Friday, December 2, 2011

How to Determine the Value of a Primary Residence

I sold my home in 2007 and I am still renting today. According to the three mathematical valuations methods that I use it no longer made sense to own a primary residence in 07’. The irony was that everyone else in the country was climbing over themselves to buy a home in the most overpriced housing market in our nation’s history.

I used my three mathematical valuation methods to determine that it was a fantastic time to buy a primary residence in 1996. Back then I stretched to buy a home that was 5 times my household income. Maybe the purchase was a bit imprudent but what the heck, it was a great time to buy. And, even though houses were cheap, The Herd of clueless investors didn’t whan to buy a home in 96’.

We are animals and our Herd Mentality usurps our common sense much of the time.
It is happening today:

• Why does everyone want to purchase gold now at $1,800 an ounce? The time to buy was in 2001 at $275 an ounce. Today investors are climbing over themselves to purchase an overvalued asset that gives no investment return and is difficult and expensive to sell.

• Why would anyone in their right mind buy a 30 year treasury bond now? Yields are at historic lows which means prices are at historic highs as people are rushing to purchase this “perceived” risk free investment.

• Why would anyone have a significant portion of their retirement in the stock market now? We are heading into a global recession and the worst economy in the past 70 years. Most publicly traded companies are not growing; they are cutting costs to increase their profits. But investors don’t care about the quality of the growth or what will happen in the near future, they are only concerned with following The Herd into the current overvalued market.

• Why would anyone pay bubble prices in the housing market? Some young families are still purchasing overpriced homes that will be underwater in 5 years.

People are Herd investors.

This is why it is imperative that you use some sort of time tested valuation method to put a price on the most expensive asset you will ever own.

Perhaps the best method to determine if it makes sense to purchase a home is to:

• Compare the monthly cost of owning vs. the monthly cost of renting.

Without considering inflation, you should be able to own a home for a little less per month than renting a similar home. You will pay less to own because of the lost return on your 20% down payment and the ridiculously large transaction costs when it’s time to move.

The Rent vs. Own comparison method has been used for generations to determine whether it’s better to buy or rent a home. It always works.

The only other variable that effects the equation is inflation.

So now that we are in deflation, which is the opposite of inflation, it makes sense to pay less to purchase a home compared to renting a similar home.

In 7 to 10 years once inflation rears its ugly head, it will then make sense to pay a bit of a premium to own a home.

It makes no sense to pay a premium for a home in a stagnant economy. This is why I am not rushing out to purchase a home in Walnut Creek and Pleasant Hill. It is still a little cheaper to rent.

Then there are the “higher end” areas of Lafayette and Alamo where it is much, much cheaper to rent. Many “high end” areas are still stubbornly stuck in a bubble as young families purchase homes that will almost certainly be underwater in their mortgages in 5 years.

The second valuation method that can help determine the fair value of a primary residence is:

• Comparing Household income to Home Price.

Throughout history families did not speculate on their “primary residence. They wanted to be able to “afford” their home.

It may seem strange now but historically people have felt that it was prudent to pay between 2 to 4 times their household incomes for a primary residence. During good economic periods they would pay up to 4 times their household income and during questionable economic periods they would be more conservative and pay 2 times.

Our grandparents chose to buy homes at 2 times their household income.

Contrast the prudence of our grandparent with our generation.
Five years ago, as a nation, we were desperate to pay 8 times our household income for a place to live even though we could rent for half the price of owning.

In California buyers were climbing over each other to pay 10 times their household income for 4 walls and a roof.

It did not make any mathematical sense then and it still doesn’t today.

Many buyers in Walnut Creek, Pleasant Hill and Lafayette are still paying 6 times their household income for a house.

Considering that we are in deflation and that we are entering the worst economic period in our nation’s history, would it not make more sense for home buyers to be paying 2 times their household income for a home?

This brings us to our last valid method to value real estate. It is driven by looking at historical trends:

• Comparing Current Sale Prices vs. Historical Trends

This method is used by professors Karl Case and Robert Shiller. They created the Case-Shiller index. With the Case-Shiller index Robert Shiller was able to intelligently argue that we were in a massive real estate bubble from 2003 through 2007.

The fact that no one listened to him creates a good argument that it is extremely foolish not to use mathematically driven valuation methods to determine when to buy real estate.

In 2007 I made my own graphs of the national and local real estate markets. I compared aggregate income to house prices. The charts pictured a huge bubble. I tried to show this bubble to a number of people and no one could see it. In nature herd animals focus their attention side to side watching the actions of The Herd instead of straight ahead.

So it made sense that no one in The Herd could look at something directly in front of their face.

I am absolutely certain that the Rent vs. Own; Household Income vs. Home Price and Historical Trend Methods are the only 3 viable ways to determine the utility value of a primary residence.

Unfortunately our government, the financial sector and most economists do not seem to want anything to do with mathematically driven valuation methods.

Their goal is to keep our nation of clueless investors in a herd. For the past 8 years they have been content to stand at the edge of the financial cliff and wave The Herd into purchasing overvalued homes.

Even the Chairman of the Federal Reserve Ben Bernanke, who is a math genius, would never conceive of using a mathematical method to value the housing market. In 2006, just months before the housing market crashed Dr. Bernanke continued to profess there was no problem with real estate values in this country. He gave his blessing for young families to purchase the most overpricing housing in our nation's history.

Dr. Bernanke was gleefully waving a whole nation of real estate investors toward financial abyss as I was desperately fixing my home to unload it.

Today Chairman Bernanke and The Federal Reserve have been instrumental in destroying our free market interest rates in an attempt to trick more buyers back into the herd of homeowners. Even though in many cases these young families would be much more financially secure to rent for a while.

I don’t feel that tricking young people into buying an overpriced primary residence makes for a healthy housing market.

I feel that fairly priced assets and transparent and free markets are the foundation of a healthy economy and a free society.

Unfortunately Dr. Bernanke, our financial sector, most of our government and The Herd of clueless investors feel that overpriced assets driven by unsustainable debt and corrupted markets hidden by economic disinformation will lead to economic prosperity.

I will wait to buy a home until it makes financial sense for me to do so.

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