Searches for house prices predictions are a frequent way people find their way to this blog. I imagine these are people considering buying or selling their residence. House price direction is less important to this decision than it might seem. What’s important is the amount of money tied up in a house vs the amount of value provided by owning the house.
Suppose the costs of interest plus taxes, insurance, and upkeep work out to 9% of a the cost of a home. The a $200,000 dollar home requires $18,000 a year or $1,500 per month. If rent on a comparable place is more than $1,500, owning it is providing net value. This formula works the same regardless of what percentage of the home is financed.
Generally houses that are well maintained stay at about the same inflation-adjusted price over time. Years where prices change 10% are an anomaly. They are rare, though, so you can safely focus on the calculation of the amount of money tied up in the house and ignore the unlikely possibility of price fluctuations.
A change in interest rate affects the whole formula. What if rates go from 5% to 10%? That 9% value becomes 14%. The reasonable price for a house drops considerably. Since rates are at an all time low, my guess is they will be going up and houses will be getting less expensive.
This guess on my part shouldn’t influence someone’s judgment. What should influence a decision is the comparison of the actual costs of ownership versus comparable rent in today’s market. If this formula tells you to buy a property and my prediction of falling house prices comes true, you still won’t get hurt unless you want sell that property and not buy another one. If my prediction is wrong and house prices rise, owning a house during that time won’t help unless you sell it and use the proceeds for something other than real estate.
The deciding factor should be “Does the property cash flow?” not “What will prices be in the future?”
I have never owned real estate investments apart from my own home. I would love comments from people successfully earning money in real estate who will certainly know more than I do.
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CJ - all the finance talk brought a tear to my eye...sigh.
ReplyDeleteJust wondering, were you a finance minor? I see that you are an engineer.
One suggestion, you have to adjust the interest rate down to take into account the fact that mortgage interest is tax deductible.
Two thoughts, there are several other benefits to home ownership. Principle accumulation, equity, improves your credit and you can turn up the music as loud as you want. In my opinion, these make home ownership less like a common good and more like a luxury. Put houses in a similar class as cars and compare buying to leasing.
Your taxes and insurance premiums also effect the discounted value of a home. My own area has extremely low housing values due to record high property taxes. As a result, property appreciation is flat. Taxes go up every year eating up the price accumulation.
I once did an economic model for home prices for a local realty. I found the biggest factors on price to be location, garage (because I live in NY tundra) and number of bedrooms. However, I did not do a time series including interest rates. Wish I had.
@conservative generation
ReplyDeleteThank you for the feedback.
My father is a banker, so I was exposed to finance at a young age. I don’t have formal training in it; it’s just a hobby. I have some unorthodox on the subject: Loans personally signed for by an individual are almost always bad. The idea of credit scores was created by banks to promote their products.
I will try to do a post soon answering your questions about the mortgage tax deduction, equity, credit score, and freedom to turn up the music.
CJ,
ReplyDeleteI completely agree with you. I myself rent and I never regretted a bit. Financial calculation was always in favor of renting. There are some items that are not easily assigned $$ value to (e.g. loud music) but regardless, renting has equivalent stuff: pick up and leave whenever you are not happy with your current school district!
But the best of all, there is so much better use for your money (comparing to tying it down in bricks as a down payment, and be on a mercy of real estate appreciation) that I personally have no inclination to buy a house at all (short of zero money down).
Using Pyramid Investing, one can make a fortune almost guaranteed and waaaay faster than even during the wildest real estate bubble appreciation era.