UT Sunday Home Section article “Is there a buble? Do the math”

[KingKong]

Have you read this article?

After reading this article, I am very worried about the quality of economic professors in this country 🙂

First of all, the method employed by this couple has long been the practice of real estate investor. I, for one, is a casual real estate onlooker, already use similar methods to evaluate deals.

Second, their assumptions about annual appreciation rate of 6% is laughable. Historically, just around 2% to narrowly beat inflation. Currently, there is no arguement that we are at a market top. Even the bulls admits that. The only disagreement is which way to go from here:
1. flat line for a while,
2. slowly downward, then recover
3. bubble burst.

What’s your take on their study?

[pencilneck]

Their study is total BS of course. This question and answer segment from There Is No Housing Bubble came to mind. Very funny stuff:

http://www.thereisnohousingbubble.blogspot.com

Question: Prices have gone up so much in the last 5 years. I’m worried about buying at the peak and overpaying for a house. The house I’m considering is a fixer upper in North Oakland. It is 1100 sq. ft. and needs a new roof. The asking price is $675,000. What should I do?

Good question. First of all, remember, you can not over pay for a house. In fact, as I proved previously, the more you pay for the house the more money you’ll earn in the long run. I know some deluded renters are screaming at their monitors right now “that’s the stupidest thing I ever heard!” Here’s the proof. Let’s say you buy that house for 675K and we’ll be very very conservative and assume only 10% yearly appreciation instead of the industry standard 20%. After 10 years you’ll have a little over 1 million in equity (even if you negatively amortize a few hundred thousand you’re still sitting on a mountain of cash). Now, let’s say you aggressively bid 750K on this Oakland charmer. After 10 years at ONLY 10% appreciation on the higher price you’ll have over 1.2 million in profit. That’s right, you made an extra $200,000 by “overpaying” for that house. As the math above proves you can not make a mistake of overpaying for a home. In fact the only mistake would be passing on that cute Oakland home.

[Bugs]

The idea of analyzing the value from an income standpoint is nowhere near new. I do it all the time when I’m appraising income properties such as apartments or office buildings or multi-tenant retail properties. Breaking the “income” down by net proceeds of the rent and net proceeds of the eventual sale and adjusting for the effects of inflation to render a current “value” indicator are also common valuation tools being used by appraisers every day. I don’t really see why the economics community is deeming this “new” other than the fact that Income is seldom considered to be the driving factor for properties that are primarily purchased by owner-users rather than income-oriented investors.

As has been alluded to above, when looking at an investment with a long term cash flow analysis, the assumptions used are critical. The article made light of “quibbling” about the assumptions, but when the holding period stretches on for more than a couple years it takes only very minor variances on those assumptions to completely dork the results. The reason for this is because of the effects of compounding. That is, an assumption of 6% average annual increase over 5 years will result in a 33% increase in the value. If you knock that assumption down to even 5% it reduces the increase to only 27%. So the difference between a 6% average increase over the next 5 or 10 years is going to be DRAMATICALLY different than an average increase of only 2%.

The other problem with their methodology is that they’re applying that average rate of increase based on the current price, not on the historical average upon which that increase is based. The historical average over the last 60 years is about 2% – 2.5% depending on which index is being used. But that 2.5% is based on the trendline itself, not any specific point that contributes to the trendline. The trick in doing Net Present Value (NPV) analysis is to reasonably forecast what’s going to actually happen during the next few years. If we’re on the down side of the trend we can reasonably project a higher-than-average rate of increase for the period starting low and going high. Conversely, if we’re at a high(er) point in the trend it would make sense to project a loss – not a gain – during the period from the high to the low.

So, if you think we’re in the New Paradigm where the old trendline no longer applies and the values will stabilize more or less where they are now, an assumption of a 2% average annual increase over the next 10 years would be reasonable. If you think we’re at the bottom end of a big increase then the 6% assumption would be reasonable. Personally, I don’t think either scenario is reasonable at this time and I’d be using a rate of decrease, not increase, to apply over a holding period starting right now.

In summary, I think the gathering of comparable data and their initial methodology are both reasonable, but parts of their application are poorly developed from a valuation standpoint. This is probably as a result of neither of these people actually being in the business of real property valuation – they’d get hammered if judged by our standards for not supporting those assumptions. They’re academics working in the macro, not appraisers working in the micro.

If there was any interest in doing so, we could build one of these NPV worksheets and see how the results turn out. We could do that by picking a specific property with a known rent, finding comparable sales data to determine a market value for it, and then running the income/expense, cost of sales and NPV calculations over a limited holding term to see how such an investment would stack up. We could even do a few what-ifs, using different assumptions to demonstrate the effects of those assumptions and to provide alternative ways of considering them.

Anyone interested in seeing the Pepsi Challenge?

[powayseller]

Hey Bugs, you’re a brainiac! If you took the time for the Professor Challenge, you could send it to newspapers, etc. In studies like this, the assumptions are crucial. You’ve outlined why their study is so flawed. I personally would have assumed a 10% annual decline. My conclusion would be to rent. This again goes to show that economists cannot be trusted just because of their title. I started a topic about economists we can trust: I figure anyone who didn’t warn about a housing bubble is not worthy of my reading. If these folks can’t see we’re in the biggest asset bubble in history, why should we read anything else they might say?

Of course, for the doubters, we must take the time to show the weakness in the paper. Bugs nailed it.

[BostonAndOC_RE_perspective]

I am another lurker deciding to join in…

I moved from South OC to metro Boston 3 years ago (job promotion). I work in sales for a Fortune 100 high tech company. I have a wife and 1 child, and make ~$150K (one income). We own here.

First, some statistics on the town I live in now:
Population: 25K
Avg household income: $95K
% adults >25 yrs with a minimum of a BS/BA: 49.5%
Avg house price: ~$500K

The only downside is that it is COLD in the winter, but the quality of education, number of educated people (all my neighbors!), cheap housing and Bay area-level salaries make moving back a tough decision. Being from LA, graduating from USC and living in SoCal my whole life, I miss the action. Here though, my boy could choose from Philips Exeter or Philips Andover or phenomenal public schools, likely giving him a better chance at the Ivies than 95% of CA public schools. He also has the advantage of my wife staying home with him, as I don’t need her income to pay our mortgage.

That said, we will likely be moving back in 1-2 years, and I am salivating at the market conditions we will encounter. Why? Because the vast majority of purchasers in OC and SD bought their houses in the last 2-3 years with nowhere near the income to qualify for conventional 30 yr loans in a tight credit environment. What do you call some joker making $80K a year taking on a $500K mortgage (and most are much larger)? An uninformed gambler. Talking to a friend that has been an OC mortgage broker for 13 yrs, these income/debt levels are the norm. I asked if she’s seeing $200-250K in annual income for a $600K mortgage. She laughed. The sad truth is that OC and SD lack, for the most part, high paying corporate jobs that require a degree or advanced degree. When 18% of the population could be one bad quarter away from selling used cars (all the RE people) one can see the makings of a localized economic depression. It reminds me of that clasic Doors song “Blood on the Streets”, except that instead of “the town of New Haven” or “Fantastic LA” substitute “OC and San Diego”. LA and SF/SJC have a much larger base of high-paying jobs that are non-RE related, and will likely be more resilient markets.

Thoughts from the forum?

[powayseller]

Welcome to the forum! Can you give us some info from out in the field? How is corporate spending? Assuming you sell products to companies, are they in a purchasing mood? Will company capital investment take over when the consumer slacks off?

As far as the economy, in my opinion, a recession is coming, and it will be nationwide in scope. I wish I’d received more feedback on my recession post from a couple days ago. Lest you think it’s gloomy, I believe a healthy economy consists of ups and downs, so a recession is natural. How many economists predicted a recession? Economists are usually full of hope, aren’t they, as they work for companies whose interests they must promote, or they are so far removed in an ivory tower, that nothing fazes them (sort of like those Ponoma housing bulls whose study was based on the ludicrous assumption that housing will go up 6% anually).

I also wrote a post about the SF housing market. It is more resilient, and was during the last downturn. I didn’t know why, but the higher-paying jobs are a plausible explanation. However, even there the ARM usage has been high, and wherever there’s an ARM, there’s a likely foreclosure lurking in the near future.

[BostonAndOC_RE_perspective]

Poway,
Corporate spending is booming. To put it in perspective, I just wrapped up an incredible Q1 that exceeded our quota to the effect we hit the 200% accelerator! I call on a Fortune 500 account (large OEM), selling specialized products for major telecommunications networks. There is a major network transformation underway for things like IPTV and mobility applications that is driving a big upcycle in telecom investment.

Any recession will be, IMHO, predicated by a weak consumer. Like I said, you have lots of people with high debt loads that lack stable 6-figure corporate jobs. Besides a professional income, I also have first-rate healthcare ($350/month for the family), a company car, stock options, and a PENSION! OC and SD just aren’t the place one finds these kinds of jobs, but rather the is the land of the small business owner, service professional (i.e. attorney) or RE industry tool. An engineer for my company living in SD probably makes $20-30K less than the guy working in San Jose, strictly due to the local “cost of labor”.

Everybody I know who lives in the Bay area makes >$200K. You’ll see ARMs, because even a guy making $200K has a tough time with a $1.5 million shack in Piedmont (premier East Bay family area). Chances are he’ll have plenty of qualified buyers there, however, compared to a guy making $80K trying to flip his $750K Irvine condo to a bunch of guys in similar economic boats.

Boston is unique in that most people are very well educated, and as such would never over-leverage themselves. My town is the kind of place where the guy down the street driving the 5 year old minivan is worth $20 million.

So in summary, any recession will be fueled by a lack of consumer spending. What will be interesting to see is whether business investment picks up the slack. And, oh, by the way, inflation? Double digit percentage raises were the norm at my Fortune 10 company this year. The skilled labor market, at least in high tech, is tighter than it has been since 1999 (though this can be attributed as well to 9/11 and the lack of visas available for the majority foreign-born US engineering and science grads). After all, how many of your friends have degrees in EE or CS? I’m the only one in my circle.

[powayseller]

Are sectors outside of telecom booming as well? Many companies are flush with cash, and using it to buy back shares, rather than spend it on R&D or capital investment. Why?

When I was at Neiman Marcus last week, the cosmetics sales lady told me their business was booming. They have the best store in their chain and have exceeded their quotas. But they cater to rich people (I only buy my face cream and makeup there). She gave an example of a recent customer, a lady who was there for only a few minutes and bought a $10K purse, two $10K necklaces.. She told me that her store is not subject to recessions, because rich people can always shop.

I hope corporations can pick up the slack for the consumer. But then, if the consumer weakens, why would companies invest in their growth? If sales decrease, wouldn’t companies cut back spending as well? If corporate spending increases, wouldn’t it be channeled toward cost cutting, such as getting a phone system to replace the receptionist, better inventory tracking, stuff like that?

As far as the degrees, my husband is a Professional Mechanical Engineer, I have a BS in Computer Science and MBA, and most people I know have computer or chemistry degrees.

[sdrealtor]

Sorry to jump in but this smacks of the “but it’s different in (fill-in the blank..in this case Boston) here” argument permeated by the permabulls. BTW, I havent checked lately but distinctly remember SD having one of the most highly educated populaces in the USA. We may be underpaid but we sure aren’t stupid. We are willing to make less to live in a better place. It’s sounds like you are resigned to this fact as well with a return planned in a couple years.

BTW, I have two master degrees and a wife that stays home with my kids also.

[uncle_git]

What sectors of telecomms are you seeing an expansion in at this point BostonAndOC_RE ?

I assume you work for IBM…

[powayseller]

Sdrealtor, I hope everything turned out ok with your son. You didn’t mention it again, so I assume it did. We do earn less in SD for the same jobs, yet pay more for housing (relative to the rest of the country). This double whammy is called the “Sunshine Tax”.

[lostkitty]

That is FUNNY stuff! Must be a professional comedian.

[Farls]

Boston,
You have provided some good info…I agree with you 100% that many in San Diego and OC bit off a lot more than they can chew regarding their home purchases. The income just does not support the purchase prices.

But, to say that people from Boston are too educated that they would never over-leverage themselves is laughable. Sure you have some minivan driving guys worth $5million…But you also have the Mercedes leasing people in debt up to their eyeballs. I’m sure Powayseller can find you some info on homes in pre-foreclosure now in Boston. American’s spend more than they earn everywhere…..

I’m not sure it was necessary to talk so much about your income and education. It seemed to me you were bragging about it. You said you were in sales…what makes you so different from a car slaesman or a real estate agent? I know a lot of “tools” in the real estate business who make a lot more money than you do….even one from USC…They could look at you and conversely say…”Look at that guy…He paid $XXX,XXX for the fancy degrees and only makes $150,000″…

[BostonAndOC_RE_perspective]

Farls,
You make good points, and as a first time poster I respect the feedback.

Believe it or not, people are incredibly risk-averse out here. The majority of my peers and managers have 15 year mortgages and are on track to pay them off early. I am an oddity in that I moved here. Most everyone else is from here, and would never leave. Mostly Irish guys, firmly rooted. Comparing this group to my peer group in OC, the difference in spending habits with similar income are striking. Its not fair to chalk it all up to education, but perhaps lack of exposure to the accoutrements of the “good life” that we all enjoy(ed) so much in OC is an education unto iself 😉 Incidentally, the areas in Boston that are seeing rising inventory and price cuts are in marginal areas that appealed to marginal buyers that were marginally qualified. You could compare these areas to an Inland Empire or Lancaster/Palmdale from a relative desirability perspective.

Lastly, I understand your comments regarding stating income and education. I did this to baseline my “demographic”, and then frame the comparison. I lived in South OC before we moved, and while the neighborhood was nice and mostly families, I believe that less than 25% of my neighbors had jobs that required a degree. Many of them sold for large cap gains, and aspired to move to Coto etc. So they make $400K on their home, keep $100, and put $300K down on a new $1 million home in Ladera Ranch. Now they have an exotically financed $700K mortage to service, but still on their relative OC median income of ~80K (or $160K if dual income). How will they do it? They have no idea. No knowledge of fixed income markets, no knowledge of the Carry Trade, blindly believing they will experience double digit appreciation annually, allowing them to perpetually pull cash out at low rates and postpone their day of reckoning. I feel for these folks, but they’re mostly uneducated and more likely to be caught up in a mania.

To do sales at my company, you are required to have a minimum of a BSEE/BSCS/BSCE. We are required to manage executive relationships, hit quotas for sales and demand creation, and directly and forcefully challenge our executives when they make decisions adversely affecting our customers. It takes a lot of confidence to demand accountability from a guy running a $1 billion P&L. I constantly try to get colleagues that work in marekting, business development etc to come out and experience field sales, but most people don’t have the stomach for it. So I guess you could say its not a whole lot different from RE, except that it requires a formal education and likely provides a more secure career path – and the chance to work around some incredibly smart people that serve to remind me that I am nowhere near as smart as I think I am sometimes.

I have a wide variety of friends, both childhood and college, that are in various aspects of real estate. One was a high school dropout and is now a successful residential agent, two others went to USC with me and are mortage brokers, and the most successful ones are in commercial RE. Their career earning patterns look like a volatile stock’s chart. The big difference between us is my pay goes up every year, guaranteed (barring a huge meltdown in semis or my inexplicable shift to a life of crime), and I control my own destiny. I’m also fairly young, and can expect some huge capital gains from my stock options and restricted stock grants over the next 20 years I plan to work. Retiring any earlier would be cheating myslef out of a bigger pension.

So I don’t doubt at all that you know many folks with no education making more than my stated income. But in OC and SD, the percentage of them that derive that income from a stable source (i.e. not fully commissioned) is small, much smaller as a percentage than Metro Boston, which is both Silicon Valley East and the #2 financial center after NYC (Fidelity and many other huge mutual funds are HQd in BOS). At the end of the day, its all about jobs, and OC and SD are sorely lacking in high paying professional job creation.

I look forward to the lively exchange of information on this blog.

[BostonAndOC_RE_perspective]

Uncle Git,
Optical networking is booming. Ethernet is spreading from the LAN to the carrier networks. The recent Infonetics report forecasts the Metro Ethernet market tripling to $15 billion by 2009. ILEC video distribution (IPTV) is finally putting all those miles of dark fiber washed clean by CH13 from Global Crossing’s balance sheet to profitable use.

You’re close, but my firm in HQ’d on the west coast. IBM doesn’t pay that well and they’re stingy with the stock.

[Author]

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