Selecting the Right House
by: Brent Orrico (Director Banner Corporation and President of FAO Corporation, an asset management company, and is a principal of B & O Financial Management Company, with which he has been affiliated for 14 years. Mr. Orrico also serves as a director of Islanders Bank.)
Much advice is offered to the first time homebuyer on choosing the right home. Most of it's bad! Rather than following the advice of late night infomercials and mortgage brokers operating out of the trunk of their (leased) cars, most homebuyers would have been best served to follow these three easy, common sense rules:
- 1. Buy a house you like living in
- 2. Don't buy more house than you can afford; and
- 3. When you're not sure, go back to rule # 1!
While these rules may seem obvious, we are experiencing a housing crisis today that could not have occurred if these had been followed by most buyers. So why do people use more care picking out an I-Pod than they do purchasing what is probably their most valuable asset? In many cases, it is exactly the fact that the purchase is so significant that buyers don't trust their own intelligence and, instead, turn to a gaggle of advisors, pundits, self-styled authorities and self-serving promoters to seek advice. The problem is, what you get is quite often a misleading cacophony of half-truths, generalizations, exaggerations and, my favority, conventional widsoms.
So why isn't the conventional wisdom reliable? Well, first of all, if conventional wisdom in the investment area were effective, everybody would be RICH and no one would need advice from experts. Unfortunatley, most conventional wisdom is best described as wishful thinking without using any math. Particularly in the areas of finance, economics and investment, where most people feel a bit uncomfortable in DIY mode, a horrendous amount of misinformation gets passed around widely and often enough to become, eventually, so ingrained in our way of thinking that one can hardly be convinced it is total nonsense. Here are a few pertinent examples.
A HOME IS A GREAT INVESTMENT. Hardly. A residence is a necessary investment, like kids' braces. It can also be a "good" way to preserve capital and keep up with inflation. It can also be a source of great satisfaction and enjoyment, not to mention security and well-being. These are not insubstantial factors and should never be down-played. But purchasing a home because of its investment value is practically never a good decision, even when housing prices rise after the purchse.
Yet, I will always get a room full of dissent and counter-argument when I make this statement, despite the fact that over a quarter of today's homeowners owe more than the value of their homes, foreclosures are approaching Great Depression volumes and short sales outnumber regular transactions in almost every major market in our country. The argument goes that this market is an "aberration" (yeah, and so was the one in the early 1990's, the late 1970's, the 1960's and from the beginning of the Great Depression until the end of the Korean War, just to trace the last 100 years), or this was caused by Wall Street, or Congress or the neo-Fascist world conspiracy! The fact is, it was caused by the same thing that causes all price changes: Supply and Demand. We built too many houses given the number of qualified buyers; hence, prices declined, and, with them went the equity of over-extended (often with second mortgages on top of the firsts) home owner/borrowers who really believed (now I know who watches Survivor and thinks it is real life!) that housing prices always go up.
The drawback to home ownership as an investment is that (1) buying a house is expensive, maintaining a house is expensive and selling a house is expensive and (2) even if you sell it at a "profit," (sic) you still have to find a place to live. And, guess what? While your house was going up in value, so were all the others, including the next one you are going to buy!
Beyond the cost of the home and the requisite downpayment, buying a home with a mortgage carries what the industry refers to as "Closing Costs." These can range from a few hundred dollars up to as much as 5% of the purchase price (remember, the down payment is not included here). Then you have to maintain the home, an expense that has a bit of sticker shock for most first time buyers. There is insurance, utilities, real estate taxes, upgrades, maintenance-no, you can't call the landlord anymore to fix the leaky pipes-and, eventually, the replacement of most of the major components of the home.
There's also interest on your loan. Now, yes, we know it's deductible. But what does that really mean? For sure, it does not mean you reduce your tax bill by the amount of the interest you pay. It only reduces your taxable income dollar for dollar. But, for a lot of first time homeowners, particularly with families, the rate at which their income is being taxed may be less than 20% (your "marginal" tax rate). At the 15% tax rate (think family of four with income of $70,000), every $1,000 you spend on interest only saves you $150. Same goes for real estate taxes. And you thought you were "wasting"" that $1,150 a month you were paying for that 2 bedroom apartment.
But the fun really starts when you go to sell. Unless you are clueless enough to believe you can sell your home yourself without taking a big discount in price, you will engage a realtor, and he/she will charge you 6.0% of your selling price. Not to be outdone, the State will get another 2.0% out of you in transfer taxes, recordings, title insurance, etc. Oh, and did we mention the realtor insisted you REPLACE that old roof of yours ($26,769) or they couldn't sell your house without a big-time disclosure to the buyer. And, about those old carpets in the living room. . . .
So, forgetting about the cost of maintaining the home (hey, you did a lot of the work yourself!) and even ignoring the cost of the new roof, you paid about 2% getting into the home in closing costs and about 8% selling it. So, you needed to have the actual sales price of your home be 10% higher than what you originally paid for it just to BREAK EVEN. (Here's a good time to go read Rule # 3 again)
By analogy, compare "investing" in a home and "investing" in a company like, say, Boeing. If I spend $10,000 on Boeing common stock, that's all I ever have to spend. No mainenance, no insurance, no roof! In fact, in good times, they might even send me a dividend. If Boeing stock goes up 10%, I pay a small commission and keep the rest. If it goes down 10%, I can sell and keep 90% of what I started with. But most importantly, I don't have to own Boeing stock. When I sell, I can put the money in my pocket. If I had to buy the stock back-like I have to buy a house to live in when I sell the one I was living in-I have gained nothing from an investment standpoint.
Compare that to your house purchase. If you put 10% down to buy a home, and it doesn't go up in value so that you sell it for what you paid, after your 10% selling costs, you lose your entire investment. And we already described what happens when it goes up 10% in value.
So why aren't houses GREAT investments? While the great social commentator, Will Rogers, was correct in advising his audience to "buy real estate: they aren't making any more of it!", the reality is that a home-except in cases of substantial (read: Expensive) additions and improvements-is a static asset. A three bedroom, 2 bath, 2 car attached garage home will always be a three bedroom, 2 bath, 2 car attached garage home. It will just be older! In fact, without all that maintenance stuff we discussed, it eventually will be a three bedroom, 2 bath, abandoned home, with a 2 car attached garage. By comparison, a company, like Boeing, if successful, is a dynamic asset that grows and changes. It can increase its market share, improve its profit margin, add product lines and generally increase its total value. A home, conversely, incurs a change in value primarily through population growth (more people, no more Earth) and the nominal inflation of the value of the currency.
"But,"" cries conventional wisdom, "THERE IS ALWAYS INFLATION!"
Actually, that's not true nor even close to true. If you study a chart of inflation rates in the US going back to the first condo at Jamestown, you will find that, though periodically broken by short term inflationary periods, and, for that matter, short term deflationary-read DEPRESSION--periods, usually resulting from banking panics in the pre-Federal Reserve days, inflation has been the exception, not the rule. Unfortunately for most of today's observers, one of the most egregious exceptions to the Rule occurred in the 1970's during the OPEC crisis. Inflation rose to double digits for half a decade, adjustable rate mortgages reached rates in the 20's, and wage and price controls were effected by one other than your United States, we of the free market system, of America. This was an event that tainted the perspective of many considered to be financial "experts" today.
The crisis also led to the deregulation of oil prices, airlines and the banking system (interest rates on savings accounts used to be regulated by the government). The effect of these deregulations was to begin the wringing out of the inflationary structure that had been created in the US by years of war, social engineering and cold war fears. Since that time, sustained periods of inflation have not existed, culminating in an environment today where "inflation-indexed" benefits from the government are actually scheduled to decline due to deflation (but, don't bet on it. Congress isn't very good at letting its constituents whine!)
"Hey, but housing prices did rise during the early 2000's, in some cases doubling and tripling in value! What about that, smart guy?"
Yes, prices did accelerate in the early 2000's, primarily as a result of a shortage of housing that occurred at the end of the 1990's when the economy was stagnant and the construction industry was scared feces-less by the impact of 9/11 and memories of the last housing collapse, followed by very low interest rates and a Congressional effort to make everyone a homeowner (see below). Where the percentage of American families that owned a home had hovered around 60% since the end of the Viet Nam War, the actions of the government to provide financing to all potential homebuyers (read: Sub Prime, Alt-A, No Doc. . .) the percentage jumped to nearly 70% by 2007. That's a lot of purchasing power-we economists like to call it DEMAND-chasing after the available supply of homes. Simple economics: more demand leads to higher prices. Higher prices led to higher loan amounts, and, eventually, bigger collapses. Now the market is faced with not only a bad economic environment littered with thousands of unsold homes, but also the reality that we will probably slide back to the 60% home ownership level that appeared to be an equilibrium point for many years. That means that nearly 15% (10/70) of the homeowners at the peiak of the market will not be buying again, but rather will return to being renters. So the market will have to absord all these unsold homes with a shrinking number of qualified buyers. "But shouldn't we be creating more, not less, home owners?"
Hey, there's another conventional wisdom. HOME OWNERSHIP IS THE AMERICAN DREAM. Sure it is' if you're a homebuilder or a realtor! But I suspect for many underwater owners, it's now more of a nightmare. But, why did we believe this? Well, every member of Congress spouted it at one time or another. We gave tax breaks to home owners; set up huge government mortgage companies to help provide financing; created an entire savings and loan industry expressly for the purpose of financing home purchases; and decried publicly the unfairness inherent in the plight of people who didn't own a home. The infomercial at 2:00 am on the cable network told us we needed to own a home and that we would make a killing. The newspaper ads glorified home buying. And, it just seemed like a good thing!
Now, it is true that everyone needs someplace to live. A home, fitting your style and needs, and affordable given your expected earning potential, is ONE good way to meet that need. But broccoli is good for you, too, but that doesn't mean everybody has to eat it, nor does it mean the government should subsidize that one vegetable to the detriment of all other healthy foods.
Reality is that home ownership has its benefits and its costs, just like any other commodity in the world. But it is not an absolute best, or even feasible, solution for everyone. Fact is, there are a few very wealthy people who choose not to own a home, at least not as a primary residence, because they don't want to be tied to a single location and because they have better uses for their investment money. There are also many at the other end of the financial scale who, smartly, realize that if their income is curtailed, it is a lot easier to walk away from a rental then a big mortgage. Hence, Rule # 1; if it fits your style, go for it, but only bite off as much as you can chew. And, how much is that?
So: how much is all I can afford? An old rule of thumb in the industry was that your monthly mortgage payment plus one-twelth - or, one month's worth - of the total of your annual real estate tax and home owner's insurance should not exceed 35% of your monthly gross income. Violate this rule at your own risk.
ADJUSTABLE RATE MORTGAGES. Whether it rose to the status of conventional wisdom or not, many first time home buyers were led into adjustable rate mortgages to finance their homes on the premise-and I am not making this up-that by time the rate adjustments made the mortgage unaffordable for them, they could sell the home for a nice "profit."" (And then do what? asks the cynic! Buy a smaller home you can actually afford? Move back in with Mom? Do another ARM and figure this time it'll all work out? That's what crazy people do: perform the same act over and over expecting a different result each time!). Adjustable Rate Mortgages are actually a very effective financial tool when used properly, but the use to which they were put in this housing disaster was the farthest thing from propriety.
The characteristics of an ARM are that the initial rate (it's known as a "Teaser" for a reason!) is not only below the true market rate for these instruments, it is normally a rate that will NEVER occur in a normal economic environment. So, a borrower needs to know that, once the loan adjusts, the payment will be higher, you just don't know how much. To offset this rise in rates, the proper application of an ARM as a financial tool would require the borrower to make a lump sum payment at the time of the adjustment to lower the outstanding balance sufficiently to maintain either the same payment as the original monthly payment or at least reduce it to a manageable level.
If your finances do not provide you with the flexibility to make these kinds of large sum "balloon" payments, you should not get an ARM loan. And if a fixed rate loan requires a payment you don't think you can afford, go back to Rule # 2!
Josh Billings
Josh Billings, the 17th century humorist, once said, "Advice is like castor oil, easy enough to give but dreadful uneasy to take." In the coming weeks we will be gathering and expressing sound advice for things Real Estate. Our goal will be not only to provide it, but provide it in a way that is "easy to take." Stay tuned.
By the way, Billings also said, "Genius ain't nothing more than elegant common sense."
