Wednesday, April 17, 2013

Home Prices and Inflation ... Borrowing Excessively to Buy a Home is Never a Good "Investment"

The myth of home ownership as being a great investment for individuals is just that -- a myth.

So is the myth that prices will always rise and that we should buy a home or anything else with lots of borrowed money at the earliest opportunity to do so.

When we put the myths together, we get housing bubbles and an unsustainable debt burden. This is the inevitable result of far too many financially incapable home buyers unnecessarily and inappropriately speculating on future home prices as they borrow to the maximum and focus strictly on the required monthly debt service payments.

By so doing, these 'happy home buyers' ignore the huge debts they are incurring at the time of purchase. And they never take into account the probability that while the inflation adjusted value of the home is likely to deteriorate over time, the original principal amount of the loan will remain as an obligation of the borrower.

And that if we go later 'underwater' and stay there long enough, we will drown in debt.

Why Home Prices Change (or Don't) is written by housing expert and economist Robert Schiller and contains many interesting facts worth considering:

"WHAT prices will today’s home buyers get if they sell a decade from now?
Most people live in their home for many years. They don’t need to view it as an investment at all, but if they do, they surely need a long forecasting horizon. . . .     

There has been some good news lately: home prices have risen over the last year, and with those gains there has been a renewed sense of optimism. But do these price increases mean that homes are now good investments for the long haul?       
Unfortunately, no. . . . one-year home price increases, after correcting for inflation, have had almost no statistical relationship to increases 10 years down the road. Thus, the upturn last year is irrelevant to long-run forecasting. . . .
Inflation has a major impact on long-term home prices. So do the costs of construction. . . .
Home prices look remarkably stable when corrected for inflation. Over the 100 years ending in 1990 — before the recent housing boom — real home prices rose only 0.2 percent a year, on average. The smallness of that increase seems best explained by rising productivity in construction, which offset increasing costs of land and labor.
Of course, home prices are likely to be much higher in 2023 when measured in nominal dollars — those that aren’t inflation-adjusted. . . . nominal prices will be roughly 25 percent higher, over all, in a decade.
All else equal, the current Fed policy would have this effect: a home selling for $200,000 today will sell for around $250,000 in 2023, though the real price — corrected for inflation — would be unchanged. But because people often forget to correct for inflation, they may have the illusion that the market is improving.
In an ideal world, steady and uniform inflation would have no effect on rational decision-making because it affects incomes as well as prices. But in the real world, inflation does affect our psychology. People feel more optimistic when their nominal pay rises or when a neighbor’s house sold for more than they paid for theirs. But in thinking about investments for the long term, we should focus on fundamentals — on real, inflation-corrected values and on the economics behind them.
Here is a harsh truth about homeownership: Over the long haul, it’s hard for homes to compete with the stock market in real appreciation. That’s because companies whose shares are traded on a stock exchange retain a good share of their earnings to plow back into the business. The business should grow and its real stock price should also grow through time — unless the company makes poor decisions, as some certainly do.
By contrast, real home prices should decline with time, except to the extent that households shell out some money and plow back some of their incomes into maintenance and improvements, because homes wear out and go out of style.
Housing is an ambiguous investment to evaluate, because a good part of its real return typically comes in its providing a place to live, not in providing dividends paid in cash. . . .
Then there is the role of the construction industry, which is very good at building new homes and will crank out many more of them if prices rise relative to construction costs. It’s logical that homes’ ultimate values should be affected by home construction costs.
In a 1956 study of home prices by the National Bureau of Economic Research, Leo Grebler, David M. Blank and Louis Winnick documented a substantial decline in inflation-corrected construction costs per housing unit in the first few decades of the 20th century. They traced this decline to multiple causes, including a decline in the number of rooms per home, the use of gypsum wallboard in place of plaster and of asphalt shingles in place of slate, a shift in construction to lower-cost Southern climates and a relative increase in the number of multifamily housing units and apartment buildings.
The authors concluded that the long-run movements in construction costs and home prices are “remarkably similar.”
This was the prevailing theory of home prices at the time: construction costs drove the entire housing market. That view — which implies that increasing productivity has restrained prices and could do so in the future — is very different from the focus on financial pressures and speculative bubbles that drives much of our thinking now. . . . 
THESE variables alone suggest how tricky it is to forecast your home’s value when the time comes to sell. Prices can go down as well as up. That is also true for investments in general, of course, and is why generations of portfolio analysts have advocated assessment of risks, and not just extrapolation of recent trends, as the key to intelligent investing."
Summing Up
Homes are places to live. And we all want to live in a nice place.
Home ownership, on the other hand, is a form of savings or financial speculation based on borrowing, as the case may be, and it's not a financial investment.

It's usually the most leveraged and only 'speculative investment' that most people make.
Putting so many eggs in one basket is never a good idea, especially early in adulthood when the risks and rewards of home ownership versus alternative investments have not been fully considered.
So taking the time to look before we leap, and to achieve a basic level of understanding about the ACTUAL history of inflation adjusted home prices is important.
Similarly, working hard to achieve basic financial literacy early in life is a great habit to acquire for ourselves and then pass along to others.

That's my take.
Thanks. Bob.

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