Predicing the Real Estate Bust and Transferring Risk

There is a good story on Calculate Risk on predicting how long it will take the housing bubble to deflate. If it follows that path of the LA housing bust in the early 90s, it will mostly deflate by 2010 and bottom out in 2013.

This is interesting, but market risk shouldn't matter too much to families buying a residence if the property costs less than the family's net worth.

Consider a family with a net worth of $300k in a $200k house. If real estate falls 15%, their house is worth $170k. They have lost 10% of their net worth. The costs of owning a home (insurance, taxes, maintenance, interest) predominate over movement in housing costs.

By contrast, if their net worth had started out at $30k, the change in housing prices would have wiped them out.

Both the $300k and $30k families should weigh the costs of ownership vs. the cost of renting and, all things being equal, should take the lower cost choice. The difference is the $300k family can afford to accept more risk. The $30k family might forgo owning a home even if it were the less expensive choice if they feel they cannot accept the risk of market fluctuations wiping them out. If they rent, their landlord is making a profit for taking the risk off of the family.

This payment for risk transfer is similar to insurance. Poor people pay for towing insurance on their auto policy until they save up enough money that they can easily handle the costs if their car should need to be towed. Similarly, people increase the deductibles on all their insurance policies as their reserves of emergency cash increase.

Poor people end up paying the rich to carry risk for them. Is this unfair? Should the economic system be changed to reward those who do work rather than those who take financial risk? These questions are way beyond the scope of this post.

The point is people should calculate how much risk their taking versus the benefit they're getting for taking the risk.

In my area this is a moot point when it comes to housing because the costs of renting a home are less than or equal to the cost of owning one. As the bubble deflates (probably in the form of nominal rents rising faster than nominal property values) and it becomes profitable again to be a landlord, people will have to ask if lower property costs are worth the market risk.