I heard some guy, some housing analyst on CNBC yesterday, tell viewers that homes were more affordable in 2003 than they are today due to the fact that people had better access to adjustable mortgages and interest only financing. He went on to criticize Case-Shiller as being backwards looking, even 7 months old data. Further he went on to say that the market is poised to drop because we can see the sales numbers are declining and month over month appreciation has slowed to a crawl. As my wife likes to say, “What a dufus.” Let me explain.
First, homes are not less affordable now. Prices are only marginally higher than they were in 2003. We are at or around 2004 levels. Second, 5/1 and 7/1 ARM’s are still being used. I personally have never use a traditional 30 year mortgage. Others like me have not either and the reason is simple, I do not expect to pay off my home – ever. The reasons are many and varied. For one, I don’t plan on living here for 30 years. Two, I save a lot on money by carrying shorter term, thus lower interest rate loans. A 5/1 today might start as low as 2.625% for the first 5 years vs. a traditional 30 year which is around 4.375%. That is an enormous savings over the first 5 years. Enormous. Third, I am in my peak earning years and my taxes are at the highest level. I need the interest rate tax deduction. If I were to have paid down a traditional 30 year mortgage for 15 years, I would find myself paying more towards principle than interest, limiting and reducing my much needed deduction. Fourth whether my home sits at 80% loan to value or is paid off, the appreciation is the same. Therefore, given the high cost of real estate relative to other investments, I want as little money in the home as possible. This maximizes the rate of return on that money by using “leverage.”
Leverage comes from the word lever; think two rocks and a tree branch in which the branch serves as a lever to allow you to move a much larger rock than you could do without the 2nd rock and lever. Thus I am leveraging or maximizing the growth potential of my money. Here’s how it works: Let’s say I invest, $100,000 or 20% for the purchase of a $500,000 home. If that home goes up 10%, I am $50,000 ahead. What did I invest? $100,000. If I gained 10% on my $100,000 say in the stock market, my gross return is $10,000. Thus the advantage of real estate is that my $100,000 investment goes up by the percentage of the entire investment not just the portion I put in. So instead of a 10% return on $100,000, I get a 50% return ($50,000 gain is a 50% return on my $100,000 investment.) Moreover, the money that is not “stuck” in my real estate, is working for me elsewhere ie: 401K or even in additional real estate investments, which are taking further advantage of the considerable leverage real estate as an investment offers.
As for the idea that this market is somehow losing steam, all you have to do is look at the numbers in any given market and you will see that the market is slowing as it used to do every fall. Real estate is a seasonal business. People prefer to buy when the kids are out of school and not when it’s snowing or they are preparing to roast turkey. Moreover, the biggest reason for slowing sales is lack of inventory. This is especially true in California. Recently Toll Bros. acquired Southern California home builder Shapell Homes, for $1.6B. They reasoned that they picked up 5,200 lots in established neighborhoods, in communities where there is a shortage buildable single family lots. They showed a chart to their investors demonstrating that based on the 35 year average, California has under-produced homes over the past 7 years to the tune of a staggering 770,000 units. In other words, California based on 35 years of data is 770,000 units short just to keep up with its average population growth and family creation. Because the state is in such short supply of new homes (and even the housing permit report that came out yesterday said single family home permits were up only .8%. This is likely due to the shortage of buildable lots), we will be in a perpetual state of shortage for years and years to come.
I will conclude like this: Mortgage rates are compellingly low. 30 year mortgages are not the only game in town and as long as we have a continuation in the shortage of inventory like we currently have, the real estate market is going to remain stable, with prices increasing gradually. Appreciation is an inevitability not an anomaly and real estate remains the single most powerful tool for wealth creation.