Sunday, August 10, 2008

When Is The Bottom? - IER House Valuation Workshop

At the 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. What Might that business be called? (Edit: On 9/25/08, WaMu was seized by the FDIC)

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.


Anonymous said...

Hi E,

As you may or may not know, I started real estate in NJ/Philly in 1990 and then to Orlando Florida in 1995 and 1996.

In all of those areas at that time there was a loose "1% rule of thumb". A condo that sold for $89,000 rented for $890 a month. A townhome that sold for $159,000 rented for $1,590 a month and a house that sold for $250,000 rented for $2,500 a month.

While I don't do the math of housing prices being attached to median income, I do think the 1% rule for rent prices and housing prices will start to come back to a sane level.

That would mean prices would have to drop by at least 50%. Sounds crazy, but people who were thinking of buying a house for $1M are now only qualifying for $490,000.

I started in a market where prices dropped that doesn't sound all that crazy to me.

It's hard to think about the long term investment of real estate without seeing all of the people who bought at a fraction of current prices. The elderly couple with $13M worth of property that they are now retiring on that they bought over the full length of their lives at a fraction of current value.

Flippers are like day traders as are people buying for the short term. But you can't look at return without looking at long term appreciation.

I agree it looks impossible for someone to make money in real estate over time from current elevated levels. But I am reminded of the day I looked at the Dow at 2,950 with the same thought.


Jillayne Schlicke said...

Hi Eleua,

Out in the classroom, Realtors are saying "Rents are now's the time to buy instead of rent!"

Here are some other arguments I hear on a regular basis:

Since banks will likely raise interest rates in order to make up for all their's a great time to buy because you can lock in a lower fixed rate loan.

In some pocket areas, home prices are still going up...

I'm troubled by one thing from your IER class.

It's beyond debate that banks have to get back to sane lending practices. But I was always taught that banks make money by lending money. So if banks have to slow down their lending, this means all the current bank write-downs we're reading about is going to continue for quite a long time. Do you agree?

Instead of a big crash, the economy is being brought down slowly; step by step.

Could this then be translated into the housing market where we'll see the market continue to go down for a long time in an orderly, stair-step fashion?

Thanks for the lesson.

Eleua said...


You bring up a good point. I neglected to include the "1% rule" when doing rough estimates of a homes value. In the example I used, the 1% rule would peg the value in the low $200s. Obviously, a slightly below median home isn't going to rent for $6500/mo, so that shows just how out of whack current pricing is.

I do believe that real estate can be a viable investment in the future, but as I said earlier...

"The difference between a good home and a good investment is the price you paid for it."

We are going to work on that pricing mechanism to get housing back to its foundational value.

Ardell, thanks for stopping by. You are one of the good ones.

Eleua said...


Thanks for stopping by.

Regarding what you are hearing in your classes, I would say that it sounds more like RE agents are looking for anything to justify buying a home.

Rents may go up temporarily as a result of people shying away from the frenzied buying orgy we had. Part of that buying orgy was the drop in rents due to people buying many second and thirds as investment properties, while the avialable pool of renters was being chased into homes with subprime mortgages. Any such blip will be offset by the coming income drops in a contracting econom. The eventual REO and seller capitualtion will throw many homes on the market as rentals to help stem the bleeding from lack of sales.

So, in the near term, rents may rise a few points, but in the intermediate to long term, the ability for people to pay higher rents will be diminished in the face of exploding rental inventory.

Lower rents. Lower actual value of homes.

This makes sense. In recessions, people have less money. The housing boom created lots of inventory that were being masked as "investments."

If banks hike interest rates and tighten lending standards, it might make sense to buy now, PROVIDED YOU NEVER WANT TO SELL. If you plan on selling at anytime in the next 20 years, your prospective buyers will face higher interest rates and tighter lending standards. That equates to you buying at the peak (or just off-peak) and selling into a very, very depressed market. No thanks. I'd rather save my money and buy when prices are lower and the potential for appreciation is greater.

You are 100% correct that banks make money by lending money. If lending slows down, then they will make less money and will have less money to offset the stupid loans they wrote over the past few years.

If I understand your question, then my answer is that banks will still be forced to write-down their stupid loans and their profitability will suffer due to lack of volume.

I think bank write-downs will come in proportion to the default rates of the products they produce. This is driven by home prices. Being upsidedown is the large driver of mortgage defaults.

If we get a major economic dislocation, then we might (hopefully) get a very deep and thorough cleansing of our system. Granted, that probably includes a stock market crash and a systemic banking failure. It is my hope that we can rebuild a viable system that isn't geared to speculation and asset inflation.

If not, then we get a slow bleed that could take decades to resolve. Think Japan. Housing prices went down for almost 20 straight years, and this is a country with 5X the population density of California.

Anonymous said...

Disclosure: I don't think I'll ever make it to "think Japan" :)

Here's a question I've had with no one to ask it of.

Lenders charged more, much more, for risk associated products. Rates on sub-prime were as much as double the rate of a non-risk assoicated loan. So why is everyone crying for them as if they didn't understand why double the interest rate might have it's consequences? Did they view being able to charge 10% interest rates as simply a means to get more without the risk? Is anyone that stupid?

If they are still getting double the interest rate on the loans that didn't go sour, haven't they simply been hit with the business risk they were more than willing to assume? Aren't they being well compensated by the 8% to 12% rates they are getting on the % of subprime loans that didn't default?

As to rentals, all the people who can't buy or don't want to by, and all the people defaulting on their mortgages, will flood the market with more people who need to rent vs. buy.

The homes that can't sell being rented by the people who can't or won't buy. Will be interesting to see how that supply and demand plays out.


Eleua said...


"Did they view being able to charge 10% interest rates as simply a means to get more without the risk? Is anyone that stupid?"


The banksters all thought the retirement fund and money market managers would continue in perpetual cluelessness and buy their dreck, no matter what the quality.

They were wrong.

Once risk reasserted itself, the game was over. The problem comes from the degree the banksters descended into financial oblivion. They are so far gone that they have effectively taken all of us hostage, which explains all the government actions and bailouts.

Stupidity should be painful, and in this case, it is.

Regarding the supply/demand of rentals and purchases in the future...

I think the available homes will outstrip people's ability to rent them at a decent rate. Wages drive rents and we overbuilt in the latest run up. Both of those say that rents are going down, and I say that home prices will fall to parity (in terms of PITI).


Anonymous said...

Your math is wrong. You wouldn't expect a Treasury rate of return from income property because the underlying real estate will appreciate at the rate of inflation, unlike a bond whose par value N years out will be in inflated future dollars. It's more like "I Bonds" or TIPS (and I Bonds presently pay 0% nominal). And better than owning gold or another commodity. If you recalculate on this basis you may find that, while overpriced, it's not near as out of whack as you suggest.

Eleua said...

Anon 15:35,

So wrong. Show me the law that states that homes appreciate with inflation.

Did Bainbridge RE appreciate at the inflation rate from 1997 to 2007? No. Did Detroit? No.

Last year, inflation ran about 7%, but Bainbridge RE shrank 15%.

What if we get DE-flation? Your bond will look pretty good at maturity.

My entire point was that the extra money between price and value represents the SPECULATIVE PREMIUM, which is the money you commit to attempt to capture this "inflation" you talk about.

"Investing" is about value and dividends. "Speculation" is about greater prices and greater fools.

I stand by my analysis and numbers. You don't know that prices will appreciate, and you can't forecast the return.

Anonymous said...

"So wrong. Show me the law that states that homes appreciate with inflation."


someone said what I have felt all along.

Even "TheTim" thinks that houses should go back to some "inflation adjusted" value.

Those that think that way are our future knife catchers.

Anonymous said...

4% premium over Treasuries seems excessive.

Traditionally mortgage bonds traded at around 100 points above Treasuries. Since rental does require management, some additional premium is needed, but 4% over Treasuries is unreasonable.

7% cap rate is considered good in real estate. Rentals have risk (and so does every other asset), but generally rents increase over time and benefit of depreciation also needs to be taken into account.

Eleua said...

Fair point. If the 10Y T-bill is going out at 4%, and I can get 5.5% on a CD, I would like a few more points to justify the effort and risk.

Some people are happy with 7%, I just threw in 8% for discussion's sake.

I am of the opinion that perpetually rising prices have made lower cap rates acceptable. If that goes in reverse, then I would expect to see cap rates rise.

I'm not going to quibble over a point for the purposes of this example.

Thanks for stopping by.

Anonymous said...


You can't know that prices of a given asset (be it gold, RE, or stock) will go up or down, so it's true you are exposed to risk. But it's also true that, over the long haul, there is extremely high likelihood of positive rate of inflation (govts like to print money!). Thus such assets will be worth future inflated dollars than they are today. Whereas the Treasury's par value will be worth the same amount of future dollars.

The better comparison w/ income property is perhaps a dividend-yielding stock. No one expects a dividend yield above Treasury rates, even for a staid cash cow company. Because the underlying corporate asset - while it could go up or down in the short run - is going to go up over the long run thanks to inflation.

None of this is to say that BI RE is not still over-priced!

Anonymous said...


you probably can get 5.5% now at a bank that may qualify for FDIC Friday night special, solid banks have CDs under 5%. Many commercial properties sold at mid-6% cap rates. Under 6% is considered sub-par and a high-risk deal.

Cap rates always depend on bond rates. Certainly if Treasury pays 7%, people will aim for 9% and higher cap rates.

Eleua said...


I am of the opinion that the 10Y T-bill rates are going to go much higher in the near future, which will drive all rates higher, and asset prices lower.

I think prices and cap rates in today's market is a bad entry.

Anonymous said...


Excellent piece!

Glenn Tilton

Looking to Buy said...

Can you provide any specific help on homes for someone looking in the area now. As an outsider, I find it tough to tell if the value of a home is there.

looking to buy said...

I am military too if that helps :) I know it goes against SPECTRE and everything but I could use the help.

Eleua said...


It would be foolish for me to give specific advice based upon a few sentences, but in general, my thoughts on the subject are fairly clear.

Purchasing a home at this time is almost certainly going to be met with a very substantial capital loss over the next few years. I know the temptation to buy a home at your first opportunity is very powerful, but ask yourself this:

If someone came up to you and said that he would pay you $150K (tax free) if you would agree to rent for the next year to 18 months, would you?

Think about it. If a home sold for $650K at the peak, and now goes for $500K just 13 months later (with the drop accelerating), you just sidestepped a $150K landmine, to say nothing of the cash-flow considerations of renting vs PITI.

As far as the military angle goes...

If you are retired, why blow the entire retirement on a bloated house payment? If you are not retired, why take on excessive debt? NIS looks at debt loads when reviewing your various clearances, and excessive debt loads are a way to get your TS pulled. Just wait until all these E-5 to O-4 people start to fall behind on their payments, and see what happens inside the various commands. It will be ugly.

Nice rentals are out there. Come October 1, the people that held out their homes for sale are going to panic. Rents will start to trend in your favor, and prices will accelerate to the downside.

Bottom line. Never be in a rush to incur debt, especially near the peak of the biggest credit bubble in world history. Don't chase the house - let it come to you.

BI Renter said...


2 years ago, you were a you're friggn' Nostradamus.

So what I hear is - no need to hurry into purchasing ... that the Speculative Premium still has a way to unwind.

But won't Obamamania, Paulson's equivalent, the fed, WS (et al.) make every effort to keep cheap money available for some time to come? There seems to be quite a bit of resilience in keeping your mentioned credit bubble alive.

BI Renter

Eleua said...

The new Treas Sec will likely get passed a grenade without a pin. Skeletor (Paulson) is doing everything he can to keep this from blowing sky-high, even if it means that they have to break the law.

The credit bubble can't stay up indefinitely, as credit originations are going to tank in the face of escalating defaults. Cheap money is being cycled in from our trade deficits with China and Japan, and as their economies faulter (under a declining US consumer), the amount of dollars available to cycle back into the US goes with it.

Export nations will also try to sell off their US Treasury holdings to fill the gap left by the US consumer, which will raise interest rates and further choke off debt origninations. That's where this gets very exciting.

Anyway...expect the powers in NY and DC to keep the party rolling as long as possible. They are only making it worse.

Not only do I expect the speculative premium to vanish, I expect it to go negative and become an buyer's discount. This will also happen in the face of falling rents.

So yes, Bainbridge is going to get a lot cheaper.

BTW, while I expected Obamassiah to win, that could be changing. He should be up by 20 points by now, but he is barely even. He still has the "Bradley Factor" to overcome, and I expect that to be in the neighborhood of 8 to 10 points.

Looking to Buy said...

Thanks for your help! Oddly enough, I told my wife (whom is out looking at houses today in Bainbridge) that we probably need to look for rentals based on all the info on your website. She still went around today and we found two good deals out of the shacks in Bainbridge trying to sell for 400K+. Hopefully everything will work out with one of them.

Roger Ingalls said...


Why not use median household income/median price ratio as an indicator of fair market value?

That ratio barely budged in the Seattle MSA between 1980 and 1990, and didn't really shoot up until after the loosening of credit in 2000.

Here's a link.

I enjoyed your posts, even if it scares me half to death.


How do you know if you have hit bottom ask those that have been though it before.

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