At the

When home prices have gone up 150-200% in a decade, a 15% rollback isn't exactly a buying opportunity. Keep in mind that during the run up, the "experts" all predicted that prices would not decline, but would level-off and allow incomes to catch up. When confronted with a slowdown, these same experts said that a 10-15% rollback would represent the "worst-case" scenario.

The delusion is understandable. Bainbridge Island is populated with Babyboomers, and Boomers have seen property prices increase for the bulk of their life. In fact, real estate is the one "investment" that Mouseketeers think they know well. The prospectus for a Boomer's investment in real estate goes something like this:

As we like to say at the

For example, if we have a home that is located in a neighborhood where the median household income is around $75K (the Bainbridge median), and the home represents the median home, what would the value be? Let's say that it rents for $2100/mo, with property taxes of $3600/yr.

Why is the rental rate important? Given that all but the truly clueless believe we have been in a credit bubble, and that bubble distorted the prices of things purchased with credit (homes), we should expect to see a difference between the bubble value (price), and the non-bubble value (rental value). This is because rents do not move up and down in a credit bubble, as easy credit terms are not available to renters like they are to home owners. Put in another way, you never heard advertisements on the radio, or TV that told renters that they could reduce their payments and get more house, with cash back, and no credit checks. These programs were only available to people that were buying or refinancing homes. Renters had to rely on good, old-fashioned income ratios to qualify for their leases, and the rates they pay reflect the true value of the property.

After all, the only "dividend" the mortgage throws off is not having to "throw your money away on rent."

The difference between the rental value and the price is the

$2100/mo equates to $25,200/yr in gross income. That's all you get. That is the absolute maximum amount of cash the home can generate. That also presumes that you keep all of it.

The county assessor still gets her chunk.

The property manager gets her chunk (unless you do you own management).

The property still needs maintenance, and that comes out of the owner's pocket.

The house will likely be vacant from time to time.

If this is your biggest "investment," then you need insurance.

If taxes consume $3600/yr, and property managers get 10% (likely 15%), and the house is vacant 10% of the time, while you are dumping $500/yr into maintenance (optimistic), then your net cash generation, before income taxes, is $ 15,160/yr. This presumes you paid cash for your house and there is no mortgage. Your insurance is $900/yr.

That is your return on investment. What yield are you seeking? Are you going to accept a yield that is below that of US Treasury debt? If so, why are you risking so much for an investment that yields less than the safest investment on earth? You have to command a higher interest rate than that of a T-Bill, or CD at your local bank.

How much of a premium do you need? That varies by individual, but given that real estate is actually somewhat risky (vacancy rates, tax hikes, bad tenants, unforeseen maintenance expenses), you should ask for a few hundred basis points above Treasury debt. If the 10 year T-Bill is yielding 4%, and a bank CD is yielding 5%, one would think that an 8% ROI would not be unreasonable. If I am only going to get 5%, why would I even bother with all the fuss and hassle of putting up with renters and a home that needs maintenance, when I can take my money to the bank and spend my time golfing?

At 8%, your yield goal multiplies your net cash by 12.5 to arrive at the value of your "investment." $15,160 / .08 = $189,500.

YIKES! Can anyone find a Bainbridge home for this price? If so, does it rent for $2100/mo?

If we raised the rent to $2200/mo, did our own property management, and lowered our yield to 6%, we still arrive at $312,667. This presumes that with the orgy of building that has taken place, the amount of rentals on the market would command such a price. Keep in mind that $2200/mo is 35% of the median income for Bainbridge Island. Home costs have historically capped-out around 28%, and the renter will normally carry his own insurance.

If that house has a current market value of $650,000, then the

In order for the rental value to equal the speculative/market value of the property, the "investor" would have to be content with a 2.3% ROI in the managed property, or 2.9% ROI in the unmanaged property. Just for perspective, a 120 day CD at American Marine Bank goes out at 2.45%, and I'm guessing you don't have to worry about fixing a roof, replacing a water heater, or scramble to find tenants when September comes around.

The above example is EBIT (earnings before income taxes and interest), but the overwhelming majority of "investors" will carry a mortgage. This begs the question, "Does it cash flow?"

Let's see. If we have a 6.5% mortgage and a 15% down payment, then our payments on a 30 year-fixed run $41,944/yr. That's an annual cash-flow loss of $26,784, assuming there are no further hikes in taxes, maintenance, or any prolonged vacancy period. Remember, our rental assumptions were fairly optimistic.

At the end of 10 years, the total cash outlay was $267,840 in direct cash-flow losses, plus the original 15% down payment of $97,500 for a grand total of $365,340, or $3,044/mo (average).

You should have $182,144 in equity, but you still have to pay approximately 7% in closing costs and real estate fees to get at that money, which reduces your equity to $136,644, assuming you broke even on your house price (sold it for what you paid). Remember, we are not calculating

So....our "investment" cost us $228,696 over 10 years. That is money that we flushed away. It would be more if that original $365,340 was earning 5% in a CD, but for our comparison, we assumed the "investor" kept his cash in his mattress.

In order to beat the 5%, our home price would have to appreciate to offset the amount our negative cash-flow would have grown to at 5%, which is $508,619. That is the amount the owner would pocket at the closing. If the "investor" owes the bank $467,856 at the 10 year mark, then the property needs to sell for $976,474 AFTER REAL ESTATE FEES AND CLOSING COSTS! In order to pay Cookie and Candi, we need to sell our "investment" for $1,049,972.

Good luck with that.

Is this scenario reasonable? Look at the price/income ratio.

Currently, the median household income for Bainbridge Island is $75K/yr, which puts our $650K median house at 8.67X income. If we assume an above-trend line income growth for Bainbridge of 3%, then in 10 years the median income will be $100,700, which puts our price/income ratio at 10.4X income. You would have to assume that we would get an above-average income growth (after a spectacular 25 year bull market), and that future buyers would wish to buy your tired rental for an 10.4X ratio, when you only paid 8.67X.

Keep in mind that prior to the credit bubble, a 4X income ratio was considered very exotic and the normal range is from 2.5-4X income. Sub-2X incomes are not unheard of in some parts of the country with high incomes.

What would the value of the median Bainbridge home be if ratios were in historic norms?

$187,500 to $300,000. (Didn't we see $189K earlier in this example?)

What if we overshoot in the correction to 1.75X? After all, we have lots of new inventory with a population that can't even keep schools open. If a major Seattle employer gets wiped-out in the credit crunch for writing zany loans and playing fast-and-loose with their accounting, that will be a gut-punch for Bainbridge incomes.

Also, how many new Bainbridge residents have been selling real estate for a living? How many write loans, do appraisals, home repairs, additions, and speculative building?

Had enough? I have not. Let's look at sustainable lending, as the unsustainable lending is what got us in trouble in the first place.

If we assume that the only debt our prospective home buyer has is the mortgage on his house, and that historical, sustainable mortgage debt loads have topped-out at 28% of gross income, then how much house can we buy at 6.5% and $75K/yr gross income? They can afford $21,000 for principal, interest, taxes, and insurance (we will assume no HOA), which equates to $217,343 if we still have the taxes and insurance listed above. If we drop the taxes to 1.5% of purchase price, then the house value goes up to $221,136.

Remember, other debt (student, plastic, auto, personal) will start to weigh on a bank's ability to fund your mortgage. Our example was a "debt-free" person seeking a mortgage. How many of those people in the median income range do you know?

All the above examples presumed that we are not in a massive economic downturn and that interest rates remained at 6.5%. Both of these assumptions are not realistic. Run the numbers with mortgage rates at 9% to 14% and you will likely get a feel for what the next 10 years will look like.

I hope you enjoyed our workshop. The

Stay solvent.

Ernst Stavro Bloviator

Senior Fellow, IER.

__Institute For Economic Reality__, we are always trying to help people out of their self-imposed, colo-cranial economic impairments. Judging by the volume of chatter on how the real estate market is suddenly "affordable," it would appear that we have our work cut out for us.When home prices have gone up 150-200% in a decade, a 15% rollback isn't exactly a buying opportunity. Keep in mind that during the run up, the "experts" all predicted that prices would not decline, but would level-off and allow incomes to catch up. When confronted with a slowdown, these same experts said that a 10-15% rollback would represent the "worst-case" scenario.

The delusion is understandable. Bainbridge Island is populated with Babyboomers, and Boomers have seen property prices increase for the bulk of their life. In fact, real estate is the one "investment" that Mouseketeers think they know well. The prospectus for a Boomer's investment in real estate goes something like this:

Property prices have gone up, so they will continue. My real estate agent said this is the "bottom," and I had better buy now or be priced out forever (they would never tell me something that is self-serving and against my interests).Is there an objective metric to value a home? Should you jump all over a home that has been reduced in price $10,000, or wait for a better value?

As we like to say at the

__Institute For Economic Reality__, the difference between a good home and a good investment is the price you pay for it. There are many good houses on the market, but we have yet to find a good investment.For example, if we have a home that is located in a neighborhood where the median household income is around $75K (the Bainbridge median), and the home represents the median home, what would the value be? Let's say that it rents for $2100/mo, with property taxes of $3600/yr.

Why is the rental rate important? Given that all but the truly clueless believe we have been in a credit bubble, and that bubble distorted the prices of things purchased with credit (homes), we should expect to see a difference between the bubble value (price), and the non-bubble value (rental value). This is because rents do not move up and down in a credit bubble, as easy credit terms are not available to renters like they are to home owners. Put in another way, you never heard advertisements on the radio, or TV that told renters that they could reduce their payments and get more house, with cash back, and no credit checks. These programs were only available to people that were buying or refinancing homes. Renters had to rely on good, old-fashioned income ratios to qualify for their leases, and the rates they pay reflect the true value of the property.

After all, the only "dividend" the mortgage throws off is not having to "throw your money away on rent."

The difference between the rental value and the price is the

*speculative premium*. That is the amount of money that you are committing to attempt to capture a rising sales price of the home. Given the recent national obsession with the concept, it should be no wonder to people that people have committed lots and lots of money to chasing higher resale values.$2100/mo equates to $25,200/yr in gross income. That's all you get. That is the absolute maximum amount of cash the home can generate. That also presumes that you keep all of it.

The county assessor still gets her chunk.

The property manager gets her chunk (unless you do you own management).

The property still needs maintenance, and that comes out of the owner's pocket.

The house will likely be vacant from time to time.

If this is your biggest "investment," then you need insurance.

If taxes consume $3600/yr, and property managers get 10% (likely 15%), and the house is vacant 10% of the time, while you are dumping $500/yr into maintenance (optimistic), then your net cash generation, before income taxes, is $ 15,160/yr. This presumes you paid cash for your house and there is no mortgage. Your insurance is $900/yr.

That is your return on investment. What yield are you seeking? Are you going to accept a yield that is below that of US Treasury debt? If so, why are you risking so much for an investment that yields less than the safest investment on earth? You have to command a higher interest rate than that of a T-Bill, or CD at your local bank.

How much of a premium do you need? That varies by individual, but given that real estate is actually somewhat risky (vacancy rates, tax hikes, bad tenants, unforeseen maintenance expenses), you should ask for a few hundred basis points above Treasury debt. If the 10 year T-Bill is yielding 4%, and a bank CD is yielding 5%, one would think that an 8% ROI would not be unreasonable. If I am only going to get 5%, why would I even bother with all the fuss and hassle of putting up with renters and a home that needs maintenance, when I can take my money to the bank and spend my time golfing?

At 8%, your yield goal multiplies your net cash by 12.5 to arrive at the value of your "investment." $15,160 / .08 = $189,500.

YIKES! Can anyone find a Bainbridge home for this price? If so, does it rent for $2100/mo?

If we raised the rent to $2200/mo, did our own property management, and lowered our yield to 6%, we still arrive at $312,667. This presumes that with the orgy of building that has taken place, the amount of rentals on the market would command such a price. Keep in mind that $2200/mo is 35% of the median income for Bainbridge Island. Home costs have historically capped-out around 28%, and the renter will normally carry his own insurance.

If that house has a current market value of $650,000, then the

*speculative premium*is $460,500 (or 71% of the price) for the realistic example, and $337,333 (or 52% of the price) for the delusional "investor" that is content to take large risks and expend a lot of effort to barely beat the local bank's CD.In order for the rental value to equal the speculative/market value of the property, the "investor" would have to be content with a 2.3% ROI in the managed property, or 2.9% ROI in the unmanaged property. Just for perspective, a 120 day CD at American Marine Bank goes out at 2.45%, and I'm guessing you don't have to worry about fixing a roof, replacing a water heater, or scramble to find tenants when September comes around.

The above example is EBIT (earnings before income taxes and interest), but the overwhelming majority of "investors" will carry a mortgage. This begs the question, "Does it cash flow?"

Let's see. If we have a 6.5% mortgage and a 15% down payment, then our payments on a 30 year-fixed run $41,944/yr. That's an annual cash-flow loss of $26,784, assuming there are no further hikes in taxes, maintenance, or any prolonged vacancy period. Remember, our rental assumptions were fairly optimistic.

At the end of 10 years, the total cash outlay was $267,840 in direct cash-flow losses, plus the original 15% down payment of $97,500 for a grand total of $365,340, or $3,044/mo (average).

You should have $182,144 in equity, but you still have to pay approximately 7% in closing costs and real estate fees to get at that money, which reduces your equity to $136,644, assuming you broke even on your house price (sold it for what you paid). Remember, we are not calculating

*speculative premium*, but are merely looking at the value of the investment without the idea that home prices will perpetually escalate. Prices can go either way.So....our "investment" cost us $228,696 over 10 years. That is money that we flushed away. It would be more if that original $365,340 was earning 5% in a CD, but for our comparison, we assumed the "investor" kept his cash in his mattress.

In order to beat the 5%, our home price would have to appreciate to offset the amount our negative cash-flow would have grown to at 5%, which is $508,619. That is the amount the owner would pocket at the closing. If the "investor" owes the bank $467,856 at the 10 year mark, then the property needs to sell for $976,474 AFTER REAL ESTATE FEES AND CLOSING COSTS! In order to pay Cookie and Candi, we need to sell our "investment" for $1,049,972.

Good luck with that.

Is this scenario reasonable? Look at the price/income ratio.

Currently, the median household income for Bainbridge Island is $75K/yr, which puts our $650K median house at 8.67X income. If we assume an above-trend line income growth for Bainbridge of 3%, then in 10 years the median income will be $100,700, which puts our price/income ratio at 10.4X income. You would have to assume that we would get an above-average income growth (after a spectacular 25 year bull market), and that future buyers would wish to buy your tired rental for an 10.4X ratio, when you only paid 8.67X.

Keep in mind that prior to the credit bubble, a 4X income ratio was considered very exotic and the normal range is from 2.5-4X income. Sub-2X incomes are not unheard of in some parts of the country with high incomes.

What would the value of the median Bainbridge home be if ratios were in historic norms?

$187,500 to $300,000. (Didn't we see $189K earlier in this example?)

What if we overshoot in the correction to 1.75X? After all, we have lots of new inventory with a population that can't even keep schools open. If a major Seattle employer gets wiped-out in the credit crunch for writing zany loans and playing fast-and-loose with their accounting, that will be a gut-punch for Bainbridge incomes.

**hat**__W__**ight that business be called? (Edit: On 9/25/08, WaMu was seized by the FDIC)**__M__Also, how many new Bainbridge residents have been selling real estate for a living? How many write loans, do appraisals, home repairs, additions, and speculative building?

Had enough? I have not. Let's look at sustainable lending, as the unsustainable lending is what got us in trouble in the first place.

If we assume that the only debt our prospective home buyer has is the mortgage on his house, and that historical, sustainable mortgage debt loads have topped-out at 28% of gross income, then how much house can we buy at 6.5% and $75K/yr gross income? They can afford $21,000 for principal, interest, taxes, and insurance (we will assume no HOA), which equates to $217,343 if we still have the taxes and insurance listed above. If we drop the taxes to 1.5% of purchase price, then the house value goes up to $221,136.

Remember, other debt (student, plastic, auto, personal) will start to weigh on a bank's ability to fund your mortgage. Our example was a "debt-free" person seeking a mortgage. How many of those people in the median income range do you know?

All the above examples presumed that we are not in a massive economic downturn and that interest rates remained at 6.5%. Both of these assumptions are not realistic. Run the numbers with mortgage rates at 9% to 14% and you will likely get a feel for what the next 10 years will look like.

I hope you enjoyed our workshop. The

__Institute For Economic Reality__seeks to push back the frontiers of economic cluelessness. By now, you should be familiar with the amount of*speculative premium*that exists in Bainbridge Island real estate. Your homework assignment is to calculate the value of a second/third/vacation home with people laboring to make their payments under the above mentioned conditions. Remember, the latest "bailout" from Hank Paulson removes the tax write off for the "2 in the last 5" provision of a secondary home.Stay solvent.

Ernst Stavro Bloviator

Senior Fellow, IER.