Wednesday, November 25, 2009

How are Home Prices Determined?

Our tax laws have changed over the years to encourage incurring indebtedness. The tax break for home mortgage interest served only to increase the cost of homes (while keeping the effective monthly cost the same).

Let me illustrate this last statement with an example. In a rational Real Estate market, the cost of renting a dwelling is usually higher than the monthly carrying cost. Otherwise, landlords would not make any money.

So for example, if you can rent a home for $1000 a month, the cost of taxes, insurance, and mortgage should be no more than $1000 a month. Say the taxes and insurance are $200 a month and prevailing Mortgage Interest rates are 9%. Doing the math, this means the purchase price of the home should be no more $100,000 as the mortgage on such an amount would be about $800 a month on a 30-year mortgage.

Note that if interest rates go UP, the amount of the purchase price will go DOWN - and vice-versa. The housing "boom" of the 1990's and 2000's can be explained in part as a result of lowering interest rates over time. It is a simple cause-and-effect see-saw and anyone who tries to tell you otherwise (and there are legions of "analysts" who claim that interest rates do not affect home prices) is being disingenuous.

Note also that if property taxes and insurance skyrocket, as they did in South Florida in the 2000's, that the value of the property will also drop, if the monthly carrying cost is to remain the same.

Again, market rents are determined by market rates, not by the carrying costs of the landlords. And again, there are those who claim otherwise, and they are either fools or liars.

But getting back to our example, suppose the government passes a law saying that mortgage interest is deductible? What happens? Well since the buyer gets back nearly 25% of that interest on their taxes, and most of the initial payments are interest, that means the monthly payment is effectively $250 lower. Which means for our monthly $1000 carrying cost, the homeowner can "afford" to pay $120,000 for the house.

So playing games with taxes and incentives does little more than affect prices. People will pay the most they can "afford" in the marketplace for a home, provided it is not more than the cost of renting a similar home. Home prices are not a function of construction costs, but a function of what people can afford, which is a function of the various elements affecting the overall monthly cost.

Similarly, the mortgage term affects price. 50 years ago, most mortgages had terms of 15 years or less. Since monthly payments were higher, not surprisingly, houses cost less (even taking intervening inflation into account). 50 years before then, when long term home loans were virtually unheard of, prices were even further reduced.

So what home prices are is often determined by things other than the underlying "value" of the land (which is a nebulous term anyway). What something is worth is what people are willing to pay for it.

In most housing markets, what people are willing to pay for property is a function of supply, demand, and also income. If you live in a rural area where incomes are low, and land is plentiful, then property values will be cheap. On the other hand in an urban area, where people have high incomes and all the land is built on, prices will be higher.

But even then, the law of supply and demands has its limits. And that limit is monthly cost. If Joe Paycheck can afford to pay $2000 a month for a house, he will buy a house than costs $2000 a month.

But what that means is, if the taxes are $200 a month, the insurance is $100 a month, then he only has $1800 a month to spend on mortgage principle and interest. What this equates to in terms of home price (at 10% down) in turn, is determined by mortgage interest rates.

So if rates are at 7%, he can borrow about $275,000. But if rates are at 5%, he can borrow nearly $325,000. So if he is bidding on a house in a climbing market, and can afford $1800 a month in payments, he may be willing to go higher.

So you see, there are a number of factors that drive housing prices, not just "supply and demand" - although that has a huge effect in some markets, such as Las Vegas and South Florida, today, where the number of homes greatly exceeds demand.

But overall, affordability drives prices. Everyone would like to own a home - if that can afford it. So prices will drop until a home is affordable. No home sits empty for lack of a buyer - for long.

Note that the other costs mentioned - insurance and taxes, can also affect prices, as they reduce the amount of money from the monthly payment that the owner can "afford" that is applied to P&I. If insurance and taxes skyrocket, the price of the property may plummet. And this also goes true especially for Condo Fees.

So, to summarize, there are a number of factors affecting home pricing:

  • As interest rates go up, home prices go down.
  • As taxes go up, home prices go down
  • As insurance goes up, home prices go down
  • As condo fees go up, home prices go down.
In South Florida, we had a near-perfect storm in this regard, and I am not talking about the Hurricanes (although they helped). In addition to overbuilding (law of supply and demand, again, increasing the supply), the insurance rates in many places skyrocketed after several devastating hurricanes hit the area. This made it harder to sell houses in the area, as they were more costly to own. Suddenly, hurricane, flood, and homeowners policies were costing thousands of dollars a year.

And with the rise in prices, the local municipalities decided to jack up the property taxes. Since many older homeowners were "homesteaded", newer buyers, and out-of-town investors were socked with astronomical tax bills.

In many older Condos, investors and developers cut the condo fees to attract buyers. Once the investors and developers sold out, the Condo boards discovered they were nearly broke, and the buildings needed much deferred maintenance. So fees were jacked, and worse, special assessments levied.

And many folks bought properties based on adjustable rate mortgages with no docs and "teaser" rates that jacked way up. So once interest rates went up, they were literally priced out of their homes.

The Real Estate market went completely out of whack. A simple condo that might rent for $1200 a month would cost $4000 a month to own. It simply didn't make any sense. And of course, eventually, the market collapsed.

Today, we are faced with similar problems. Interest rates are being kept artificially low, for the time being. But many municipalities are jacking tax rates to cover deficits. And homeowners insurance in many coastal areas continues to climb.

If interest rates start to rise, they will dampen any increases in home prices, and perhaps even cause home prices to drop.

Because, bottom line, if no one can afford the monthly payments, your house doesn't get sold, period.