Saturday, 28 May, 2005

The Housing Bubble

Walk on to any car dealer's lot and engage a salesman.  Shortly after the pleasantries are done, he will ask you two questions:

  1. What kind of car are you looking for?
  2. What monthly payment can you afford?

Your answer to the first question tells him your dream.  Your answer to the second tells him your perception of reality.  I can almost guarantee that the finance company will approve you for a larger payment than you think you can afford.  Knowing this, the salesman will view your answer as a beginning negotiating position.  His job is to talk you into spending more money:  a higher payment amount, a longer term, or a lease.  The salesman will never mention the car's price.  That's irrelevant.  It's all about the payment amount.

Home sales have gotten a lot like that over the years.  "Cheaper than rent!"  "No cost move-in!"  "Own your dream home for under $1,000 per month!"  Advertisements very often will not include the total price of the home, or will include the price and finance terms in fine print at the bottom (or in "fast talk" at the end of the radio ad).  It's not quite as bad as with car sales, but it's getting there.  People aren't paying $150,000 for a house.  They're paying $1,000 per month (PITI).  That would be okay, except for a few major problems.

What does it all mean?  Consider Joe Average who bought his $150,000 home for no money down on an interest-only loan at 3.5%, with a five year adjustment term at which time he starts paying the principal.  Right now his interest payment is about $440 per month.  Add taxes and insurance, and his house payment is probably about $700.  That's way cheaper than rent.  You can get a very nice house for $150,000 if you don't mind a 45 minute commute into the city.

Joe is counting on his salary to increase in the next five years, so he's not terribly worried about the higher payment he'll have to make then.  Plus, he figures, if his salary doesn't increase enough, he can just sell the house and reap a small profit from the increased price.  It's a nice dream, and neither the builder nor the mortgage company is going to discourage Joe from holding those ideas.  They're wrong ideas, but following them seems to have worked for people in the past.

So what happens in five years?  First, interest rates have climed to 7%.  Joe's monthly house payment, including principal, interest, taxes, and insurance, goes from $700 to $1,200.  The economy is flat or maybe in a downturn so Joe can't afford that extra $500.  He'd like to sell his house, but there's a glut of homes on the market and the rising interest rates have depressed prices.  He finds that if he's lucky he could get $150,000 for the house before he pays the real estate agent's commission, but there are a dozen similar houses for sale in his neighborhood that have been on the market for over six months.  Joe's only reasonable course of action is to just walk away.  Besides, he bought the place for no money down so he really doesn't have much to lose.

I'm not just spinning a fantasy here.  Check out this Washington Post article.  People are buying more house than they can afford, interest rates are rising, and salaries aren't rising as fast as people are spending their future income.  We're in the middle of a housing bubble and I think we're headed for a crash the likes of which we haven't seen in a very long time.  This will be worse than the fallout from the late 1980s S&L crisis.  I think there are going to be many people walking away from homes that they can no longer afford.  A guy with cash will make lots of money picking up abandoned properties and holding them for a few years.

I've been known to be wrong from time to time, and I sure hope I'm wrong on this one.  But I fear that I've read these tea leaves correctly.  We'll find out in the next couple of years.