360. Now let's get AMORT for per 1-12 (first year). We found that total interest=16,706 in the first year. So we can deduct more then standard deductions. Additional deduction is 16,706 - 10,000 + 2,000 = 8706 That additional deduction in 25% tax bracket will give us 8706*25%=$2176 saved in taxes. 2,176 / 280,000 = 0.78% So we calculated that in the first year we have 0.78% tax bonus in addition to 6% interest we pay to bank. For comparison I also calculated that in the 10th year tax bonus will shrink to 0.63%, still not bad. BTW, the higher the rate the larger the bonus:)

1. Sellers to buyers ratio. Did you notice that any house coming to market sells in maximum 1-2 days? We have like 10-20 buyers for every seller in the market. Do you think it’s crazy? Think about buyers, how can you win a bid for a house if there are 10-20 people competing with you? Did you notice that buyers max out their mortgage payments a way out of what they can really afford? And that’s not all. They still can’t win a bid for the house. They have to get ARM or interest only loan (that’s on top of maxed out mortgage payment) just to be able to compete with other buyers. Do you think it makes any sense to get these “non-traditional” loans if you know that interest rates are rising and your mortgage payments will increase beyond imaginable? Why buyers are doing such crazy thing? There is only one answer: if they don’t do it, they can’t compete with other buyers. You need to be really crazy and fully committed to screw up your future to get some hope of winning the bid for the house. Now the key question: is there any room to get more buyers? Look, market is driven by sellers and buyers. Even if the current crazy ratio stays forever then housing prices will be the same, it means they will not grow. I think normal ratio of buyers and sellers is closer to 1-1, once the ratio goes down it will put pressure on prices, but even if you believe that current ratio and craziness is not going to change then it means there is no room for housing prices to grow. Now even you believe that housing prices can’t go up.
   
2. Raising rates. This is a real killer. This thing will go and plunge the housing prices and there is no force that can stop it. This topic is widely publicized in the media, so I’ll just make couple of quick points. You know that even slight 0.5% increase in rate, will have to increase mortgage payment significantly and since payment is already maxed up (also using ARM and interest only option) so it can’t go up, so if people can’t pay higher mortgage payment then the house price just has to decrease in couple dozens of thousands of dollars. You already know that, right? Now, I’d like to address phenomenon how did it happen that 30-year rates are still low and not about 9% where they should be by now. Look, Fed rate was 1% so 30-year rate hit minimum (and what did it do to housing prices? Right J) Now, Fed said we’ve starting to raise overnight rates, but 30-year rate didn’t move. Hmmm, something’s weird here. Fed rate went up to 2%, 3%, but 30-year rate went even a little lower. Hmmm, something’s very weird here. Today Fed rate is almost 4%, Fed said there is no stopping in rising rates in the future, nobody can imagine where the Fed is going to stop, but 30-year rate still barely moved. Isn’t that crazy? Look at the numbers. Why would somebody give you money for 30 years at 5.5% rate, if he can do it overnight (1 day is a way less then 30 years) and still get full 4% return? There is so much less debt risk if you know you gonna get your money back next day instead of hoping that you’ll get it back in 30 years. That’s why I think mortgage rates are going to skyrocket and there is absolutely no way to keep those at the same level as today. Given that even if you believe the crazy thing that mortgage rates are not going up, you definitely can’t believe that they can go down. Because of rates it means you believe housing prices will not go up, in the best case they can stay constant in the next visible future.
   
3. Home builders believe their profits are going down. Did you check home builders companies recently? Don’t believe what their CEO’s say, look how much people who profit from homebuilders business (the shareholders) are willing to pay for their companies. KBH’s P/E = 7.8, CTX’s P/E = 7.5, LEN = 7.9, RYL’s P/E = 8.8. Why would great American companies that grow their earnings 25-30% every year would be so cheap?  For comparison every other average American company that can grow earnings 25% has P/E 40-50. Even MSFT’s P/E is 22, but nobody believes MSFT’s earnings can grow any close to 25%. Why would homebuilders be that cheap? There is only one reason: investors believe that homebuilder’s profit is going to decline because real estate prices will decline. If you don’t believe your home price is going down, go buy some KBH @ 7.8 P/E.

If you’re still not bored and you still continue to read this (most people are getting bored easily so they just go buy what grows up in price: like real estate in the past yearsJ, or internet stocks in 1999-2000) I guess I probably convinced you that housing prices are not going to grow up, in the best case they will stay constant at the same level they are today. Maybe I didn’t convince you that prices are going down, but at least by now you believe that prices will stay constant in the future. You’ll say: “So what? That’s good for me. I just care so I don’t loose my money.” - Wrong! Constant prices are really bad for you, they gonna hurt you and If I’m not lazy to write another story I’ll tell you why.