I’ve been getting multiple e-mail requests about doing an analysis about renting versus buying especially in high priced areas. Since in my mind’s eye, the answer is rather clear for the moment since any equation will tell you outright that buying does not make sense with current prices and trends. There was no point in using mortgage calculators or figuring out tax breaks since the numbers were enormously tilted for people to rent or lease out their living quarters in banana republic metro areas. Yet it is important to understand that there will be a time, as has been the case in history, when purchasing a home will make economical sense even in bubblista areas. We can argue the merits of the pride of homeownership and the joy you get from having the unrestrained power to paint your living room hot pink, but it is hard to place a momentary value on that. And in the world of real estate investing, economics means everything as those in the subprime arena are learning the hard way. So we will simply focus on measurable numbers since it is pointless in using housing pundit rhetoric since many recent new homebuyers are learning that the only loyalty home builders have is to the bottom-line. First we will examine the fascinating fact that in many healthy metro areas, rental prices will increase while home price trend lower. Then, we will look at housing price declines and why spending $1 for two shiny quarters isn’t a smart way to invest. And finally we will delve into the tighter credit markets and the implications this will have on purchasing a home in the future.

Rental Prices will go up in the Short-term

First, let us take a look at rental prices in Los Angeles County via the Census Bureau:

Median Rent:

2005: $918

2004: $873

2003: $821

2002: $768

Keep in mind this is aggregate data for a county with the population of 9,758,886 people. But the trend is unmistakable, rental prices are going up across the board. From 2002 to 2003 rent prices went up 6.9%, from 03-04 they went up 6.3%, and from 04-05 they went up 5.1%. This trend is also appearing in more recent data even in the face of the mounting housing downturn. This data is useful because the majority of people in Los Angeles County rent. Yes, we hear the famous line of 70 percent of US households own their home but this is the Republic of Southern California and 51 percent of households rent. Clearly this trend will continue since many people will be losing their homes. And don’t believe the rhetoric from the housing lenders that they are trying to help these folks from losing their homes; they are using Orwellian propaganda trying to make is seem that they have their best minds trying to rework mortgage structures with at risk owners. What they call support is a piecemeal budget analysis with someone telling you, “maybe you can take on another renter or maybe you can cut back on your discretionary spending” but nothing in terms of true help. The true help would come in the form of restructuring the debt with a monetary cost to the company for putting people into these diabolic loans. Meaning, they would need to subsidize their mistake of putting people in mortgage products that had no possibility of being repaid and essentially converted the lender, Wall Street, and the buyer as a speculative racket that might as well be doubling down in Vegas. Again, we are hearing all this talk about help but nothing is happening. These folks are all hoping Uncle Sam will be there as the lender of last resort but somehow we are deeper in mortgage sewage than the government realizes. Then we have bizarre things happening in the current market and apparently everyone is now part of the housing complex.

Back to the renting issues. How are prices still going up in the face of what is happening? It is rather simple if you think about it. Many of these current subprime buyers will lose their home. They should have never been put into these mortgage products to begin with. So they will become part of the rental demand market. In addition, you have prospective buyers sitting even more steadily on the fence since there is little doubt housing is imploding. Even the most avid housing pundits are tempering their speech realizing that they’ll be seen as an enormous anti-Nostradamus by making chump predictions. So the demand being placed on the rental market will accelerate in the next year. Southern California is already a healthy rental market and with the accelerating mortgage problems, we will see rental rates remain healthy and possibly, increase at a stronger pace. In addition, you will see some sellers who are unable to sell that will become “unsuspecting” landlords. To recoup some of their losses they will need to charge higher rental rates but only to the extent that the market will bear. As you can see from our data, rental rates should trend upward by 5 to 7 percent which ironically, should increase the CPI owner’s equivalent of rent.

Spending $1 for a Kick-Back of Two-Quarters

But what about the tax benefits of owning? Aren’t all renters simply flushing their money down the porcelain toilet of perpetual loserville? First, there is a mistake in believing renting provides no economic benefit. Everyone needs shelter unless you are going the way of the nomad and living under the San Gabriel river. Renting provides the same economic substitute as owning a home aside from tax benefits, equity buildup, and the ability to take a sledge hammer into your kitchen wall should your heart desire. The only problem in hyper bubble markets like Southern California, renting an equivalent place will cost you 2 times less than owning. So for example, you may be able to rent a home for $2,200 that would cost you $4,000 if you were to buy it. And that $1,800 is being invested ideally at a rate outpacing inflation. The way housing is currently going, you’d be better off playing Keno at your local Indian casinos. So let us run some hypothetical numbers:

Home Price: $500,000

Rental Equivalent Price: $2,200 per month

Down Payment: $25,000

Assumed Rate of Return on Investments: 7%

House Payment: $4,057

Tax Savings: $806 (25 percent tax rate)

Principle payment: $424

Net House Payment: $3,252

With these assumption we will also use wonderland inflation data from the ministry of truth otherwise known as the BLS. We will assume inflation is running at 3 percent. In addition, we can safely assume that appreciation will be non-existent for a few years but we are being generous and factoring a 2 percent appreciation for this home. The inflation rate is important because this impacts our overall rate of growth in rental payments. Like I previously stated, we expect rental rates to go up in the short-term, but they will start trending down as the market starts seeing employment losses which lag. So assuming all of the above, purchasing this home will not break even until get this, 17 years! And why is that? Because we are investing the saved difference into an investment that is yielding only 7 percent. Here’s the break down after 17 years:

Value of Investment: $324,517

Value of Home Equity: $320,859

So it isn’t clear that you should own since the above factors in the tax savings as well. In the short-term scenario the numbers become even more obvious. If we are to look at the 5^th year of owning this home, this is what we find:

Value of Investment: $106,843

Value of Home Equity: $56,379

And again we are factoring in a 2 percent growth rate for housing. Many bears are predicting nominal losses in the double-digits. So we are talking about a six-figure losing proposition for at least the next few years. Plus, what can you get for $500,000 in Los Angeles County right?

Tighter Credit Markets

The credit markets were self correcting until the Fed decide to jump in and give the implication that they were the lender of last resort. Now the implication is that we will have a bailout and the market is rejoicing. Yet looking at the mortgage reset charts and mortgage equity withdrawals, it is clear we are only entering the first stage of a multiyear housing bear market bailout or no bailout. And when we look at Real Homes of Genius, we understand that fraud and outright speculation will come crashing down. You must ask yourself that a large proportion of our population was involved to some extent in producing products that provided no socio-economic benefit to our society. 2/28 loans? Option ARMS? Need we dig into more data of people making $9 hour being put into loans with the assumption they are making $157,000? The only people benefiting from these loans were Wall Street and the lenders. No one else. Initially the claim was these people now have the pride of homeownership but what a crock that was. Lenders will continue to tighten since risk is now perceived in the market. This will make it more difficult for people to refinance, purchase discretionary items, and in general will put a pause on the consumer spending which greases the wheels of the American economy. We talked about debt being seen as the new form of money. But all this is changing. And Americans with a negative savings rate will have a hard time doing a paradigm shift in which lenders will require a down payment. Even a miniscule down payment like 5 percent will bring the market to a screeching halt. Everything is borrowed.

No one has a crystal ball into the future. Even Alan Greenspan didn’t see the subprime mess coming (or at least he would like us to believe that). Big Ben even in May of this year talked about the subprime market being contained in a “silo.” And of course we have the heads of housing lenders and builders making fools of themselves by making outlandish predictions that are now being verified in the arena of reality as false. Save up, run the numbers, and the time will come to buy. But right now, against the propaganda machine of the housing industry, this is not the time to buy a home.

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This entry was posted on Tuesday, October 9th, 2007 at 10:48 pm and is filed under Real-estate news. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.