Wednesday, January 27, 2010

Lafayette Lotto

Since 2007 I have compared the Lafayette housing market with the state lottery. Both have big winners and both are run by the government.

Once in a while a high end home in Lafayette will sell at 2007 peak bubble price. This event can create up to a million dollar gift to the seller above the "present value" or utility value of the home. The short term dysfunction in pricing props up the comparables and allows other sellers to continue the lottery. Historically, after a bubble, "high end" home prices trend downward much more slowly than their "lower end" brethren. Interestingly, most of the "high end" areas of the Bay Area are not trending down to fair value, they are staying close to 2007 bubble prices.

I made up the term "lottery" because I needed a new word to describe this unprecedented economic behavior. Our nation's leaders are desperately borrowing trillions of dollars from our children as they frantically attempt to keep home prices in a bubble. The end goal is for real estate values to stay unaffordable for the future generations that will have to pay off this boondoggle(scheme that wastes time and money).

I am not a psychologist so I don't quite understand why we hate our children as we are attempting to mortgage their future with stifling debt and unaffordable homes. But I am an accountant with a degree in economics so I do understand that this market manipulation is unsustainable in the long run.

I don't disagree with a flood of money to help the unemployed. I take pause when our government unconstitutionally borrows trillions of dollars with the malicious intent to artificially distort capital markets so they can reward bankers and speculators. The amount of money being spend on bailing out banks dwarfs the money going to the unemployed 100 to 1.

The worst part of it is that this malicious money only creates short term distortion and will have no long term effect on the housing market. No amount of hope, money and debt that our politicians and their lobbyists throw at our housing market will keep real estate prices from going back to valuations that are in line with historic value trends.

Lower priced housing markets like Antioch are almost through the bubble. Some "low end" areas are selling below 1998 prices. In Antioch it is easy to see how prices come back to fair value. Presently Antioch prices are below fair value compared to rents and household income. Speculators are being kicked out of the market as young families and prudent investors are able to feel the joy of owning a home that is "affordable". This is the same feeling that my generation was able to enjoy for 25 years up until 2001 when the government and the banks colluded to make real estate unaffordable.

The wave of foreclosures in Antioch is allowing families to trade hundreds of thousands of dollars of debt for rents that are half of their former mortgage payments. The only cost is a 2-5 year ding in their credit. Each foreclosure eliminates personal debt and in the end makes our country stronger. Why is the government involved in this at all? Well, it appears that they feel that all bankers need large bonuses to keep the country strong.

There is a rebirth happening in Antioch and other "lower end" housing areas. This has nothing to do with the government. Houses are coming back into line with fair value. This is a wonderful event. Fairly priced assets are the foundation of a sound economy. The fact that our government is attempting to fix prices with Ponzi schemes and market manipulation makes me question the soundness of our government.

It will be a long slog for "high end" real estate. The government would say that Lafayette is benefiting from the stimulus. I myself do not see any benefit to manipulating the housing market to delude young families into bad investments. House prices must come in line with intrinsic value in the future. I believe it is unethical for our government to spend trillions of dollars of our children's money to slow the process.

Let's look at the significant variables that will drive future high end home values:

  • Prices on homes in Lafayette are selling at a 30% premium in relation to intrinsic value. Prices are also out of line with historic value trends. This makes sense because most of the time house prices find equilibrium at prices that buyers can afford. Eventually Lafayette prices must fall in line with rents and household income.
  • If interest rates rise from 5.5% to 8.5% then homes must be discounted by 25% to have the same mortgage payment. As interest rates rise real estate prices fall - always.
  • People are presently not saving. Historically we have saved 10% of our income. Future discretionary spending on housing will be reduced in the future due to higher savings rates that are in line with historical norms.
  • Taxes for the upper middle class will increase at least 10% in the future. The upper middle class will pay for just about all of the debt that is presently being created by our government. This will also have a large effect on discretionary spending on housing.
  • Rents in "high end" areas are trending downward so renting is becoming even a better value.

I can think of no scenario in which these 5 drivers will not push high end prices down at least 30%.

There are many other factors that will effect real estate in the future. Almost all of them will have a negative effect on "high end" real estate.

The recession of 2011 will have a significant effect on our nation's psyche. Hopefully this watershed event will send our nation on the road to saving instead of speculating. We must understand that the easy money of the last 25 years is over. Our government is spending trillions to keep the party going but this government largess must end soon. The longer it lasts the bigger the bill for the upper middle class taxpayer of Lafayette and for our country.

New buyers in "high end" Lafayette will slowly sink underwater over the next 5 years. During this time they will be responsible for the lion's share of the debt that is being created by our government. $1.3 trillion divided by 290 million is $4,500 a person. So this year an upper middle class family of four is responsible for about $45,000 of deficit for 2009. It works out to $4,500 for each family member and $4,500 each for another family of four that does not pay income tax. Also they will pay for half of an Antioch middle class family. Remember, the top 50% of taxpayers pay 96% of income tax with the highest proportion going to the upper middle class.

The $45,000 debt is just for 2009. The government is planning to run these deficits for at least 10 years. So multiply the $45,000 by 10 to get a realistic idea of an upper middle class family's portion of the government deficit.

The stimulus ends up being a circular function as it flushes through the upper middle class. The government debt is creating market dysfunction that is allowing high end home buyers to overpay for real estate. These new buyers will be underwater in their homes in 5 years and also be responsible for the $450,000 worth of debt that distorted the market to make the house seem like a good deal in the first place.

Let's look at the numbers comparing buying a mispriced home or renting the same exact $1.2 million home:

Realistic estimated loss in property value over 5 years = $300,000

Difference in cost of rent to house payments after tax = $120,000

Difference in cost to move = $48,000

So as a home buyer you are locked into a possible $420,000 loss until you decide to pay $48,000 to exit the investment.

As a renter I can move as many times as I want. I can buy a house next year or in ten years as my down payment grows with interest.

Also my landlord is responsible for cleaning my pool, maintaining my yard and cleaning my gutters.

It doesn't quite seem fair.

It's almost like there's a renter's bubble in Lafayette.

As a renter the only thing that I miss out on is the chance to hit the Lotto.

Saturday, January 16, 2010

Almost a Homeowner:

I monitor the Lafayette housing market very closely. A couple of weeks ago a Real Estate Owned(REO) property came on the market that was very intriguing. It was a great lot with an older home on it that was priced at 2001 value. I inspected the structure and determined that I could rehab the house for $70,000 thus making the total cost of the property around $650,000.

I am presently not anxious to own a home in the Bay Area because home values are due to fall another 30% in the high end areas like Lafayette. But this house was pretty special.

On the property's third day on the market I made a low offer that was accepted by the bank. I had a termite inspection and found some wet wood termites. Not a big problem. Dry wood termites are the killer. So far so good.

I received the preliminary title report and decided to perform my due diligence on the "chain of title". I went to the county and found that the bank had botched the foreclosure of the property. There were 2 investors named on the Grant Deed and one of them was not included in the Notice of Default or named in the Foreclosure.

I informed the title company that I needed this included in the title insurance. They mentioned this to the bank and of course the bank backed out of the deal. They are going to start the foreclosure process again and hopefully do it right this time.

The funny thing about this deal is that I mentioned the tarnished "chain of title" to a couple of real estate agents and they said that I shouldn't worry about it. Of course now they admit that I was right. Real estate agents are a little to easy going sometimes.

I would like to express that if you are buying real estate in today's dysfunctional market you must to be very careful:

1) House Value: House prices are still 25% overpriced in Lafayette. If anyone tells you differently they are basing their assessment on emotion and not on the numbers. House prices in Lafayette are on average hovering at 2004 values($440 sq. ft.). Every so often a home comes on the market at a good value. It is normally snapped up immediately. Most of the home inventory in Lafayette is still priced at bubble values. If you buy a house in Lafayette at 2007 prices($545 sq. ft.) you could lose at least 30% of your investment over the next 5 to 7 years depending on the area. Some areas need to trend to under $250 sq. ft. to fall in line with historic value trends. One can argue against this fact but you will be using emotion, nostalgia and hope to defend your convictions. All numbers, trends and economic indicators point in the other direction.

I myself would not consider buying a home priced over 2001 value. In Antioch homes are being sold below 1998 value($110 a sq. ft.). Lafayette was selling at $213 a sq. ft. in 1998. About twice as much as Antioch. Presently the price per square foot difference between Antioch and Lafayette is 4 to 1. This change in buyers attitudes is not the magic of Lafayette but the stubbornness of high end markets to reprice. The same trend happened during the 1990 housing bubble. The same trend has been happening in Japan for the last 20 years.

The price of any home over the long run will trend with household income and rental prices. Antioch is driven more by rental prices. Lafayette is a little more affected by household income. Antioch housing prices are a good value compared to rents in the area. Lafayette homes are a terrible value in relation to household income, rents or any other variable you might care to use to compare.

The last problem with the Lafayette housing market is that there is far to much debt. Also, unfortunately, most of the houses that were bought after 2002 were financed with adjustable rate mortgages that will recast before 2013. A contracting economy, increasing interest rates and exploding "option ARM" loans will have a very negative effect on all high end markets for the next 5 to 7 years.

One could argue that the Antioch real estate market is forming a price bottom. No one can intelligently argue that any high end area of the Bay Area is close to a bottom.

2) Get good advice: Be careful, there are a lot of salespeople that will push you to buy a house. I love the quote by Upton Sinclair: "It is difficult to get a man to understand something when his salary depends upon his not understanding it."

Even neighbors, friends and family can be salespeople. Anyone that presently owns a home has a vested interest in puffing up prices. Most of these people have unrealistic expectations created by the previous 25 years of easy money:

  • The government is the key to solving our economic problems
  • You don't need to save because you can retire with the equity in your home
  • Real estate prices always go up
  • Cash flow is not important when buying a rental property
  • Debt is important to economic prosperity
  • It is not important for our country to save because we will always be able to borrow from foreign nations
  • Buy a home while interest rates are low

The easy money period is officially over. Anyone that does not realize this fact is probably not going to give you the best advice.

3) The Economy: This area was my biggest concern when I made the offer on the house. Our economy is in a deflationary environment. Interest rates are set to increase. Unemployment will be high for an extended period of time. Almost none of the present economic malaise is priced into public opinion.

We have just ended the biggest private sector debt binge any country has ever experienced and now our strategy is to use taxpayer debt to grow the economy. What most people don't understand is that the "private sector" and "the taxpayer" are the same thing. Our citizens are being sold on a policy of borrowing money to pay off their own debt. This machination would be funny except that about a trillion dollars a year is being skimmed off the top by the government. The interest on the trillion dollars a year of graft will be paid by our children to foreign nations.

In 1985 foreign nations owned less than a $1 trillion in US investments. Today, 25 years later, foreign nations own over $15 trillion in US investments. Of course this is not the problem. The problem is the growth trend and our nation's willingness to "give away our country" instead of balancing our budget. If the present trend continues, in the future our largest government expense will be interest payments to foreign nations. Also, we will have a more difficult time paying this debt if a significant amount of our country's productive assets are owned by China, Japan and The Middle East.

Savings and increased productivity are the only ways to increase a nation's standard of living. The debt we are creating will actually reduce our standard of living as our children make onerous interest payments to foreign nations.

I am a little disappointed in not getting the house in Lafayette but there will be many more opportunities in the future as "high end" real estate prices trend downward.

Monday, January 4, 2010

The Sleep at Night Portfolio

During my years of investing I have found that I am very risk adverse. I hate taking risks in my investments although I also find it distasteful to miss out on big gains in the stock market. My portfolio needs to trend with the S and P but at times trend away from The Herd. The Herd is the group of momentum speculators that distort valuations in dysfunctional markets. The Herd does not look at historical valuation trends. The Herd drove the market to unsustainable highs in October of 2007 and also to extreme value in March of 2009.

I was out of the market in October of 2007 and dove into the market in March of 2009. Presently the stock market is 20% overvalued by historical standards. I have adjusted my portfolio to take only 15% of the gains on upswings in the market. I will move in and out of the market for the next year or so trending away from the movements of The Herd. I would like to lean toward market neutral until The Herd realizes that the taxpayer ATM can't create future wealth. It took The Herd 5 years to realize that the homeowner ATM was not the road to riches.

My concern back in 2007 was capital preservation. My sleep at night portfolio managed well during the recession. It is up about 14% since October 2007. The S and P index is down 25% over the same period.

My portfolio will always under perform during periods of market overvaluation. Presently the S and P is about 20% overvalued. I have only taken 60% of the profits in the S and P since May. But when the market was undervalued in March and April I was able to take 120% of the profits of my benchmark. My investments ended the year only taking 95% of the S and P gains. Very boring but of course I didn't lose an hour of sleep worrying about my investments.

My 95% take rate for 2009 does not include the small 1.2% distribution that I pay myself for managing the account. This distribution is annuitized so that I don't have to pay the early distribution penalty to the IRS. The management payment that I pay myself is similar to what most people pay their financial advisors or mutual fund managers. Most people don't realize how much money is siphoned out of market gains from investment management. I keep this money separate just as a reminder.

If you have a financial planner that invests in mutual funds there would be a 1% charge for the planner on top of an average 1.25% charge for the mutual fund manager. In my situation I am my own money manager and the bulk of my investments are invested directly in stocks. Therefore I pay no fees or charges. This is a very large savings in the long run. Let me explain why.

Presently the stock market is overvalued by 20% so I feel that it is prudent to only expect to make gains on the 6% corporate profits over the next 20 years, not including inflation. Let us assume that your financial planner takes 1% of your investment and your mutual fund company takes 1.25%. If there are 6% stock gains over the next 20 years then your portfolio will end up with an overall 3.75% year over year return. That works out to a little over 131% return before inflation for twenty years. Without the money management fees you would make 221%. Quite a difference.

If you feel that the 6% return is low please Google "Japanese lost decade". You will see that thanks to the advice of top Wall Street economists Japan has been able to have almost zero equity growth for twenty years. So I don't think 6% growth is unrealistic.

Our Financial Elite have a very impressive track record in Japan and they are presently providing the same unsound advice to our government.

So in theory, assuming 6% stock market returns, you can almost double your investment return by managing your own account and investing directly in stocks. It's not for everyone but it is sure something to think about. There is also a side benefit to managing your own investments. Less of our nation's resources are funneled to the Financial Elite of Wall Street.

One other area that will be a disappointment in the future are bonds. As interest rates rise long term bonds decrease in value. We have spent the last twenty years on the windward side of the interest rate mega bubble. These gail force tailwinds have made massive gains for stocks, real estate and especially bonds. We are starting a new mega bubble which means severe headwinds for bonds and real estate. This is the end of easy money and no one is talking about it or seems to care. It is a little disconcerting.

This is my advice. Don't plan on using speculation as an investment vehicle. Learn to save. I sold my house in 2007. Presently I am saving 50% of my "take home" household income while renting a home. It sounds crazy but to me it just seems like the prudent thing to do in this dysfunctional economic environment. This is an extreme contrast to 15 years ago. From 1995 until 2005 I didn't save a dime. It was almost foolish to save. There were huge stock gains and even bigger housing gains. During that period saving was unnecessary.

This easy money period is over. We have ended the interest rate mega bubble and we are creating another. There will be no gains in housing or bonds for the next 10 years. Stocks will gain 6% a year. If you are worried about inflation please Google "Japanese lost decade" to quell your fears. It is very unlikely that The Federal Reserve can create significant inflation before interest rates rise above historical trend. Once we see real interest rates above 10% then we can talk about inflation. Presently we have no idea what the real interest rate is. The government is spending trillions to distort the market. This market manipulation could go on for a generation just like Japan of the last twenty years.

As a country we need to save, pay down our debt and stop speculating. During the 1990's and 2000's the easy money made anyone who borrowed money and speculated with it a financial genius. Stocks, bonds, real estate, collectables, commodities, it really didn't matter where the money was invested. It was a boomtime and everyone made money.

The investment winds have shifted. For the next 10 years we will have a lot less financial geniuses. The smart money will be saved.