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Scott Burns' Articles -- Recent and Archived

The Sublime Beauty of Falling Knives

knife1.jpgWould you dare buy a house in California today? In spite of mind-boggling prices, the short answer is, "Yes--- under certain conditions."

This is not the answer I expected to find. Those of us who don't live in one of the "super cities" look at giant price tags on the coasts and shake our heads.

"No way. Prices have to fall. This is unreal," we say.

The median home price in San Diego, for instance, was $579,800 at the close of 2006. That's a hefty premium over the median resale price in Fargo ($136,600), Kansas City ($153,100), or Cincinnati ($138,700).

For people with ordinary incomes, homeownership in the super cities is virtually impossible.

Well, it may be virtually impossible, but it can still be beneficial.

If you take the economists' consumption-smoothing approach--- which means you focus on maximizing what you consume over your lifetime rather than your net worth--- a future of flat prices is fine. A future of declining home prices is actually better.

Let's take the case of Arlo, a 35-year-old anesthesiologist in San Diego. Arlo is starting his first job in a group practice with a starting salary of $200,000. First, he can actually qualify for a house in San Diego. That's good because Arlo's wife, Amanda, is about to stop working and they want to buy a house.

Arlo and Amanda must make an enormous commitment even as headlines shriek about falling prices. In 2006, San Diego prices fell 4.5 percent. Arlo and Amanda face a simple but stark question: Do they dare to catch a falling knife? If they do, what difference can it make in their life--- now and in the future?

Intuition says they should rent. San Diego rents are about half the cost of buying and financing a comparable house. But intuition is wrong. In fact, there is a sublime beauty to falling knives. It still pays to buy, not rent, with this caveat--- Arlo and Amanda must be confident they can remain in the house for many years.

More important, Arlo and Amanda will enjoy higher lifetime consumption with homeownership compared to renting, even though renting costs far less to start. While the cost of owning the house takes $55,942 of their income in the first year--- versus $30,000 for renting--- they'll enjoy $95,560 of real annual consumption, over and above shelter expenses, for the rest of their lives. All other assumptions equal , they'd have $91,370 of consumption as renters.

Taking the risk of homeownership improves their standard of living by 4.6 percent--- for life.

How can this be?

As renters, they would pay $63,435 in taxes in the first year (federal, state, and FICA). That's $14,336 more than they would pay as homeowners. The tax gap continues throughout life, though it diminishes slightly each year. (All results were obtained using ESPlanner consumption-smoothing software.)

Late in life, when their mortgage is paid off, their cost of shelter is less than renting--- and their income tax bill is still lower than it would be if they rented.

Renters have another liability. To smooth their consumption, they need to save more because rent rises with inflation while the mortgage is fixed and shrinks in real value each year. The cash to balance that comes from other consumption. Over their lifetimes the renters accumulate $1,284,016 in investment assets from saving (not home equity). The homeowners, meanwhile, save less every year but accumulate investments of $1,060,870. In spite of this, the homeowners enjoy a higher net worth in every year due to rising home equity. Even if the house rises only with inflation, its real future value will reach $600,000 when the mortgage is paid off.

But what happens if the house loses value? Another surprise!

If the house loses value at a 2 percent real annual rate, Arlo and Amanda will enjoy an additional increase in lifetime consumption to $97,839 a year. That's an increase of 2.4 percent. This happens because they will benefit from declining real estate taxes and insurance, measured in real purchasing power. Their home equity and net worth will be less: But their lifetime consumption--- the money they can spend on things other than shelter--- will rise.

Perversely, if the value of their home rises 2 percent faster than inflation, the money available for lifetime consumption will decline to $91,251 a year--- about the same as what they would experience by renting.

So here's how rent vs. buy plays out if you use consumption-smoothing. If San Diego home values rise with inflation or decline, Arlo and Amanda will enjoy a higher lifetime standard of living than if they rented. If the real estate market continues to soar, their lifetime standard of living could be reduced to that of a renter--- but they would have the option of selling.

On the web:

The Consumption Smoothing series

April 2, 2006: Is there an economist in the house?

April 4, 2006: The Wrong Number

April 9, 2006: When Quick Is Dirty

April 11, 2006: Soliciting Risk April 15, 2006: Get Real about Retirement

April 16, 2006: Free Money, No Heavy Lifting

April 18, 2006: The Value of Everything, the Price of Nothing

April 23, 2006: Should the Poor Invest More in Stocks?

April 25, 2006: Financial Malpractice

ESPlanner consumption smoothing software ------------------------------------------------------------------------------------------------

Personal finance writer Scott Burns is syndicated by Universal Press. His twice weekly column appears in newspapers from Boston to Seattle. He is the Chief Investment Strategist for AssetBuilder, Inc. Readers can register at www.scottburns.com. Questions/comments can be posted directly. They can also be sent, without registration, to scott@scottburns.com. Questions of general interest will be answered in future columns and on this blog.

Click on the "Archive" navigation to see other columns. All comments are welcomed and appreciated.
Published Apr 07 2007, 12:00 PM by scottb
Filed under:

Comments

 

ABModerator03 said:

Scott,

You said that the cost of insurance would go down if the value of the house declined. I believe that this is not the case. The value of the land is what tends to cause large jumps or declines in the value of a house, but land is not insurable by a homeowner. You can only insure the house for the cost of rebuilding. I think it unlikely that the building costs would actually go down even though the value of the house went down. Note: Some mortgage companies say that you must insure for at least the value of the mortgage, but this is not true, and most reputable insurance companies will refuse to overinsure a house. The disreputable companies will accept the extra premum to overinsure, but will not pay to your limits in the event of a total loss because you did not have an actual loss of greater than the rebuilding cost of the house.

This problem is most often seen on the coasts where a $1,000,000 house can easily be a building worth $200,000 on a small lot with the lot worth $800,000.

Bryan
April 7, 2007 6:31 PM
 

ABModerator03 said:

Scott-

Interesting take on renting vs. buying a home. We're retired in our mid-60s and currently rent. We are trying to decide whether to continue renting vs. buying in the current real estate market and whether it would be better to wait another 2-3 years before taking the plunge. If we buy, our price range would probably be in the low 200K range. I wonder what light "consumption smoothing" might shed on our situation, versus the 30-somethings in your example. Would appreciate any guidance you can provide.

BillE

From Scott Burns:

The older you are, the less you benefit from the impact of inflation on a mortgage. That's why many retirees should consider moving to a smaller house or renting after they retire. Doing so will liberate their home equity and allow it to earn income while cutting their direct shelter expenses at the same time.
April 7, 2007 8:18 PM
 

ABModerator03 said:

Declining real estate taxes under a declining real estate value scenario......what planet are you on?

From Scott Burns:

More about the sublime beauty of falling knives.

Many readers doubt my sanity after the column on the consumption smoothing view of buying an expensive home. I should have done a better job explaining the implications of a very long term view.

Although I stated this was a lifetime perspective in the column, I should have illustrated how tiny shifts in assumptions make very large changes when you are considering the next 55 years. Reader response also reveals a problem that behavioral economists are now exploring--- our tendency to think that the future will be just like the recent past.

In fact, we need only look back a few decades to see how much things change, particularly price levels. When I graduated in 1962, the average starting salary for M.I.T. graduates was $6,000. It was a reasonable income at the time and one company built an entire advertising program selling its suits as "for the young man who wants to make $10,000 a year by the time he is 30." Today, $6,000 or $10,000 qualifies as a below poverty income. It's difficult to get our heads around earlier price levels.

Let's start by comparing some of the figures for the renter and $600,000 homeowner. At age 35 Arlo is committing to pay $41,982 a year in mortgage payments compared to $30,000 a year in rent. Arlo also has property tax, operating/repair expenses, and insurance costs that are estimated at another $14,000 a year. Fortunately, his income taxes are lower due to a full plate of deductions.

If the home value rises with inflation of 3 percent, here is how the real dollar cost of rent versus buy compares at different times:

Time Mortgage Other Total vs. Rent 2007 $41,942 $14,000 $55,942 $30,000 2012 $36,179 $14,000 $50,179 $30,000 2022 $26,921 $14,000 $40,921 $30,000 2032 $20,032 $14,000 $34,032 $30,000 2036 $17,798 $14,000 $31,798 $30,000 2037 $0 $14,000 $14,000 $30,000 2047 $0 $14,000 $14,000 $30,000 2057 $0 $14,000 $14,000 $30,000 2060 $0 $14,000 $14,000 $30,000

When measured in dollars of constant purchasing power, the cost of the mortgage shrinks year after year while other costs rise with inflation. As a consequence, the homeowners face nearly equal costs compared to the renter by the time the mortgage is paid off--- but they have developed $600,000 in real purchasing power in home equity, about $20,000 of equity for each year of ownership.

But it gets better.

Once the mortgage is paid off, the homeowners only have the ongoing operating costs. As a consequence, their cost of shelter is only $14,000 a year until they die. As renters, their cost of shelter would be $30,000. The ESPlanner program calculates everything in dollars of current purchasing power. If it didn't, we would constantly be comparing apples to oranges. Worse, we'd be dealing with gigantic numbers that seemed implausible--- just as starting salaries for MIT graduates in 1962 seem implausible to us today.

If this house was sold during the intervening years, we would not have these results. A house that rose in value with the inflation rate over 55 years could have dramatically higher or lower values at any time in between.

A friend of mine, for instance, bought a "falling knife" house in Los Angeles in the very early 90's. He bought too early and missed the bottom. As a consequence, he was "upside down" for most of the 90s. He would have lost money had he been forced to sell. Others can tell similar stories of home purchases in Boston and Washington during the same period.

Today, he is way passed being upside down. His house has more than doubled from its original value. If he sold today he would enjoy a substantial gain and a nice annual growth rate. But he isn't going to sell. He will only know the rate of appreciation on his home when he sells, many years from now. It may be close to the rate of inflation. It may be a percentage point or two higher, or lower. The only thing he knows for sure is that a 15 or 20 percent decline this year or next won't be relevant. Long term, shifts of one percentage point a year have a gigantic impact.

Small changes, however, can have a big impact over a long period of time. If the house loses value at a real rate of minus 2 percent in a 3 percent inflation, it will rise a nominal 1 percent a year. As a consequence, the nominal tax and insurance bills may rise but the real tax and insurance bills will fall. As a consequence, the real cost of shelter will decline somewhat, liberating income for other purposes--- so consumption other than shelter rises even if home value falls in real terms.

The same thing happens, in reverse, if home value rises 2 percent faster than inflation for 55 years. The taxes and insurance bills will rise as the appraised value rises, absorbing more income than would be needed if the house value rose with inflation. So the real cost of shelter rises somewhat, reducing the amount of income available for other purposes. And consumption other than shelter falls in real terms.

You can understand this by considering the homeowners equity in their $600,000 home in current dollars under the three scenarios:

Home Appreciation Rate Year 2 percent At 3 percent 2 percent Over inflation Inflation under inflation 2007 $36,953 $24,953 $12,953 2012 $218,104 $142,406 $73,912 2022 $572,142 $348,471 $182,749 2032 $934,506 $530,455 $285,292 2036 $1,086,817 $600,000 $327,291 2037 $1,108,553 $600,000 $320,745 2047 $1,351,320 $600,000 $262,072 2057 $1,647,252 $600,000 $214,132 2060 $1,748,077 $600,000 $201,539

The important figures here are the ones after 2036, when the home mortgage is paid off--- they represent the sale value of the house in dollars of 2007 purchasing power. As you can see, the difference is vast and you can expect taxes and insurance to be affected, even if other expenses rise by the same amount.

The idea behind this exercise was to explore the long term implications for homeowners in the mega-price cities. It was NOT an exploration of alternatives and tactics. (Think of it as a GO exercise, not a Chess exercise.)

It's also important to realize that consumption smoothing software doesn't assume that "the highest net worth wins." It calculates, over a lifetime, the amount you can devote to consumption, ex shelter, after taxes and any long term commitments you choose to make. Instead of asking you to guess at the standard of living you can sustain over your remaining lifetime, it calculates it for you. Then, having established a baseline figure, you can change assumptions and test whether different alternatives (selling the house upon retirement and renting, moving to another state, etc. will increase or decrease the lifetime consumption you can sustain.

Because the calculations are done over such a long period of time--- 55 years in this case--- changes in assumptions seldom produce dramatic or mind-boggling results. But they ARE dramatic--- while the short view is speculating about value declines of 20 percent in high priced cities, the long view shows that annual appreciation of minus 2 percent real would cut the value of the $600,000 San Diego home by 2/3rds.

The ironic result is that if prices rise by 2 percent over inflation, the homeowner leaves a large estate--- $1,748,077--- while if prices decline by 2 percent real the homeowner leaves a much smaller estate---$201,539. The larger estate, however, comes at the expense of lifetime consumption because the depreciating house gives the homeowner a higher standard of living than other owners AND the renter.

If you are still shaking your head, don't feel badly. This is a very difficult subject to get your head around. The calculations can't be done in your head and the interactions between different factors often bring surprising, counter-intuitive results. That said, I believe the consumption smoothing approach to financial planning is the next step in the discipline. Just as most financial planners were unaware of stochastic analysis as recently as 10 years ago but have now embraced Monte Carlo modeling, because it allows us to plan for an uncertain world, I believe dynamic programming and consumption smoothing will displace conventional planning.

Economist Larry Kotlikoff and I are in the final stages of writing "Spend Till the End" for Simon & Shuster, to be released sometime next year. Just as "The Coming Generational Storm" introduced thousands of readers to the idea of generational accounting and the consequences of government over-promising, we hope "Spend Till the End" will introduce consumption smoothing to a broad audience.
April 8, 2007 3:17 AM
 

ABModerator03 said:

Hi Scott,

I'm curious as to the nature of your assumption that property taxes decline with home values. Are you assuming that if homes decline by X% the taxes decline by X%, or is it a more subtle calculation?

One of my side line jobs (appointed volunteer position) is to sit on the financial oversight committee for the town of Lexington. As part of that job I make projections of expense and revenue growth, and the result of such growth on property taxes. So I have a pretty good idea of how this works in this state, and suspect other states are not too dissimilar.

In MA at least there is, to a first order approximation, no reduction in home property taxes due to declining home prices. In a nut shell, the process is that the town first decides how much money it needs, and that amount is apportioned to residential and commercial property. The residential amount is then spread among the homes by home value (a home that is worth twice as another pays twice as much).

If all property doubles in value the tax does not change, although the tax rate ($/thousand) is halved, because the fundamental amount is how much the town decides to collect in the first step of the process does not change. Likewise if all values fall.

The caveat is that if residential values fell and commercial did not, there would be some shift from residential to commercial in the second step of the process. Of course the reverse can happen too. This effect can be substantial, but still it is nothing like having property taxes tied directly to home values.

I expect something similar happens elsewhere - the amount of money needed is largely what drives property taxes, not home values.

Rod
April 8, 2007 8:38 AM
 

ABModerator03 said:

Please post this model for ESPlanner users

From Admin:

You can download zipped excel files by clicking here.
April 8, 2007 8:49 PM
 

ABModerator03 said:

Hi Scott, In your modeling of this situation did you take into account that homeowners have to pay for the upkeep of the house, including both recurring and non-recurring expenses. These are not negligible.

Regards, Bob From Scott Burns:

There was some allowance for ongoing ownership expenses. Whether it was adequate or not is open to question. You can learn more by checking the excel spreadsheets the lay out expenses, etc. in constant dollars.
April 9, 2007 9:04 PM
 

ABModerator03 said:

The idea that rising housing prices could actually be worse for a homeowner than falling prices seems quite counter intuitive. One problem with this example is that in California property taxes are fixed and do not rise with rising home prices. This would change the calculations. Could this be one of the reasons that California home prices have risen so much faster than some other area? Conversely could the high property taxes in Texas which are constantly updated be one of the reasons home prices in Texas lag behind? Maybe we really do intuitively understand consumption smoothing and Texas property values are more rational than they seem at first glance. From Scott Burns:

Economists call this a "tax capitalization effect." When the tax burden on something is reduced, it's value as an asset tends to rise. Similarly, when the tax burden on something is increased, its value as an asset tends to decline. Some of the boom in housing prices, I believe, can be traced to the liberalization of gains treatment--- for most couples, being able to sell a home and realize a $500,000 gain without paying taxes is a major boon. So people bid up the price of houses.

The same thing operates in the impact of real estate taxes. Homes with high taxes tend to be depressed in value. Houses where I live---Santa Fe, New Mexico--- sell at crazy prices relative to Texas because the taxes are less than 1/2 percent of market
April 11, 2007 9:02 AM
 

ABModerator03 said:

Hi Scott,

I'm still struggling with the idea that falling property values will lead to falling property taxes.

Here at least what drives taxes is the cost of running the town: the cost of education, the cost of repairing roads, the costs of health care for employees, none of which are tied to property taxes.

Rod Cole From Scott Burns:

All of that is true and it may pose a significant limitation to the simple use of an annualized decline rate. It is also possible, however, that the burden of real estate taxes can undergo substantial shifts over long periods of time due to (1) changes in relative assessments and (2) new additions to the tax base.
April 13, 2007 8:37 AM
 

ABModerator03 said:

Scott,

Looking at the analysis, it shows real rents tracking inflation.

I believe that this assumption may be incorrect.

I believe, but have no evidence to show, that rents will more closely track local real estate prices than general inflation numbers.

This assumes a free market, with no rent control, and a reasonably long time horizon.

This may change some of the numbers with regard to the advantages of renting versus buying.

Bryan
April 14, 2007 7:09 PM
 

ABModerator03 said:

I mentioned this consumption smoothing idea to my wife who had two comments which were in essence: "when have you ever heard of real estate taxes decreasing, if the house decreases in value, the rate will just go up. Have you ever heard of school districts asking for less money than last year?" "Who says insurance costs will go down because the house costs less, we're facing perhaps losing our home insurance because we're on Long Island and potentially face a major hurricane. Plus insurance companies want to make up for the large losses they've incurred from Kathrina and other disasters. Hard to believe they'd cut costs."

With these considerations I think the apparent benefit of home ownership declines. On the other hand this same issues may pass through to a renter also. From Scott Burns:

Remember, it's a model and it covers a 55 year time period. In that much time the tax base of an area can change dramatically, with new additions working to dilute the weight that falls on the older properties that may have fallen in value.

You should also note that the model calls for a 2 percent real decline in a 3 percent inflation environment. As a consequence, the nominal tax and insurance bills increase throughout the period but their real value, in constant purchasing power, declines.
April 16, 2007 9:32 PM
 

ABModerator03 said:

USA Today, of 4/25/07, seems to support the claims that declining house values, as of this year, have not produced reduced real-estate liabilities for owners:

http://www.usatoday.com/printedition/news/20070425/1a_lede25.art.htm
April 25, 2007 12:59 PM
 

Registered Investment Advisor said:

By Scott Burns A recent listing of mortgage foreclosure rates in 100 top areas drew a lot of attention

February 22, 2008 3:22 PM

About scottb

Scott Burns has covered the changing world of personal finance and investments for nearly 40 years. Today, he ranks as one of the five most widely read personal finance writers in the country. Scott began his career as a newspaper columnist at the Boston Herald in 1977 where he was also the financial editor. Nationally syndicated in 1981 and now distributed by Universal Press, the column appears in newspapers from Boston to Seattle. In 1985 he joined the staff of the Dallas Morning News where his column quickly became one of the most widely read features in the paper. He left the Dallas Morning News in 2006 to become one of the founders of AssetBuilder and its Chief Investment Strategist. Burns is a graduate of Massachusetts Institute of Technology (1962). He has written four books, including "The Coming Generational Storm" (MIT Press, 2004) coauthored with economist Laurence J. Kotlikoff. His fourth book, also coauthored with Kotlikoff, will be published this spring by Simon & Schuster. "Spend Til' the End" uses consumption smoothing to demonstrate the errors of conventional financial planning. His business experience includes working as a staffer for a major consulting company and service as a director and audit chairman of a NASDAQ listed manufacturing company. He and his wife divide their time between Dallas and Santa Fe, New Mexico.
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