Tuesday, February 06, 2007

Timeless advice on lifetime home purchasing from iTulip

Earlier, 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.