Friday, March 17, 2023

House Trap, Mouse Trap, Part II

People are going to discover, yet again, the fallacy behind the monthly payment mentality.

I started this blog over a decade ago after a major real estate meltdown cratered the economy.  It may seem like ancient history - particularly to someone of college-age for whom those events took place while they were still in Cub Scouts - but it wasn't that long ago.  The problem back then - and in 1989 in the previous iteration - is the same problem we are having today.  People buy houses based on monthly payment and don't think too hard about the overall cost or sales price.  You can lose tens of thousands of dollars this way - and end up insolvent as well.

In the run-up to the 1989 meltdown and the 2009 meltdown, housing prices jumped by 20% a year, which is unrealistic.  Even with inflation raging at 9% last year, a 20% increase in housing prices makes no sense.  And indeed, last year, we started to see the deflation of prices in housing, as the average price dropped, nationwide, from $400,000 at the beginning of the year, to $360,000 by the end.  That's a ten percent drop.

The problem this time around is interest rates. As I have noted before, there is a see-saw in housing prices, as monthly costs and interest rates determine what most homeowners can "afford" to pay, based on prevailing interest rates.  But other things can affect prices, too, such as property taxes, insurance, and condo fees and special assessments.  Most people think of these things as "trivial" expenses, but in some markets, property taxes on even a modest house can be $10,000 or more.  Hurricane and flood insurance can top that, near the beach.  And condo fees can add up to thousands a year - with tens of thousands in assessments.

Since most middle-class people don't have cash to pay for a house, they have to borrow.  And the amount they can afford to borrow is based on monthly payment, which in turn is based on their income.  One reason I went to law school and got a higher paying job was so that we could afford a house.  Funny how that works, eh?  But if we assume the buyer can "afford" $2000 a month in monthly payments, well, that buys a hella lot less house at 7% than at 3%!

In fact, you can calculate it quite easily.  For example, a median-income home mortgaged for $400,000 at 3% would cost $1686 per month.   At 7% interest, $1686 a month only supports a mortgage of $254,000.  You can see how interest rates really affect home prices.  You can also see how much further home prices have yet to fall as rates go up.  The bloodbath is just starting.

But what about the other half of the equation?  Suppose you already own a home and want to downsize in old age or move up as your family gets larger?  If you bought a few years ago and are sitting on a 3% mortgage, you might not want to give that up - rates may never be that low again in your lifetime.  We saw this in the late 1970's when rates shot up to double-digits.  I had an older friend back then who had a "traditional" 6% mortgage and his bank wrote him a nice letter asking if he would like to just pay off the remaining balance in one lump sum?  The bank was sitting on a 6% asset in an era of 14% mortgages.

You can end up trapped in a home, as a reader once suggested many years ago.  And in part, I feel that way, even though I am debt-free at this point.  If I were to sell right now (presuming the crazy prices were still in effect) I would have to pay the same amount for a house elsewhere.  But property taxes in other jurisdictions, such as Florida, are outrageous for newcomers (and let's face it - who wants to live in Florida anymore?).  Insurance is also a five-figure proposition in many places, which is why we sold an inherited house on Ft. Myers beach - even if we owned the place outright, we would have to rent it out most of the year just to cover the insurance and taxes!

So we stay put - trapped in our house, so to speak.  But it is a nice trap, to be sure.

Others are trapped by the rise in interest rates, as a recent Fortune article points out.  If you bought a two-bedroom home in the suburbs and now have another baby on the way, you might feel a bit trapped if you want to move up - or just move away for a new job.  If you have a 3% mortgage, the prospect of buying another house may seem daunting - at 7% everything is far more costly to buy, even as prices drop.  The problem is, prices haven't dropped enough yet.

But that's where it gets sticky.  The 3% mortgage may be "affordable" but if prices drop 20-30% you may be "upside-down" on your house, and unable to sell it, should you decide to move up or move on.  You are no longer trapped in a comfy trap of low monthly payment and low interest rates, but the prison of an underwater mortgage.

Coming soon to a neighborhood near you!

Of course, this raises the question, why haven't prices adjusted already?  And the answer is the same as we say in 1989 and 2009.  Prices tend to undershoot and overshoot before there are corrections.   We saw people paying top prices during those previous meltdowns, even as all the signs of a bubble were present - houses staying on the market longer and longer, price adjustments, incentives, etc.  These things tend to collapse in an avalanche all at once.

And similarly, prices may stay low, even after conditions improve.  I noted before we were buying foreclosure properties as late as 1998 - nearly a decade after the 1989 debacle.  When I mentioned to my friends we were investing in real estate, they all cried, "Don't do that!  I lost my shirt in real estate back in 1989!  You need to get in on the ground floor of this 'dot com' thing, it's going places!"  But within a few years, they saw I was making money and doing OK and they all jumped back into real estate, paying top dollar for rental properties with a negative cash-flow, expecting prices to double in a matter of a year or two.

Come to think of it, I have a lot of brain-dead friends, eh?

Prices are determined by supply and demand, and that in turn is driven largely by emotion, which makes pricing irrational at times - too high one month, too low the next.  We see this today with "inflation" in food prices.  Everybody complains about it, but they don't change their shopping habits until their credit cards are maxxed out.  Worse yet, people go out and spend more without thinking of the consequences.  People - middle-class people - are spending $20 to have a McMuffin delivered to their door, and putting it all on a charge-card.  It makes no freaking sense.  And eventually, the fad will die off as people run out of money.

So we have a weird situation right now.  The cost of housing is staggering - price are high and interest rates are high.  Since prices are high, property taxes and insurance goes up as well.  But people aren't making twice as much money as before, so how can anyone afford it?   Since so many people are "sitting" on an "affordable" 3% mortgage, they have no inclination to sell, which means a tight housing market, which in turn keeps prices high (demand is still great, but supply is limited).

Eventually, something has to give - the bubble bursts.   A coder for a "tech" company that offers an "app" to deliver your fast-food is laid off, as the company never made any money and the fad is fading quickly.  He looks for a job, but can't find one, locally - every other "tech" company is laying off as well.  So he has to move - and the only job he can find is working as an IT tech for a law firm in Chicago - for a lot less money.   Problem is, a plethora of other people in his area are in the same boat - and upside-down on their houses as well.  Bring on the short sales!  Foreclosures!  Bankruptcy!  No one ever saw this coming!   Why can't a company just keep losing money forever and ever?

But that hasn't happened - yet.  Our poor coder friend will hold out, collecting unemployment (which will hardly cover his credit card bills) and using up his meager savings, convinced that Apple is going to call any day now and set up that interview.  It takes a while for people to realize that their "dream job" was more of a mirage - an aberration, not a normality.  Getting paid hundreds of thousands of dollars a year to code HTML makes no sense at all.

And a lot of those people will wished they save more of that money instead of blowing it on stupid shit like McMuffin delivery.  I say this from experience - we had a lot of fun, to be sure, but fun doesn't have to involve setting piles of money on fire.  No, it really doesn't.

That is the sad part, of course.  A lot of "little people" will lose it all, or just lose a lot, in these economic cycles.  Some folks make a pile at the same time.   The worst is the fellow who held out for years, thinking, "The housing market is crazy! I'm not paying these prices!" until he finally gives in, just as the bubble is about to burst, and over-pays for a house, using some tricky hand-grenade mortgage - and ends up in default.  The real estate agent told him to "buy now before he is priced out of the market forever!"   But in a year or two the same house is for sale for less than half of what he paid for it.

I saw this happen before - twice - in my lifetime.  It will happen again, not exactly the same way, but in a similar way.   There are signs - real estate going up in value by 20% a year.   Labor shortages.  Radical changes in interest rates.  Inflation.  If it wasn't for the pandemic, maybe we would have been through this already and it wouldn't have been so bad.  But the government set piles of money on fire during the Trump administration.  Trump famously said that the government should borrow yet more money, as interest rates were so low.  Well, rates have gone up, and the government is now further in debt.

The government is in the same position as the unlucky homeowner.

The good news is, we will survive this.  It doesn't mean an end of capitalism (sorry, lefties!) or that fascism is the answer (sorry righties!).   People will pick themselves up, dust themselves off, and start over again, vowing never, ever, ever to make those same mistakes yet again.

Well, at least not for another decade or so!  Every generation, it seems, has to learn this harsh lesson.