Static...Or Not?

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Janet_IHB

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<p>Static…Or Not?</p>

<p>There was a very lively debate on the income numbers over the weekend! </p>

<p class="MsoNormal">Included in this debate, was an assumption – or rule of thumb – of reversion to the mean where median home prices return to a maximum of 4x the median income.</p>

<p class="MsoNormal">(This isn’t a debate on the number 4 per se, so we will go with it.)</p>

<p class="MsoNormal">The argument is, that this relationship has held up for time immemorial, and should essentially always hold true. </p>

<p class="MsoNormal">But is it true?</p>

<p class="MsoNormal"><strong style="mso-bidi-font-weight: normal">(Please don’t howl – this is not a grand prognostication - this is a discussion of theory only!)</strong></p>

<p class="MsoNormal">This argument does not allow for the assumption of accumulation of wealth, particularly real estate wealth.</p>

<p class="MsoNormal">Let’s look at some numbers.</p>

<p class="MsoNormal">Let’s say we have a home bought in year 1 at $100,000 with an income of $25,000 and $20,000 down.</p>

<p class="MsoNormal">We will assume identical rates of growth (5%) for both the home and the income.</p>

<p class="MsoNormal">At the end of 30 years, the home is worth $411,614 and the income has grown to $102,903.</p>

<p class="MsoNormal">However, <strong style="mso-bidi-font-weight: normal">not counting equity-by-appreciation</strong>, the original $100,000 purchase price has turned into real estate wealth by virtue of being paid off.</p>

<p class="MsoNormal">This may not seem like a lot, but what happens after this cycle repeats itself several times – and at multiples of $100,000?</p>

<p class="MsoNormal">Any addition to real estate wealth - whether by loan payments, equity appreciation or increases in downpayments – will have a tendency to increase what people can afford.</p>

<p class="MsoNormal">How fast? I don’t know. But the median home purchaser should have more real estate wealth over time.</p>

<p class="MsoNormal">(I am open to the possibilty of mitigating facts.)</p>

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<p>It's fantastic when you <strong>hang on</strong> to that wealth, instead of:</p>

<p><img alt="" src="http://farm1.static.flickr.com/184/365308677_3e8bfa6c7c.jpg" /></p>
 
The situation you describe sounds much like the one in Japan. After a couple of generations of saving, prices started to get bid up so high that it took a gift from parents to enter the housing market. The scenario can play out where generational equity inflates housing prices. Of course, the Japanese housing market was unable to sustain this forever and fell into a 16 year deflationary spiral of continually falling real estate values.





The main problem with the above theory as a permanent elevation of house prices is that entry level buyers are excluded from the market due to lack of savings or downpayments. This causes the move up market to grind to a halt, and the entire merry-go-round ceases to move -- which is where we are now in our market.





Also, people have been converting this equity into cash and spending it rather than letting it accumulate as home equity.





<img alt="" src="http://www.irvinehousingblog.com/wp-content/uploads/2007/08/mewkennedygreenspanq107.jpg" />





If people were actually letting their equity accumulate, the phenomenon described in the original post might come to pass (if the entry level problem could be addressed). Unfortunately, many people do not let wealth accumulate and instead convert it to spending.
 
When you think about our current level of pricing, two fundamental questions remain:





1. People in Irvine made lots of money 10 years ago relative to other communities. Why was the relationship between income, rent and house pricing so much different then?





2. Why can I rent a place for half of what it would cost me to own it when 10 years ago these numbers were equal?
 
<p><em>"The main problem with the above theory as a permanent elevation of house prices is that entry level buyers are excluded from the market due to lack of savings or downpayments. This causes the move up market to grind to a halt, and the entire merry-go-round ceases to move -- which is where we are now in our market."</em></p>

<p>Interesting point.</p>

<p>So we would be penalizing the very people who worked diligently their entire lives to build real estate wealth, because that very action shuts out future generations.</p>

<p>That part kinda blows! Pardon the language.


</p>
 
<p>IR,</p>

<p>Your other questions have merit.</p>

<p>The answers are as you believe they are.</p>

<p>I am only examining theory here. </p>
 
<em>"So we would be penalizing the very people who worked diligently their entire lives to build real estate wealth, because that very action shuts out future generations."</em>





Exactly. That is part of the point of todays satirical post. When wealth in real estate is created because the people in an area invested in education and brought up income levels, then the actions of the past generation really does benefit them through increased real estate wealth. When the wealth in real estate is created through financial innovation rather than an increase in earnings, we better be very sure this innovation works out. Right now, it doesn't look promising...





<em>


"I am only examining theory here."</em>





I appreciate that. I like examining an issue from all possible angles. It is the only way I can see if I am missing something.
 
<p>Oh sorry, Janet -</p>

<p>Didn't want to make you think that I was tricking you into something ...</p>

<p>I'm totally clueless when it comes to rates and points and all those mortgage terms. Was just told by friends that they think the Feds will lower the rates next week and that may affect my interest rate (?).</p>
 
<p>Are you getting a fixed rate loan or a hybrid?</p>

<p>In either case, at this stage in your purchase, you must monitor rates at least daily.</p>

<p>Little blips either way will have consequences.</p>

<p>When to lock has been a vexing question forever!</p>

<p> </p>

<p> </p>

<p> </p>
 
<p><em>"I'm totally clueless when it comes to rates and points and all those mortgage terms."</em></p>

<p>Arghhhhhh - did my post a while back not help? </p>
 
<p>Janet, why do you think "So we would be penalizing the very people who worked diligently their entire lives to build real estate wealth"? Real Estate is a great creator of real, particularly when it cash flows. Today, in SoCal, RE doesn't cash flow very well. It's kind of like Amazon.com in 1999, the price reflected the next 25 years worth of projected earnings. Today, it is still down 20% or so from peak, in another year, maybe maybe two or three, maybe less maybe more, it may actually reclimb to that peak. </p>

<p>Seven years isn't that long, but the stock, unlike homes, hopefully doesn't come with a heavy carrying cost. </p>

<p>LL, wish I knew what Bernake was going to do. He's in a bit of a conundrum. No cut - tank the markets, maybe jeopardize banks. Cut - potentially start the dollar deflation.</p>

<p> </p>
 
<p>NSR,</p>

<p>I'm just reacting to IR's observations.</p>

<p>If the need to accomodate first time homebuyers is paramount, then real estate wealth will have an artificial ceiling. </p>

<p>That will have the effect of diminishing the effectiveness of actions of preceding generations.</p>

<p>Unless, as IR points out, earning power is elevated at a very high rate.</p>
 
<p><em>"I'm sure it helped - I just have a bad memory (?)"</em></p>

<p>Do you perform surgery? </p>
 
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