Saturday, July 16, 2011

Evaluating a Home Purchase - Post Bubble

As I stated in my last post, I'm not in favor of buying a home given the current and medium-term economic projections. With that said, I'll outline a typical home buying scenario, how to evaluate costs, and provide some methods for managing your risk should you choose to buy (if you're ready to buy skip to Part IV). There are plenty of arguments both in favor and against home ownership, but here I'll boil it down to the hard numbers and hopefully provide some useful insight.

Typical Case: Part I
Figure 1: Input parameters for
Zillow mortgage calculator.

We'll start by defining a typical case, which is outlined below.
  1. Home Price: $175,000 (near the median U.S. home price as of 2011)
  2. Down Payment: $17,500 or 10% of the home value (chosen to be low for risk management purposes)
  3. Loan/Principal: $157,500 (home price minus down payment, $175,000-$17,500)
  4. Interest Rate: 4.4% (prevailing 30-year rate as of July 2011)
  5. Mortgage Type: Fixed 30-year (an adjustable rate is not advised)
  6. Property Taxes: 1.4% (varies considerably by state and locality)
  7. Home Insurance: $700/year (varies considerably by location, this is roughly the national average as of July 2011)
  8. Private Mortgage Insurance: $77/month (based on home value to loan ratio and mortgage details. A down payment of 20% or more does not require mortgage insurance)
Figure 1 provides a snapshot of the input parameters for a mortgage calculator that can be found at Zillow.com. If you use their calculator be sure to click the advanced arrow to include property taxes, homeowner's insurance, and private mortgage insurance. In addition, click on the "Advanced Report" to get the amortization schedule and a detailed cost output. It should be noted that several costs and credits are not included, namely, maintenance, Realtor fees, and loan initiation fees, to name a few. In addition,  tax benefits from interest payment deductions are not evaluated.
Cost Evaluation: Part II
Figure 2: Total monthly costs associated with the home purchase outlined in Figure 1. Maintenance costs can be added to the 'Homeowner's Association Dues'' if desired.
Running the calculator results in the output shown in Figure 2. The total monthly payment is $1,128 and does not include maintenance costs, which may average 5-15% of the monthly payment. The greatest cost is associated with the principal and interest payments (70%) followed by property taxes (18%), private mortgage insurance (7%), and homeowners insurance (5%). Over the course of the 30-year loan the total interest payment amounts to $126,231 (72% of the current home value) and other sunk costs (taxes, fees, & insurance) amount to $122,378 (70% of home value) as seen in Figure 3. Overall, the total cost for the home after 30 years amounts to $406,108, or 232% of the current home price.
Figure 3: Total cost breakdown for all parameters (top), and a visualization of the amortization schedule broken down into principal and interest (bottom).
Now for the detailed amortization schedule, which includes the portion of your payment that goes to paying off the principal and that which is lost to interest. In theory, the principal goes toward building home equity whereas the interest goes to the bank and becomes a sunk cost (i.e. it adds no value). It should be noted that the breakdown in Figures 3 & 4 are for the principal and interest components only and do not include taxes, fees, and insurance as outline in Figure 2.

At the end of the first year the total payments amount to $9,458 where $6,869 (73%) goes toward interest and $2,589 (27%) goes toward paying down the principal. If you include taxes, insurance, and fees the breakdown is less favorable where $13,536 is paid in total, $6,869 (51%) goes to interest, $4,078 (30%) goes to taxes, insurance, & fees, and $2,589 (19%) goes to paying down the loan. Put another way, 81% are sunk unrecoverable costs, and 19% goes toward paying down the mortgage. On a monthly basis, this means your monthly payment of $1,128 is divided into two categories: $914 of sunk costs and $214 toward paying down the loan (for the first year). Over time the percentage of your payment that goes toward the principal increases, as seen in Figure 3, thus the first year is the most unfavorable for building equity. It gets better over time, but the cross-over doesn't occur until more than 15 years later, and even longer if you include taxes, insurance, & fees.

I've been careful to distinguish between "paying down the loan" and "equity." Often these terms are used interchangeably, but they are not the same thing. You're only building equity if the home value is stable or increasing, otherwise you are subject to a 'net equity' which depends on the market value of your home AND how much of the mortgage has been paid down. As an equation: Equity = Home Value - Outstanding Mortgage Balance. In our example, if the home value drops by a mere $2,589 (only 1.5%) in the first year, your equity from mortgage payments is completely wiped out. 
Figure 4: Monthly amortization schedule for the first year. This concerns the mortgage payment only and does not include other sunk costs.
Now comes the argument about renting versus buying. The typical argument against renting, is that you are "throwing away" money and not building equity. This is entirely true, but with home ownership you are also throwing away money through interest, property taxes, insurance, and maintenance.

So what's the take away? You are throwing away $914/month and paying down your debt by $214/month for the first year when buying a home. If you are renting for less than $914/month then  buying a home is not cost effective, at least for the first year. As a further example, say you are paying $750/month for rent. Under that assumption, it would take 14 years before your rent cost and sunk home ownership costs were equal (see Figure 5). The point being, owning is NOT always better than renting. It depends on rental rates, how home prices are trending, and interest rates at the very least.
Figure 5: Yearly amortization schedule for the first 15 years. This only includes the mortgage.

Risks: Part III
As a new home owner your immediate concern is preservation of your home's value by minimizing losses and maximizing gains. In the current environment, minimizing losses is more of a concern and this can be achieved by managing risk with appropriate hedges. This starts by understanding your risks as outlined below.
  1. Home Value Falling: If the market turns south and your home value drops your equity can be wiped out rather quickly. Leverage works in both directions and is equally vicious. Prior to the housing collapse, falling prices weren't seen as a risk factor because "home prices have never fallen." Famous last words.
  2. Foreclosure/Default: If you lose your source of income, you're still responsible for all of the costs associated with home ownership. If you can't pay up, you lose your home, and if a short sale isn't possible, all the equity that you've built (if any) goes to the bank. If you are underwater, the bank loses. That's how a secured loan works.
  3. Liquidity: Home values rely on access to leverage through credit. If credit doesn't exist, demand is reduced, and prices fall, or you simply can't find a buyer in a reasonable time. Of course, a buyer always shows up if the price is right and your time frame is long enough.
  4. The 'flations: Stagflation, hyperinflation, deflation...take your pick. All of them are bad news for home owners. One might argue that hyperinflation makes it easier to pay off your mortgage with devalued dollars. That may be true, but only if you have assets to sell for dollars. This is one of the key components to managing your risk in the prevailing economic climate (see Part IV). In a hyperinflation, wages don't increase at the same rate. Wages are 'sticky' along with rental rates and other contract related cashflow structures. What does scale is highly liquid assets that can be revalued in a very short time to keep pace with quick price movements (i.e. gold & silver).
  5. Property Taxes: This may be somewhat odd to include, but it's certainly a risk as state and local governments are pressed to close budget shortfalls. States must have a balanced budget (unlike the federal government) and may resort to aggressive property tax increases to achieve that end.
Strategy: Part IV
  1. Find a Bargain: This is a buyer's market where homes can be found far below market value for a variety of reasons. Often it's a result of foreclosure or a desperate seller trying to get pennies on the dollar for their equity before the bank swoops in. At first glance, a good deal may seem like a no-brainer, but if the neighborhood is full of them, then the deal will become the norm, bringing down the value of 'comparables' and your home's assessed value. Let me explain a little further. Home prices are assessed by finding similar homes in a particular location and evaluating recent sales. If many homes in a particular neighborhood have sold at deep discounts then the 'comparables' that your home is assessed against will have a lower price, and in turn, your home will be assessed at a discount. Don't get caught in this trap. Look at Zillow.com and see what homes are selling for in your neighborhood of interest. If the area has been decimated by deep discounts, or numerous homes are for sale, be wary, especially if the latter is true.
  2. Avoid Fixers: Traditionally fixers have been a great way to add 'sweat equity' and flip the home for a profit. Don't try it. Material costs are increasing and the housing supply is saturated. If someone has a choice between buying a new home or fixed up home, well, 9 times out of 10 they'll pick the new one. Also, if the market turns south the capital invested into fixing a home may evaporate, putting you in a worse financial situation. Generally, you invest when a market is trending with you, not against. 
  3. Minimum Down Payment: When you initiate a home purchase you put two things on the line, 1. your credibility (credit score) and 2. your down payment. If you default, you lose your down payment and your credit score plummets. If you're suddenly underwater on your home, a strategic default may be a viable option. In the current environment it must stay an option. You'll want to put as little on the line as possible to minimize your losses should you have to take this route.
  4. Diversify Savings: This component is critically important and can actually be a real boon should hyperinflation, currency collapse, or strong inflation occur. I exclude deflation, because it would inevitably trigger a currency collapse or a hyperinflationary response. So how do you hedge your currency risk? Save 20% to put down on a home, or $35,000 in our example above but only apply 10% ($17,500) to the home purchase and convert the other 10% into physical gold and silver. In this way you have hedged your currency (dollars) with money (gold/silver) that is highly liquid. So how does this protect you? If the value of the dollar falls gold and silver will rise to compensate. Here's an example. Say your 10% goes entirely to gold and it increases by 6x like it did in the last decade as shown in this post. Now your $17,500 in gold is worth $105,000. If you went 100% into silver and it performed as it did in the last decade, it'd be worth around $175,000, enough to purchase your home outright. 
  5. Evaluate Home for Cashflow Potential: If you find a job in a different state or have to move for any number of reasons, it may be profitable to rent your home out. Vacancy rates are on the decline nationwide, which will put upward pressure on rental rates. If a lack of rental housing develops, you'd have a home to capitalize on that trend. Think like a business person and develop as many 'outs' as possible, becoming a landlord is one of them.
Words of Caution: Part V

The world is undergoing dramatic changes across a broad spectrum of areas including the monetary system, access to resources, aging populations, environmental destruction, and wars to name a few. In this environment anything can happen, and it becomes very important to manage your risk and to not be afraid of deviating from tradition. This isn't a time of booming economic prosperity where you can do no wrong. In the '90s this seemed to be the case with stocks where all you had to do was buy and hold. In the early 2000's it was a similar case with housing. Buy a home, any home, it didn't matter because the market was on fire. You couldn't go wrong. The equity and housing bubbles both ended abruptly and violently. Now we're in a debt bubble of epic proportions fueled by the lender of last resort---central banks around the world. At some point the bubble will burst, creating the greatest collapse of our lifetime. Though this sounds dire, it shouldn't keep you from living your life as you wish. If you want a home, can afford it, understand the risks, and have a plan to manage your risk, then do it. There's always a way to get to where you want, but you must be smart about it. Learn to anticipate and ride the tsunamis as they come, because they will come...

Resources: Part VI

Zillow.com - As mentioned several times before, Zillow is a great resource. You can check property taxes, estimated prices, evaluate homes sales, review previous sale dates & prices, and a number of other things. Explore it thoroughly if you're in the market for a home or just want to see how much your friends, bosses, or neighbors home is actually worth.

CalculatedRiskBlog.com - This is an excellent source for up-to-date charts on a number of economic indicators including housing. Here's a direct link to the charts gallery.

Wednesday, July 13, 2011

Silver Chart - Potential Breakout

The silver chart looks poised for a breakout based on the 50-day SMA crossover, which has historically (over the past year) indicated a change in trend from consolidation to a fast move breakout. The last barrier to a 'trend change' is the current consolidation channel represented by cyan in Figure 1. The channels have typically lasted roughly 3-months, with the current cycle approaching the end of its consolidation period. Either a strong breakout is in order, or continued consolidation. If the mining shares are a leading indicator, a breakout seems more likely, especially with QE3 expectations fueling the fire. The conditions are similar to the breakout that began in August of 2010 when there were rumblings of QE2. Anyway, stay tuned, it may get interesting.
Figure 1: 1-year daily silver chart. Notice the crossover of the 50-day SMA and the consolidation channel periodicity. Overall, there is a strong potential for a fast move should the chart breach $39.50 (click image to enlarge).

Thursday, July 7, 2011

Buying a Home - Things to Think About

Let's first get this out of the way, I don't recommend buying a home given the current economic conditions. The primary reasons for not buying are summarized below: 

  1. There are better assets that will yield a much better return (silver, gold, oil, agriculture etc.).
  2. There is still downside risk (i.e. prices may still fall 20% or more for various reasons). 
  3. The only direction interest rates can go is sideways or up. Sideways is what you want if you're buying. If they go up, home prices will have to come down. Rates can't go any lower thanks to the Fed. Overall, I expect rates to increase, and when they do, dramatically. Stay away from adjustable rates if you do choose to buy.
  4. High unemployment will force people to take jobs in various parts of the country. Home ownership thwarts mobility and it may be very difficult to sell if you need to move.
  5. The baby boomer generation isn't getting any younger, and as they age they will pass away or move to retirement communities, freeing up homes, and increasing  supply.
  6. Foreclosures are still occurring and shadow inventory continues to mount. This is producing a supply glut that the market isn't fully pricing in.
  7. Homes are a liability NOT an investment. They become an investment when they're producing cashflow through rent payments. This isn't '05.
  8. As commodity prices continue to increase maintenance costs will also rise.
Now the reasons for owning a home:
  1. Everyone needs a place to live. With that said, you have to compare prevailing rental rates to the the monthly mortgage, insurance, property tax, and maintenance costs associated with home ownership. Zillow offers a good calculator to find the 'inflection' point where home ownership may make sense. I'll elaborate on this in a subsequent post and detail how to manage your risk.
  2. Vacancy rates are declining and it's becoming more difficult to find a place to rent. The population is still increasing, but builders aren't building at a rate to sustain growth. This will cause rental rates to increase, likely reducing the home/rent ratio, and making home ownership more attractive.
  3. Interest rates are still historically low and financing is cheap, though hard to come by for some people. Just because rates are low doesn't mean you should buy, it just happens to be the case.
In a subsequent post I'll outline a strategy for buying that'll help you sort out costs and how to manage your risk.