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Inflation and Housing: Calculating the Bust   (May 25, 2006)

Astute reader Richard C. was kind enough to send me a link to UCLA economist Christopher Thornberg's talk on the California housing bubble.

Richard described the program thusly: "Although a bit long to watch in the front of the computer (58 minutes), Thornberg's talk is a tour de force performance by a mainstream economist." I heartily concur.

So what are Thornberg's conclusions? His best-case scenario: no appreciation in housing through 2011 or 2012. In other words, the house that sold in 2005 at the top for $400,000 will still be worth $400,000 in 2012. Well, you sigh; that's not too bad, right? At least they're not losing money.

Alas, if only it were true. At the very modest rate of 4% inflation, the $400K house will decline to $301,000 in real dollars. Although I drew a straight line for simplicity's sake, the calculations were not straight-line. Here are the annual values after the 4% inflationary haircut: 2005: $400,000 2006: $384,000 2007: $369,000 2008: $354,000 2009: $340,000 2010: $326,600 2011: $$313,600 2012: $301,000

You might reasonably ask: if wages are keeping pace with inflation, and interest rates remain low, why wouldn't housing rise with inflation?
Thornberg's answers:

1. the U.S. and yes, even California, has experienced massive overbuilding; the number of homes built has far exceeded the growth of households. This overhang will suppress prices for at least six years.
2. The end of the bubble will cause massive job losses in the very categories which have propped up the economy: building, financing and furnishing millions of new or rehabbed houses. These job losses will knock the job-prop out from under housing values. And as everyone knows, housing declines when jobs disappear. So that's why this is a best-case scenario; a worst-case scenario would be a 25% nominal decline plus the 25% real-dollar decline due to inflation.

Watch the presentation, look at his charts and prepare to accept the realities he documents.

OK, so the homeowner is down 25% by 2012; that's not too bad, right? But wait--we forgot about subtracting the costs of ownership and the opportunity cost. As readers have pointed out, I have under-estimated both the opportunity cost (the cost of leaving a down payment sitting in a depreciating house rather than in, say, high-yield corporate bonds paying 6% annually) and in the cost of ownership above and beyond the rental price of the same house in the same neighborhood.

The proprietor of the excellent View From Silicon Valley blog wrote to explain how I had likely over-estimated the tax benefits of a mortgage deduction and under-estimated the property tax costs of owning compared to renting. In a previous example regarding a hypothetical $400,000 house purchased in 2005 with 20% down and a conventional 30-year fixed-rate mortgage of 6%, I had estimated the Value of the tax write-off of mortgage interest at $6,000 and the annual Net loss in owning compared to renting at $6,000. View From Silicon Valley noted:
This ignores the standard deduction. (I think it's now close to $10K for married tax filers?) Thus, the net savings on taxes may be zero, depending on other deductions. (Admittedly, even a moderately sophisticated buyer --one who actually does the math and is depending on the $6K deduction to make the buy decision work-- probably has other deductions.)

Also, I noticed you omitted real estate taxes in your example. On a $400K house at 2% (less in California, more in other locales), that's another $8K. Admittedly this is also deductible, so "only" a $2,960 deduction. In addition, Property Tax is among the first tax deductions you "lose" when you hit the AMT (Alternative Minimum Tax) which may be a big surprise if/when Congress fails to extend the current rules.
Another knowledgeable reader, Wayne D., describes the opportunity costs of owning a house, and provides a careful analysis of the costs of renting vs. owning:
A small, but significant point left out of your analysis is the opportunity cost lost of the $80K (down payment). That's about $4K per year at 5% interest, which should be put into any equation evaluating losses. That increases their total losses because the $80K, of course, was tied up in a losing investment when it could have been earning interest.

I recently did an analysis of rent vs. own when it comes to having a large downpayment (we sold our house a year and a half ago, and are now renting). My analysis showed that the larger the down payment available, the higher the total increased cost, compared to renting. Ironically, the less money you have in the bank, the closer the numbers become (rent vs. own). In the case of a 50% down payment, the cost to own vs. rent was a multiple of 15X! The majority of this came from the loss of income from the down payment, and included all elements of the equation (prop taxes, insurance, tax breaks, maintenance, etc.).

I hadn't seen anyone analyze this previously (as everyone seems to have no money these days), but it's a real question when you consider people (like me) who would be trading up versus renting.

Here's my quickie analysis.
To summarize: if the buyer of a $400,000 house in 2005 had taken a conventional mortgage of 80% and made a 20% down payment, then we have to figure the opportunity cost of that $80,000 which is "dead money" in a non-appreciating real estate market. At a very modest 5%, (you can get 6% or even 7% nowadays), the homeowner's $80,000 cash would grow to about $113,000 by 2012--a total of $33,000 in lost income they could have earned had they rented rather than owned.

Given the complexities of calculating the tax benefits of mortgage interest (about $19,000 in our hypothetical example of a $320,000 fixed-rate 30-year mortgage at 6%--check calculator at MSN Money yourself to confirm) and the local costs of property taxes and insurance, I believe an estimate that it costs $500 more per month to own a $400,000 house than it does to rent an equivalent home is conservative; in much of the nation, I think $1,000 a month would be a more accurate number.

This conservative $6,000 "annual cost of owning" works out to a net loss of cash in the household by 2012 of $42,000--more, of course, if that $6,000 had been placed in an account drawing 5% interest. Added to the $33,00 in opportunity cost, this household would be $75,000 poorer by 2012 than a family which had rented for those seven years.

In terms of a family balance sheet, the renting family is $75,000 richer and the homeowning family is $75,000 poorer. In terms of assets and liabilities, we could deduct this loss against the family's assets--i.e. the $400,000 house.

The point is simple: without significant annual appreciation, owning a house which was purchased 2004-2005 makes poor financial sense. If there isn't annual appreciation above and beyond inflation, then owning a house is, in a strictly financial sense, a bust.

For more on this subject and a wide array of other topics, please visit my weblog.


copyright © 2006 Charles Hugh Smith. All rights reserved in all media.

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