Saturday, February 20, 2010

Delayed Gratification?

One of the topics that I love to discuss with my kids is saving. The longer one can delay gratification the better. It builds character as one is creating a pool of assets which could directly lead to comfort and security in the future.

Contrast this concept to the fact that our present government is desperately trying to force our insolvent banks to lend as much as possible to our insolvent households. I'm sure this dynamic makes sense to most of the Wall Street economists that are advising our government but on paper the numbers don't work.

Anyway I would like to suggest some other numbers that don't work. Buying a home in a "high end" area of San Francisco instead of renting.

Let us suppose there are two people that want to live in Lafayette for 7 years. Let's call them "you" and "me". You buy a $1.2 million home and I rent an identical home. We both have a 30% down payment.

But we must agree on what the future will be. I say homes will trend downward 30% in 7 years. You say homes should increase slightly. So let's say that prices will stay the same. I don't agree with it but I accept the premise.

I am sure we can both agree on a historical 6.5% return on stocks and we will let you have a 6% loan.

Now let's look at the numbers. At the end of 7 years I will have made $500,256 cash gains and you will have made $85,764 in equity.

No, I didn't misplace a decimal point.

Your mortgage, real estate taxes, extra insurance and maintenance for your home is $6,188 after the $1,158 itemized deduction subsidy from our government.

I will pay $4,000 to rent the same house. I will put the $2,188 that I save each month in the stock market and after 7 years will have $264,457. I will also earn the same 6.5% on my down payment which will be another $235,798. This is a long term capital gain of $500,256 in 7 years.

You will tie up your down payment for 7 years as you make very large interest payments to the bank.

At this point you are saying, "what about your capital gains tax?". I will say, "what about the 6.5% cost of selling your home?" Both charges to exit the investment end up being a little over $75,000. Let's call it a wash.

Is it possible that my rent will go up some? Yes. But it is much more likely that your home will go down in value much, much more. By my calculations about 30%. With a 30% discount the price of your house would still be overpriced compared to 1998 values. Back in 1998 homes were affordable compared to rent and household income. Housing markets almost always trend toward affordability. The last ten years have been a very, very large anomaly.

The example above is what I mean when I talk about affordability. Homes in Lafayette are unaffordable. Look at the numbers!

I would have $860,256 minus capital gain taxes, to put as a down payment on my $1.2 million home if I wanted to buy it. This includes my original down payment with capital gain plus my profit from renting with my long term capital gains.

So if I purchased then my housing costs after the tax deduction would be $1,907. This is $4,280 less per month than you would be paying if you had stayed in you house.

But my original premise for posting was Delayed Gratification and the example above actually gives me a beautiful house with free pool and lawn care.

So what if I decided to delay my gratification for a few years and live in Walnut Creek to save money. Suppose that I decided to rent a smaller place for half the rent. Then I would be able to pay cash for a house next to yours in a little over 8 years.

I will not pay a mortgage payment for 22 years while you are paying $5,036. I will have $2.8 million in the bank and a home in 30 years. You will have just a home.

The numbers are outrageous but they are not the main focus when I choose to rent instead of own a home. I am not renting to save $2.8 million in the next 22 years.

I am renting because of the huge downside risk in high end housing. Real estate has always trended toward affordability. To think that this time is different is lunacy. There are no variables in the future that can possibly drive real estate prices in high end areas to more unaffordable levels short of the government giving upper middle class taxpayers money. Realistically the opposite will be true. Taxes for residents of Lafayette will skyrocket in the future. The top 50% of wage earners pay 96% of the taxes. Almost all of this debt that our government is creating now will be paid by people that live in high end areas. And just in my opinion, rightfully so.

There will be no positive inertia in the future that will push high end real estate to more unaffordable values. But there will be many, many factors in the future that will push prices toward affordability. Affordability is where prices trend most of the time and that's a good thing.

There are great examples of affordability in many lower end real estate markets. In Antioch, Sacramento, Las Vegas and Phoenix homes are below fair value. In these areas and many others it is cheaper to own than rent. By historical standards this is not unusual. Real estate prices trend toward affordability so sometimes they are below fair value and sometimes they are above. As a value investor, if I lived in Antioch I would definitely buy a home.

The Lafayette housing market will absolutely come back to affordable levels at or below 1998-2001 pricing. There is also a chance that they could go below fair value.

As a value investor the chance to lose $360,000 or more by choosing to spend an extra $2.8 million on housing does not make sense.

There is one last idea that the gullible will parrot from the salespeople that are trying to entice them into 30 years of debt servitude. A house is "inflation protection".

Let me explain the chain of events that are in process. Our economy is contracting. This is the opposite of inflation. If our Federal Reserve is lucky enough to debase our currency enough to create inflation then interest rates will spike first. This will cause stagflation exactly like the 1970's and eventually inflation like the 1980's.

So if we are eventually lucky enough to get inflation first we must deal with spiking interest rates. These higher interest rates will collapse housing prices. At that point one could argue that housing would be an insurance against inflation but not now.

Presently housing is not an inflation hedge in fact it's just the opposite. You won't be able to use real estate or long term bonds as an inflation hedge until interest rates are 2/3rds of the way to the peak in the interest rate cycle. That is a long way down the road. We are presently at the bottom of the interest rate cycle. Inflation is not even a variable that I am presently considering.

Inflation might not be a factor for 7 years. Hence my example above comparing renting to purchasing.

During the Great Depression our country incurred economic contraction just like today. But ironically when you read memoirs of investors during that time period their biggest concern was inflation. It's very similar to today. As our economy is contracting most people are worried about inflation. Inflation is the next red herring that Wall Street will use to take your money. We are not even close to stagflation much less inflation.

My recommendation is the same today as it was 10 years ago. Only buy a home when it's affordable. When we are halfway up the next interest rate cycle then we can talk about "inflation protection".

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