Wednesday, September 23, 2009

The Dream of Home Ownership, or Nightmare?

The Dream of Home Ownership - or Nightmare?

It seems that everyone in the Federal Government wants us to buy a house. Politicians, when running for election, speak of the "American Dream of Home Ownership" as if were the holy grail or the ne plus ultra of living.

The tax code has been skewed to encourage home ownership, both for individuals and for investors. If you make any amount of money at all, it seems the best thing to do, tax-wise, can be to buy a house. And financial advisers are quick to make that recommendation. But remember, as I have stated in the past, you can't deduct your way to wealth. Even the $8000 first time home buyer tax credit is no bargain, if the house ends up being a financial nightmare.

Home ownership is not for everyone, nor should it be. And whether or not you should own a home or even "dream" of home ownership depends a lot on your life circumstances and individuality. For many people, renting a home is a perfectly acceptable alternative and even a superior economic one. The Government would do better to get out of the home-selling business and let people make their own economic decisions without tax incentives.

In the wake of the Real Estate meltdown, many people are struggling to rebuild their finances, after getting sucked into the investment market or after jumping on the home ownership bandwagon, too late in the game. They are asking themselves why and how this "dream" became such a nightmare. Often these were the most unsophisticated investors or home buyers who were encouraged by this "dream of home ownership" talk or the promise of quick profits to invest in a market that was incredibly overheated.

Is Home Ownership right for you? Let's explore the history of home ownership and whether or not it is best for your circumstances.

Owning a home is no big deal, really. After owning several, both as personal residences and as investment properties, I can say that it is no "dream" at all, jut a series of obligations and maintenance chores. If you have never owned a home or never owned investment properties, it may seem exotic and desirable. But like a high-performance car, once you own one, it is just, well, a CAR, and a rather expensive one at that. Sometimes, most times, wanting is better than having.

And as others have pointed out, owning a home really means only that you eliminate one landlord. All Real Estate in the US is taxed by local authorities. So if you "own" a home, you still have to pay "rent" to your local Government landlord. Don't believe me? Stop paying your taxes and find out how quickly you'll be evicted from the home you thought you "owned".

If you go back a few decades, you'll find the idea of home ownership as being the "American Dream" was laughable. The "American Dream" was to become successful and make money, not buy a place to live. Before the Great Depression, home mortgages were nearly non-existent for most buyers. For those who were able to get them, the terms were pretty onerous. The term for repayment was often less than 10 years.

As I have noted in other articles concerning "funny money" such as Student Loans, once you make more credit available a funny thing happens - prices go up. In the late 1930's new home loans, guaranteed by the Government became available, with terms up to 15 years or more. Suddenly, owning a home seemed like a possibility to more and more people.

And since you could borrow for longer periods of time, you could buy larger and fancier homes. Back then, most homes had one bathroom. By the 1960's the idea of two, three, or even four bathrooms became quite normal for many middle-class families. So as more money became available, prices went up and houses got larger. But the monthly payment, in terms of percentage of income, remained about the same. Suddenly, the home became this huge investment, rather than just a place to live.

After World War II, mortgages were extended to 20 and then 30 years, and down payment requirements loosened. Not surprisingly, a housing shortage started, as returning GI's wanted to buy houses with this new funny money. Developers scrambled to build suburban tracts, while traditional city dwellings (often rental apartments) devolved into slums. You could take a suburban farm, chop it up into tiny little lots, put cheap houses on them and double or triple your money in a matter of months. Raw land was cheap, but packaged home units could be sold to individuals at relatively high prices because mortgage money was available.

Interest was deductible from your taxes, so having a mortgage or other debt was, in some respects, a bonus, as you could deduct the interest from your income and not pay taxes on it. Buying things "on time" flourished. Home ownership increased dramatically, but for a large segment of the population, mostly the poor, renting was the norm. Down payment requirements were still fairly hefty, and as a result, most poor people could not afford to buy houses.

The very rich tended to rent as well. Downtown luxury apartments were rented to wealthy tenants - the idea of the "condominium" had yet to catch on in a big way.

In the early 1980's, however, the tax deduction for non-mortgage interest was eliminated. Overnight, credit card interest, car loan interest and consumer debt interest was no longer deductible. It took a number of years before the market figured out how to deal with this new landscape. At first, people merely took it in stride, deducting only the interest on their homes and then biting the bullet on other credit.

But by the early 1990's, as interest rates fell and credit became more readily available, something new happened - the home equity loan. People started using their homes as a source of credit. A home equity loan, "secured" by the equity on the house, could be used to purchase a car or other item, or used to pay off other consumer credit. Of course, the IRS rules limited home interest deductions to only to debt for the purchase price of the home. At first, this limited deductions to those who had paid down the balance on their home. But since the IRS did not have the manpower to check everyone's mortgage balance and purchase price, many homeowners took the deduction, sometimes unknowingly or encouraged by their lender.

At the same time, requirements for some mortgages became increasingly lax, including down payment requirements and documentation requirements. In addition, frightening new financial instruments were created to allow people to buy homes with nothing down and make low payments - at least for a limited time.

So the funny money faucet was turned on FULL, and we had Real Estate bubbles. First in 1989 and then again in 2009. Twenty years apart almost to the day. No one ever seems to learn.

Like in any bubble, the people who jumped at these bad bargains, right before the bubble burst, were the least educated. They saw all their friends buying houses and making money and decided to wait, their instincts telling them that something wasn't right (always listen to your instincts). But eventually, something in them snapped, and too late, they decided to "jump on the bandwagon" and buy, only to have it all go horribly wrong. This pattern is not atypical. Often the most conservative investors end up getting fleeced as they succumb finally to a moment of madness after years of stingy living.

For investors, the tax code provided similar inducements to invest. For an investment property, you can depreciate the property every year on your taxes. For many people, this seems confusing, as Real Estate generally appreciates in value. But what the term means is that you take about 10% of the cost of the property off your income every year when figuring your taxes. If you can get past the meaningless term "depreciation" it is not hard to figure out (just as understanding entropy and enthalpy is really easy once you stop trying to understand them and just figure out how the equations work).

So, if I buy a $100,000 condo, every year, I can deduct $10,000 from my income, which saves me about $3500 in taxes every year. The exact numbers are different of course (consult a tax counselor for details) but you get the main idea. Buy a few investment properties, and pretty soon your tax bill is dropping in half.

When I started buying investment properties, I used the "old school" method of mathematics. I figured that the rental income should pay for the mortgage and all expenses and hopefully leave a dollar or two left over. The Depreciation Deduction was a bonus, in my figuring, and then the appreciation of the property a long-term investment goal.

When the market went nuts, new investors entered. They figured in the tax deduction as part of the break-even picture. Or worse yet, they took on deals with negative cash flows, on the theory that the overall appreciation in the property would dwarf the monthly negative drain. And of course, we all know now how that worked out for them. By the time the madness had started, I sold out, thankfully.

So where does that leave us today? Well, back where we started. Real Estate is going back to its roots as a rather mundane "investment" that is not for everyone. When I started buying Real Estate, the philosophy was very conservative. I would read Real Estate columns such as "Ask Bob" in the Washington Post, or House Calls by Edith Lank ( These writers reflected the common sense of the era, common sense that should be applied today. I have boiled down this common-sense advice to six simple Rules.
1. It takes 5 years or more for appreciation in Real Estate to exceed the transaction costs in buying or selling, so if you plan on staying anywhere for less than five years, rent. 
2. You should put down 10% or preferably 20% as a down payment to secure the best interest rates, avoid mortgage insurance, and insure you are not "upside down" on a loan, should the market go down. You should always seek out a fixed-rate mortgage at the lowest possible rates, even though it requires more documentation and is harder to get. 
3. Never buy a house that is beyond your means. A buyer with mortgage payments exceeding 33% of their income is considered "stressed". 
4. When buying investment properties, the cash income from rentals should equal or exceed the cash outlay in mortgage, taxes, insurance and repairs. Assume a 10% vacancy rate. 
5. A home is nothing more than a series of components that wear out over time. Each lasts approximately 15 years or so. Budget for repairs of these components and avoid the temptation to replace perfectly good parts to "update" a home when more mundane things will wear out first. 
6. Owning should not cost more than renting.  Does renting make more sense for you?  Home ownership is fine and all, but if it costs more to own than rent, maybe the market is overheated.
If you play by rules like these, you will likely never get burned in Real Estate. However, Rules like these often mean you can't afford to buy a home or investment property at all - or that you can't afford that "dream home" mini-mansion.

So, is home buying right for you? Let's apply these five Rules and see how they work.

1. It takes 5 years or more for appreciation in Real Estate to exceed the transaction costs in buying or selling, so if you plan on staying anywhere for less than five years, rent.

Karl Marx once said that land or home ownership was a bad idea, as it tied workers to the land, preventing mobility of the workforce. Everything else Karl Marx said was a load of hogwash, but the was onto something with that comment.

We see today in many impoverished places like Flint, Michigan, or Central New York, that people are clinging to these areas, hoping that "the jobs come back". In many cases, they are invested in the area, literally, through home ownership. They cannot leave the area without walking away from their modest investment (losing it entirely or making very little). So they stay, hanging on to what little they have, rather than migrating to where there is work and money to be had.

Mobility is a very useful thing, and if you are tied to a house or location, you often have to pass on opportunities that involve mobility. I remember being offered a job in Japan once, only to turn it down, as I felt I could not give up my house and garden and other "things" that tied me to Virginia at the time. It probably was the right decision for other reasons, but mobility should not have been a consideration.

If you are working at a job, consider your future there. If you are working for a government agency and plan on staying there 10 years or more, then owning a home might make sense. But if you plan on changing jobs or transferring, then it may not. In a normal Real Estate market, it takes 5 years or more to recoup your transactional costs just to break even.

When you buy a house, you have to pay closing costs, points and other transaction fees. When you sell, you have to pay a 6% real estate agent fees as well as other closing fees. Combined, these fees can amount to nearly 10% of the sales price. In a normal Real Estate market, where home prices appreciate 2% a year, it may take 5 years or more to "break even" on owning Real Estate.

So, if you've moved to the big city for a job opportunity, think hard before buying a place. You may be moving sooner than you think, and you could lose your shirt. See also my article "Never Buy a Condominium!" which details the particular pitfalls of that genre.

2.  You should put down 10% or preferably 20% as a down payment to secure the best interest rates, avoid mortgage insurance, and insure you are not "upside down" on a loan, should the market go down. You should always seek out a fixed-rate mortgage at the lowest possible rates, even though it requires more documentation and is harder to get.

Leveraged deals are never good deals. If you have bad credit, it doesn't mean you can't borrow money, only that the terms you pay will be onerous. The car dealer who advertises their "bad credit specialists!" is not trying to help you, only themselves.

Large down payments result in lower monthly payments and lower interest rates, as the risk of default is far less. You are better off saving up for a down payment than trying to take advantage of one of these crazy leveraged deals. Or even better off walking away from the idea of home ownership.

Yes, if the market goes up, you can refinance, it is true. But then you incur yet more financing charges and closing fees.

The same is true for variable-rate loans and other exotic financial instruments. Home ownership should be a long-term proposition, so you should be thinking long-term in terms of financing. Getting into a house with a low "teaser" rate is no bargain if a higher rate could later force you into foreclosure.

3.  Never buy a house that is beyond your means. A buyer with mortgage payments exceeding 33% of their income is considered "stressed".

Granite counter tops and three-car garages are nice and all, but not necessary to daily living. Most modern homes are designed not for the occupant's physical needs, but for their emotional need to impress people they don't know. The status kitchen and status bath are the norm, these days. Useless whirlpool tubs, for example, are designed to impress those who tour the home, but don't really provide any real value (and waste huge quantities of water). So-called "gourmet" kitchens are often owned by people who microwave all their pre-made meals.

A couple with no children has no real need for a five-bedroom house. But Real Estate agents will always push the idea that you should "buy as much house as you can" to "maximize your interest deduction".

Again, you cannot deduct your way to success. While an interest deduction is a nice thing to have, it does not create wealth. And looking at your home as this mega-investment rather than a place to live is one sure way to get into trouble.

One reason homes in the USA have exploded in terms of size, cost, and amenities, is that people buy things they don't want themselves for "the resale value". So, the theory goes, buy a home with five bedrooms, because someone else might want five bedrooms. But unless you have four children (increasingly rare these days) chances are you don't need all that space. And chances are, there are a lot of other people who don't as well.

Smaller homes can cost less to own, less to maintain, and less to heat and cool. The idea of the smaller home is starting to catch on, but the "buy as much as you can afford" mantra is hard to kill off.

4.  When buying investment properties, the cash income from rentals should equal or exceed the cash outlay in mortgage, taxes, insurance and repairs. Assume a 10% vacancy rate.

Do the numbers, as they say. If you don't have a positive cash flow with a rental property, chances are, owning it will make you poor in the short run, as you run out of cash every month trying to "carry" the property. Factor in vacancy so you won't be surprised when a tenant moves out (hint: Make your rents attractive so tenants stay. Higher rents often lead to tenant churn, which negates the increase in income).

I have seen situations where a Real Estate agent will advise an investor to charge maximum rent for a property, and after it sits un-rented for six months, suddenly has a buyer for the now-distressed landlord - at a bargain price, of course.

5.  A home is nothing more than a series of components that wear out over time. Each lasts approximately 15 years or so. Budget for repairs of these components and avoid the temptation to replace perfectly good parts to "update" a home when more mundane things will wear out first.

I sold a home to a fellow a few years back. He had rented all his life and had no idea how to even fix a bent paperclip. A year later, there was a puddle of water in the basement and he called me, asking me to "fix the basement".

I was flabbergasted. "I'm not your landlord," I replied, "You own the house now." He protested that he should not have to pay for repairs to his house.

"Well, when I owned it, I put in the new furnace, the new air conditioner, the new hot water heater, the new roof, the new windows, the new wiring, the new kitchen, the new carpet, the new driveway, and the new porch. Guess what? Now it's YOUR turn!"

It turns out he had never cleaned the gutters on the house ("Why do I have to do that?" he asked) and the water poured over the tops and did not drain away from the foundation. The idea that you have to spend a few Fall days on a ladder cleaning out dead leaves was alien to him. After all, at his apartment, the maintenance man did this.

But in addition to basic cleaning and maintenance, a home requires repair over time. Roofs leak, appliances die, furnaces break down. Plumbing bursts, wires fry. It all goes bad over time.

Most components on a home require replacement every 15 years or so. Appliances have a design life of 15 years, so factor that in when buying a home. If all the appliances are 10 years old, figure on buying new ones in a few years. And this is also true for furnaces, hot water heaters, and other built-in machinery. You can nurse along older appliances and fixtures for a few years, if you are handy. But eventually, they all go South and require replacement.

Shingle roofs last 15-20 years and require replacement. Some might go as long as 30 years, but that's not the norm. Floors need to be refinished, carpets get worn. Eventually, the whole house gets replaced over time. It is merely a collection of parts that wear out.

And after 30-50 years, other things wear out. Plumbing goes bad. The main sewer line cracks. Wiring becomes obsolete or hazardous. Foundations settle or leak. As the home owner, you have to fix these things. It is your responsibility.

Many people getting into the home buying game during the bubble didn't understand this, as these were the hard-core renters who jumped on the "home ownership" bandwagon after reading about it in the paper. The failed to budget for repairs, and this came back to haunt them.

Worse yet, many Americans try to "update" a home and replace perfectly good appliances and kitchens (and baths) to "increase value" of the home, while failing to budget for repairs of older items later on. I've seen perfectly serviceable kitchens, maybe 5-10 years old, torn out and discarded because the color of the appliances was not considered "trendy". Later on, when the furnace breaks, the homeowner is broke.

Real Estate Agents love to say things like "You'll get the most bang for your buck in a kitchen or bath remodeling". But what they fail to mention is that what this really means is that for every dollar you spend on these items, you will get the most back (usually 75% or less) compared to say, a den remodeling (30% or less). Like deducting your way to wealth, you cannot remodel your home into a mansion. Remodeling is expensive and the increase to the value of the home is usually less than the costs of remodeling. This has always been true, but in the age of television shows such as "flip this house", a rule that has been forgotten. So forget the "dream kitchen" and focus on doing regular maintenance. Remodel the kitchen when it is worn out - and not before.

And when remodeling, consider carefully before going with "trendy" kitchen and bath designs. In the 1980's the tile counter-top was all the rage. But by the 1990's they looked dated before their time (all that grout!). Similarly today, people are jumping on the "stainless steel appliances" bandwagon, which shows signs of petering out already. A dated-looking kitchen will make your home hard to sell later on and may decrease its resale value. However, a basic kitchen with sound appliances in neutral decor may neutrally affect value, while providing years of reliable service.

Some folks bought new construction, on the premise that if everything was "new" they'd have a few years of "no maintenance". But new homes can have their own special problems - like a new car the first year it is under warranty. Usually the home builder makes repairs if there are problems. But sometimes, they don't. And in the last bubble, many went bankrupt, leaving homeowners with no recourse to chronic repair problems, such as Chinese sheetrock, or defective roofing.

Personally, I'd prefer to buy a house that is a few years old than "brand new". The hassles of home building and the "punch list" are not worth it.

6.  Does Renting Make Sense for You?

I have friends who have rented all their lives. They have moved from apartment to apartment, usually with a fabulous view. They have good incomes and can "afford" to own a home. But they prefer to rent. Why?

Well, for starters, they have no maintenance to deal with. Something breaks? Call the maintenance man. No gutters to clean, no furnace filters to change.

And unlike a Condo, no Condo Board to deal with. The landlord makes the Rules - for everyone - and they are not subject to endless debate. And the rent is set by the market, not based on some deferred maintenance nightmare created by a Condo Board.

They have a smaller space, but enough for themselves to live in. They have a fabulous city view and an indoor place to park their car. No lawn to mow. No gardens to mulch. No tree limbs falling through the roof after a storm. No basement to flood when the power goes off.

Not a bad deal, really.

But what about the rent? The fear many have is that "the rent will go up and up" over time, and that they will be forced out of an apartment. A home sounds like a sure deal - a fixed-cost living arrangement that is also an investment. Neither are necessarily true.

While a fixed-rate mortgage may insure the monthly principle and interest stay the same, there are other factors, such as insurance, maintenance, and especially taxes, that can increase the monthly carrying cost as surely as a rent increase.

The economic meltdown has left States scrambling to balance their budgets. Many States are doing this on the backs of homeowners, by forcing more expenses on the Counties, which in turn increase property taxes.

Property taxes of $3000 a year on a modest house in a modestly taxed State are not unusual. In some States, such as New York or Florida, taxes of $7000 or even $12,000 are not unheard of - for homes that are decidedly "middle class". At the present time, many people are trying to sell such homes in my area, after being socked with tax bills as high as $15,000.

Imagine paying $1200 a month in property taxes. It is not far-fetched. And historically it has been a problem. Most jurisdictions have tried to attack the tax problem by offering discounts for Senior citizens or "homestead" exemptions. The problem has been (and continues to be) that many older folks end up being taxed right out of their homes - often homes that are "paid for" after 30 years of mortgage payments.

So the idea that "owning" a home (remember, you don't really own it outright, you only rent it from the Government!) as a means of having "level" payments over time is flawed. Increases in property taxes and maintenance costs over time will increase the cost of home ownership over time as well.

And the idea that the home will increase in value..... well..... do I even need to address that? If you are lucky, it may go up a few percentage points a year, in a normal market. We are returning to a normal market.

And speaking of market, guess what sets the price of rents? Yup, supply and demand. Contrary to popular belief, rents have not skyrocketed over the years but have remained relatively flat. During the housing bubble, many investors bought properties to speculate - and rented them out. This increased the amount of rental property available and drove down prices. Now that the bubble has burst - well, you guessed it - more properties are going on the rental market. Being a landlord these days sucks. It is a game of margins, and not very good ones, either.

Yes, in some areas and regions, rents can increase dramatically due to certain events. But the renter always has the option of moving to a cheaper area. The homeowner can find themselves stuck in an "upside-down" or unsalable house, if the property taxes shoot up. As a renter, you at least always have the option of moving. The homeowner only has the option of walking away and ruining his credit.

My friends who rent are doing all right. No, they did not make a lot of money during the recent "bubble" - but they didn't lose any, either. They've traveled all over the world and generally enjoy themselves. They've never been "house poor" (and there is no such thing as "apartment poor" when you can move). They can move at the drop of a hat to new places when new opportunities arise.

And a funny thing, too. As renters, they tend to accumulate a lot fewer "things" than home owners do. When you rent, there are fewer places to store "junk" and as a result, you buy less and get rid of more. Home owners with their mini-mansions tend to fill up their three-car garages with boxes of crap.

So many the "Dream of Home Ownership" is not a dream after all. It is just having a place to live - a place that can go down in value, requires a lot of maintenance and upkeep, and can make you "house poor" and keep you tied to one spot.

For many folks, renting just makes sense. Once we strip away all the hoopla about "The Dream of Home Ownership" the reality is just basic dollars and cents. And if we stripped away all the tax incentives, I suspect many more people would choose to rent rather than buy a home.