Timeless advice on lifetime home purchasing from iTulip
Posted by ML on February 6th, 2007
In an earlier post (at InvestMiddleWay), I wrote about how the stocks of home builders and mortgage lenders are diverging from the actual weakness in the residential market. In this post, I want to concentrate on the “real” aspect of the residential real estate market. I’ll start off by commenting on a lifetime home purchasing plan from iTulip and discuss my own view of housing valuations afterward.
For those of you familiar with Eric Jansen or his iTulip website, advice on buying homes is probably the last thing you expect. Indeed, iTulip first made its name by calling the tech bubble correctly. More recently, it has been calling for a popping of the housing bubble, such as this article in 2005. To me this actually makes them more credible as the source is free of the usual biases and ulterior motives. At any rate, I found the advice practical, prudent and well thought out. Here is an excerpt:
Step 1: Buying your first home*. Buy a modest house as soon as you can. That means a house that’s not as nice as the one you grew up in, and one that needs some work. But you’re young and smart. Swing a hammer. Slop some paint. It’s one that you can afford using the 20/28/36 mortgage rule… Consider a variable rate mortgage that doesn’t adjust for seven years. You may find it cheaper than a fixed rate 30 year mortgage. You’re going to move in four to six years anyway–this house is just a way to get to the house you want but can’t afford yet. No, not some suicide loan with a teaser rate that adjusts after the second full moon in the first year of the dog or whatever. If you are smart enough to be reading this but can’t understand a loan you’re offered then it’s garbage. Don’t buy it. Good loans are easy to understand.
Buy in a town with a good school system if you can because the price will tend to hold up better during inevitable real estate downturns. Don’t buy a house at the top of the market in a lousy neighborhood…
Step 2: Buying your second home. Four to six years later, sell the modest house and use the profit as a down-payment on your first good house. Again, look into an adjustable mortgage that stays fixed for seven years.
Step 3: Buying your third home. Four to six years later, sell the good house and use the profit as a down-payment on a great house. Take out a 15 year fixed rate mortgage and pay if off in ten years.
Using this method, by age 50 you’ll own a great home free and clear, while riding the real estate cycle up and down and without having to win the lottery.
What not to do:
• Nothing. Wait for money to fall out of the sky. As you can see, the process takes time. Starting a 20 plus year process works better when you’re 25 than when you’re 40. (See caveat*, below.)
• Buy more house than you can afford using the 20/28/36 mortgage rule…
• Purchase a suicide loan, liar loan or other horrific loan product. (These are soon to be nixed by regulators, anyway.) If you can’t afford a home with a fixed rate mortgage or a seven year adjustable on the 20/28/36 rule, look for a smaller house or condo or wait until you’ve saved more money and your income is higher.
• Consume your home equity…
Just as there is no more ludicrous form of slavery than the one we can impose on ourselves using unsecured debt to purchase depreciating assets like cars, there is no greater freedom than owning a home clear of a mortgage. Getting there isn’t rocket science.
Housing Bubble?
Of course this being the iTulip, there is a caveat:
* Note on Step 1, Buying your first home. We are early innings in a real estate bust cycle. These tend to last five to seven years but this one may last as long as (ugh) fifteen years, due to the extreme of the housing bubble. This boom peaked around the middle of 2005, and may not bottom until 2010 or even 2015.
Obviously, iTulip believe we’re still in the early aftermath of a housing bubble. Whether to call housing a “bubble” is just semantics, but it’s plain as day that prices have increased significantly in many coastal markets. The following article contains a table of 5-year (to Q1 2006) appreciation rates for 275 metro areas compiled by the Office of Federal Housing Enterprise Oversight (OFHEO). The gains range from a meager 8.32% for Lafayette, IN to a blistering 146.4% for Madera, CA.
The key question to ask at this juncture is what kind of appreciation is reasonable? I use a simple rule of thumb based on Robert Schiller’s work that in the very long term, home values only keeps up with inflation. For inflation, one can assume 3% per year if one wants to used the government CPI number; 5% per year is probably more reasonable if true living cost like food, energy or insurance are included; or one can use 7% based on M3 growth. I’m feeling generous so let’s use 7% for now. In five years, it gives an “in-line” appreciation rate of 1.07^5 -1 = 40.2%.
To appreciate how much home value have increased across the country, note that if we rank the 5-yr appreciation rates as compiled by OFHEO from the lowest to the highest, 40.2% (my in-line figure) corresponds to 151/275, 80.4% (2x in-line figure, getting warmer) to 213/275, and 120.6% (3x in-line figure, hot, hot, hot) to 255/275. 12 of the top 20 gainers are in California, the rest in Florida. Although more than half of the nations market appreciated less than the “in-line” figure of 40.2%, the value of the homes in the hottest areas are much higher. Consequently, the mortgage backed security market is dominated by issues from those areas.
If I were in California or Florida, would I start the long term home purchasing program as outlined by iTulip? No way! Had I been in one of the cheap locals? Absolutely! How about something in-between? As an example, let’s consider the city of Philadelphia that had a 5-yr appreciation rate of 74.29%. My quick rule of thumb says it was 1.7429/1.402 = 24.75% overvalued as of Q1 2006 as opposed to over 70% overvalued in Madera, CA by the same methodology. The answer here is not so clear cut. There are a number of other factors to consider:
- House values can revert to the mean via a combination of price decline and inflation.
- There are tangible psychological benefits to being an owner provided household finances are not stretched.
- Price and availability of rentals
- The length of time one intends to stay in the home
In the end, I can see a rational person going either way.
Obviously my rule of thumb is just that: a quick estimate based on a single variable. It assumes all housing markets are fairly valued five years ago and doesn’t take into account housing quality or other specifics. The OFHEO data paints a bleak picture for RE in the formerly hot markets in California, Florida and possibly Arizona and Las Vegas. Lenders and builders in those markets will be under pressure but the majority of markets across the nation will not be affected much. While it’s too early to call for a housing bottom or a soft lending, we will not have a great depression either.
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February 6th, 2007 at 6:41 am
A “Bubble”, well… there are certain areas that you hit on which have seen extreme price appreciations, but have come down from their highs. I’m not sure how you can put a price tag on say Philly being overvalued and compare it to California areas or Florida. I personally live in Florida and while I think it has become overvalued to an extent in certain areas, how do you compare Florida to Philly, Vegas, Cali, Texas etc. So as far as Philly being 25% overvalued as compared to Madera, Cali, you have to take many other things into the equation. Location, Location… Location, amount of land available, businesses in the area, salary, schools, ammenities etc etc.
I just don’t see how people can say this area is X % overvalued compared to site XY. If you compare them straight up, then yes it’s obvious to see the price increases, but that’s why it’s real estate and a house is an investment.
I also find it extremely hard to believe that the housing “Bubble” would continue through as long as 2015. I have not read the article, but does Eric Jansen go indepth about the % of correction he expects for certain areas? As we all know there are many other areas that will only appreciate over the next 5-10 years while other areas could slow and possibly fall, but I do not see a housing bubble for the sector as a whole.
I always find articles on other aspects of the economy interesting, but 2010-2015 is a long way off and in any market there are highs and lows and certain sectors which have runs and then have large drops. The housing market is no different, and while we have seen some large increases in coastal areas, there is no way you can compare a coastal area to Philly, and say the coastal areas are overvalued. There is no easy way to value properties, but people normally pay more for location, to include views.
The bottom line is certain areas are probably overvalued, but there is only so much land out there and even less coastal land. With the baby boomer generation about to retire, that is going to bring a mass exodus from the working population to the retirement areas.. and we all know were those are.
February 6th, 2007 at 10:45 am
Ray,
I think you’re reading too much into the article. My model, which I admit did not take into account many specifics of housing, looks at the RELATIVE appreciation rates versus M3 growth rates. No more.
When I say Philly is 25% overvalued, it means RE in Philly appreciated 25% above M3 growth in the preceding 5yrs. It makes no judgment of whether RE in Philly is over or undervalued, against any arbitrary standard or anywhere in California.
Desirability of location may well be the cause of the difference in appreciation rates but that is beyond the scope of what this simple rule of thumb is intended to measure.
As for Eric Jansen’s forecast. Let me say that all bubbles started as an idea with a sound footing which is why they attract a following in the first place. Bubbles usually last longer, grows bigger than anyone can imagine at the onset. Unfortunately, the same can be said for the contractions that follow.
I stress again that I was talking about relative valuation between Q1′06 and 5 yrs prior. As you said,
“The housing market is no different, and while we have seen some large increases in coastal areas, there is no way you can compare a coastal area to Philly, and say the coastal areas are overvalued. There is no easy way to value properties, but people normally pay more for location, to include views.”
I plan to revisit this topic in a year or two. I’ll make sure to look up Philly and Madera, CA again. I promise to look at the relative price change only, but I’m willing to bet that Madera will have dropped more (or appreciated less) than Philly. Any takers?
February 6th, 2007 at 11:11 am
Very informative post.
February 6th, 2007 at 11:18 am
My point was to present a more logical representation of the housing market. I was not trying to poke holes in either argument or documentation. I think my comments normally coorelate to the working class and more of a common sense approach.
As far as M3, goes I thought the government stopped providing that data and now only supplies M1 and M2 data. (M1 and M2 data – http://www.federalreserve.gov/releases/h6/Current/ )
M3 FYI: http://www.federalreserve.gov/Releases/h6/discm3.htm
February 6th, 2007 at 12:20 pm
Ray,
I understand the point you were making. I also know it’s a touchy issue so I didn’t want to go into it
FWIW, I believe housing in certain areas of CA and FL was in a bubble. The real sad part is the people suckered into buying houses they couldn’t afford with a load they didn’t understand.
As for M3, you can find “reconstructed” data from a couple of sites. The one I follow is http://www.nowandfutures.com/key_stats.html.
February 6th, 2007 at 8:49 pm
My take on buying your first home is as follows : Buy what you can afford. Be conservative. Only 20% of your gross monthly income should go towards your mortgage payment. If you are conservative, you can withstand the ups and downs of the real estate market better.
February 6th, 2007 at 9:24 pm
I earn minimum wage and there is NOTHING I can afford or qualify for.
All I see in my future are rent increases, homelessness, and destitution. How can I protect myself from these things?
February 7th, 2007 at 9:29 am
Terry,
If you only make minimum wage, I hope it’s because you do not yet have the job skills to make more. If you are young and are attending college, then you have plenty of time, if on the other hand you are in your late 20s or early 30s, then you need to look at getting some sort of education. A Degree is a degree, it doesn’t matter if it costs $200K or $15K. At the very least get your associates and use those technical skills to get a better job.
If you are only earning a minimum wage it is going to be much harder for you to be able to afford a home. If you do not see things changing in the future, you might need to move to a location that has a lower cost of living. You could look at buying a house, but renting out a room or two and have the renter pays your mortgage.
It’s never an easy thing, but striving to reach a goal over time will eventually pay off.
February 7th, 2007 at 9:33 am
In response to Mr Credit Card,
I don’t feel sorry for anyone who purchased a home at “inflated” prices. If they bought the home looking to flip, then it was a short-term investment and no a true home purchase. If they bought a home they could not afford, they did not do the math.
It is easy to get a 15 or 30 year fixed and know your payments. If they selected a 5 year or longer APR, they would also know what their payments would be and it hasn’t been 5 years. So, the only people who would be hurting are people who 1, thought they could flip their house and make a quick 20% or so, or people who did not sit down and calculate what they could afford.
I like your site Mr Credit Card =) but I just don’t think that anyone should feel sorry for people who buy things they can’t afford.
February 10th, 2007 at 9:57 pm
Terry,
Home ownership is not the only way to build up assets. A no-load energy fund may be a better way.
However, I agree with Ray that increasing your income potential is the more important thing in your life. It may involve getting more education or relocation. If you’ve decided the current arrangement is not working out, then you have to make some changes.