You'd Be Smarter to Rent

Ask someone whether you should rent or buy, and almost unanimously you'll be told to buy. Rent, people argue, is akin to throwing away money - you're lining your landlord's pockets! Throw in the dizzying rise in home prices, the tax benefits on interest rates for primary residences, and it's a no brainer, right?

Wrong.

With home prices as grossly over-inflated as they are today and with rent prices at much saner levels, the smart consumer today will opt to rent rather than buy. A recent Economist article - Still Want to Buy? - highlights the growing disparity between rents and home costs, as the following graph illustrates:

A ratio of 100 is the average home to rate cost ratio. However, around the world this century has seen a dramatic and alarming rise in this ratio. While the rise is less than in many other industrialized nations, it's still around 30% higher than the average. The Economist article puts it all into focus with this quote (emphasis mine):

"The figures look even more striking in the San Francisco Bay Area, where it is possible to rent an $800,000 house for $2,000 a month. Making the same assumptions about rents and house prices, but also deducting tax relief on a fixed-rate mortgage and adding property taxes, a buyer would pay $120,000 more over seven years than if he had rented. House prices in San Francisco would need to rise by at least 4% a year (2% in real terms) for it to prove cheaper to buy a house. Since 1950 American house prices in real terms have risen by an annual average of just over 1%. To expect them to rise faster from their current dizzy heights smacks of irrational exuberance, to say the least."

If you are not currently in the house market and are considering buying, hold off - rent costs have never been so low.

Speculation in San Diego

There's a great two-part article by Rich Toscano on the housing bubble in San Diego over at the Voice of San Diego website (Part 1, Part 2). In his article, Rich looks at the common misconceptions for why there has been such a rapid increase in housing prices here in San Diego. Many people attribute it to low interest rates, population outpacing housing growth, and San Diego just being such a nice place to live. From the article:

Conventional wisdom goes that San Diego is experiencing a severe housing crisis with no end in sight. The recent run-up in home prices is completely appropriate due to the supply and demand imbalance caused by a lack of developable land, years of under building, and a huge surge in population due to San Diego's desirability as a place to live. Adding fuel to the fire is the fact that San Diego's wealth has grown significantly due to its robust and diverse economy.

Sounds pretty convincing. The only problem is that it's entirely false. There is no housing crisis. There has been no population boom. Local incomes have not even kept pace with inflation. And while San Diego may be a nice place to live, it was also nice five years ago, when homes cost half as much as they do today.

Rich then shows how each of these claims is overexaggerated. For example, while it is true that since 1999 San Diego's population growth has outstripped available housing, the delta between the growth rates - 1.7% population grown annualized over the years 1999-2004 vs. 1.3% housing growth annualized over the same set of years - has far outpaced the growth in housing prices, which have more than doubled during the same period. Despite the rise in home prices, rents have risen much less over the same period, and are actually slowing in their annual increase. A friend of mine who works in the rental property management field recently told me that over the past one to two years rents have been pretty flat. (Of course during this same period home prices have continued their illogical climb.) One graph that was particularly alarming to myself was the graph plotting average home price against average salary over this time frame. This graph, shown below, illustrates the unsustainable situation we find ourselves in now:

In Part 2 of his article series, Rich pins the blame for the rise in house prices on investor speculation, dubbing the San Diego real estate market a "classic speculative bubble." These statistics, from the article, sure are sobering:

• 80 percent of mortgages were adjustable-rate, meaning that many borrowers were speculating that their salaries or home equity would increase faster than their mortgage interest payments.
• 47 percent of mortgages were interest-only, meaning that many borrowers were speculating that their salaries or home equity would increase faster than their mortgage interest payments and the eventual addition of mortgage principal payments.
• 27 percent of mortgages involved no down payment, meaning that many borrowers could (and did) use ultra-low rate interest only ARMs with no money down in order to afford far more house than their incomes would typically allow.
• 37 percent of condo conversion buyers were investors, meaning that, given the comparatively low rents discussed above, the only possibility of these people not losing money is for condo prices to rise enough to cover the current negative cash flow.

We only need to look back a few short years to the dot com collapse to see the end product of rampant speculation. While homes are less liquid than equities, and hence a sharp and immediate drop-off is less likely, I still think we're poised to see a rather painful drop in home prices and a scary increase in foreclosures over the coming years!

Welcome!

Welcome to Ready to Burst, a site I created to chronicle the housing bubble and its inevitable burst. Over the past several years we have seen a dramatic increase in home prices around the country, more focused in certain areas. I live in one of those such areas - San Diego, California. According to the San Diego Housing Commission, as of March 2005 the average new, detached home in selling for $781,000. The median single family home clocks in at $530,000, a home price that less than 11% of San Diegans can afford. Despite seeing a doubling in the average home price between 2000 and 2004, the median household income increased only 10.4% (source).

I am not an economist; my experience in the real estate market is limited to the only home I've ever purchased, a condo I bought back in 2001. I don't claim to be an expert, but I do know the basics of economics and supply & demand. I know that when the price of a good or service becomes radically out of line with the wages of the consumers something has got to change. I think we are nearing the end of this explosion in home prices.

If your average home owner had fiscal responsibility in the front of their minds instead of house fever, I don't think we'd be in a housing bubble. Sure, we still might have seen quite a rise in home prices, but when this had run its course we would see a plateauing of prices. With the bubble we're in now, chalk full of home owners who have adjustable rate mortgages and interest-only loans and are barely making ends meet as it is, we're going to see the bubble burst.

With this site I intend to publish various articles that I find of interest and add my commentary. I invite you to add your own commentary as well, by adding your comments to my posts. Do you think that we're in a housing bubble or will prices continue to soar unabated? When prices do stop will we see a plateau in home costs or a downward spiral?

The next few years will be interesting ones for the real estate market. We had one hell of a run up and it's going to be one hell of a ride back down. What does this mean for the average Joe? Well, if you were smart and bought a home you could afford with a fixed interest rate, you'll be OK. While the slide down may be a bit alarming, you won't lose your home, although you may see friends and family who aren't so lucky. If you bought a home recently and stretched to do so, choosing an adjustable rate or interest-only mortgage, I fear things will be dire for you. And if you've yet to enter the real estate market, have patience! Home values are at insustainable highs right now, and are bound to come crashing down. Patience is a virtue, doubly so in the realm of finances. Prices will come down so wait until that happens and look for motivated sellers and you should get one heck of a deal compared to today's outrageous prices.