Buying a House - A Risky Proposition?
After renting four homes in the San Francisco Bay Area this decade, I bought a house last month. I had been a long-time advocate of renting rather than buying, so what drove me to buy a house now? Has the time come to buy a house as an inflation hedge? Buying a house should be a matter of risk, not price.
First, let's look at prices. Home prices have come down substantially in areas where subprime lending was most prevalent, but have held up better in more affluent areas. In Palo Alto, where I bought my house, prices are down, but not by much compared to the run-up in prior years. One reason is that the typical Palo Alto homebuyer had a greater financial buffer and may have been able to hold off selling their home if they don't like current market prices. There is also less pressure in more affluent neighborhoods because of foreclosures; note, by the way, that the recent abatement in foreclosures on a national level is mostly a reflection of bottlenecks in processing foreclosures - the pipeline of homes in various stages of default has continued to grow steadily. The reality is that many higher end homes in Silicon Valley have been bought with "options money" - that is, the cashing in of previously awarded stock options. However, the number of potential homebuyers able to purchase with "options money" is presently very small. As a result, while home prices in higher end neighborhoods in Silicon Valley have held up longer, the downward pricing pressures may last longer. A similar analysis can be applied to other regions; further, as baby boomers retire, fewer McMansions will be needed, putting long-term pressure on high-end real estate. As a result, my assessment is high-end real estate is likely to lag in any housing recovery. In the same context, consider the trend to have bonuses vest over years with claw-back provisions (in what may be the beginning of a trend, Goldman Sachs just eliminated the cash element on bonuses for its top executives). While that may be healthy (although never underestimate the creativity of con artists amongst them to hide their dealings throughout the vesting period), that is bad news for New York and Connecticut luxury goods dealers and real estate; New York governor Paterson has realized that tax revenues have also evaporated, and is now urging banks to pay bonuses. But I digress...
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A lot has been said about the affordability of homes; even with the price adjustments to date, a dual income family can barely afford a home. 50 years ago, a single breadwinner in the family with an average income was able to afford a house. Because of various government subsidies - whether through subsidized loans (think Fannie Mae, amongst others) or artificially low interest rates - home prices have been pushed to artificially high prices. Many of these policies are put in place with the best of intentions, but all efforts to make homes more "affordable" have actually done the opposite for future buyers. If you want affordable home prices, don't subsidize buyers.
Fannie Mae was first established in 1938 to promote home ownership to low-income families; the scheme it promotes lasted for 70 years before it imploded and the government had to take Fannie Mae into conservatorship. Few have noticed that Fannie Mae, now that it is a quasi-government branch, continues to have access to the Federal Reserve's (Fed's) discount window. That's akin to the Treasury borrowing from the Fed, rather than issuing bonds to finance its spending.
The policies are designed to push home prices higher. That's because when a great number of home owners are under water in their mortgages, they may stop spending, pulling the U.S. consumer "machine" to a grinding halt. And that's policy makers' worst nightmare, as it jeopardizes their re-election odds. What is different about the current bust is that the Federal Reserve has teamed up with politicians to push home prices higher at just about any cost: ultra-low interest rates and aggressive intervention in the mortgage market through purchases of mortgage-backed securities (MBS) stems against natural market forces playing out.
Simplistically speaking, homeowners who are underwater in their mortgages have a couple of choices:
• Homeowners can work harder to earn more and pay off excess debt. Though, while that may happen on select cases, it is unlikely real wages will soar anytime soon.
• Homeowners can downsize. That's the healthiest choice as someone who downsizes will once again be able to save and one day, possibly, be able to afford that larger home. However, a homeowner who is subsidized to stay in a home they cannot afford may never be able to save, as all their hard-earned money is continually poured into the home; that person won't have the savings, either, to fix the roof or take care of other ongoing maintenance issues associated with home ownership.
However, downsizing implies foreclosures, bankruptcies, bank write-offs, not the type of headlines that get politicians re-elected.
• Receive a government bailout through inflation. If real home prices won't move up, the Fed can try to engineer a higher price level by flooding the market with freshly printed dollars. Just a few days ago, Fed Chair Ben Bernanke once again emphasized how going off the gold standard during the Great Depression allowed the Fed to allow the price level to rise. He cherishes that "flexibility". Of course it's difficult to engineer just where that inflation will fall, but if you create enough inflation, odds are that home prices may also rise.
Potential homebuyers will find reasons why prices should be lower; once they switch to being homeowners, many find thousands of reasons to justify why their home's value should be higher! However, when faced with such opposing forces, the decision to buy a home should not be an assessment of price, but one of risk. Can you afford not just the monthly mortgage payments, but can you afford it should the price of your home come down? Market forces warrant lower home prices to bring them in line with incomes; as such, that risk must be taken into account, even if we trust helicopter Ben to create house price inflation.
When discussing Sustainable Investing choices in my book SustainableWealth, I list renting rather than buying as a sacrifice. Beyond the reasons given here, Patrick Killelea in his blog eloquently lists many reasons why "it's still a terrible time to buy". Yet, when you rent, you have few rights as a tenant and you may be asked to leave your property when your lease is up; often, leases are only a year. In my personal situation - we have four children - it's not that easy to find a rental home that satisfactorily accommodates us, and every move is a hassle. Is it worth the many thousands one can save a year when renting? Looking at the pocket book, yes, but it is more of a sacrifice than, say, saving money with a low budget vacation instead of spending vast amounts for a stay at a luxury resort. My wife did also make the point that she would like to own a home before the kids are in college (our oldest is twelve; our youngest two).
Some have said that home prices have gone up since the beginning of the decade and we should have bought a house earlier. But these arguments miss the point about risk - it would simply not have been prudent for us, just as it wasn't prudent for millions of others. In our particular situation, we were investing a lot into our business throughout the decade; now that the business is running well, we can afford the risks associated with home ownership, including the risk that the price may fall.
But I was motivated by more than the ability to bear the risk. If you have followed my writings over the years and read my book, you know that I'm skeptical of the economic recovery. Specifically, I cannot see a sustainable recovery even if all the fiscal and monetary stimuli get the economy to grow in the short-term: if and when the Fed starts to tighten (raise interest rates or mop up all the excess liquidity), I'm afraid the economy may crash right back down, precisely because we did not allow homeowners to downsize, i.e. the de-leveraging to play its course. With too much leverage still in the system, the Fed simply may not be able to fight inflation without destroying all the "progress" it has achieved in reflating the economy. Because of this conundrum the Fed may find itself in, the Fed is, in my assessment, going to firmly err on the side of inflation: something that may push home prices higher.
One key reason why inflation may result from all the policies employed is that the money isn't flowing to the intended parts of the economy. Sure, those with pristine credit get financing at ridiculously low levels right now. But what about Dubai, Greece, Ireland or American consumers with scars on their credit history? For most of these groups, if credit is available at all, it is at a cost they can't afford. Because the money doesn't flow to the places policy makers would like it to flow, they print ever more money and institute ever more aggressive stimulus programs.
With that in mind, future access to credit is a real risk. Governments around the world will need to raise unprecedented amounts of money to finance their deficits. Will there be credit available at reasonable cost to you and me? Banks are racing to pay back government loans, not because they are suddenly so healthy, but because of the burdens that come with having the government question your business and compensation decisions. If you look at how the Treasury markets are behaving, you would think another crisis is just around the corner: one month Treasury bills recently auctioned off with a zero yield (negative after commission) - that's a few days ago (December 8th), not a year ago (click here for auction result) - and that's not a sign of a recovery. Sure one can argue that this means the governments will simply continue to print money in an ill-guided attempt to unfreeze the markets, but my concern is that unless you are in bed with the government, you may not have access to credit. And if you are a weaker government, you may also have an increasingly hard time financing your debt. Incidentally, the latest U.S. 30-year auction drew disappointing demand.
I am a big believer in scenario planning; if a scenario has a sufficient enough probability, then I take it into account in my investment allocation. The big advantage of scenario planning versus merely forecasting the most likely outcome is that one takes boundary conditions / black swans / flat tails / call them what you want, into account. Is a crash in this or that market likely? Possibly no, but is it a risk you can afford to ignore? It's important to move beyond analyzing, to implementation, otherwise the exercise can be worthless, or worse, you may incur significant downside costs.
Through a home purchase, I can extend the average maturity of my personal debt substantially through a conventional 30-year mortgage (maturity means the date on which a debt security is due and payable). Businesses and governments manage the maturity of their debt, and so can you. The U.S. government has the equivalent of an adjustable rate mortgage and in recent weeks has shown signs of shifting from shorter-term debt to longer-term debt. As the U.S. government refinances into longer-term debt, the cost of long-term financing for everyone may go up. This doesn't mean that I encourage folks to exchange their unsecured credit card debt with a mortgage where the creditor may seize your home, but if you access the credit markets through some other means - a car loan, a business loan or other investment property - accessing the mortgage market may be a way to lock in low long-term rates.
Of course there is the valid concern home prices may fall as long-term rates rise. I can't give specific investment advice in this analysis, but if you have debt, you may want to consider refinancing it to take advantage of current long-term rates.
In my situation, I bought a house to take the scenario into account that inflation may eventually push home prices higher. If the government actions cause inflation, but they can't stop it in time - and remember: nothing in this crisis has really worked out as policy makers intended - real estate may once again be treated like hard assets and investors may want to hold on to anything but U.S. dollar cash. While real estate is a hard asset, it has not been acting like other hard assets because of the leverage included in most real estate ownership; in a period of credit contraction, the weight of the credit contraction may be overwhelming. But pushed hard enough, real estate will at some point also join the rise of other hard assets. If we did not have Bernanke as the head of the Fed, I would assign this a low probability; but with him at the helm, I very much doubt he will deviate from his determination to move home prices firmly higher to bail out all those with too much debt.
Conversely, there is a risk to holders of U.S. dollar cash: cash is at risk of losing its store of value and investors may want to take a diversified approach to something as mundane as cash. As a result, I took buying a home a step further and hedged my down payment against a weakening of the dollar. This is not something I would necessarily recommend to others as such hedging carries its own set of risks and may not be appropriate for many; I engaged in this risk not because of some "profit potential" when measured in U.S. dollar, but because a) I see downside risks to the U.S. dollar and b) I can afford the risks associated with the hedging.
If my concern is right and inflation will be a serious problem, at some point investors may grab any hard assets, not just precious metals and commodities, but also housing, amongst others; in that case, it may be a profitable investment. As such, I see it as a diversification; however, for those who consider the same, do remember that housing is typically a highly leveraged investment and being wrong can be rather costly. In summary, I bought a house because I can afford to be wrong on the risk that inflation may get serious enough to push home prices higher.
In my book (just released - order now), SustainableWealth: Achieve Financial Security in a Volatile World of Debt and Consumption, I dive into the dynamics that drive this world before discussing how you can invest in a boom, in a bust, in a personal or economic crisis. Make sure you sign up for the newsletter and follow the blog.