patrick.net

SFW wrote:

"..The property owners who are regular posters are mystifyed by this bubble and would like to see the housing market come back to reality (with a small ‘R’) so that our society can function rationally again.."

She left out the part about how we'd like to see the correction Flush the Toilet of some of the petty burgeois arrogance, too.

GC,

That's true to some extent, everybody has different utility functions. However, theotherside's argument extends to everybody and argues that buying is relatively low risk when it is not. He or she also build up a series of straw man arguments and falsehoods (ex: we can earn more than 12% over 5 years if we parked money in 6 month treasury bonds; saying US$ is a liability-which is on its face false).

Or the main straw man, this fearful owner selling merely in anticipation of owning in a couple year. Nobody here has encouraged that! We have current homeowners who are staying put even though they're convinced of a 30%+ correction! This blog's consensus was always towards the macro problem of a housing bubble and the problem of buying, especially stretching to buy, now.

Furthermore, I think RE is going to drop a lot more than 20% from height to final low point.

Finally, it's just hard for me to think that buying a house makes any sense for any practically utility function. Could the ability to paint walls and install new windows really be worth losing hundreds of thousands of dollars over? Even Randy H, who has the money and strong motives to buy, is staying put in a less than perfect position, because the potential cost of buying now is so high.

Could the ability to paint walls and install new windows really be worth losing hundreds of thousands of dollars over?

No, but the perceived ability to extract tens of thousands of dollars every year seems attractive.

"No, but the perceived ability to extract tens of thousands of dollars every year seems attractive."

I heard that goes really well with corian counters.

Someone said,
"We have current homeowners who are staying put even though they’re convinced of a 30%+ correction!"

GC replied,
"If they are really convinced, they would sell and buy back later. That’s a rational approach. If they don’t take this route due to emotional attachment to their houses — which is quite understandable — we can justify the emotional needs to paint and modify and do whatever one wishes to his own dwellings."

Yes I am convinced of at least a 20% correction, no I would not sell and buy back later. That is my rational approach and is not because of any emotional attachment. It is because of the proposition 13 tax basis, and because of the transaction costs.

It is rational that I don't want to give up my Prop 13 tax rate and also it is rational that I don't want to pay all those transaction costs.

Theotherside isn’t lunatic. I think people who sold hoping to buy back at a lower price might have been acting too smart. You buy when you need a house and you sell when your situation demands it. That way there’ll be no worries.

Theotherside/MP/ConfusedRealtor/FaceReality is setting up a straw man argument here. Yes, some have sold and hope to "wait it out" in a rental for a while. But even Randy H will agree (I think) that this strategy is cumbersome and low yield. If you were planning to sell anyway, okay, maybe renting a while isn't a bad idea (our case). Doing it solely for the purpose of profiting from market fluctuation seems not a great idea IMO. Wouldn't it be less cumbersome to time the stock market :) ?

The better "arbitrage" is to sell in a high-cost area (BA) and move to a low cost area and profit from the housing cost differential.

theotherside, I just don't know what your point is? And to whom are you trying to make this point? Nobody here is saying you should sell your $1.0m house that you bought in 2000 with 20% down and a FRM, if in fact that's your situation. So who cares about this time-machine-financial-analysis? What's the point?

Doing it solely for the purpose of profiting from market fluctuation seems not a great idea IMO. Wouldn’t it be less cumbersome to time the stock market :) ?

Did not intend to be a flipper, but I bought and sold in just 2 years. 2004-2006. Got in with next-to-nothing down and walked away with more than one haha, tax free. To make that kind of cash with almost nothing down is not easy to do in the stock market.

@theotherside

You are smarter than Casey. You are smart enough to weave your bullshit here with reasonable coherence. I still think you should have stayed in IB. Even you have to admit you'd have made more $ if you had, even if you raked it in during the RE bubble.

By the way, I'm still waiting for your criticisms of "The Bubblizer". You keep throwing numbers around as if you haven't forgotten how to RPN on your 12c. So, show me where the model is flawed. Excel won't kill ya. Just breath deeply, collect your thoughts, keep both hands on top of the table, and do some (wait for it) 'analysis'. I know you know how to do analysis.

Now to deconstruct a selected samples of your bullshit:

You have to be able to afford the payments
That’s the idea of getting a fixed rate :-)

Fixed payment loans are more expensive (the payments are higher) over the early loan because, well, the lender demands higher premium for fixing rates.

Housing prices are _not_ very well correlated to interest rates
Not true if you control for inflation

Show me the data. Wait! You can't. And there's a little principle called "The Fisher Effect" which makes your statement simply ignorant. If interest rates are tied to inflation, how do you control rates for inflation? Boggles the mind, I'll tell you. Congratulations, you win a double score -- wrong about the data and wrong in your explanation.

Accountants won’t be able to do much with most people’s taxes
Youa re free to make your baseless assumptions but after having been called Casey Serin on this board, it can only be uphill from here

Baseless: see your previous bullshit comment.

1- Ok, YOU ARE RIGHT, I forgot to add about $500,000* 0.12 = $60,000 (but I doubt it will change the conclusions)… :-)

Silly me, and here I thought I earned right around that amount in the first year alone, with a market risk of less than 0.2, at about 96% tax exemption. A return of 0.12 would be a market risk of like 0.05. I guarantee you my invested equity is marginally safer from $USD pressures than is your home. Or are you paying your principal, interest, taxes and insurance in euros?

2- I assumed 5.5% for realtor fees and 1.5% for transfert fee & sales tax & various fixes not 7% relator fees

5.5%??? I didn't even pay f-cking 5.5% when I bought my last house in 2002. The agents split 3.5%, and I paid about 2.0% under asking (yes, not all homes went in bidding wars -- I never competed for a home). No one with half an ounce of grey matter pays anything close to full commission on expensive homes. I know agents are splitting less than 3.0% these days on some deals for homes over $2m.

Hey! You never answered last time you were around here. I'll say it slow for you,

w-h-a-t ___ d-o ___ y-o-u ___ d-o ___ f-o-r ___ a ___ l-i-v-i-n-g ___ ???

skibum,

selling in the high cost area and buying immediately in a low cost area is the fastest way to piss away hard earned (ok, perhaps not that hard) equity. The best way is to sell in the high cost area and rent in a low cost area and wait for re-entry point after the crash.

Many people who left California adopted this strategy of selling out and buying immediately in another low-cost state at the height of the bubble in 88. I heard from several people who did that, all of them confessed that by parking their money in a house that appreciates much less than homes back in BA actually ensured that they could never come back to buy again, while their initial intention was to wait for a re-entry point into the Bay Area in a state of lower cost of living. What they forgot was, their house doesn't move up as fast when things recover, and when things tank in general, their state where there are fewer higher-paying jobs tend to have a harder landing in housing compared to the BA.

I think what Randy did was fine, if I were in his situation (pocketing all gains tax-free, and locking in a higher tax-base), I would have done exactly the same. People who sit tight are usually those who got in with a very low tax base and therefore become enslaved by prop 13.

Oh, and I sold my house for life reasons, not because of the bubble. My decision was not to sell, I had no reasonable choice in that matter. My decision was _not to buy back in_ because there was a bubble.

There is a big difference, and you know it if you think back, real hard, to your (dare I say it) analysis skills.

(not aimed at you OO, but at "thebizarroside")

theotherside,

you conveniently forgot that by selling Randy's house at $1,500,000, he actually set free his initial down payment, $200,000, and pocketed $500,000 tax free. Taking out the 5% transaction cost of $75K, he now has $425,000 net earnings plus $200,000 dp, a total of 625,000.

So what does Randy do with $625K? Assuming 4% after-tax CD, $625K is yielding $25,000 a year, a total of $125K in 5 years, ignoring compound interest and possible rate hikes. Now he has a total of at least $750K by 2010.

5 years later, buy back the original home of $1M, he puts all the cash accumulated from the previous transaction back into the house. Assuming 2% closing, $20K, he puts altgether $730K down, taking out a mortgage loan of $270K.

Meanwhile, while you do nothing, you still have a loan balance of at least $750K in the same darn house in 5 years. As you said, it is all about the cost basis.

I am not even starting to count Randy's cash flow from rental savings to stay in the same home.

OO,
I'm not talking about parking your cash in a home in a lower appreciation rate location. I'm talking about pocketing the difference and placing it into other investment vehicles. A location arbitrage makes sense to me mainly if for life reasons you want to move anyway. And the way the BA is headed, there are many (nonfinancial) reasons to move away!

Thanks OO. *Not all numbers above are specifically precise; but then I don't really want to publish my tax returns, given I'm not running for office (so far as I'm aware).

But in general, a relatively modest retracement of home prices results in multiplied advantage when buying back in. Because, as you said, it's all about cost basis.

All of 'thefantasyworldside's scenarios are carefully and purposefully dependent upon a very narrow price correction. She also conveniently switches between nominal and real to prove her points.

Nominal to real to unreal...

New thread Mail in the Keys

WHY would he buy back the house? Given the rent being paid, it is only worth 300K. If the spread remained, say both go up at 5% a year, post bubble he still should not buy. Given you scenario, yes, selling and then rebuying is silly, but this scenario I would not buy it back. You get the 4% which would be higher if you are claiming mortgage rates going up in the future. Anyway here are how your numbers spell out.

Net gain on the house $395,000 (1.5 mil x .93 - 1 mil orig cost)
$395,000 + $4700 (mo savings put in savings) per mo at 4% net after tax
at the end of 20 years he has $2,600,000 in the savings account. (You and I both know you can do better, I can get 5.5% right now at WAMU!)

You keeping your 1 million house average 5% appreciation per year for 30 years = $4,321,950 - less the original $1,000,000 is

$3,321,950 Gross profit less:
$354,970 Net prop taxes (1.25% rising 2% per year 507101 * .7)
$770,603 Total interest with tax break (1,100,800 * .7)
$302,536 Selling costs (7% at time of payoff)
$300,000 Maint (10K per year, on a 1 mil house that is cheap!)

Total mo payment is $6737 PIT&maint w tax deduction incl.

Net profit is 1.53 million to buy
or 2.6 million to rent

Renting is clearly the better option under your scenario.

The Other Side

Hey Randy H, my friend, You really don’t get it?

Ok, I will try a very simple example (ignoring principal) for you

1- Let say a builder sold us 2 identical houses in the same subdivision in 2000 for $1,000,000. We both put 20% down and get a 5.75% 30 year fixed mortgage.

2- It cost us $4,000/month { $4668 + $1000 (localtax+insurance+maintenance) }* 0.7 (tax deduction)

3- In 2005, you sell your house for $1,500,000 and I keep my house. You rent the exact same house for $1900/month (5668*0.3) and save $2,100/month.

4- Your monthly savings (assuming a 4% APY after tax on a CD) will yield an average of 12% over the 5 years or $141,120 (2100*60*1.12) out of which you have to pay $125,000 in closing cost (7% of $1,500,000 when you sell and 2% for closing cost when you buy).

5- In 2010 you buy back the same house with a 20 year mortgage at 6.5% (20 year to compare apple to apple, with higher rate to justify such a steep drop in house price due to FB’s unable to refi)

PS, I did this on the fly to respond to otherside so feel free to challenge my numbers, I'm pretty damn good but not perfect, and some people calculate things differently, although my way is normally pretty objective.

Tax break should be 40%, not 30%, imho. Fed + State is much more likely to be 40% for a home buyer. For me it is actually 46%.

Remove transaction costs from selling the house and compare the $2.6M vs. the home, It still favors renting, but only just barely.

The real problem with your analysis is that you compare "risk free gains" with home price gains, which are clearly not risk free. There should be some kind of discount for the risk you are taking in holding the home.

The 20 year average ex ante risk premium is about 3.75%. Ex post is much higher, about 6.0%. But then, I can't accurately predict ex post, ex ante.

But I'd agree that the "present value intangibles" tend to close the gap in favor of ownership, so long as the holding cost to rent ratio returns back to somewhere near it's long run equilibrium of 1.5-1.7. It's more than double that now.

You are correct about the tax rates (using his numbers) but thinking about it further a lot of FBs buying a 1 million dollar house are in the lowest tax brackets so 15% fed, and 6% or so state. ha ha ha

Another cost is that your gains free limit is 500K for a married couple (pretty sure) so there is capital gains tax on most of the windfall on that deal.

Transaction costs are a hard cost and do need to be included.

Another point is that house isn't worth 1 million so the assumption of a temporary 20% dip is the biggest flaw in the poposal, since I believe that house is worth less than 300K in present dollars (which does not change when adjusted for inflation in the future).

I am normally a big advocate of home ownership, just not during this inflated bubble. There are many intrinsic qualities of ownership even when the numbers are a push. This is a very severe case where houses were priced 2 and even 3 times what they are logically worth. Come on, 200K mobile home double wides WTF?

Jimbo, for me personally I discount risk from a cash flow, but realistically 5% as an average is pretty fair. You are technically correct.

A simple way to look at it is do you want to pay interest on someone else's million dollars to leverage 1 million in housing, or would you rather earn interest on what you can save each month with zero leverage?

One or the other will be the clear winner depending on the model. Some people go by emotion or rules of thumb, like I can have a dog, or I don't want to make my landlord rich. My rule of thumb is when it is close to a push, just pick the risk free option.

One of the things that people on this site forget is calculating the benefit of owning a house PAST 30 years. Yes, Randy might have more 'net worth' at 30 years investing rather than owning, but at 40 years, big difference. The reason a home is a retirement vehicle is it eventually DRASTICALLY reduces your monthly expenses when you've paid it off entirely.

Additionally, you can 'downsize' and own a smaller home outright as well and have another chunk of cash to live off of.

Unfortunately, many people these days don't treat a house that way. They treat it as an ATM, or when they DO retire, they trade UP houses, and wind up paying a mortgage all through their retirement. (And often use it as an ATM as well.)

SF Bubble, absolutely true. Two points though.

1. Small percentage actually stay for 40 years. Most people will be dead then at present life expectancy.
2. You are living rent free anyway because you can more than easily pay the rent from your interest earnings far sooner than waiting to pay your mortgage off.

The reason I put a liquidation sale at the end is because if there is no harvest at the end what's the point? The buyer saves 4.5million that he never uses? Then the return on equity at that point is 0, that's a bad move. I sold my houses at the peak because renting was a very low return on equity.

Another rule of thumb which worked well for me.

Time to buy = return on investment (fully discounted risk) is greater than other avenues.
** In other words don't buy a rental which doesn't have a cap rate higher than other avenues. Must also generate a monthly cash flow so watch the borrowing costs compared with the cap rate. I will never understand someone buying a rental with a negative income stream, that is subsidizing the tenants's housing.

Time to sell = return on equity (equity in house/income stream) is less than the safe rate. **careful to use this in a flat market because in a normal market your equity does well with leveraged appreciation. Appreciatin does need to be factored as part of the income stream.

Owning a home is a form of savings, technically, to an individual home owner. It is no different than putting money into a money market except for a different risk profile and some different math -- except for the loan. And, the present value of the loan (assuming fixed interest simple term loan with no penalty) is largely computed by 3 factors: leverage, tax shelter, embedded option.

I modeled everything but the PV of the embedded option in my Bubblizer. If you want to model that you can either use some very qualitative inputs into a real-option value, or you can value it like a callable bond.

Sensitivity analysis on present value opportunity costs reveals that two factors comprise nearly 50% of the action: Home Price and Tax Shelter. Mortgage interest rate, contrary to common belief and realtor rhetoric, is merely an average factor mathematically. Of course, things like interest rate have a larger psychological effect than their math would imply, therefore it can affect the macro market despite fundamentals.

Since most people don't understand leverage well, that leaves the tax shelter as the largest input factor which also correlates to its psychological impact on market behavior. I theorize a few things about why this is so: 1) people mistake or don't understand the difference between a tax deduction and a tax credit. 2) people hate taxes and feel any deduction is a greater gain than it is financially. 3) many people over-withhold their taxes causing bigger year end returns, which they are prone to attribute to home ownership even though only a portion may be due to the home mortgage interest deduction.

Also, when talking about long-term ownership to full equity, zero loan, the present value of the tax shelter reduces in sensitivity. That is because the deductible interest portion becomes less over the term, during some period of the term (depending upon one's age) taxable agi is rising for most people, tax rate/bracket adjustments always lag nominal income inflation (witness the current AMT situation).

Finally, once one "owns" their home outright, they are effectively renting to themselves for a discount (cost of taxes, insurance, maintenance and holding costs discount for risk). If we set that portion exactly to rent times a fractional constant, we can determine the value to the owner is only the amount "harvestable" from realizing their savings that sit in the form of a house.

All residential housing is eventually consumed or passed on to other savers through inheritance. There is nothing financially magical about a house. It's just a different kind of savings account with different correlations and risks, and a roughly constant potential long-term discount-to-rent.

God I'm glad I have finally found intelligent people to bounce these concepts around with.

Malcolm,

I still don't think you should add transaction costs at the end for the FB. You could just as logically add a transaction cost for the JRB at the end, which would assume that they would buy a house with their savings.

I don't see why anyone needs to sell their home at the end of analysis. Even in the case of someone dying, their heirs could just chose to hold onto the home, either to live in or rent out.

Which reminds me, does the basis cost for tax purposes of real estate get adjusted up the same way it works for stock? I am hardly in a position to do estate planning yet, but it would be an interesting thing to know.

@ eburbed,

I've come to the conclusion that EVRYTHING goes up and down together in the new economy. There is no benefit from diversification of asset class or international/domestic. It is all about liquidity. Is the spigot on or off? Lately it's off but at anytime the FRB may decide it's time to turn it back on and at that point your tech stocks will be moving up again.

Paul

'Which reminds me, does the basis cost for tax purposes of real estate get adjusted up the same way it works for stock? I am hardly in a position to do estate planning yet, but it would be an interesting thing to know. '

A couple of things since I think I know what you are asking:
Under prop 13 your taxable basis is based on the market value of the house at the time of purchase, and can also be adjusted at a time you add someone to the title or sell to a new buyer. The tax rate is a flat 1% plus local voter approved assesments. The assessed value varies with the market but it basically is irrelevant because the actual tax bill can only go up a maximum of 2% per year. It is capped. So in my case even though my house almost tripled in value, my tax bill is only about 10% higher than when I bought the house. 2% increases in property tax is nothing. It is a genuine perk.

If you are asking about the cost basis for depreciation, or for captial gains, the cost basis is what you paid for it, and you straight line depreciate the improvement portion over a fixed amount of time. I think it is 28.5 years, but I'm not 100% positive of the time period. This applies to investment properties since you have gains exemptions on your primary residence.

Jimbo, even though the transaction costs are significant it doesn't change the outcome. You are correct in your challenge, but again, I would have to say without a harvest there is absolutely no point to paying 3 times the monthly cost to live in the house. Someone would be better off sitting on the sidelines until either it seemed rents were going to skyrocket, or prices plummet to justify the decision.

The percentage of people who stay in the same house for 40 years is minscule. I'd speculate that it is less than 5%. In doing financial modeling you would normally use an average which currently is someone moving after 7 years. In that case, the proposal is ludicrous.

Sorry, I meant to ask if the cost basis got adjusted upward after you die.

If you own stock, when you pass it on to your heirs, they get the basis adjusted upward to the value it was worth when you died, potentially giving them a huge tax break. This is called a "step up in basis."

http://www.pathtoinvesting.org/fyp/cost_basis_stock/cost_basis_041.htm

Does real estate get the same break? Somehow, I doubt it, but I am curious.

Yes, I agree, for the average investor it makes no sense whatsoever.

But in modeling for a person's individual personal case, you can make different assumptions, based on what you plan on doing in your life, and see how the numbers work out with your plans.

If fact, one could argue that this is called "retirement planning" and doing a good job at modeling various scenarios and picking the best one is the key to prosperous and comfortable Golden Age!

Parents can transfer property to their heirs at the same cost basis in California. Also to a grandchild if the parents are deceased. This is up to $1,000,000.

A change in ownership includes almost all transfers of title in real property. Some changes of ownership that are excluded from reappraisal include the following:

The transfer of property between husband and wife;
The transfer of the principal place of residence between parents and children (and the transfer of up to $1 million of any other real property between parents and children) if an application is filed properly (Proposition 58);
Persons over 55 years of age can buy a residence of equal or lesser value than their existing home and transfer the current tax value to the new home within the county (Proposition 60).

Jimbo,

Your heirs get the property at the stepped up basis so there is a huge tax break when they sell (capital gains). Furthermore, because of Prop 58, you can pass on your property at its Prop 13 value. There are some limits which you can read about here:
http://www.boe.ca.gov/proptaxes/faqs/propositions58.htm#4
Overall, strong incentives to never sell a property once you have it. My (free) advice is:
1. Sell half the duplex to your renters (when are you going to see these prices again :-) )
2. Enter the condo lottery (you should win sometime in you lifetime)
3. Pass your condo onto your kids (in the mean time, rent it out or live in it).
Not financial advice.

Yeah EBGuy, I think that is exactly the best course of action, financial-wise. Condo conversion causes a step-up in Prop 13 tax basis, but we didn't buy *that* long ago.

I doubt this is going to happen though, we will probably end up keeping the whole place, but that is not a financial disaster either, just not the fastest way to retirement.

I'll bet a lot of attorneys are hating life since the Internet came on line. All of those links are money out of their pocket for legal advice. Life is good.