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Minyan Mailbag: Real Estate (Continued)

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Thanks David!

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Note: Our goal in Minyanville is to remove intimidation from the financial markets and encourage an interactive dialogue among the Minyanship. We share this exchange between two worthy Minyans with that very intent.

The following was sent in response to a Minyan Mailbag posted on Friday afternoon regarding real estate.

Greg,

Just wanted to chime in on the letters about Arizona real estate. I don't know about that market---there may be demographic factors at work that will support more price gains---but I do know about California. And I don't like what I see here.

In the Arizona example, it makes perfect sense that a home's price goes up as rates go down---so long as the only buying criteria is the cost of the monthly mortgage payment.

However, in booms gone by (particularly here in California), interest rates didn't seem to have the same catalytic effect. In the boom from about 1977 to 1982, rates were actually rising. In the boom of the
late '80s, rates were pretty much unchanged from 1986 to 1990. And, in fact, when the market was in decline in the early '90s, rates were falling.

So what has changed this time? I'm not sure. Perhaps it is our trust in and readiness to finance everything that has made so many focus on monthly payments rather than nominal costs.

I think this will prove to be a mistake for many who are now buying(financing) in fast-inflating real estate markets. Homes are not cars or refrigerators or big-screen TVs. If I lease a car, I know I can afford about $450 a month. I really don't care if the nominal price of the car is $25,000 or $50,000. I don't plan on ever selling the car or even taking possession of it. I just care about the monthly cost. No one finances a car or big-screen TV with the thought of having the item retain (or improve) its value. They just worry about affording the monthly.

But a home is thought of as an appreciating asset that will be sold some day at a profit. Given that homes turn over, on average, every 5.5-7 years, it is clear that many, if not most, of today's buyers will have built very little equity in their homes upon sale---none if they go the interest-only route. Any gain they see will have to come from asset appreciation. So the nominal price they pay becomes critical.

The point is: many now are coming up with very creative ways to be able to afford to buy a home. They find a way to get the payments down to a number they can make. But will they ultimately be able to afford to sell it? Let's say a buyer today goes for an interest-only purchase on a $500K home. In five years time, perhaps the market corrects 10%. In California, homes have tripled in value in six years so a 10% turnback is pretty small potatoes. The home will then be worth $450,000. With no equity, the seller will have to come up with the difference, plus commissions, for a total of about $77K. Obviously, if prices fall more than that, the situation would be even more dire.

Imagine someone buying a car under the same scenario. The dealer says the car will cost $450 a month. But you will have to also compensate the dealer for the difference between what the car cost and what it will be worth five years hence. I can imagine car buyers would be carefully scrutinizing the nominal price of the car they are buying.

But mortgage buyers aren't doing that today because they are under the impression that home values always go up. And they have.over time. But there have been a number of periods where this is distinctly not true, particularly in overheated markets. Homes in California, for example, have risen in value a point or two above inflation for the past 40 years. Not bad. Yet in San Diego last year, homes rose 28% Y-O-Y while inflation was 3.3%. So there is plenty of room on the downside.

Having a monthly payment metality may work just fine when financing a car or a plasma TV. But it could prove disastrous when buying a home, especially now, especially in California.

Sincerely,



Minyan David

No positions in stocks mentioned.

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